Traders Gonna Trade

Your brackets should be in by now. The 2014 NCAA Tournament gets underway in earnest in less than an hour. I think it’s the best three weeks of the sports year. As always, I picked my Duke Blue Devils to win in our family bragging rights bracket. Doing so has served me well in the past.

This year, Quicken loans is offering $1 billion for a perfect bracket, with the prize insured by Warren Buffett’s Berkshire Hathaway. But you probably shouldn’t play, and not just because your chances of winning are so slim. Even so, the lure of playing in a tournament pool is very strong. Millions play — even President Obama plays, if not for money (since it’s actually illegal to do so) — and lots of workers will be less than fully productive for the next couple of days as they try to keep up with what’s going on.

But today I am reminded of 1991. UNLV was the defending champion and came into the Final Four unbeaten and unchallenged. In the national semi-final, the Runnin’ Rebels met my Blue Devils, a team UNLV had destroyed the previous year, 103-73, in the most lop-sided championship game in NCAA Tournament history.

It was U-G-L-Y in 1990 and most people expected more of the same in 1991. Happily, that wasn’t what happened.

But my story today isn’t about the game itself or even the tournament, exactly. In those days, Wall Street trading houses had big tournament pools that featured high entry fees (and thus big prizes for winners) with serious bragging rights at stake. Significantly, because there were lots of traders involved, lots of trading went on. You could call most any major shop and get a two-sided market on any team to win the tournament.

This fact is noteworthy because one particular trader was absolutely convinced that UNLV was going to repeat as champions. More particularly, he was convinced that Duke would not win the tournament and shorted the Blue Devils big without hedging — expecting to profit handsomely when elimination ultimately came. In other words, he was looking to make big money on the trade and not just on the spread. Moreover, losing would mean not just lost potential profits — he would have to ante up real cash. As the expression goes, he was picking up pennies in front of a steamroller.

Wish GrantedOur poor schlub was pretty nervous on the Monday after the UNLV upset, but Duke still had to beat Kansas that evening(ironically, it was April Fool’s Day) to win the title for the trader to have to cover his shorts. He feigned confidence, of course, but nobody was fooled. When Duke prevailed over the Jayhawks, 72-65, the fool was six figures (plus) in-the-hole.

The trader made good — sheepishly and painfully — but the brass learned a lesson. Thereafter, the big firms no longer allowed employees to organize tournament pools and trading on the pools that existed was strictly prohibited. It was even enforced. Rumor has it that this was part of a quiet agreement between regulators and internal compliance officials, who were understandably concerned about what had gone on. Wall Street pools still existed after that, of course, but they were now run exclusively on the buy-side; we on the sell-side still played, but it wasn’t the same. There wasn’t any trading that I’m aware of. And that’s a good thing.

Traders are going to trade. And without careful oversight, position limits and careful hedging, it’s inevitable that people will get in big trouble. That lesson applies to NCAA Tournament pools and to any security you might want to name. It applies to your personal portfolio too.

Good luck to your favorite teams.

Market Democratization and Summer’s End

HamptonsSince returning home with my mother after birth, I have been hospitalized twice.  I had my tonsils taken out at age five and I contracted meningitis about 25 years ago. When I suffered from the meningitis (thankfully the viral kind rather than the much more dangerous bacterial sort), I was admitted on the worst possible day of the year.  I went into the hospital on July 4.  Since newly minted physicians start their internship years on July 1 each year, since July 4 is (obviously) a major holiday and since that particular July 4 was a Friday and thus the start of a long week-end, pretty much the only doctors around that day had roughly 4 days of experience.  Total.

It wasn’t a good day to get so sick. Continue reading

Nobody goes there anymore — it’s too crowded

When I was a young lawyer I got to meet the great Yogi Berra in a professional context. The Hall-of-Fame catcher and former Yankee manager was a delight in every respect.  He was a very insightful and successful businessman too.

As almost everyone knows, Yogi is also extremely quotable. Yogi’s sayings – “Yogi-isms” – have become part of the cultural landscape.  They entertainingly fracture the language but do so in very interesting and sometimes enlightening ways. 

You can observe a lot by watching.

It was déjà vu all over again.   

When you come to a fork in the road….take it. 

The future ain’t what it used to be.

One of my personal favorites is nobody goes there anymore…It’s too crowded. In the trading and investing world, it’s remarkably shrewd advice.  What works today doesn’t necessarily work tomorrow, in large measure because investment success draws crowds of copycats.  That demand – which can readily become excess demand and thus make its object bid-up and too expensive – often means that what was a good trade becomes played out and no longer is a good trade.  If a trade gets too crowded, you don’t want to go there anymore.

As reported by BloombergBusinessweek, this concept was well illustrated (albeit in a different context) during the recent presidential election.  The Obama campaign was extremely successful raising money over the internet, to the tune of $690 million, particularly via the use of email to potential donors.

Lots and lots of email. 

The email appeals used by the campaign were the product of rigorous experimentation by a large team of analysts, said Amelia Showalter, the campaign’s director of digital analytics. “We did extensive A-B testing not just on the subject lines and the amount of money we would ask people for, but on the messages themselves and even the formatting,” Showalter said.  The campaign tested multiple iterations of each email – often as many as 18 variations – before deciding what to blast out to tens of millions of subscribers.  It’s a great metric – test, re-test, quantify, analyze, adjust and target.  All investors should be so disciplined.

“When we saw something that really moved the dial, we would adopt it,” said Toby Fallsgraff, the campaign’s e-mail director, who oversaw a staff of 20 writers.  Interestingly, despite their intensive and extensive experience, the staff was remarkably poor at predicting what would work and what wouldn’t.  Ugly stuff worked.  A casual sound worked.  Profanity worked.  Surprisingly, no matter how much email was sent, very few recipients opted out.  Jon Stewart hilariously lampooned this effort here (“They’ll end up spamming the living s*** out of you!”).

This adaptability is important from an investing standpoint.  We need to be agnostic as to approach and ideology and simply focus on what works and adjust as things change.  Our points of view and opinions, no matter how strongly held, should always be tentative and subject to change due to new or better evidence.  

One reason things change is that trades get crowded and played out.  You can have too much of a good thing, as the Obama campaign found out.  No email was perfect and none kept working indefinitely. “Eventually the novelty wore off, and we had to go back and retest,” Showalter said.

As Felix Salmon recently put it, “anything which works will eventually stop working, and the less intuitive it is, the more quickly it will stop working.”  In a proposition that is both intuitively appealing and academically supported, as more people enter a trade or employ a strategy, the more and the more quickly their success will deteriorate.  As Yogi himself would recognize, it ain’t over ‘til it’s over, but eventually it is over.

Gross Harbinger

Bill Gross is out and about proclaiming the death of equities (more detail here; others have mined this ground already, as I pointed out back in May). In sum, Gross wonders how stocks can keep appreciating at a 6.6% annual rate (as they have, after inflation, since 1912)  in this “new normal” economy, in which GDP growth remains stubbornly low.  Putting aside the fact that we have the world’s most prominent bond investor dumping on his lead product’s chief competition for assets, what should we make of what he says?

My view is that Gross is a harbinger (but not an indicator) of the next secular bull market. 

As I keep arguing, since 2000 we have been suffering through a secular bear market, subject to extreme cyclical swings in both directions. I hope that – as with the famous BusinessWeek cover – the current equities death watch is a leading bullish indicator or even the inflexion point to a new secular bull market. But I doubt it. Despite decent P/Es, other long-term valuation indicators (P/B, PE10, Q) as still too high. Even so, as my friend Tadas Viskanta sagely points out, “the seeds of a generational bottom or a new secular bull market are being sown. Unfortunately with these seeds we do not know how long it will take them to germinate.” In the meantime, investors would be wise to preserve capital by managing risk first while still looking for ways to invest profitably and well. 

My bottom line:  equity prices are still “too damn high” to get very excited long-term.  Retail investors are leaving equities and have been doing so since 2007, as Jason Zweig points out and as illustrated right.  But history suggests that we won’t see the shift to the next secular bull market until the market completely capitulates.  My best guess is that we’re still a significant ways away from that.  Besides prices that remain too high, the economy still needs further deleveraging, the “fiscal cliff” awaits, Europe looks far worse off to me than the markets imply (despite some decent arguments to buy it), ongoing domestic political gridlock appears inevitable and institutional investors have not yet given up the ghost. 

I could be wrong, but I expect the current secular trend of volatile cyclical market moves in both directions to continue.  Moreover, any strategy that makes a dramatic move away from equities runs a serious risk of underperformance, especially given current bond yields and the recent poor performance of hedge funds and other alternatives.  I generally prefer hedged equity today (not to be confused with hedge funds as a class), for what it’s worth.

Some have suggested that the Gross pronouncement is a good reason to buy.  For trading purposes that may be correct. But I don’t see it as a long-term buy signal.  Bespoke noted yesterday that the famous 1979 BusinessWeek “death of equities” cover I referenced above was no buy signal either (a point I made back in May). That secular bear market continued into 1982. Claims like that made by Gross have been made before during this secular bear and will likely be made again before it’s over.  Harbinger?  Sure.  But I suspect that the pain will be much greater before this market capitulates and lots of other people will suggest that equities are dead. 

There are plenty of reasons to fear equities generally during a secular bear market, but this one will end.  Equities are not dead.  American innovation is not dead.  We are 12 years in and secular bear markets average about 17 years in length.  Given how much more swiftly markets move today, this market may well fail to last 17 years.  But are the Gross comments a signal to load the boat?  I don’t think so.  Not yet. I want equities really to be dead (at least mostly dead?) before I do that.

Positively Terrifying

The Los Angeles Times published a fascinating (if a bit under-sourced) piece this week about how Baby Boomers who are worried about the lack of money in their 401(k)s and IRAs are day-trading within their retirement accounts.  The article as a whole is terrifying.  Here are some particularly scary quotes:

  • “[S]ome aggressive investors have begun day trading their nest eggs — all in a bid to make up for lost time.”
  • “As many as 40% of people trading options at the Motley Fool do so in retirement accounts, said Jeff Fischer, an options advisor at the investment website.”
  • “Americans are a collective $6.6 trillion short of the amount they need to retire comfortably, according to a 2010 analysis by the Center for Retirement Research at Boston College.”

Read it and weep.

 

My Investing Checklist

Barry Ritholtz is working on a checklist of the most common errors investors make (and checklists can be extremely valuable). Here’s my list of such errors and some related maxims.

  1. Understand the “arithmetic of loss” (a 10% loss followed by a 10% gain does not get you back to even).
  2. Correlation is not causation; consensus is not truth; and what is conventional is rarely wisdom.
  3. High fees are a major drag on returns; tax advantages and consequences matter a lot too.
  4. All other things being equal, ETFs are better than mutual funds.
  5. Complex instruments, reaching for yield and illiquidity are usually more dangerous than they appear.
  6. Asset allocation is more important than the product selection of a portfolio’s component parts.
  7. Since passive management beats active management most of the time, it is the appropriate default.
  8. Be clear about and cognizant of what Barry Ritholtz calls the “long cycle” – secular and cyclical markets.
  9. Our psychological make-up and the behavioral biases and cognitive impairments caused thereby conspire against our investment success and even when we recognize these problems generally, we typically miss them in ourselves (“We have met the enemy and he is us” – Pogo).
  10. Forgetting that nobody is close to objective and that nearly everyone wants a piece of the action will cost you a lot of money.
  11. An otherwise great investment plan can readily become a disaster is it doesn’t line up with our understanding, goals, objectives and risk tolerances.
  12. Risk is a complex and multi-faceted thing – it’s much more than just volatility.
  13. Manage risks before managing returns.
  14. Never lose sight of the facts that investing is both probabilistic and mean-reverting.
  15. Saving, trading and investing are very different things.
  16. We always know less than we think we know; thus forecasts are rarely even close to accurate.
  17. When making a trading decision, measure twice, cut once.
  18. It’s very dangerous to fight the Fed and/or the government.
  19. When reading financial or investment papers, the best stuff is usually in the footnotes.
  20. When you have reached your goal, stop playing.
  21. “For the simplicity on this side of complexity, I wouldn’t give you a fig. But for the simplicity on the other side of complexity, for that I would give you anything I have” (Oliver Wendell Holmes, Sr.).
  22. Data should always trump opinion and ideology.
  23. It is little consolation to lose less money than others or less than one’s benchmark.
  24. History doesn’t repeat, but it does rhyme.
  25. Save as much as you can as early as you can.
  26. Always have a contingency plan.
  27. Create and implement a written investment policy statement; review it often but alter it rarely and only for very good, data-driven reasons or due to a change in personal circumstances and after very careful consideration.
  28. When the cost of a negative outcome is greater than you can bear, don’t do it (or get out), no matter how great the odds of success appear.
  29. “This time is different” Is almost never true, especially in investing.
  30. Re-balance regularly.

Against the Odds

The similarities between trading and gambling begin with the idea that both involve speculation.  But they don’t end there. 

Blackjack played with a perfect basic strategy typically offers a house edge of less than 0.5%.  However, a successful card counter who ranges his bets appropriately in a game with six decks can achieve an advantage of approximately 1 percent over the casino, with advantages up to about 2.5 percent possible in various situations.  These numbers vary, obviously, on account of skill and other factors. 

Thus a counter with an average bet of $100 is looking for a return of about $1 or so per hand or about $50 per hour.  However, variance is high.  Thus the standard deviation for that player is about $1,400 per hour.  That’s a tough way to make a living, even without casinos actively trying to prevent card counting and frequently banning those who do (except in Atlantic City since New Jersey law prohibits the banning of card counters). 

Ed Thorp, an academic and advanced math expert, is generally viewed as the “father” of card counting – he certainly pushed it into the public consciousness.  His 1962 book Beat the Dealer outlined various strategies for optimal blackjack play. It should be noted that although mathematically sound, some of the techniques described in Thorp’s book no longer apply, as casinos took counter-measures (such as no longer dealing to the last card).  In any event, Thorp wrote the book on card counting – both literally and figuratively.

A surprising number of traders either got their start in the gambling world or are also involved in it.  It should be no surprise, then, that Thorp followed up Beat the Dealer with 1967’s Beat the Market and became a hedge fund manager. As well as being the “father” of card counting, he’s probably the “father” of market quantitative analysis too (see Scott Patterson’s engaging book, The Quants for more).

Doing the probability analysis to be a card counter is similar to probability analysis done by traders, and the connection is obvious.  Today’s high frequency traders may well be, in effect, card counters (their success rates suggest that they are).  But the connection between sports betting and the stock markets may be closer still.  One of my favorite mortgage traders from the 1990s got his start towards trading as a college student gambling on sports, often betting both sides and taking advantage of bookies’ shading the line in an era before the internet and immediate information when disparities of 3 points or so between “home” and “road” bookies was commonplace. 

That said, sports bettors, like most investors, aren’t very good overall.  In both situations most are driven and undone by their emotions.  For example, recent research from Sports Insights suggests that the higher percentage of bets the favorite receives, the less likely they are to cover (favorites receiving 75 percent or more of the wagers covered the spread just 46.1 percent of the time).  This animal spirits tendency is well-known.  So much for efficient markets in sports betting at least.

But since sports bettors must pick 52.4 percent winners just to overcome their inherent 11:10 disadvantage (sports books are in business to make a profit, after all), this is very significant information.  Although good data is obviously hard to come by, most analysts suggest that the best Vegas touts have a win rate in the area of 55 percent (see here for more).  Indeed, it appears doubtful that more than 5 percent of touts have a lifetime win rate of the 52.4 percent needed for profitability. That makes sports gambling a very difficult way to make a living – the margin of error is small and, as with blackjack, variance is high. 

For example, suppose a bettor went 58-42 (a very respectable 58% win rate) over the course of an NFL season, betting $1000 per game.  That bettor’s end result would be only $11,800. You’d need a hedge fund and lots of leverage to make that a big money-maker. Yet if someone were confident that s/he could win 80 of his or her next 100 bets, s/he could turn $1,000 into $15 billion by proper proportional betting – all over the course of a single season. 

In Vegas, many touts claim ridiculous win rates against the spread.  Some (try listening to Saturday morning sports radio) suggest “investing” in sports gambling.  Similarly, most active managers would have you believe that they are all you need to access untold riches.  In each scenario, it is very possible to succeed.  But success is far less frequent than advertised and far less lucrative as well.

Is it News?

On a day with a big data announcement, like today, one might expect that the various news outlets might generally agree on what’s moving the markets.

Not so much.

According to CNBC (please overlook the dreadful prose), “[s]tocks opened lower [today] after the monthly government non-farm payroll rose less than expected and as traders continued to closely monitor events in the euro zone as the G20 Summit in France took place.”  Fox Business agreed:  “Stocks were off to a gloomy start in the last trading day in what has been a volatile week for Wall Street as traders mulled fresh data on the jobs market and continuous developments on Europe’s debt crisis.”   Bloomberg’s spin was slightly different:  “Stocks, the euro and Italian bonds fell as a disagreement on boosting the International Monetary Fund’s resources to fight Europe’s debt crisis overshadowed a drop in the U.S. jobless rate.”  The Street‘s headline focused on NFP and said that “Stocks Fall on Lackluster Jobs Data.”  CNN emphasized jobs too:  “U.S. stocks opened slightly lower Friday following a disappointing jobs report.”

Which was it — NFP or Europe?  The answer is both and neither.  On more ordinary days, what’s going on is even more elusive.

I’ve sat on enough fixed income trading desks to know that there are always many reasons why people trade and those reasons are often unknown and concealed.  I have no reason to believe that equity traders are any more forthcoming.  Obfuscation is common — in all directions.  Even flow trading desks never have a great handle on what’s driving whom. 

One common objection to the complete digitization of trading is the difficulty of monitoring “flow” and the reasons for it without the human connection.  And there is certainly value in that for traders.  But that value is easily overstated. 

A big trade after a big number might be in response to the number.  But it might also have been planned before and delayed to get past the risk of the number.  Or it might simply reflect redemptions due to poor performance, or something else.

Back in the days when I was routinely asked about flow and called upon to interpret what’s driving whom on a day-to-day and sometimes moment-to-moment basis, I was careful to talk to traders, read the latest news and collect whatever other information I could before opining.  But, even at best, the information I offered had to be treated very tentatively. 

Information is cheap but meaning is expensive.

The traders I talked with might not be seeing all the flows.  Or they might be longer (or shorter) than they’d like and are biasing their commentary accordingly.  Or maybe they’re distracted about something.  Or perhaps they’re angry with me for not pushing what they had to sell hard enough and freezing me out from the best intel they had. Everybody has an ax to grind.

Obvious takeaways:

1.  For investors, these headlines are essentially all noise and can readily be ignored.

2.  For traders, these headlines (and any claim to trading “news”) are — at best — only a small piece of the puzzle of what’s going on.

_________________________

A version of this post appears at Business Insider — here.

Trading v. Investing

Trading and investing can both be effective strategies and they generally agree on a number of major points.

  1. We want to succeed. Traders will generally define success a bit differently, but we all want it just like we all want to be profitable (thank you, Captain Obvious).
  2. We need a carefully designed plan and must execute it.  As the expression goes, nobody plans to fail but we do fail to plan. Investors and traders who are successful over the long haul rely upon an evidence-based plan rather than luck.
  3. We must be contrarian.  Traders can follow a trend and be successful for a while, but long-term success for traders and investors alike requires going against the flow because the markets are a zero sum game.
  4. We must remember that “this time isn’t different.” The markets are mean-reverting. Ignore this at your peril. 
  5. There is no such thing as a free lunch.  In other words, risk and reward generally correlate.
  6. We must control our emotions. Impulsive actions based upon emotions, intuitions or one’s “gut” will be costly.
  7. Most players will not control their emotions.  This fact provides tremendous opportunity.  As Warren Buffett says, be greedy when others are fearful and fearful when others are greedy.
  8. Costs matter.  Whether these are transaction costs, fees, taxes or something else, overall costs have a huge impact on the bottom line.
  9. Always consider who’s on the other side of every transaction.  As the expression goes, if you’ve been playing poker for 20 minutes and haven’t figured out who the patsy is, it’s probably you.  Which leads to…
  10. Am I a being duped? We all want to be Michael Burry.  That starts by not being Wing Chau.  Of course, we can all be both (think John Paulson).

But the contrasts between investing and trading can be dramatic, as illustrated by the metric below.

We all have trouble thinking long-term, of course, in part because we tend to discount future value far too much (along with difficulties on account of optimism bias and what Dan Kahneman calls the planning fallacy — we tend to overestimate our ability to control the future). If you doubt me, ask yourself how your diet and exercise plans tend to turn out. So, are you a trader or an investor?

Making Book and Making Trades

I had a paper route as a kid.  It was an evening paper, which meant that I made my deliveries after school.  One of my first stops was a barber shop that fronted for a bookmaking operation.  Even as a kid I could see that something was off because there were always a bunch of men sitting around in the afternoon without getting haircuts and the barber/owner had two telephones. 

Naturally, I wanted to get in on the action, but the proprietor (wisely) never even acknowledged that there was gambling on the premises.  However, he did agree to allow me to bet on the area football team’s game each week (the Buffalo Bills)  for his subscription.  If I picked the game right, he paid double and, if I missed, he got a free paper.  I generally won, but I suspect he considered it a loss leader for future business. 

Most people conceive of trading in a similar way.  The idea is to pick winners.  And they’re right to a point, but only to a point.  You see, whenever I’d get cocky about my winning record, my bookie would remind me that I wasn’t picking against the spread — I was picking outright.  Because stocks have prices, trading isn’t really about picking outright winners.  It’s like picking against the spread.

That’s the basic point that index advocates make with respect to beating the market.  They say that the market immediately prices in all information related to a stock’s value so that it’s impossible to win overall “against the spread.”  That’s false, of course, because the market is not a weighing machine — rationally weighing intrinsic value via price — it’s a voting machine — reflecting  popularity decisions about stocks, which can be wildly irrational.

A fallback position of index advocates is that the irrational judgments of individuals somehow add up to rationality, in a sort of Wisdom of Crowds effect.  But as these experiments show, crowds can lead to big mistakes and perversely give their members false confidence at the same time on account of social influence.  Moreover, a new study suggests that markets become more unstable and prone to bubbles precisely as they move closer to the ideal of information efficiency.  Finally, game theory helps clarify optimal (rational!) behaviors in simple strategic games, but it becomes largely irrelevant in complex games — many agents with many strategies (like markets). In that setting, as this study shows, dynamical systems theory offers far more insight into system dynamics.  We aren’t terribly rational much of the time.

The academic points outlined above are probably better made by another gambling example.  An old trader friend from New York got his start (of a sort) in trading by gambling in college.  This was in the days before cell phones and on-line gaming.  My friend would work a gambling arbitrage (subject to serious counterparty risk) by betting against the home team with a nearby bookie and against the visiting team with a bookie in the visiting team’s city to take advantage of the wide diversity of point spreads.  As with stock prices, point spreads do not reflect an objective assessment of the relative strengths of teams.  Rather, they reflect the betting habits of bettors and thus the irrational hopes and fears of fans.  Optimism bias is never more prevalent than among fans of sports teams.

None of this is to suggest that it’s easy to beat the market or to beat point spread with any consistency and persistency.  But as any bookie willing to share will tell you, spreads are made not to reflect the relative strength of the teams but, instead, to balance out the bets on each team.  Trading is no more rational than gambling.