An Investing Lesson

A fascinating observation from this post about new chess champion Magnus Carlsen:

Instead, it appears the key to his success is taking games that he used to consistently lose — especially games as Black — and instead forcing them into a draw.

There may be an investing lesson in there somewhere. Success is too often seen as the culmination of a series a grand, dramatic moves, when the humdrum routine of avoiding harm is at least as important.

Adventures in TAA

I wrote my first tactical asset allocation system over a year ago (see the alpha version here). Not because I was enthralled with the power of the approach, but because I was concerned that my discretionary trading results would suffer a serious decline following my demise. For the sake of the family finances I wanted something that could function well without me.

Though it shouldn’t be, it’s still a work in progress. It shouldn’t be because even something as simple as the Permanent Portfolio has worked pretty well over several decades, and may perform relatively better as time defeats each wave of “smarter” approaches.

As logical as that is, I can’t do it. I feel stupid using something that simple and have to “improve’ it. So the challenge is to create something that will make me feel smart enough to be comfortable and stick with it, while preventing the additional complexity from having any real impact on the results. Ideally the embellishments should be like the Emperor’s new clothes: Good enough to fool the user, but in reality non-existent.

I had to wait a year for a little turmoil in the bond market, but after some modification I think I have a good candidate. It still needs another year in the sandbox and some tedious QA on the code, but here’s what I’ve learned so far:

  1. For a set it and forget it long-term system, momentum has been, and is likely to remain, the best method for selecting positions. Human psychology has been remarkably stable over centuries, and most people are sheep, so trends are likely to exist as long as humans remain in their current form. Mean reversion will always be around too – but it may stubbornly refuse to revert in your financial lifetime (which leverage in any form will considerably shorten).
  2. The number of simultaneous positions you should hold ends up a function of risk tolerance. Holding one position at a time in a fund switching system generally yields the best absolute returns, but the volatility which creates those returns cuts both ways. It looks great on paper when you know how it all turns out, but when you’re down 35% and staring into the great unknown it feels entirely different. For me, limiting the maximum number of positions to 2 or 3 funds seems the best balance between risk and reward.
  3. However it’s measured, momentum is a trend following approach and is therefore prone to whipsaws, especially in sideways markets. Including 20 highly correlated stock ETFs in your system is going to multiply whipsaws by at least 20-fold as it jumps from one to another, while adding far less than 20-fold improvement in returns.  Pick one fund in each asset class (preferably the one with the lowest cost and highest daily volume) and leave it at that. If you can’t hold the line there, then split your money and trade separate portfolios to limit the number of trades between correlated assets. One pot for international, one for domestic, or whatever floats your boat. Putting it all into one bucket will chop you into ribbons.
  4. Cash is an asset class which should be in any TAA system. It’s been almost 40 years since cash was truly king for any length of time, so it’s easy to dismiss the value, but that also means the next coronation is that much closer.
  5. Forget benchmarking. Beating some index means nothing to you as an individual. Your personal goals alone should determine success or failure. Technically, if you are beating inflation by even a little over time, you’re ahead of the game – and over sufficiently long periods I’m not sure much more is possible. If that’s not enough for you, reevaluate your spending and goals. Money is only a means to an end. Figure out what ends you’re really seeking with your money chase. Here is a good one (via Abnormal Returns).
  6. Test your system over as much data as you can and with the worst cases you can devise. Don’t assume the 20th century was a representative sample. In the last part of the 19th century deflation was frequent, incomes and GDP rose at the fastest rate in US history, and the stock market went pretty much nowhere for long periods. If the world has to make sense to you for your system to work well, it’s doomed.
  7. Simple = robust. It’s the fifth law of thermodynamics or something.
  8. Devising a system that’s truly agnostic about the future is extremely difficult. Biases resulting from early experiences can shape a lifetime of investing. So many assumptions are buried in how you view the world and markets, it’s hard to discover and unravel them all. Read every market history you can find to gain a better understanding of the possibilities.

Though successful investing can be described very simply, implementation soon reveals an abyss of chaos and confusion lurking behind those simple ideas. In moments of despair, remember that living below your means will solve the majority of your financial problems given time, regardless what happens in the markets. Your most important task as an investor is to avoid making that too difficult.

The Trouble With Indicators

Market indicators can be like the mythical sirens luring men to their doom. With an irresistible song promising to pick a turning point or signal a trend, they all have the allure of nailing it at some point. But what’s the single best market indicator? Price, plain and simple. It may not be the most satisfying answer, but it’s the only market data that directly changes your account balance. No matter what arcane financial alchemy you can devise, price will always determine its success or failure.

Unfortunately for dreams of easy riches, price is also one of the worst indicators for gaining an edge over the competition. It’s the most widely watched number there is – even your favorite contrary indicator relative knows when the Dow hits a round number. Further, no matter how much fancy math is applied to the price data it can’t increase the amount of information it contains. As a result, the long run results of any system based on price will be quite similar to those of a simple moving average. You really can’t squeeze blood from a turnip.

In trying to overcome these downsides investors turn to indicators like volume, breadth, sentiment, intermarket analysis, and countless others – even economics (a clear indicator of desperation). Though these all add potentially useful information, it comes at a significant cost: They will all hurt your returns. They aren’t 100% correlated with price, so by definition there will be times when price does one thing and they do another, which ultimately leads to additional losses. To avoid that it’s tempting to add more indicators, each attempting to overcome the shortcomings of another, but that’s a sure path to decision paralysis. They’ll most often be contradictory with no clear signal, and in the rare case they’re in agreement they’ll almost certainly be wrong. [1]

What’s the solution? The ideal approach depends on your personality, but the generic version is to change your goals from beating the market to coexisting with it. Buy and hold is almost impossible to beat for mere mortals so stop adding complexity and risk trying to do it. As long as humanity avoids a downward spiral to extinction, a basic moving average system can perform more than adequately to fund a comfortable retirement over a career (see here and here). In many cases outperforming the broad averages on a risk-adjusted basis, while requiring very little time.

That seems like an easy sale, so why don’t more people keep it simple and avoid the troubles with indicators? First, because humans are never satisfied with anything for very long, the urge to tinker and “improve” can become nearly irresistible. Second, individual psychology can make simple trend following approaches difficult (typically due to a need to be right or feel superior), and it can take years of work to alter those preferences. Lastly, “outperforming on a risk-adjusted basis” is really just another way to say “underperform with smaller losses.” Even though that may be the optimal strategy for most people, it can be hard to stomach when trapped in conversation with the latest crop of bull market geniuses who’ve all doubled their money in the last 3 months.

The real money is made by people who are still playing the game 20 or 30 years later. If it takes very low drawdowns to keep you from bailing out, that’s the best approach for you to achieve your goals, even if it means lagging some benchmark to the point of embarrassment. You don’t have to worry about losing assets under management or beating the competition, the happy ending is all that matters. Leave the cornucopia of indicators to the flash in the pan home run hitters. Sustainability is the real key to financial success.

______________________________________

[1] Not because that’s just your sorry luck, but because other market participants will make trades based on far less information while you’re waiting for a consensus, effectively front-running any trades you finally get around to making.

Automation =/= Salvation

Today software is often seen as the solution to nearly all of mankind’s problems, and to an old fart like me, when I’m not swearing at it too much to notice, information technology can indeed seem nearly miraculous at times. But before allowing yourself to be overcome by the siren call of technology as the solution to your problems, here’s something to consider: If you can’t get a slow, manual, human-based process to work well, all that automation will do is allow you to screw up at a much faster pace, with every mistake instantly propagated throughout the system.

The latest software and technology doesn’t guarantee success, and the lack of it doesn’t guarantee failure. The process itself is far more important than the platform and software than runs it, whether it’s a co-located HFT black box or the wetware between your ears.

A Harsh Reminder

I’m taking a break from my break to bring up an important and frequently forgotten rule, unfortunately inspired by this: Hiker who died after falling from Palolo trail ID’d

I was first made aware of this rule by a man working for the electric company way back when they had to physically climb up the utility poles to do repairs.

The Three Point Rule

It’s quite simple: Maintain three points of contact at all times! One hand and two feet, two hands and one foot – in dire straits I suppose one hand, one foot, and your teeth could count. Holding onto someone else only counts in a life threatening situation where the other person volunteers to risk their life to save your stupid ass. Any time there is even the faintest, farfetched possibility of danger this rule must be followed without fail.

The point of the rule is if one point of contact fails you still have two more to save yourself. This also requires maintaining your balance to avoid over-reliance on those three points of contact. Therefore, leaning out to take a one-handed picture defeats the purpose and breaks the rule because if your handhold fails you’re done. Three points of contact are your insurance policy, but having insurance doesn’t mean you’re free to start a bonfire in your living room.

When I talked that lineman he was nearing retirement and had never had an accident on the job. He told me the most dangerous time was when the new guys had been on the job just long enough to get comfortable. They’d been told the rules and heard all the horror stories but they’d almost invariably stop following the rules because they no longer felt the same fear as when they were new, and before long they’d fall.

This applies to any risky endeavor really. Your level of comfort doesn’t change the nature of the situation. Comfort is more a function of familiarity and ignorance than actual risk. Follow the rules and live to risk another day.

Epistemology on the Beach: Questions About Skill

How much skill is possible in the markets? I think the answer is often far less than we like to assume, yet that answer should impact everything you do. At the extreme, if the future isn’t predictable to any degree then any perceived skill becomes merely a comforting fiction. The older I get the more I conclude that we all succumb to that fiction to a significant degree. I think some level of skill is possible, but not an impressive level, and certainly not market-beating skill over the long-term.

For example, one fiction may be that successful investors pick a style of investing that suits their personality. This seems quite reasonable because any strategy can only work if you stick with it, and it isn’t hard to find examples that support the idea. However, it may succeed only because it reinforces a lucky match between personality, style, and market conditions. Those with the right personality for the times survive and are remembered as the investing greats of that era and the rest fade into oblivion.

Mauboussin and others have said the ability to lose on purpose is one way to distinguish skill from luck. That’s an appealing idea since it’s easy to imagine taking the opposite position on all your best trades and conclude your success is largely the result of skill. But could you really go against your natural inclination, take the opposite side of the trade, and then manage the position to realize the expected loss? If your behavior isn’t held constant why are you allowed to assume everything else would  be? Human preferences aren’t static so it’s never as certain as it appears.

Mauboussin further argues that results in the markets end up depending mostly on luck because of the preponderance of skilled participants. I appreciate a compliment as much as anyone, but a simpler explanation is that the skill market participants feel they possess is an illusion. Regardless the cause, the numbers give strong evidence for market performance being far more luck than skill. Over any significant length of time the number of market beating investors is so small it’s entirely consistent with them being nothing but examples of survivor bias, regardless how compelling their rationales and manifestos may be. According to this bracing summary, less than 1/4 of 1% of mutual fund managers beat the market over 10 years (and hedge fund managers fare no better despite, or maybe due to, far greater latitude in investing decisions). Further cheery news can be found here, which also makes a good case that the dumbest money is also the smartest  Worse yet, over an investing lifetime the odds are likely even more unfavorable [1].

In thinking about the future, I view this universe as just one trial out of an almost infinite number of rounds. Learning a particular set of skills and taking certain actions can lead to particular outcomes in ways that, in hindsight, can seem almost preordained. However, that’s just one trial. Since markets move based on the changing preferences of the current participants, executing identical steps in similar situations in another trial may lead to very different outcomes, and we have no idea what the distribution of outcomes looks like on that meta level. Starting again from time 0, and ending right here, reading this, has a probability of approximately equal to zero.

Question #1: Trading is always a matter of odds and small edges. No matter how long your trading career, it’s only a very small sample from a vastly larger unknown population. Your results could be entirely from sampling error. In how many universes do you think your attempted losses to prove your skill would actually be realized?

Question #2: A number of experiments have caught humans unconsciously making up reasons for rapid, instinctive behavior after the fact. In some cases the subjects remain unaware of this reversed causality even when their explanation is preposterous. To borrow from Taleb’s title, how do you know you aren’t being fooled by randomness and then inventing skill as the explanation for your success?

Question #3a, b, and c: There’s no disputing it feels like market success requires skill, but some gamblers have an equally intense feeling they’re on a hot streak. Would the skill to beat the market feel different from the skill to under-perform in a sustainable way? Even over a number of years, both could result in similar strings of winners and losers, with similar returns. How do you know which you have? Many have been very wrong about that answer and in fact had neither skill (see here for an amusing rundown). How do you know you aren’t one of them, waiting to be discovered?

Question #4a, and b: Imagine you are transported 500 years into the future and forced at anti-matter gunpoint to get into the market, without really understanding what’s being traded, what’s going on in the world, or if any other market participants are human. What approach would you use? How is this scenario significantly different from the situation faced every day in the markets?

Think about it for a while. Do you feel shaken and humbled yet? I often feel as though I’m flogging a dead horse when I write about money. It’s all been said before, many times, from many perspectives. I keep doing it because maybe this peculiar version, at this equally peculiar time, will click with someone. If not, and you’re still feeling smug about your skill, ask a significant other for assistance in increasing your humility. They’ll probably jump at the opportunity.

______________________

[1] For another example see Warren Buffett: More myth than legend  Great success, whether from skill or luck, quickly leads to managing an enormous pile of cash, and it’s hard to beat the market when you are the market.

Ignorance Can Be Bliss

There is an absolute limit to how much profit can be extracted from a market in any particular period of time. You will never make as much profit in the markets as hindsight and imagination can lead you to believe. Back-tested, theoretical profits will be devoured by a nearly limitless number of factors. The biggest profit eaters are shown below:Losing Your EdgeLosses from slippage, not following the plan, commissions and fees, taxes, and the relative merits of different investing styles have been covered endlessly in the financial press. But the biggest factor is largely ignored. NASAYAYA: Not As Smart As You Assume You Are. Welcome to the future! The place where everything is out of sample and all that is certain or assumed goes to die a grisly death. You think you know X. You’re certain about Y. You think 10 years of intraday data is a representative sample of something other than those 10 years. The market will react the way it “should”. You feel your past results are mostly the result of skill. Whatever it is, the more you think you know, the greater the odds that you don’t know shit. Understanding comes with a curious byproduct: The more you know, the more you know you don’t know. Thus, true insight can only come with a generous side order of humble pie.

I’ve become increasingly convinced that trading nirvana is reached when you accept your near absolute ignorance in the markets. As dangerous as the inherently uncertain future is, it’s a known unknown. The unknown unknown, and even more dangerous, is what your preconceptions are blinding you to right now.

Ben Bernanke once said he was unable to imagine a set of circumstances that would convince him he was wrong about the economy. Burdened by that level of certainty he has no real choices or flexibility left. In his world he can’t be proven wrong and if you’re right, why change?

That’s the exact opposite of where you want to be in the markets. When you accept the completeness of your ignorance you’re free to listen to the market and go with the flow. Whatever theories, beliefs, preferences and biases you have lose their power to blind you because you know they’re all crap, and any help they may provide can only be temporary.

So take a seat. It’s time to start the meeting…Hi, my name is Mortalitysucks and I’m an ignoramus.

________________________________

Next time: Knowing enough to know you don’t know much of anything isn’t the end. The next rung on the ladder of enlightenment is answering whether it’s even possible to know anything. In other words, is there really such a thing as market-beating skill? How should the answer alter your approach?