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How to Lose $3 Million in 1 Second

Losing money is one of the loneliest feelings. It was Oct 22nd, 2008. Lehman Brothers, the investment bank, had filed for bankruptcy the month before. The markets were panicking. A thousand people surrounded me, almost all of us slouched in our seats, staring at computer screens. I had eight, all flashing prices of assets that I couldn’t touch, but, oh, I could feel.

I myself was waiting for one price to flash, an interest rate in Brazil. I had bet that rates would lower over time, from 15.10% to 14.50% or so. The size of my bet was 20,000 USD for every one hundredth of a percent (or 20k per basis point). A move from 15.10% to 15.00% would make me 200,000 USD. A move to 15.20% would lose me the same amount.

I sat with a knot in my stomach, nervously chewing a swizzle stick, waiting for the markets to open in Brazil at 7 am. I jotted down worst-case scenarios, and then turned them into doodles. The default of Lehman had unleashed market hell. I closed my eyes. You could hear the markets, a trading floor filled with murmurs and sighs, the cumulative sounds of disappointment.

The Brazilian rate was a tiny yellow box on one of my screens. I had been in the office since 4 am, waiting, trying to extrapolate from other prices, from other assets how much money I would lose (or make). The price the following day had closed at 15.90%.

This day all assets, stocks, bonds, commodities, interest rates, everything, were trading in two distinct camps, going opposite ways. Most prices were falling, dramatically. A full-on Guppy Suck: Prices were spiraling lower like dead fish flushed down a toilet. Money was going into a few lucky assets, safe havens they were called, things considered having no market risk. Short maturity US bonds. Cash. The correlation between assets was approaching one or negative one.

My Brazilian rate started trading. It blinked 17.40%, 1.50% wider than the prior day. I was out 3 million dollars, and I had no chance to trade. No chance to get out at 15.50% or 16.00%. The market had gapped. I got up, shot a bird at my screen, punched it, and then walked to the bathroom.

More here – Scientific American

Would You Take The $10M


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Hindsight Is The Perfect Investment Tool

I got bounced the table below the other day for comment which is interesting because my comments are generally so what. I have no idea where it came from so cannot vouch for its veracity. So treat it with the usual caution you apply to something you have not generated yourself.

Asset comparison

I am not certain what the value of such tables is unless it is to convince us all to put our energies into investing a time machine so that we can go back in time and load up on Bitcoin, although this in the manner of all paradoxes would probably remove the value of the event. However, the table does serve some instructional value in that it only tells part of the story – so I have redone the chart and added in the MaxDD for each instrument over this time frame.

r2

For shits and giggles I have also added to the table the total Division One Prizes for Powerball since 2010, as you can see it is a very tidy sum. There are two issues that need to be addressed. The first is the obvious statement that the past is not the future. The failure to understand this is a mistake I used to see brokers make all the time. Periodically our research department would produce a list of the best performing stocks on the ASX, the dealers would then be encouraged to get on the phones and sell these stocks on the basis of what they had done in the past. Clearly this reflects a breach of the past is not the future doctrine and is something that is even reflected when performance results are presented to retail investors. These investors are constantly warned that past results may not be reflected in future results and this is a reasonable warning.

The other point that needs to be made about this sort of table is that the trajectory of the price of an instrument in obtaining those returns needs to be considered. You have to ask yourself whether at any pint during your investment in Bitcoin whether you could stomach an 80% drawdown. My guess is that most would not be able to hang on through this sort of event, even if they were informed that price would recover.

Compounding – if you live long enough to enjoy it.

I have just finished reading Edward O Thorps autobiography A Man For All Markets which is an excellent little read and a good addition to any traders library. In the book Thorp talks about he value of compounding returns. There is no doubt that success is trading or investing is based upon compounding your gains over the long term. Compounding is a wonderful tool in that what seem to be small quanta of difference can over time lead to an enormous difference in returns. For example an investment with a return of 10% compounded annually for 10 years yields $259,374 whereas the same investment compound at 11% yields $283,942. Extend the holding time to 20 years and the figures becomes $672,750 and $806,231 respectively. Time is the key to compounding and this is a point Thorp makes, he also makes the important point that most lack the patience to do this.

However, there is a sting in the tale of compounding that I have noticed that those on the sell side of the business either abuse or simply do not understand and that is one of scale. You will often see very long term charts of an index or an instrument and it shows a wonderful upward trajectory (well you wouldn’t show things that didn’t work) and the message is that you simply have to hold for whatever the requisite time is and you will eventually have a small pot of gold. The key word here is eventually because what is often overlooked is the time to achieve these mythical gains. There is no doubt at all that compounding is a very powerful tool and when combined with consistency and patience achieves remarkable things.

However there is always a but we need to be aware of. To demonstrate this I found a centuries worth of data on the All Ords and using $1 as the starting investment plotted what the return would be over the next 116 years.

$1

If you had started with $1 in 1900 and simply let the compounding returns of the index take its course you would have $487,801.23. At first glance this is quite impressive – the markets very long term rate of return sits at about 9% and if you let it do its thing for a long period of time then you get an impressive number at the end. However, there are two things to be aware of in viewing this data. Firstly, the time taken to achieve your goals, not only is the time itself a problem but the erosion of the value of your investment over time is a problem. I had a cursory look for long term inflation data but couldn’t find much dating back beyond the 1940’s but if you assumed an average inflation rate of 4% then this puts a large hole in the real end value of your investment. The second issue that is not addressed is the trajectory of the journey – the chart above is not of a capital guaranteed term deposit but of an index. The somewhat linear trajectory of the graph is deceiving since it does not take into account the extended and deep bear markets that were experienced. There were years when the market went nowhere and these events are testing for even the most hardened buy and hold advocate.

Time is both the ally and enemy of those who understand how to use compounding and it is this dualism that we need to be aware of. The practical implication of this is to leave your money in your trading account for as long as possible before taking it out and spending it. The impact of large withdrawals is quite remarkable in the damage it does to accounts but some people cannot resist spending in the short term to ensure they live in poverty in the long term

Timing Is Everything

It is no secret that I am not a fan of fund managers of any kind, be they the more exotic style of hedge fund that exists as an idiot tax for those who invest in them, the standard vanilla equity investment fund or the legally mandated rip off that are superannuation funds. My objection is simple, if you are going to take billions in fees  from people then you had better deliver something other than perpetually under performing the market. In a puff piece that looked somewhat like a marketing exercise Morningstar the ratings agency has named the top investment funds in Australia and the list was picked up by Fairfax and covered here. I have copied the list of top funds below.

1491953010731

Source – Fairfax

The article talks about the value of investing in the number one ranked fund since it has outperformed the index over the last 10 years – this point got me thinking about using 10 years as a point of comparison and the notion of starting points in general. As a general point I find selecting 10 years interesting since it makes certain that the funds are compared against the index during and post the GFC and it doesn’t take a genius to work out that the average return from the index since that time has been poor.

I decided to have a deeper look at the impact of starting times upon portfolios by digging up some data on the All Ordinaries Accumulation Index which is now referred to as Total Return Index since it includes the return from both gains in the index and dividends. Starting in 1960 I looked at what your average return would be to the present day if you had started investing at a given point. For example if you had invested in an index linked fund in 1960 your average return up until the present date would have been 13.53% whereas if you had begun your investment journey in 1994 your average return would be 9.99%. This might not seem to be a substantive difference but over time it adds up to a small fortune.

Capture

What interested me when I looked at this data was the remarkably consistent nature of the returns – they are all positive. Whilst, this is to be expected it is nonetheless interesting that the index doesn’t put together strings of negative years and this is shown in the raw data that I will look at later. What is also evident is that there seems to be a tailing off in average returns which is more obvious when this data is plotted as a chart.

r2

The reason for this drop off can be found in the raw data as shown below. This data is the true return for the index for each year in the sample.

r1

In this table I have highlighted each year where the return was over 25%. You can see a cluster of such returns in the 1970’s and 1980’s with a drop off in 1990 and 2000 and since 2010 there has not been such a year. In performance outliers count disproportionately and when they are lacking things look bleaker. I have no real explanation as to the rationale for the drop off in returns although I would surmise it may be simply due to a lack of funds flowing into the market due to the real estate boom. My recollection of the lift in 1991 and 1993 where due in part to the pent up recovery in the market post the 1987 crash but also that real estate struggle under the regime of high interest rates so we had an asset rotation underway.

Despite this drop off in returns over the past decade there is still no compelling reason to buy a managed fund. However, it is important to note that these are average returns over deep time – it in no way diminishes the importance of not being in the market when the market has nothing to give you. What also amazes me about fund managers is that they believe timing is so hard when in fact with simple mechanical rules it is remarkably easy as I have already demonstrated here using the ETF STW. Trading is only as hard as you make it or in the case of fund managers it is only as hard as you want to make it appear.

 

 

 

 

Even The Best Stock Pickers Cant Beat Bots

BlackRock shook the world of active management on Tuesday when it announced that it had fired five of its 53 stock pickers. BlackRock will also move $6 billion of the $201 billion invested in traditional active management to quant strategies.

The announcement may not sound earth-shattering, but it augurs a larger trend: Traditional active management is dying, but perhaps not for the reason you might think.

 The evidence has piled up in recent years that the vast majority of active managers fail to beat the market net of their fees. A common reaction is that beating the market is too difficult and that it’s therefore a waste of time and money to try.

But just the opposite is true. As I’ve previously noted, the problem is not that active managers fail to outperform the market; it’s that they keep that outperformance for themselves through high fees. In the meantime, index providers have turned traditional styles of active management — such as value, quality and momentum — into shockingly simple indexes run by computers. Those indexes have beaten the market and are now widely available to investors as low-cost smart beta funds.

Smart beta has proved to be a popular alternative to traditional active management. According to Morningstar, investors pulled $313 billion out of actively managed mutual funds over the last five years through 2016. At the same time, they invested $314 billion in smart beta mutual funds.

More here – Bloomberg Gadfly

PS: This is not so much fear the bots as fear the model. It has long been known that humans cannot beat simple models that can be run on home computers. Stock pickers or analysts generally do not have a model for stock/instrument selection rather they have a very loose aggregation of factors that are based around the need for a compelling narrative. And narrative is the least reliable mechanism we have for making a judgement since it more often than not flies in the face of data.

WTF Is All The Fuss About

This article is apparently doing the rounds and it purports to look at the supposedly new development of predatory short selling and uses the attack on Quintix by the US group Galucus as proof of this and along the way we get the usual dose of perceived wisdom from Gerry Harvey. Whenever such a piece on short selling appears it is predicated on a few basic assumptions.

  1. Short sellers drive down the price of instruments thereby engaging in a form of pseudo market manipulation
  2. Short sellers tend to target decent businesses and decent people and are therefore un-Australian
  3. Short sellers know what they are doing and are always profitable.
  4. Knowing which stocks are being shorted will give you an edge.
  5. Predatory short selling is a new development.

The article identifies a series of stocks that are among the most shorted on the ASX and I have reproduced this list below since it gives me a starting point for looking at some of the actual data surrounding these stocks.

shorts

What I wanted to look at was some of the performance figures that you might derive from shorting these stocks. The first thing I did was assume that exactly one year ago 1 shorted $1 of each of these stocks. I then valued these stocks as of last nights close and generated the following table.

value of $1

The current value of this basket of stocks is $10.9, so in a year I have made $0.10, if I had simply bought the index and held it passively for the same period I would have made $0.11. Speculation has to be worth the effort, particularly speculation such as short selling that exposes you to substantial risks and can be regulatory and management nightmare. However, this sort of comparison is unfair since short selling is a trading strategy – it requires active management. So it would be more appropriate to look at the peak to trough movements in these stocks over the past year and this is what the table below tracks.

up_down

As can be seen some of these stocks have had substantial movements in the past year and there are only three where movement to the upside outpaces the move down. Interestingly, as a statistical fluke the average gain and average loss sits at 31%. From a trading perspective there always needs to be a recognition that stock prices move in both directions – unfortunately for passive investors fund managers only seem to accept that stocks prices move up. The value of short sellers is the knowledge that markets move in both directions and that this provides an opportunity for profit. However, this raises the additional question of whether short selling has both an influence on price and is utilized to make a profit. For this to occur large short selling positions need to be put in place whilst the stock is stagnant and then used to drive prices down. Therefore we should see an increase in the number of shorts before a stock falls and for this number to accelerate as pressure was brought to bear. To test this assumption I looked at some charts from the Shortman.com.au site which is used as the basis for the first graph in this piece and I have reproduced them below.

table

To be honest I am buggered if I can see a relationship between the lift on the number of short sellers and a decline in price. What I see is a mixed bag of short sellers being late, being early, not being there at all and getting lucky. Granted using the old Mark 1 eyeball is a dangerous thing and I cant extract the data to look at the true correlation between short sellers and price. But if it isn’t obvious then crunching it statistically to find some form of relationship isn’t reliable. So we come back to the basic questions I posed above and it is worth summarising an answer to each –

Short sellers drive down the price of instruments thereby engaging in a form of pseudo market manipulation

Not from what I can see. In fact if anything short selling is a boon to the market since it aids in liquidity, price discovery and as ASIC found much to its chagrin during the GFC it dampens volatility.

Short sellers tend to target decent businesses and decent people and are therefore un-Australian

People who complain about short selling fail to understand the basic mechanics of all trading is to elicit price discovery. The marekt then votes on its future view of this discovery – markets look forward not nackswards. So when you see the price of groups such as HVN get the wobbles it is the market voting about what it perceives to be the future prospects of this company in light of changes in technology, consumer bahvious and competition.

Short sellers know what they are doing and are always profitable.

Not from what I have seen

Knowing which stocks are being shorted will give you an edge.

See above – also consider the most you can make is 100% and that is functionally impossible. Simply Google best performing stocks of 2016 and this will give you an idea of the side of the market you want to be on.

Predatory short selling is a new development.

From my historical perspective I would say that short selling now is harder than it used to be. There are restrictions on naked short selling and the settlement system we operate under makes it hard to game the system. Back in the day when we had 14 day settlement you could short sell a company and buy it back before settlement and if you were careful no one was any the wiser. With instantaneous settlement this is actually very hard to get away with. As I said from a simple back office perspective short selling equities is a pain in the arse.

 

 

 

 

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The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.