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Trading In Uncertain Times

The problem of trading in uncertain times crept up on the Mentor Program Alumni forum and I have been thinking about my answer. The original answer I gave is shown below –

I think one of the things you need to be able to do is to define what is uncertainty. If you opt for volatility as a proxy for uncertainty then you see something quite interesting. The VIX which is known as the fear index and should reflect uncertainty is actually at sitting somewhere near its long term average, indicating that the players who make up this index don’t actually see any uncertainty and are not asking for an increase in the risk premium they demand. Te same is true if you look at the historic volatility in the Dow which is also sitting at a 9 year low.
From my perspective is the issue is not uncertainty in markets but uncertainty in decision making that is brought about by listening to external sources. If you switched off the news and all the associated commentary and simply looked at markets what would they tell you?

What has caused me to think further about this overnight is the notion of what actually is the uncertainty that is being referred to. Is it a true physical uncertainty or a psychological perception brought on by exposure to the narratives of others. I had a look at Wikipedia for a more formal definition of uncertainty and it gave the following –

Uncertainty is a situation which involves imperfect and/or unknown information. However, “uncertainty is an unintelligible expression without a straightforward description”.[1] It arises in subtly different ways in a number of fields, including insurance, philosophy, physics, statistics, economics, finance, psychology, sociology, engineering, metrology, and information science. It applies to predictions of future events, to physical measurements that are already made, or to the unknown. Uncertainty arises in partially observable and/or stochastic environments, as well as due to ignorance and/or indolence.[2]

You will notice that the definition holds at its core the uncertainty inherent in predicting future events. In fact the science of probability is based around trying to deal with the fact that the universe is an uncertain place. However, uncertainty is the default setting in trading – the outcome of all trades is unknown until they are closed. It is this uncertainty that gives us the potential to be profitable, investments that have known or certain outcomes have no risk premium attached as such they offer little in the way of return (think bank deposit). This definition is therefore of little use in unpacking the notion of  a change in traders uncertainty quotient. Granted we can respond to changes in volatility and we have tools to measure this but this is a reasonably common occurrence in trading and there are strategies that can be put in place to deal with this. In fact very basic position sizing and volatility based stops self correct to deal with this sort of problem.

So I am drawn back to the idea that what actually changes is the tone and intensity of the narratives that people surround themselves with. This ever increasing crescendo of noise is bound to take an effect on peoples psyche particularity at present when the world appears to be spinning out of control. However, notice I used the expression appears, I used this term because appearances and reality are not the same thing. What brings some equilibrium back to the noise of others is as always context, the markets tell a completely different story. Whilst the breathless gibbering that is the media may consider the present to be the most troubled time in history and need to shout about it at every opportunity neither that markets nor history itself would agree.

This is the most salient point for traders with regards to what is considered uncertainty. Uncertainty is the environment within which we operate as a broad observation but beyond that it is actually the markets themselves that define what is actually uncertainty and they can do this by readily accessible metrics. When volatility and in turn risk premiums increase then we can say that uncertainty has increased. However, even here people try inject their own primitive narrative into events as the VIX which is a widely known measure of volatility is referred to as the fear index when it is nothing of the sort. However, this is the natural human desire for drama, we all have a friend or relative who is addicted to drama and those in the news media, particularly the financial arena and prime diva’s. So if you find yourself believing that uncertainty has increased but markets dont agree then you will need to do something about what leaks into your brain.

 

The Purpose Of Life Is Not Happiness: It’s Usefulness

Let’s just accept that. Most people love to analyze why people are not happy or don’t live fulfilling lives. I don’t necessarily care about the why.

I care more about how we can change.

Just a few short years ago, I did everything to chase happiness.

  • You buy something, and you think that makes you happy.
  • You hook up with people, and think that makes you happy.
  • You get a well-paying job you don’t like, and think that makes you happy.
  • You go on holiday, and you think that makes you happy.

But at the end of the day, you’re lying in your bed (alone or next to your spouse), and you think: “What’s next in this endless pursuit of happiness?”

Well, I can tell you what’s next: You, chasing something random that you believe makes you happy.

It’s all a façade. A hoax. A story that’s been made up.

More here – Medium

The Facts Of Luck

One of the greatest computer programmers of all time grew up near Seattle. He saw an upstart company, Intel, making computers on a chip and was among the first people to see the potential of these so-called microcomputers. He dedicated himself to writing software for the new device and, by one account, “wrote the software that set off the personal computer revolution.”

In the mid 1970s, he founded a company to sell software for micro-computers. In the early history of the company, “the atmosphere was zany,” and “people came to work barefoot, in shorts,” and “anyone in a suit was a visitor.” But the company was soon highly profitable, and by 1981 its operating system had a dominant share of the market for personal computers that used Intel microprocessors.

More here – Fast Company

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

Stock Analysts’ Biases Are Showing, a Study Finds

Turns out birds of a feather flock together on Wall Street, too: Male stock analysts tend to write more favorably about public companies headed by men than about companies led by women. White analysts favor firms run by white chief executives. And Republicans and Americans in general prefer companies helmed by people like them.

It is called group bias, and four academics have nailed down evidence that it exists among stock analysts, who are paid to guide investors’ bets with hardheaded, rational views of companies’ prospects.

As a result, earnings surprises of firms headed by female, foreign or Democratic CEOs are systematically upward biased, the researchers write in their paper. In other words, because analysts have underestimated the CEOs who don’t belong to their in-group, those CEOs’ companies more often surprise the market when earnings are reported, boosting share prices.

“These results are also reflected in analysts’ buy and sell recommendations, with systematically more buy than sell recommendations for stocks of firms headed by CEOs belonging to their in-group,” says the paper, by Sima Jannati and Alok Kumar at the University of Miami School of Business Administration, Alexandra Niessen-Ruenzi at the University of Mannheim in Germany, and Justin Wolfers at the University of Michigan’s Gerald R. Ford School of Public Policy.

More here – The Wall Street Journal

Why We Think We’re Better Investors Than We Are

From their earliest days, the loosely confederated research efforts that came to be known as behavioral economics spawned a large quantity of studies centered on securities investment. This was not because the field’s pioneers were especially interested in stocks and bonds, nor was the early research commonly underwritten by financial services firms.

Rather, the hive of activity that evolved into its own field — behavioral finance — reflected that investment markets provide unusually robust data sets for analyzing “judgment under uncertainty” (the title of a seminal textbook co-edited by the winner of a Nobel in economic science, the behavioral economist Daniel Kahneman) and “decision under risk” (a phrase in the subtitle of his Nobel-winning “Prospect Theory”). Every day, global securities markets provide researchers with billions of data points for understanding how people make choices when resources are at stake and the outcome is unknown.

Which, if you think about it, is a fair description of most decisions. Indeed, the majority of cognitive biases and shortcuts that influence everyday judgment and choice have analogues in investment behavior. Consider the “sunk cost fallacy,” a primary reason an unhappy lawyer might struggle to leave the law and an unsuccessful investor might balk at selling money-losing shares.

More here – The New York Times

Living a Lie

People mislead themselves all day long. We tell ourselves we’re smarter and better looking than our friends, that our political party can do no wrong, that we’re too busy to help a colleague. In 1976, in the foreword to Richard Dawkins’s The Selfish Gene, the biologist Robert Trivers floated a novel explanation for such self-serving biases: We dupe ourselves in order to deceive others, creating social advantage. Now after four decades Trivers and his colleagues have published the first research supporting his idea.

Psychologists have identified several ways of fooling ourselves: biased information-gathering, biased reasoning and biased recollections. The new work, forthcoming in the Journal of Economic Psychology, focuses on the first—the way we seek information that supports what we want to believe and avoid that which does not.

More here – Scientific American

General Advice Warning

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