The Truth About Investing

According to Buffett’s Alpha, one of the main reasons for Buffett’s success is, “he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies.”

Investors have an uncanny knack for underperforming whatever strategy they claim to be using. The reason is, regardless what method is used, the most critical variable in its success or failure is you. All investment strategies have discretionary and active elements which depend on the actions of a frail and faulty human being, and that human element contains the potential destruction for every investing strategy.

The truth about investing is this: If I gave 100 people the mythical Holy Grail of trading systems, one which could never have a losing year, very few of them would still be using it 10 years later. You’re far too smart for that to happen to you, but what if:

  • The first 11 months of use resulted in significant losses.
  • A friend of a friend made three times as much last year.
  • Any idiot would have known the last 5 losing trades weren’t going to work.
  • The average annual return for the previous five years was a mere 1.3%.
  • You know the system is wrong about a trade, and the last 3 times you felt that way the system was indeed wrong.

Suddenly it’s not so easy. A nearly infinite number of things can result in the loss of confidence, second-guessing, and eventually abandoning a plan. Perhaps to avoid taking responsibility, investors often spend the bulk of their time on the external: The unending search for some better, smarter strategy, asset allocation, or risk management tool. Beyond pandering to the fruitless desire for certainty amid chaos, that outward focus pushes you to become a kid in the strategy candy store, lured by every new analytical temptation you see. Spend enough time in that situation and even the most resolute will suffer from willpower fatigue.

Instead, the focus should be on the internal: Understanding the feelings and emotions that drive your investment decisions. Remaining consistent over many years despite doubts and conflicting feelings, rather than any particular investing style, is what determine success or failure in the markets. The best returns with any investing style typically occur after prolonged bad patches, decade-long bad patches in some cases, and those higher returns go to those who have stuck it out rather than wandered off trying something new. Good investing should be a pretty boring affair. If that bothers you, find an exciting hobby to stay occupied.

This doesn’t mean you should never change your investing style. You may very well be more successful trying something else. It won’t be because the historical returns are marginally better (and definitely not because the backtested returns are a work of heavenly beauty), but because it’s one you’ll still be using long after it has fallen out of favor.

Finding Value

When you’re trying to find the best values in any market, you’re looking for a diamond hidden in a huge pile of manure. To find those rare diamonds you have to expect to spend virtually 100% of your time looking through shit. That’s what keeps other people from finding it first. If you want to spend all of your time looking at diamonds, go to the jewelry store and pay their 1000% markup.

That was my explanation of the need for patience when three real estate deals in a row fell apart a few years ago. Finding value isn’t for the impatient. Most of your time and research come to nothing and that can become very frustrating. The longer it takes, the easier it is to convince yourself that you have to pay up to get something worth buying. But you don’t. An individual – not handcuffed by a prospectus or investor pressures – can always keep their criteria unchanged and wait for something better. That’s a big advantage.

Finding An Edge in Life

Perhaps the most puzzling thing in my Temporal Spatial Arbitrage post was the idea of having a trading edge in life. That may be a great idea, but if all decisions in life are considered trades what on earth would an edge even be?

Reading the literature on success one could reasonably conclude that self-control, perseverance, and focusing on the process are the recipe for achieving goals. As far as that goes, I agree. It’s hard to get very far at anything without those qualities. But none of them have much to offer when it comes selecting what trades to make in life. Without some other elements, achieving what everyone else does, in largely the same ways they do, will be the most likely achievement. Why? Because your direction will be set by others, by societal custom, social expectations and pressures. Unfortunately, the odds of that being ideal for you – or of finding a shortcut to where you want to be by going along with that – are rather slim.

What else do you need? I think these are the main qualities that contribute to having an edge in Temporal Spatial Arbitrage, all interrelated:

  1. Self Knowledge. One of the biggest problems humans have is that we are very poor at predicting our emotional responses to future situations. Operating with faulty assumptions about how we will feel, we often reach our promised land only to find it wasn’t worth the trip. The better you know yourself the more likely you are to make the right choices for that future you. Yet no matter how well you know yourself, asking friends and family what outcome would most suit you will still very often be a better predictor than your own opinion.
  2. Adaptability. When the environment in which you’re operating changes, you’re able to quickly jettison your baggage and go with the flow. It may not provoke much envy but the less income you need, the more options you have, and more options equals greater adaptability. Minimalism can be very helpful, particularly since it often means less debt, plus it helps decrease your daily mental load.
  3. Independent thought. If you aren’t comfortable going your own way, it’s almost impossible to optimize your life. It’s tempting to call it being contrarian but too often that’s seen as going against the crowd regardless the situation. Truly independent thought is only intermittently divergent. Certainly, fitting with your personal ecology is important to a good life (see here), but that should influence implementation more than direction.
  4. Ability to vary perspective. Ideas precede actions. Therefore, significant change can’t happen without first seeing something in a new way. Creativity is only part of it. If the way you look at things is similar to other people, you will be condemned to following in their footsteps, albeit loosely, no matter how many new ideas you can generate. In the same way as forcing a smile can make you feel happier, changing perspective can be as simple as sitting in a different chair, facing a different direction when you think about a problem.
  5. Self Confidence. Every person is unique in the universe, so creating the ideal life requires going into uncharted territory to at least some degree. This necessity is much easier to embrace if you have confidence that no matter what happens you’ll find a way to make it work. Sadly, for some people this confidence will be misplaced. Happily, that number is far lower than an opinion poll would indicate. Experience is generally the best path to confidence, but don’t forget humans didn’t get this far without a remarkable ability to cope with disasters large and small – and often self-inflicted – so failure is nothing new and most often survivable.

Unfortunately, it’s not as simple as having the pieces and, voilà, everything changes. The qualities above are somewhat circular: Significant self-directed life changes aren’t going to happen without them, but if you don’t already have them to some degree the odds are low that opportunities for change will be identified in the first place.

Learning to be a successful trader certainly helps. Trading in the markets is a mirror of your inner mental life. Learning that the battle is with yourself rather than with the market is a major milestone in any trading career, and one which can have a multitude of positive spillover effects. Even if you decide it’s not what you like doing, or never make much money, it alters how you see the world and yourself, and improves the ability to find new opportunities in new places.

Ultimately, I think some sort of trigger is needed to crystallize all the pieces into a new world view. What that trigger could be for a particular person can’t be predicted or prescribed, but given time life is almost certain to present a suitable crisis for those on the verge. In the meantime, act like a two-year old and always ask why. It gets irritating when they do it, in part because they frequently succeed in demonstrating you really don’t know what you’re talking about, so avoid their noise and smell and provide that service to yourself. It’s shocking to discover how often you don’t know what you’re talking about regarding your life, and how much of what you do has been adopted unexamined.

Why do you need that job? That person in your life? Why do you need to spend your time doing that? Even if you are the hyper-analytical type, thinking you have all the questions answered, with a 10 year spreadsheet full of variables and assumptions for inflation, income, expenses, taxation, and a target retirement income (and I’m not admitting anything), it’s the unstated, unquestioned assumptions that will be the killers. For spreadsheet gal, can you truly stand getting out of bed each day, doing what needs to be done, where it needs to be done, to hit the needed numbers, when the entire exercise is motivated by the desire to escape from that grind to retirement as soon as possible? Probably not. Then there’s the idea of retirement; that hazy, unspecified paradise that awaits somewhere beyond the world you currently inhabit. Perhaps you should start asking a few questions about that too…

Why? Because I said so.

TAA: 2014 Year in Review

This was the first full year of real-time testing using a secret sauce version of the TAA system I wrote about here. I used three different baskets of ETFs to see what damage the future would do, each based on a different philosophy, and each trading once a month.

In a year where the S&P500 returned 11.39%, here’s how it turned out:

2014 Return

Backtested Exposure

Annual Return


Backtested Max System Drawdown

Backtested RAR/Max DD

Basket 1







Basket 2







Basket 3







[Slippage and commissions are included, but not dividends]

The best backtested returns (and highest volatility) led to the worst returns in 2014, the worst basket in backtesting was the best performer in 2014, while the most diversified and theory-free basket was closer to the bottom than the top for the year. Exactly as expected, everything is as clear as pea soup. So now what?

I think that mostly depends on psychology. The statistics I chose to display are the ones that tend to push my buttons, so I strongly prefer systems that do well on those measures. If I were a risk-seeking gambler, I’d change the system to trade only the top fund, instead of the top two, and use Basket 3 hoping for a wild and profitable ride.

At this point in life I’m not a risk-seeker (it finds me without any help), so I’m hedging my bets by putting 50% in basket 1 – which I think is the most agnostic about the future – and 50% in basket 2. Basket 2 gets the nod for simplicity. It’s the ringer of the bunch and only switches between the S&P and cash, so it has fewer trades, no fund selection dilemmas, will work even in THE Woman’s very restrictive 401(k), and manages to be out of the market ~1/3 of the time, eliminating a lot of risk from unknown unknowns.

Time will tell…


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.