Michael Covel Business Philosophies

Haven’t posted for an entire month! A lot has been happening lately in terms of finance/economics and will update really soon. A starter post to get me warmed up for more serious posts in the (very near) future.. promise!!

Taken from Michael Covel’s blog:

Bring joyful, imaginative and impassioned energy every day. You can’t fake it.
You don’t need to be ‘big’ to be good, you need to be smart.
When there is no market, create one.
Engage someone as if your life depended on it.
Nothing is more important than the wisdom to help transform someone.
Make your vision grounded in your uniqueness.
Focused on the unexamined dimensions of your efforts.
The race goes to the curious and slightly mad.
Dry obligation to anything in life will figuratively kill you.
No one gives permission. Seize the mantle.
If you can’t solve a problem, you are playing by the rules.
Hard work, sustained concentration and drive are the so-called secrets.
Telling the truth is the best defense for every situation.
Winners understand sunk costs and opportunity costs.
Plan to win, prepare to win and have every right to expect to win.
It’s in your power to change your belief systems. No one is stuck.

The Myth of Time Diversification

Something my Financial Risk Analysis professor mentioned last week:

A common argument is that stocks are safe investments in the long run because of “time diversification.” Buy-and-hold advocates argue that if you hold a stock over a long period of time, the “good” and “bad” returns will tend to cancel each other out, so time will diversify a portfolio just like how investing in multiple assets diversifies a portfolio.

The time diversification argument is only valid if there is a mean-reversion in stock returns – ie there is a negative serial correlation of returns. (In non-academic speak, this means that if returns are high today, they will be low tomorrow on average). Let’s examine the three cases of stock returns (positive correlation, no correlation, and negative correlation) and see why buy-and-hold fails in each case:

Positive correlation
Research has shown that in the short run, stock returns are positively serially correlated. This makes sense: if the S&P closed high today, it will most likely be higher tomorrow, as long as there isn’t a huge piece of bad news. Conversely, if the market closed lower, it will most likely follow its downward trend. This is how trend-followers make money. So time diversification doesn’t work in the short run.

No correlation
Even if you follow traditional academic thought and claim that stock prices follow a random walk, ie stock returns are serially uncorrelated, time diversification still does not work here. Investing over a long horizon may increase your returns over a long time, but it also increases your risk relative to expected returns. The saying “markets can remain irrational longer than you can remain liquid” holds true here – if prices follow a random walk and drift downwards for 10 years and upwards for 12 years, your return might be positive but your variance remains huge.

Negative correlation
Now let’s move on to the situation that DOES favor time diversification – when stock returns are negatively correlated. Academic research shows that stock returns do exhibit this tendency in the long run, which is nice. So time diversification does help to lower your risk relative to expected return over the long run. However, it’s easy to see that buy-and-hold is the WRONG strategy for such a situation.

Let’s say that stock returns are negatively correlated and stock prices are mean-reverting. This means that if prices were higher than a certain mean, they will eventually come down. If they were lower than the mean, they would rise. The optimal way to make money would be to then buy when prices were below the mean, and sell them when they were above the mean – a surefire way to make money if stock prices were truly mean-reverting. This strategy is known as swing-trading, and is practiced by many traders.

In any of the three cases I highlighted, buy-and-hold falls flat on its face, and yet there is an entire industry of long-only mutual funds, pension funds, “value” investors etcetc that subscribe to the buy-and-hold mantra.

That one schpiel from my professor convinced me that I should be taking his class. Now who says that all academics live in an ivory tower?

What “Everyone” Thinks

I’ve been spending the past 3 days on the “LSE City Fast Track” program, where they took selected members from the Finance department on a little schpiel to various accounting firms, banks, and financial regulatory institutions in London. It’s been an amazingly eye-opening experience, though I suspect that I had a different sort of experience from my fellow wide-eyed, eager-to-please coursemates, but more on that in a later post.

I’d like to blog about the common perception of trading, or I suppose what “everyone” thinks that they know about trading. Every time I hear the common misperceptions about trading, I have an irresistible urge to correct them, make a strong opinion, etc, but whatever I say usually falls on deaf ears. Which is very comforting, because that means very few people can bring themselves to do what I’m doing, which means that I can keep doing what I’m doing for a very long time.

My coursemates are very bright people who have all gained entry into one of the most academically challenging programs in the world at the Masters level. Most, however, have no clue about what they want to do in life. (I mean, who really does?) I don’t claim to have more financial knowledge than my fellow classmates – on the contrary, I have absolutely no interest (and no knowledge) about the whole schbang about valuations, EBITDA, strategic alignment, and all that nonsense.

However, I do know just a little bit more about speculative trading than other areas of finance, and I can immediately point out the faults in my coursemates’ views on trading:
1. You need to be constantly plugged into the news in order to be a successful trader.
2. A traders’ skills are less transferable than other areas of finance, eg in investment banking.

I’ll address the first one here, and the second one tomorrow or in the next few days. (Believe me, I have LOTS to say)

Myth 1: Being constantly aware of the news is necessary if a trader wants to be successful.
First of all, there are 2 types of traders: fundamental and quantitative. Most traders would fall in one category or the other, or have a combination of both. Fundamental traders care more about economic data, because they use economic “fundamentals” to make decisions, and probably rely more on financial news.

Quantitative traders are very different. They rely purely on price, volume, or some derivation of those figures in order to make decisions. Quantitative traders have clear, distinct rules on when to get in and out of the market based purely on price and volume.

When you mention “trader”, most people would think of a fundamental trader, and it’s easy to see why. During the Fast Track program I had an opportunity to tour a trading floor with rows and rows of traders sitting in front of 6 screens each. 1 of those screens was usually plugged into Bloomberg to get the latest economic data. It’s a common belief that once news comes out, you have to act on it in seconds if you ever want to make a profit.

Let me point out why this is wrong, very wrong. While it’s true that news like the unemployment report, housing figures, retail sales, etc do affect asset prices when they are released, this effect is often temporary. Say the market is going up, and a bad news report comes in. How many times have we seen prices dive for that day, only to climb right back up again the next day? Did the unemployment figures suddenly change the day after the news was released? Of course not. The fact is that the bad news was probably already priced into the market BEFORE the news came out. If the market was moving up before the news came out, that meant that the “smart money” (ie the insiders, the big players, the people who can move the market) felt that the market should go up.

The temporary plunge in the market was due to the actions of the common traders, those reactive traders who don’t know what’s going on. They see a bad news report and they panic, selling as fast as they can. What they don’t realize is that the “smart money” is still pushing the market up, which is why prices suddenly recover the next day.

Price, therefore, is the one true indicator about where the market is going. Financial news, analyst reports, economists’ forecasts, etc are all distractions, their effect on the markets is random and miniscule when you compare that effect to the overall market. Quantitative traders take advantage of this fact in order to make trading decisions.

However, whenever I mention quantitative trading, I often get a “oh please, not that technical analysis crap again” look from these people. Of course, I don’t blame them. They’ve grown up on a Warren Buffett “buy-and-hold” philosophy, their long-only mutual funds and pension plans have told them that THIS is the only way for them to make money in the markets. Incidentally, these mutual funds and pension plans, these buy-and-hold proponents are the exact same people who lost devastating amounts in the financial crisis.

There is a group of people who DID make a fortune though, and I can name a bunch of them: Bill Dunn, John W. Henry, William Eckhardt.. and many others. The one thing they have in common? They were all systemic traders. The evidence is overwhelming, yet people refuse to believe it even when I present it point-blank to them. They stick to their beliefs that reacting to news is the only way to make money and that markets are influenced by the so-called “fundamentals”. They stick to these beliefs even though these methods have proven time and again to lose money for most traders. There’s one word to describe a person who keeps acting in a way that harms him: irrationality.

Yet, maybe I want the world to remain this way. Maybe I want everybody to be irrational, to blindly follow those methods that have harmed them in the past. Trading is a zero-sum game, and if they want to give away their hard-earned money, I want to be there to take it. Maybe I want people to be scared of becoming a trader because they think that it’s way too hard to keep up with the unlimited stream of Bloomberg headlines. That effectively eliminates my competition, allowing me to keep doing what I’m doing for a long, long time.

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.

Words Of Wisdom

Paul Tudor Jones gave an excellent 9th grade Commencement speech. (taken from Michael Covel’s blog)

The focus of his speech was on failure: how to deal with it and how it makes you better (harder, faster, stronger), but one particular paragraph that wasn’t related to the topic struck me:

“Don’t get me wrong – serving others is really, really important. It truly is the secret to happiness in life. I swear to God. Money won’t do it. Fame won’t do it. Nor will sex, drugs, homeruns or high achievement. But now I am getting preachy.”

… What? Money and sex won’t do it? Damn. (just kidding, just kidding..)

Risk

“Many people share the view that risk is bad. As they see it, risk should be avoided – even shunned.

I don’t.

I like risk. I embrace risk.

If your goal is to make small, incremental improvements, then you don’t need to play with risk, If you want to make giant leaps forward, you cannot avoid it.”

- from “Inside the Mind of the Turtles”, by Curtis Faith.

A Flash of Inspiration

Sometimes, articulating my concepts in simple terms can give me some great ideas. I was trying to explain my research last night over the phone to the girlfriend  when I realized that I had unexpectedly come up with a focus of what I was looking for. I quickly typed out the following brainstorming points:

1) At any given time, markets move in 3 directions: upwards, downwards or sideways.

2) A successful system is one which is robust, meaning that it works across time and across markets.

3) That means that a successful system adapts to changing market conditions: If markets trend up or down, the system needs to employ a trend-following mechanism. If markets move sideways, the system needs to either trade minimally (or not at all), or to employ a band-trading/countertrend mechanism.

4) The key to making a system adaptive is to come up with an indicator to determine what condition the market is going through at the present moment. I have only read of some indicators assessing the “efficiency” of the market, though there might be more out there that fit this criteria.

5) If the indicator shows that the market is trending, then trend-following entry points need to kick in. These should should be combined with wide stops (to ensure that one does not get stopped out of a trend), as well as profit-taking exits that determine that the trend is over.

6) If the indicator shows that the market is moving sideways, then the system should either a) stay out of the market, or b) employ some band-trading/countertrend techniques with tight stops. Or perhaps a short-term market predictor might work as well.

7) Even though the system should work across different markets, it might be possible for the system to have different parameters across different markets. This is because different markets have different characteristics in transitioning from trending to non-trending phases.

Finally, a focus!

Dennis Gartman Trading Rules

Dennis Gartman Trading Rules, taken from Michael Covel’s blog:

1. Never, Ever, Ever, Under Any Circumstance, Add to a Losing Position… not ever, not never! Adding to losing positions is trading’s carcinogen; it is trading’s driving while intoxicated. It will lead to ruin. Count on it!

2. Trade Like a Wizened Mercenary Soldier: We must fight on the winning side, not on the side we may believe to be correct economically.

3. Mental Capital Trumps Real Capital: Capital comes in two types, mental and real, and the former is far more valuable than the latter. Holding losing positions costs measurable real capital, but it costs immeasurable mental capital.

4. This Is Not a Business of Buying Low and Selling High; it is, however, a business of buying high and selling higher. Strength tends to beget strength, and weakness, weakness.

5. In Bull Markets One Can Only Be Long or Neutral, and in bear markets, one can only be short or neutral. This may seem self-evident; few understand it however, and fewer still embrace it.

6. “Markets Can Remain Illogical Far Longer Than You or I Can Remain Solvent.” These are Keynes’ words, and illogic does often reign, despite what the academics would have us believe.

7. Buy Markets That Show the Greatest Strength; Sell Markets That Show the Greatest Weakness: Metaphorically, when bearish we need to throw rocks into the wettest paper sacks, for they break most easily. When bullish we need to sail the strongest winds, for they carry the farthest.

8. Think Like a Fundamentalist; Trade Like a Simple Technician: The fundamentals may drive a market and we need to understand them, but if the chart is not bullish, why be bullish? Be bullish when the technicals and fundamentals, as you understand them, run in tandem.

9. Trading Runs in Cycles, Some Good, Most Bad: Trade large and aggressively when trading well; trade small and ever smaller when trading poorly. In “good times,” even errors turn to profits; in “bad times,” the most well-researched trade will go awry. This is the nature of trading; accept it and move on.

10. Keep Your Technical Systems Simple: Complicated systems breed confusion; simplicity breeds elegance. The great traders we’ve known have the simplest methods of trading. There is a correlation here!

11. In Trading/Investing, An Understanding of Mass Psychology Is Often More Important Than an Understanding of Economics: Simply put, “When they are cryin’, you should be buyin’! And when they are yellin’, you should be sellin’!”

12. Bear Market Corrections Are More Violent and Far Swifter Than Bull Market Corrections: Why they are is still a mystery to us, but they are; we accept it as fact and we move on.

13. There Is Never Just One Cockroach: The lesson of bad news on most stocks is that more shall follow… usually hard upon and always with detrimental effect upon price, until such time as panic prevails and the weakest hands finally exit their positions.

14. Be Patient with Winning Trades; Be Enormously Impatient with Losing Trades: The older we get, the more small losses we take each year… and our profits grow accordingly.

15. Do More of That Which Is Working and Less of That Which Is Not: This works in life as well as trading. Do the things that have been proven of merit. Add to winning trades; cut back or eliminate losing ones. If there is a “secret” to trading (and of life), this is it.

16. All Rules Are Meant To Be Broken…. but only very, very infrequently. Genius comes in knowing how truly infrequently one can do so and still prosper.

Mastery

Taken from Hedge Fund Masters by Ari Kiev:

” What is mastery? Webster defines mastery as the possession of a skill or technique that implies freedom from flaws or imperfections; or skill or knowledge in a subject that makes one a master in that subject. Mastery is having supreme proficiency in a particular activity… to describe that degree of competence at which the individual is willing and able to take responsibility for the outcome of his or her efforts, even in environments where the individual does not control all of the forces, such as the markets.”

Bourne to Trade

I was watching the Bourne Ultimatum yesterday and a line from the CIA’s deputy director hit me:

“You know my number 1 rule: Hope for the best, plan for the worst.”

That’s excellent trading advice, even if it comes from a villian. Most people don’t have trouble with the first part of that sentence – I have friends who practice “buy and hold” strategies and hope like mad that their fundamentally-sound stocks will go up. Some of my strategies last year involved having upside targets that I hoped like hell would be hit.

But planning for the worst takes a lot more effort: It’s essential that I’m absolutely clear of what I’m going to do in every scenario of price movement: up, down, sideways, and of course, black swans.

Something to think about when I start intensive research on probably late Monday or Tuesday.. I’m excited to see what Neuroshell can do.