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.

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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?

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Riding the Falling Knife

Everyone is familiar with the old warning about not trying to catch a falling knife, but what if you’re already holding the dull end of that knife?

Let’s say the market is down 30% from recent highs and you’ve been short most of the way down. The prior day was a 5% down day on less than impressive volume, and today is already looking just as ugly. You’re making money hand over fist, and another big down day could add 15% in a day if you’re leveraged. Jack Schwager is bound to be emailing about his next book soon. What do you do?

Get out. Now.

Especially in the current climate, the conditions described are the perfect fuel for large, unpredictable, ham-fisted interventions. Banning short selling, closing markets, direct Fed purchases of whatever they feel like, even banning selling altogether has been tried in some countries (though it didn’t work either). Even without outside interventions, volatility cuts both ways. When the daily range gets too large in a one-way trade it’s a virtual certainty it will soon be equally large in the opposite direction, vaporizing your profits as quickly as they appeared.

It isn’t easy to abandon your fantasies when a short trade is wildly exceeding expectations. Getting out early will often leave money on the table, sometimes a lot of money, which can be very hard to tolerate. But consider how it would feel being stuck in a short while the exchanges and government engineer the biggest rally in human history before reopening the market, or if the market leaps over your stops and keeps on going, vaporizing your paper profits with the fill from hell.

Climactic declines happen the way they do because there really aren’t that many people willing to try catching falling knives. When they happen it can be a great time to be short, but don’t let greed blind you to the danger of trying to ride that falling knife all the way to the ground.

* For the bulls feeling ignored by this post, turn your tablet upside down while you read and think of Apple’s recent parabolic rise.

That’s Gonna Leave A Mark

It’s often said that picking bottoms is easier than picking tops. Logically this can really only be the case if people are using somewhat different definitions of bottoms, but I think for most it remains true in practice. However, bottom calling based on one or two indicators, while ignoring the larger context, can lead to trouble.

I always think of Tommy Boy getting bashed in the head with a 2×4. When a significant decline or negative event happens, it’s going to leave a mark. There will be echoes that reverberate through the markets as people adjust to the new reality, and how long that lasts will be somewhat proportional to the size and circumstances of the decline.

As an example, here’s a fairly run of the mill decline from the Fall of 2011:

The first drop wasn’t huge, less than 20% top to bottom, and ended with a typical volume spike. The EU troubles were in the news, along with the usual wall of worry, but mostly the market had gotten overextended. After the first bottom, the market chopped around for a while before it retested the lows, but on lower volume. There was another low volume head fake, but that’s pretty much all she wrote. Basically a slap in the face with no lasting damage, consistent with the overall context.

On the other hand, the late 2007 to 2009 period provides a great example of leaving a mark:

Though the news near the end of 2007 might have predicted otherwise, the initial drop in early 2008 was fairly normal. The period between the two bottoms was perhaps longer than the percentage drop would indicate, and the rally attempt was somewhat abortive, but the action still reflected a market taking a fairly typical heavy blow. But at that time that reaction itself was a problem since it didn’t reflect the magnitude of events that were happening. The news continued to worsen but the market rallied for a couple of months in Playtex mode (no visible means of support) before failing to make new highs.

The initial bottom after the Playtex rally could easily be rationalized as the start of a long trading range along the lows while things worked themselves out. Looking only at the chart, it was a good place to scale back in; all that was needed was a rally and retest. In fact, without paying attention to the broader context, there were four, and maybe five, justifiable candidates for a good bottom as they were happening. Instead, context grabbed a 2×4 and swung it with both hands, and jumping in at those seeming bottoms would have been ugly.

There are many indicators which can be used to signal a bottom: Breadth, volume, new lows, daily range, volatility, options ratios, and others. But nothing is foolproof in the markets – banks have paid a lot of bonus money to people who’ve proved it – and considering what mark the broader environment will leave can help improve your odds. Was that a fist or a 2×4? 

My One Investing Rule

There are many lists of investing rules, and many contain very worthwhile, valuable advice. I’ve even read some of them. The trouble is investing is a complex cognitive process, frequently accompanied by extreme pressure, and there are limited cognitive resources available to cope with it. In those circumstances, your odds of thinking of the most relevant principle out of a list of five, let alone a dozen or more, is near zero. So I try to stay out of trouble with one, and only one, rule:

It’s never that easy.

I know what you’re thinking. That’s freaking brilliant! Why didn’t anyone else think of that? But it’s not just the usual idea that you can’t get something for nothing that makes this rule important. It’s that very rarely it can seem like you can, and it’s those rare instances that are your worst enemy.

Investing is a process which takes time, effort, and execution in order to succeed. It also inherently involves a significant element of randomness. You may find a deal or trade that makes your head spin with the riches that await you, and the nature of the game means there’s always a chance you’ll be correct. Everyone has heard stories about some lucky bastard or other, and human nature makes it all too easy to believe it’s your turn to be that one lucky bastard. But it’s far more likely you’re simply overlooking something important and the seeming manna from heaven landing at your feet will later cause you to grab your head in both hands, wail and moan like a wounded animal, and wish that god had struck you dead before you got out of bed that morning.

Markets aren’t completely efficient, but they are mostly efficient. Easy money tends to be rapidly removed by the largest, fastest, most connected participants. In other words, someone other than you. When you’re in a groove, trading can indeed be easy, but not that easy. If you think it’s your lucky day, always think again. Twice. Do you really feel that lucky, punk?

Speculating in Life and Markets

Trading and life are both unavoidably speculative ventures. The future is always unknown and every choice is made in uncertainty. It stands to reason that dealing with life and with trading and investing should be very similar. Yet it often doesn’t work out that way. As Josh Brown wrote in Nine Financiers, “…The life of a professional speculator is an unpleasant one, filled with highs and lows but ultimately unsatisfying and, in all probability, mentally ruinous…” It’s not a very alluring sales pitch. But even though life beyond the market can be quite brutal as well, relatively few people view it in similarly stark terms. Are people overlooking the difficulty in life, or focusing on the wrong things in trading?

The most likely answer is both. Perceptions, and the resulting emotions, make all the difference in the quality of experience. Humans have an inherent optimistic bias in life. Evolution favors those that keep trying despite the facts in order that a few may get lucky. That bias can get derailed in trading and investing because the market is in some sense designed to prey upon our inherited decision-making heuristics. But that doesn’t mean it should be an inherently intolerable place. Life can be made as hectic as any trading day, or trades can come as rarely as you wish. Responsibility can mean burden and blame, or the freedom of controlling your own destiny. A loss can be a mortal wound to your inner self, or simply the act of buying an admission ticket. Money can be the focus of your life, or just the means to enhance it.

People bring the same basket of personal qualities to all of life. Troubled trading means a troubled life; a troubled life means troubled trading. They are both a reflection of you. At the most fundamental level, markets of all kinds exist to facilitate getting people what they want. If that’s not happening, the solution to your troubles is most likely to be found by looking in the mirror.

10 Answers To The Biggest Market Questions

As part of my continuing commitment to public service, here are the answers to the biggest questions about the markets. You can finally stop asking them.

  1. Why did the market do X? There are so many participants in the market, someone probably bought or sold today because their favorite popsicle was out of stock at the grocery store. Whatever reason you can invent, someone somewhere probably acted on it. The result of all that foolishness is the market price. Thus, the real answer to “Why?” is always the same: All of the above. A useless answer to a pointless question.
  2. Are the markets rigged/manipulated? Of course they are. Face it, if you don’t think you know something the other guy doesn’t, you shouldn’t make a trade. Don’t act surprised that everyone else tries to gain an advantage too. But until some legislator passes a bill that requires you to invest, your participation is voluntary. Figure out a way to deal with “unfair” markets, or take your ball and go home.
  3. Don’t I have to be in stocks to be able to retire comfortably? No, you need to save money in order to retire comfortably. What you do with it after you save it isn’t that important. When your costs decrease, the options you have in life increase. You become more free. People die to be more free, while you fritter your freedom away buying $5 cups of coffee, a McMansion, and a mid-life-crisis-mobile. Making up for that is what requires taking bigger risks.
  4. Is there a secret to success in the market? Yes, stop looking for a secret. One of the things that makes the markets so fascinating is that investing can be as hard as you want to make it. Like a Chinese finger trap, if you stop trying so hard it’s easier to succeed. Being simple doesn’t mean a strategy can’t work. Simple is often the hardest thing to do, so it will continue to work because few people will actually do it. It’s so much more fun to keep tinkering until you achieve a Rube Goldberg level of complexity and then sell it to some sucker, probably in local government.
  5. How can I turn $10 into one billion dollars? There are three ways: 1) Become a central bank 2) Use a magic marker, a lot of confidence, and a winning smile 3) Become immortal and avoid currency collapses. The second method is probably the most achievable.
  6. What will the market do (tomorrow, next week, next year)? Trying to predict the future is almost as foolish as thinking anyone who could would give you an honest answer to the question. Based on my proprietary indicators and years of research, I can guarantee that over any period of time the market will do one of only four things: Go up, go down, do nothing, or be closed. Be prepared for any of those events to occur at random and find a way to make money in all of them.
  7. Should I become a full-time trader? If you have to ask, then the answer is no. When you’re ready to be a full-time trader, you will take a vacation from work and one year later realize you never went back. When you have tough times, getting a job again won’t be something you consider. It’s like masturbation: You know when you’re ready and don’t need to ask someone else if you should.
  8. Which is better, fundamental or technical analysis? Both. All value is subjective so no truly objective measurement of it is possible. Fundamental analysis ensures you will eventually have a number of similarly deceived fools on board your ship, while technical analysis tells you what the rest of the fleet of fools is doing.
  9. Why should I believe what you say? Because you are a self-selected sample. You have no idea what to do, otherwise you would never click on a headline like the one I used. More importantly, I can help rationalize your decisions, while flipping coins can’t.
  10. ___________? The markets, like life, are full of disappointment. I’ve omitted the tenth question to allow you to hone your coping skills.

Your Personal Circuit Breakers

One of the most important lessons to learn as a trader is when to stay out of the market. If either you or the market strays too far from normal, it’s time to pull the plug. Exchanges have circuit breakers and so should you.[1]

Having stop-loss orders in place every time you enter a trade should go without saying, but there is more to risk management than position sizing and stop placement. Your edge exists only in conditions similar to those in which you developed it. If you can’t objectively identify what those conditions are, you will at some point be placing trades where you have no edge at all. No matter how obvious this sounds, don’t assume you’ve already sorted it out. Make a list of the conditions in which you have an edge, to prove to yourself you know them. If those conditions aren’t present, stay out. No excuses. Go to Vegas if you want to roll the dice.

In addition to keeping you out of unfavorable markets, personal circuit breakers must also address the single biggest danger to your account: You. Markets have six standard deviation moves only rarely; individuals often do. A risk management plan that doesn’t include the events in your life and your mental state is a plan to fail. Divorce, death in the family, illness, accidents, legal troubles, fatigue, disinterest, burnout, your losses and gains, extreme market volatility, and even how wobbly your chair is (see here) can alter your judgment and ability to appropriately respond to the stresses of trading. No one can handle an unlimited amount of stress. A single, small event may be all it takes to put you over your limit to the point where trading would be a mistake. Make assessing your mental state a part of your daily routine. Know and respect your limits.

If you’re often the last to know when you’re losing it, pay more attention to the reactions of those around you. Rather than arguing about whether you’re acting like a crabby two-year old, or whether you’re in a bad mood all the time, recognize those reactions as a sign that your circuit breakers have been triggered and it’s time for a break. Being taken out by your circuit breakers can be hard to stomach, but returning refreshed with a new perspective is often when performance breakthroughs are made.
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[1] Except your circuit breakers should be meaningful, effective, and unbiased.