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Even The Smartest…….

I can bet you every teenager since the age of the invention of the mass produced car has through that they invented having sex in the back of a car. This is simply the way our cultural memory works – we are disconnected in many ways from the knowledge and experience of those who have gone before. Therefore we think that we are discovering something for the first time. What prompted this odd line of thinking was that I saw a line chart of Bitcoin and I thought I have seen something like this before. I have reproduced a chart of Bitcoin below.

bc

And I was right – I had seen something like this before….from 300 years earlier.

SSB

The above chart is of the share price of the South Sea Company during what has become known as the South Sea Bubble (SSB), one of the original examples of investor mania. Think of it as the Bitcoin of 1720. The chart has several discontinuities that I have removed to smooth the data because the data flow in 1719 was not the same as it is today with changes in price often only occurring once per week. And for interest sake I have laid a 15 period moving average over price. What makes the SSB so compelling is the names of those who were caught up in it. The individual most often cited is Sir Issac Newton who could rightly be described as one of the three smartest humans to have ever lived. It is thought that Newton lost anywhere between £ 10,000 and £20,000 as a result of speculative foray into the SSB. However, much of the talk of Newtons financial folly is incorrect, it is true that he made a fortune in the early period of the boom but like most investors in speculative frenzies failed to withdraw when it became apparent that the boom was over. But Newton had a diversified approach to investing and had risk spread over a variety of instruments which accounts for the fact that he was able to absorb his losses and still have an estate valued at £30,000 when he died.

The figures quoted above are difficult to put into context because we immediately assume the £30,000 loss back then is equivalent to a bit more than £30,000 loss now. It is difficult to map the changes in the buying power of currencies over time. Using simple converters doesn’t actually present a true picture since it is not as simple as saying £X was worth 1 300 years ago therefore it is now worth £X times 10. What is more appropriate measure is to look at the value versus the cost of an physical object – this is actually fairly easy and gives some measure of the size of his fortune. Some 45 years after the SSB, Nelsons flagship HMS Victory was launched at a cost of £63, 176 – so Newton fortune was roughly worth half the cost of a state of the art warship built 45 years later. In today’s terms this would value his estate in the hundreds of millions, which seems about right as a ball park guess. What is most interesting in the SSB is the role of Thomas Guy – the founder of Guys Hospital in London. Guy was ostensibly a bookseller but reality was a shrewd stock speculator who at the time of his death left the staggering sum of  £219,499 to found the hospital that still bears his name.

The issue here is that speculation is nothing new – nor is the expression sucked in and Bitcoin for all its rationalisations is merely another bubble. One of the joys of advancing age is that you have seen it all before. I distinctly remembered being told during that dot com boom that in the future everyone would buy their pets online. Apparently no one thought through the mechanics of stuffing a hamster in a post pack….turns out it doesn’t work so well. Speculation at its heart is an emotional journey that often takes us to places and introduces us to versions of ourselves that we both dont often see and dont want to see. This is what caught Newton – his emotions overrode his powerful intellect and in the end he was little more than a mug punter caught up in the maelstrom of both events and his own emotion weakness.

 

 

 

It Does Not Mean What You Think It Means

The interview in the post below with Daniel Kahneman got me going back over some old links that looked at the application of his and Amos Tversky’s ideas to trading and the chestnut I keep coming up against is the following question.

You have been given a choice between either –

a. $100 guaranteed, or

b. A 50/50 chance to receive either $200 or nothing.

The point is made that people will invariably opt for the first choice despite the fact that the mathematical expectancy of the two choices is the same (I have something to say about this in a minute) This is used to illustrate the point that traders invariably engage in the self defeating action of cutting their profits short. My rationale as to why we do this is probably buried somewhere deep in the evolution of our psychology, which in turn is linked to our desire to maximise our own pleasure. Consider this, you are one of our ancestors and you come across a fresh kill on the tundra. A bounty like this is rare because life is harsh, short and brutish. Naturally you grab whatever you can and run away, after all the kill belongs to something else and you don’t want to be around when it gets back. You are rewarded handsomely for this behaviour by avoiding starvation long enough to breed, thereby passing on this behaviour. My guess is that those ancestors of ours who stuck around to be pigs generally didn’t live long enough to have offspring. Over millennia this behaviour finds a modern translation in that you can never go broke taking a profit and it becomes the bane of all traders.

The reverse of this problem is offered as an example of how poor we are at dealing with losses. The problem is generally framed as you have been given a choice between either –

a. a guaranteed loss of $100.

b. A 50/50 chance to lose either $200 or nothing.

Traditionally, traders opt for the latter – so we have the perfect storm of cutting profits short but letting losses run. This is the reverse of the often quoted maxim for successful trading.

However, this example has always troubled me. I understand the point it is trying to make and I think that point is valid and true, the majority of people do what Jessie Livermore describes as doing exactly the wrong thing – selling the thing which gives you a profit and keeping the thing that makes you a loss. My discomfort with this example is that it offers a coin toss and not a continuum. Trading is not a coin toss it is a continuum and our trades reflect it, so whilst the lesson for traders is valid the example used to get there is weak. The question would be better phrased and more reflective of trading if it were presented as over time you have a 50/50 chance of receiving $200 – this reflects the actuality of expectancy.

There is another point of difficulty I have with the problem and it is one of both scale and economic utility. Let me rephrase the initial question as –

You have been given a choice between either –

a. $1B guaranteed, or

b. A 50/50 chance to receive either $2B or nothing.

The psychological import of the question changes as the scale changes – this is always a problem I have had with psychology as opposed to physics. The answer should remain the same irrespective of the scale of the problem. But in the real world you would be insane to risk a guaranteed $1B on a coin toss . The decision to not risk it would not be reflective of being a poor trading but upon understanding that there was nothing you could buy with $2B that you could not buy with $1B. The decision reflects one of economic utility as much it does the psychology of those making the decision. Interestingly, there is a modern example of investors walking away from such a guaranteed payoff.  In 2010 Google offered to buy Groupon for an estimated $6B , it was rumoured that this offer came on the back of Yahoo offering $3B a month earlier. Groupon knocked back both offers – needless to say the company is valued nowhere near that now.

Trading is a complex psychological endevour and whilst some simple models do make strong points we need to be aware that the models have limitations and that trading is a fluid game that at times demands that you act in ways that a psychologist might not approve of.

 

 

 

How to beat the bookies by turning their odds against them

Mathematicians had already developed bookie-beating models that attempt to predict sporting outcomes, but they are hard to devise and don’t perform consistently. So Lisandro Kaunitz at the University of Tokyo and his colleagues tried a more direct approach: using the bookmakers’ odds against them.

The team studied data on nearly half a million football matches and the associated odds offered by 32 bookmakers between January 2005 and June 2015. For every game, the trio looked for odds that might yield a better return than the average offered by bookies – say, 5 to 1 versus a mean of 2 to 1.

Mean odds of 2 to 1 suggest the bookies collectively think this reflects fair odds for that outcome. But 5 to 1 offers higher returns should the outcome materialise. The team used the historical data to work out the optimal distance from the mean odds – the one that would give a positive payout for the largest number of games.

In a simulation, their strategy made a return of 3.5 per cent – beating random bets, which resulted in a loss of 3.32 per cent.

So the trio decided to try it in the real world. They developed an online tool to apply their odds-averaging formula to upcoming football matches. For five months, they placed $50 bets around 30 times a week.

It worked. The team made a profit of $957.50, or an 8.5 per cent return (arxiv.org/abs/1710.02824).

More here – New Scientist

Victor Niederhoffer – Lessons of making and losing a fortune

Click here.

When to let go

One of the qualities that impresses me most about people is their resilience – that ability to hang in the fight for a time long after most would have quit. And then if things have not gone their way to pick themselves up and start again. If we take a broader perspective human history in all its facets is only advanced by such people – those who stick with a situation and by simple dint of personality push through.

However, there is a dark side to this and it is the holding the line or clinging to a belief long after it should have become apparent that that they were wrong. We have all known people who have stuck with relationships or jobs long after the point of no return had been reached. And in some cases it undoubtedly not because of their resilience but rather that a change is simply too frightening or they actually lack the resources to take the plunge. But many hang in like a demented barnacle often as if to simply spite themselves – their own ego drives them towards destruction.

This ego driven headlong dive towards self destrution fascinates me because for many years I have been following the fate of John Hussman the manager of Hussman Strategic Fund. Hussman is a former professor of economics and international finance at the Uninversity of Michigan. So in an academic sense he is no fool but as is so often the case smart people use their intellectct to defend their emotional failings.

To begin to understand why I find Hussman an interesting case study we first need to understand the investment approach that this fund adopts. The following is from their prospectus –

The Funds portfolio will typically be invested in common stocks favored by the Hussman Strategic Advisors Inc, the funds investment manager , except for modest cash balances arising in connection withe Funds day to day operations. When market conditions are unfavourable in the view of the investment manager , the fund may use options and index futures , or effect short sales of exchange traded funds (‘ETFS’) to reduce the exposure of the Funds stock portfolio to the impact of general market fluctuations. When market conditions are viewed as favourable, the Fund may use options to increase its exposure to the impact of general market fluctuations.

This all sounds reasonable, it is a basic stock portfolio that at times undertake some form of hedging to reduce the impact of market fluctuations. And this approach found great success during the GFC. As can be seen from the chart below this fund easily outdistanced the S&P500 and the funds under managed grew to US$6.7 billion. Since then the fund has shrunk to approximately $US365M.

Hussman GFC

The reasons for this contraction are instructive and can be found in the funds prospectus. The fund speaks of hedging exposure in unfavourable market conditions. To those of us on the outside this means market downturns as defined by some form of collapse in the trend. This is something that is easily quantifiable and therefore is binary in nature. In my simple world the market is either going up or down. However, Hussman and his management team have a narrative and the narrative is that despite the market going up continually since the GFC all stocks are overvalued. So whilst they may be invested in these stocks they also have in place hedges of equal sizes. Hedging is a drag on performance – it costs money and this cost translates to poor performance. Since the GFC Hussman’s funds have lost on average 2.1% pa whilst the market has gained 2.3%.

Hussman Ten Year

Since the bull market began Hussman has been calling for a slide in the overall market to match that experienced during the Great Depression and he has positioned his fund accordingly. This internally driven narrative is directing the investment strategy which in in turn pushing the fund into the ground.

He has issued a never ending stream of warnings about the market –

November 2010: Bubble, Crash, Bubble, Crash, Bubble…

March 2011: Anatomy of a Bubble.

March 2012: A False Sense of Security.

November 2013: A Textbook Pre-Crash Bubble.

July 2014: Yes, This Is An Equity Bubble.

October 2015: Not The Time To Be Bubble-Tolerant.

October 2016: Sizing Up the Bubble.

March 2017: The Most Broadly Overvalued Moment In Market History.

March 2017: Expect the S&P500 to Underperform Risk-Free T-Bills Over The Coming 10-12 Years.

May 2017: This Time Is Not Different Because This Time Is Always Different.

June 2017: Two Supports Kicked Away Already.

July 2017: Salient Features Of Bull Market Peaks.

August 2017: Imaginary Growth Assumptions and the Steep Adjustment Ahead.

These market calls have an almost plaintive  nature about them, as if he is desperate for the market to agree with him and his thesis. All of this is driven by a desperate need to have the narrative proved correct, once again such a desire is more reflective of ego than common sense. To the astute trader such behaviour is incredibly strange since being wrong is part of being a trader. But so too is the ability to adapt and learn from being wrong, there is resilience and then there is suicidal behaviour that has a very intriguing tone to it. And Hussmans behaviour has a strange tone of self destruction about it.

If there were a cornerstone to trading it would be the ability not only to be resilient when in drawdown but also to accept that we get things wrong. Sometimes there is a flaw in our methodology that we have not seen and that we simply have been lucky up until this point. This does raise the question of when do you know you have entered this spiral of self destruction and to my way of thinking the answer is not that hard. If you have been losing money for the better part of a decade then it is fairly obvious that there is something seriously wrong in your methodology.

 

 

Fund Manager Scorecard

Each year Standard and Poors produce a scorecard of the performance of a regions fund managers against their comparison indices. You can find the raw scorecards here.

I decided to download the one for Australia and tidy up the data a little so it was more presentable. The chart below looks at the number of funds in various categories that have failed to match or beat their benchmark over a 1, 3, 5, and 10 year period. Just a reminder this table shows the number under performing, not the number that beat the index.

Capture
As you would expect this is one of those – I think I have seen this movie before type of scenarios. The majority of fund managers failed to match the index in all categories over all time frames. I had a quick glance at the scorecards for the other regions and this pattern repeats itself in all regions. The reasoning for this I think is that all managers are captive to the same narrative fallacies and are caught in the same academic, philosophical and psychological delusion. It is not that markets cannot be beaten because there are clearly well known managers who have beaten their index year after year. But if you based your investment strategy on notions such as the Efficient Market Hypothesis, perceptions that you know the value of  something and plain stupid ideas such as we dont need stops because we are smart and would never buy a company that went down. Then you deserve to made to look like an idiot.

However, there is a wider implication and that is the impact that this sort of massive non performance has on issues such as retirement. As I have said before part of the looming retirement crisis could be solved simply by nationalising all superannuation funds and placing everyone in an index fund. Overnight long term returns would double and fees would be more than halved. But there is also another impact and this one in related to the impact of on performance on the broader confidence in market participants. Is it any wonder that Australians opt for real estate as the prime mechanism of passive wealth creation when they hear about this sort of rip off.

Claude Shannon, the Las Vegas Shark

Long before the Apple Watch or the Fitbit, what was arguably the world’s first wearable computer was conceived by Ed Thorp, then a little-known graduate student in physics at the University of California, Los Angeles. Thorp was the rare physicist who felt at home with both Vegas bookies and bookish professors. He loved math, gambling, and the stock market, roughly in that order. The tables and the market he loved for the challenge: Could you create predictability out of seeming randomness? What could give one person an edge in games of chance? Thorp wasn’t content just pondering these questions; like Shannon, he set out to find and build answers.

More here – The Nautilus

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