Random Econ Humor

Since it’s the weekend, and no one’s in the mood for depressing griping about the economy/politics anyway, (and because I’m in the midst of the most boring vacation ever and I need some entertainment), I decided to give you some Economics humor that I’m so fond of (yes, I’m nerdy like that), courtesy of economistsdoitwithmodels.com

… I guess all economists need some way of keeping ourselves sane.

The Greenback Effect

This article from the great Warren Buffett in the New York Times yesterday pretty much sums up the question that seems to be on everyone’s mind: Will the US dollar collapse?

The conventional wisdom: The tremendous amount of liquidity pumped into the financial system combined with the astronomical debt levels of the US will ultimately lead to runaway inflation. The greenback, often seen as a “safe haven” and the most trusted currency in the world, backed by the full faith of the US government, will collapse in value. Perhaps the Renminbi will become the new currency standard of the world.

My view? It’s too early to tell, but I don’t think that it’ll happen within the next couple of years. Countries (eg China) are still too dependent on US consumers to allow the dollar to fall. If China stops buying US debt, they run the risk of a major economic slowdown. However, I think that such a scenario may be very possible in the intermediate future for a number of reasons:

1) The US is de-leveraging. This means that consumers will no longer have the spending power to purchase from markets like China. In turn, the governments of these countries will decide that propping up the US dollar isn’t going to help their economies anyway, so they’ll let the dollar fall.

2) China is already seeing the danger of holding too much US debt, and is putting in some measures to reverse the effects, such as asking repayments to be made in its own currency or holding other assets besides US debt.

3) The Fed has to answer for the baby boomers’ excesses somehow. This debt is only going to get worse, and if other countries not buying debt, consumers are not buying debt (because of deleveraging), the only way to solve this problem is to print money, which leads to inflation.

The US needs to stop using the financial crisis as an excuse to keep recklessly increasing its debt.

Happens to All of Us…

Article on the “Quarterlife crisis“, as seen on Eyeweekly.com.

Not exactly related to finance, but I figure it should probably affect most people reading this blog..

Another Bear Market?

Robert Prechter, one of the key proponents of the Elliot Wave theory, on why the current rise in the stock market is just a bear market rally – ie, we’re in for a bigger plunge.

Profitable Mistake

Remember my previous post about crude oil?

My dad texted me in church today and told me that instead of closing my mini crude oil contract at $70.66, I had mistakenly shorted the FULL crude oil contract at that price instead. The outcome could have been disastrous. Instead, oil traded down to $67.47, leaving me with a small loss of $1,557.50 in the mini contract but a large, unintended profit of $3,150 in the full contract.

I’ll sure as hell going be extra careful not to make such mistakes in the future, but thank goodness this one proved to be a good one.

Bubbles and Beauty Contests

Finally got down to reading James Surowiecki’s The Wisdom of Crowds, which I was supposed to have finished a year ago for my Public Finance class. Its thesis, in a nutshell, is that when you aggregate a diverse set of perspectives, the collective decision is often far superior to even the smartest individual in the group. While the entire book is amazing, chapter 11 is by far my favorite because it talks about financial markets.

Markets seem to be Surowiecki’s favorite vehicle for collective decision-making. And rightly so: they’re an excellent medium for aggregating the vast opinions of diverse individuals, and a market’s collective decision –the price – is almost always an accurate predictor of the true value of the asset.

However, as Surowiecki points out, financial markets are curiously inefficient. There’re so many great things to talk about in this chapter but I’ll try to zero in on his main points:

1) The nature of financial markets. Financial markets thrive on dependent, (as opposed to independent) decision-making. Keynes compared financial markets to a beauty contest where everyone had to pick out the six prettiest faces from a hundred photographs, and the winner was the one whose choice corresponds closest to the average preferences of everyone else. In short, an investor is concerned not just with what the average investor thinks but with what the average investor thinks the average investor thinks, and so on. When everyone makes their decisions based on the decisions of everyone else, this makes the market “stupid”, leading to inefficiencies such as bubbles and crashes.

2) How bubbles form. Bubbles and crashes happen because of the dependent nature of markets. Bubbles, in particular, are unique to financial markets because most people are buying a stock hoping to resell it to the “greater fool” (or the more optimistic one). Surowiecki points to a Caltech experiment that shows that a bubble forms even though everyone knows that they are in the midst of one. Everyone is convinced that the greater fool was out there. Also, would any sensible money manager be able to resist sitting out of the Nasdaq boom of the late 90s when everyone was making returns of 40 – 85%? As a result, everyone piggybacks and mirrors each other.

It is here that Surowiecki points out that for all the antipathy directed against short sellers (investors betting that the market would go down) for causing the current financial crisis, the truth is that the presence of short sellers would have prevented (or at least dampened) the bubble from forming in the first place. Short sellers help to cancel out the effects of overoptimistic investors, thus helping the market to reach its true price. However, for a number of reasons, short sellers account only for a tiny fraction of all investors, so the market is allowed to drift upward and become ever more inefficient. Which leads me to question the Obama administration’s policies on imposing all these limits on short selling – do they really know what they’re doing?

3) The role of (too much) information. Surowiecki also talks about the role that information plays in financial markets. In particular, he feels that financial news media like CNBC actually magnify the dependent nature of the stock market because “it bombarded investors with news about what other investors were thinking”. We see the effects clearly: If a CNBC analyst likes a particular stock, its price jumps mere seconds after the report is broadcast. This is hardly enough time for any investor to make an informed decision of whether the stock is a good buy. Instead, investors are jumping on the bandwagon because they know that other people are jumping on as well.

A potentially harmful effect of being bombarded with information: studies have shown that people perform poorer than if they were not given the additional information at all. More information skews the collective wisdom of the crowd, upsetting the balance between public and private information that helps crowds come to a good decision.

I highly recommend anyone studying or trading the markets to take a good read of this chapter – it’s fascinating to see how markets are not so much driven by clinical, hard facts as opposed to irrational, uncontrollable emotions.

(all the ideas in this post are the ideas of James Surowiecki and I take no credit for summarizing and rephrasing them)

Fear and Greed

So… four days since the launch of my trading system (perhaps I could come up with a really cool name for it, like Operation Make-Me-Obscenely-Rich or something), I’ve bought and sold positions in all 5 markets, gotten my feet wet, made a few accounting blunders, but am otherwise still alive and kicking.

While I’ve done a number of trades so far, some good and some bad, I’d like to blog about a particular trade that I did today where I succumbed to the two emotions that every trading book has been warning me about: (yes, as you may have already guessed from the title), fear and greed.

I was long a mini crude oil contract at $70.625. Yesterday, the market went in my favor up to around $72. (A one point move is equal to $500 USD in profits or losses) My stop-loss was set at $71.34, which would have left me with a nice profit of $357 even if I’d been stopped out. I hadn’t set any stop-losses so far, preferring the flexibility of a mental stop. If the market gapped below my stop-loss, I could always get out. But if I had entered a stop, market noise could have triggered it, forgoing my chance for future profits. Or so I thought.

I woke up this morning and checked the markets. While oil had gone below my stop the night before, it was trading back up at around $71.6. The fact that the market had gone below my stop the night before should have warned me to either a) get out or b) put in my original stop (since if it was hit, then I would have been just as well off as if the stop had triggered the night before). Instead, greed and overconfidence convinced me that oil was only going to go up and I should “let my profits run” by not setting a stop that was so close to where the market was trading. The market traded to $71.3 a couple of minutes later – now I was officially beyond my stop out point – but still I left the trade as it was, convinced that it was just market noise.

I went to the gym, but on my way back I decided that I shouldn’t deviate from the system too much: a stop is a stop. I decided that if the market was above 71.34, I would place the stop, and if it was below, I would get out. I checked the markets and I realized to my horror that oil was trading at 70.6, and then it went down to 70.55: my huge profit had turned into a small loss!

Fear hit me as I watched the figures jump up and down – there must have been a news release of some sort – as I tried to figure out when I should get out. I’d made a (perfectly legit) loss in oil a couple of days ago and I was hoping that this trade would make up for it. Now, it had turned into a question of whether it would ADD to my losses or not. When the market hit 70.66, I jumped and sold my position – leaving me with a miniscule profit of $17, but -$7 after commissions. I had pretty much broke even.

Of course, (and I’m sure many traders can attest to this experience), once I’d gotten out of my position, the market immediately began to move my way. It’s now trading at $71. I realize now that if I had set my stop in the first place, I would have been out of the market with a happy profit of $350 instead of having a stressful morning with a $7 loss.

A couple of lessons I learnt:

1) A system is a system – if a market trades below my stop out point, even if it’s just one tic below, I get out. No questions asked. This would both minimize my losses and protect my profits. While “let your profits run” is great advice for the trader, I should never use it as an excuse for greed.

2) Don’t panic in the face of fear – I should have waited for the market to stabilize before putting my trade in. Jumping in when markets are volatile is a surefire way of getting the worst price. I was right to decide to get out, but wrong in my choice of deciding when to do it.

Thankfully, this wasn’t an expensive lesson – I pretty much broke even – but it’s one where I’ll remember for a long time. I figured that I should blog about it so I can recognize the situation when I’m faced with it again.

Update: Good thing I got out when I did. Oil is now trading below $70.

Another update: An immediate benefit from this lesson learnt on stops. I placed a stop at 1000.5 while the S&P was trading at 1012. It was hit within an hour of the market opening, letting me exit with a profit of $300. Wheee-ew.

Launch!

My finalized trading system launched yesterday, ready to trade up to five markets: the USD/SGD, EUR/JPY, e-mini S&P, 10-year T-Note, and mini crude oil contracts. I’ve also prepared an additional two markets (copper and the GBP/USD) to be added for diversification in the future if the overall system does well over time.

In this trading system, I have:

1) A trend-following system that enters on pullbacks. I wish I could elaborate more on this, but its past performance is pretty amazing for a system that has only 2 parameters. Furthermore, I’ve found 7 markets to trade with in the past 2 weeks, which was much better progress than I had with my previous systems. A simple system with few parameters that trades well over a wide variety of markets = good evidence of robustness. Will be researching to see if I can add up to 3 more markets to make an even 10 in the future, though I don’t expect to add to these basic 5 markets this year.

2) A risk management strategy comprising of trailing percentage stops for every market. This adds an additional 2 parameters (1 each for the long and short side), but ensures that I never stay in a losing trade for too long. The only cause for concern is that many of the stops are relatively tight (around 1 to 2%), so many of my trades may get stopped out because of noise. However, they help to limit my risk very well, especially for large contracts. I liked the idea of ATR trailing stops for the longest time, but they involved way too many parameters. A trailing percentage stop only has 1 parameter  - again, to keep the overall system robust.

3) A Fixed Ratio Money Management (FRMM) strategy. Many people in the industry use a Fixed Fractional Money Management (FFMM) strategy, but that involves a painfully slow grow of the account at the beginning and a much faster growth at the end. A Fixed Ratio MM helps my account to grow at a much faster pace at the beginning, decreasing risk as the account grows larger. Of course, this means that I’ll be trading at the highest risk at the beginning, and I’ll probably have to tolerate a couple of months of negative equity before the account takes off. The great thing about FRMM, however, is its ability to protect profits even if the basic trading system breaks down. I ran tests over the past 9 years, and it made up to 22 times the profits the system would have made trading just 1 contract in each market. FRMM is a really fascinating system, perhaps I’ll blog about it in greater detail someday.

I ran a “paper trading” test period from June 1st to August 8th, trading on totally unseen data. (this was above and beyond my out-of-sample data that my systems were not optimized over) The results came in to show a $650 loss over two months trading 4 markets (I excluded crude oil because the system wasn’t ready at the time of testing, but it would have done well during those 2 months anyway). -A $650 loss over 2 months was well within expectations, especially with heavyweights like the T-Note and S&P contracts in the portfolio.

So there: my research over the entire summer, my hours pouring over books, Excel sheets and Neuroshell charts has finally cumulated in this trading system that I’m putting into practice. I’ve run hundreds of tests, and spent entire days on things that I’ll probably never use, but I’ve gained valuable insight on what I need to look for in designing a trading model. I’ve come to accept that this is possibly the trading model that best suits my needs, and I don’t think that I’d have been able to have the same faith in it if I’d just picked it up from some trading book. I understand that I will face risks and losses, but hopefully the rewards will more than offset them.

Let’s hope this turns out well!

A Black Swan-Proof World

Nicholas Taleb, author of the bestsellers Fooled By Randomness and The Black Swan, on how we can protect ourselves against future black swans.

“What is fragile should break only while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.”

Taleb doesn’t point out that there are drawbacks to robustness: you sacrifice performance in the present. However, as painful as it is not to be as efficient as you can today, I think he’s right – there’s no point in making a million dollars today if you lose it all tomorrow. The issue comes down to 2 choices: to specialize or to adapt. If we specialize, ie optimize our abilities, skills, and characteristics to our environment, we can do very well, but we’ll blow up when the environment changes. If we choose to be robust, we can only hope for average performance in any given environment, but we’ll survive almost any environmental change.

Bringing that issue to trading: I’ve chosen the latter route in designing my systems. My previous ATR systems performed very well – but they had 6 to 7 optimized parameters, so they were specialized to trade in that particular environment (perhaps too specialized). I’ve spent the last month working on a promising new system – the basic system only has 2 parameters, 4 if I include stops. It’s as simple as they come, and so far it’s worked on 5 markets that I’m interested in. Robustness is key – I tried to make the out-of-sample period as large as possible and checked to see if it performs well even if it’s optimized over a small period. I also tried to use markets where I’d have sufficient data to cover at least 2 different types of secular markets.

Performances were not spectacular, but I’m pretty confident that it’ll survive any sort of environment. Add that to appropriate money management and portfolio diversification, and I think I have a potentially viable trading system.

I’ll Let YOU Decide What To Do With My Money..

Something that I’ve known about for a year now, but has recently become official: The government of Singapore has full discretion over our CPF money. (CPF stands for Central Provident Fund, sort of like the equivalent of Social Security in America )

This article was cleverly worded (and headlined) to give us the impression that this policy is actually a good idea: “CPF payouts are for life. Singaporeans will receive  monthly payouts from the Central Provident Fund (CPF) Life annuity scheme for the rest of their lives although the law does not provide for it.”

However, the next paragraph reads: “…premiums and payouts are at the Government’s discretion and will vary with factors such as interest rates.” What that means is that once you’re thinking of retirement, you won’t even have full access to your hard earned cash. Even if you’ve saved up say, 200 grand, our benevolent leaders get to decide how much you’re gonna get each month. Maybe $500, maybe $100, maybe even $10, since everyone lives so long anyway, right?

Now I normally wouldn’t be too worried about this in a country that tells you how your dollars are at work. However, as you can tell from this post, I don’t have that much faith in our dear leaders’ ability to manage our money AND be honest with us. What? You’re not letting me have my money when I want it, you’re mismanaging it, AND you’re not telling us about it? I don’t know about you, but that leaves me feeling JUST a little uncomfortable with who I trust 20% of my savings with.

Let’s break down the rationale for why a government would implement a CPF plan in the first place. The answer: To help less people with less financial savvy get access to better rates of return than they would normally have. (Placing your money in a 30 year bond would make much better sense than hiding it under your bed) A second reason would be to force people to save for retirement, and make sure that they don’t blow it all on the upcoming Integrated Resort or something. These are good reasons – a government steps in and corrects a market failure of imperfect information.

What would be the most obvious solution for this? A Social Security program where people make regular contributions out of their salaries. These contributions are invested in fixed income securities, which pay off once an individual retires. These securities could come either as a lump sum upon maturity, or as an annuity, which pays every month, guaranteeing a fixed “salary” even after the individual retires. However, as someone else puts it, the key word is “guarantee.” Bank savings are guaranteed, bonds are guaranteed, hiding my cash under my bed is guaranteed. Having someone else decide when and where I can have my money is NOT guaranteed. If Temasek or GIC gets hit with another Barclays debacle again, there’s no stopping them from declaring that they want to hold on to your money for an indefinite period. Maybe they should change the CPF scheme to the “Pay Your Great-Great-Great Grandchildren Scheme”. Of course, with inflation, my 200 grand should be worth a grand total of approximately $1.93 by then.

The bottom line? I can’t change the law. I can’t do anything about it if they want to take our money and screw us over. What I can do is tell you not to depend on our Dear Leaders to take care of you when you’re thinking of retirement. Invest if you can handle the risk, buy bonds if you’re risk-averse. Perhaps those choices aren’t completely risk-free, but they’re sure as hell safer than putting your money with these dudes.