What A Nobel Laureate Can Teach Us About Trading

Boris Schlossberg

Almost anyone who trades knows about the Sharpe ratio. It’s a measure of risk earned in excess of the risk-free rate per unit of volatility. The formula basically tries to answer the question – how much risk did you assume in order to achieve that return. Now in our YOLO world where only the end result matters, one might ask – who cares? Nevertheless, the Sharpe ratio is a useful tool to see if basically, you are one trade away from total ruin and every single money manager and trader on Wall Street must submit to its measurement before having any capital allocated to them.

The man who invented the Sharpe ratio, William Sharpe, is a Nobel prize-winning economist who is now retired, but he has not stopped putting his creative mind to solving investment problems. His latest project is what he calls the ‘Nastiest, Hardest Problem’ in Retirement, namely, how do you make sure your money will last your lifetime.

We live at an interesting time in history where the human lifespan in the OECD world has been extended by 150% while working years have basically remained static. This has created what in finance is known as a liability mismatch. Retirement assets are simply not elastic enough to sustain the new longevity The problem is massively aggravated by the volatility of equity returns. Imagine you’ve been investing diligently for 10 years and have built up a nice portfolio of 1M dollars off a total capital contribution of $500,000. Then in a span of 3 months, all those profits disappear and your original stake is now worth only $400,000. Ten years of wealth-building down the drain in less than a quarter. That’s what happened to investors in 2008.

Of course with the benefit of hindsight, we know that the markets not only recovered but doubled but many people – in fact, most likely the majority – panicked and sold at the bottom and then took years to get back into the markets. It’s easy to say that investors should hold through thick and thin, but as we know from trading nobody ever does. We all sell out at the bottom. At that moment no one is thinking about compounded returns 20 years forward. We are all trying not to become homeless tomorrow.

This is the precise problem that William Sharpe has tried to tackle and he has come up with a rather elegant solution to help investors protect themselves from their worst instincts. As he tells Barrons, “The idea is that you segment your money. It’s similar to using “buckets” but with a time component. A retiree might have a box for 2020 and a box for 2021, and 2022, etc.

In each box, you have a combination of safe assets, such as an annuity or TIPS [Treasury inflation-protected securities], and a market-based portfolio, such as one with stocks and bonds. You have the key if you need to access the funds, but the idea is that, once a year, you would sell the assets in that year’s lockbox. You put all your money in locked boxes, to begin with, and you just happily open locked boxes. If you’re dead, your partner opens the lockbox, and if you’re both dead, your estate opens all the lockboxes that are left.”

Why is this better than just putting all your money into a single account stream? Two reasons. One is financial. By creating short term lockboxes that are essentially made up annuities, zero-coupon bonds, and TIPS, you assure yourself that you have the income stream to survive for the immediate future while allowing “long-tern” lockboxes remain in the equity market where the volatility does not affect your short term needs. The other reason is of course physiological. The math is the same in both scenarios. You only have so much money and it can only compound in a certain way given the performance of the assets. BUT! your ability to weather the market storm is much more durable if you were confident that your income streams were assured for the near term.

Sharpe’s segmentation idea really resonated with me because I have already been exploring it with my own trading account. Lately, I segmented my trading capital into various strategy “buckets” with a wide variety of lever and instrument factors. The results have been very promising. For the first time in my life, I have let strategies run without interference and they are really starting to perform.

Ever have a day when one bad trade tripped you up? And then you started to revenge trade and then the whole account got annihilated over what was supposed to be a 0.5% risk? This is exactly the problem that segmentation tries to cure. Because the true risk to our capital isn’t one bad trade, but what we do afterward. If you had no more money in your segmented account to revenge trade the damage would be contained.

Segmenting your capital by strategy, instrument and lever factor also has optionality embedded into the process. Let’s imagine you are a venture capitalist but instead of companies, you stake 10 different strategies in 10 different accounts. Now some – perhaps most – will blow up or lose 50% of value over time especially if you use even a mild lever factor. But one or two may be totally in sync with the current market environment and go on a massive tear tripling or quintupling their value. That’s all you need to be overall profitable – but if you have all your assets in one account you will never have the mental strength to let the winning strategies run because you will be constantly looking at the P/L of the account and taking small profits to offset the big losses.

My example doesn’t even have to be that dramatic. You could just have most strategies tread water (which is what happens in real life, at least with me) while one or two make all the money. The Pareto Principle never goes away in life. William Sharpe’s great insight is to simply harness its value for all of us.

What Marriage Therapy Can Teach You About the Markets

Boris Schlossberg

Don’t worry. I am not in counseling. My relationship is fine, thank you very much, because my wife and I naturally do two things that all therapists seem to prescribe – we give each other plenty of space and we accept rather try to change each other’s behavior.

But I am not here to talk about my marriage, instead, I want to discuss Esther Perel’s marriage therapy podcast – “Where Should We Begin?” which contains a wealth of wisdom for any relationship you have, including the one with the market. You may not have heard of Esther, but she is definitely internet famous with a TED talk that has been seen more than 13 Million times and a best selling book called Mating in Captivity.

Every week Esther does a therapy session with a troubled couple that she then edits into an hour-long podcast. The podcast has the voyeuristic pull of a detective story as she prods and pulls the hidden bits of each person’s background to create complex and fascinating explanations for why we do the things we do.

But mostly the podcast is remarkable for the throwaway pensees that Esther dispenses throughout the show in her Belgian accented English. One of her key ideas is that “You can either be right or you can be married.” which any successfully married person will tell you is eminently true.

In markets, this can be summarized as “You can either be right or you can be profitable.” The more I trade the more I appreciate the absolute truth of that idea. For the longest time, I believed that you needed to trade with large negative risk-reward ratio because you needed to be “right” to win. But as I started to develop systems that move closer and closer to even money bets I realized that being right is hugely overrated.

If you can learn to accept your spouses worst habits your marriage will be much happier. No matter how many “tweaks”, no matter how many “behavioral adjustments”, no matter how many “talks” you have your spouse is unlikely to change. People almost never change their core self and neither do the markets. Capital markets, in fact, are far more efficient and far less pliable than people and that means your opportunity for profit is more limited than you think. I used to always tell traders that you can win big or you can win often, but you can’t win big often. Now I’ve come to accept that your edge can be even slim yet viable. If you can win 55%-60% on even money bets you will be set forever but that means you must be accept losing. A lot. Trades come in streaks and a 55% edge can easily result in 4,5,6, sometimes even 7 losers in a row and still be viable.

Which brings me to my favorite Esther Perel saying – be reflective, not reactive.

Anyone who knows me for more than a minute knows that I am the embodiment of reactive behavior. There is no debate I won’t join, no argument I won’t start, no fight I won’t jump into at a moments notice. And of course, that behavior spills over into trading all the time. Did I get stopped out? Well, f- that, I am going in again, at double the size because the market is full of morons and doesn’t know what it is doing. Of course, reactivity rarely succeeds.

So today I tried something different. Today was ECB day and after Draghi’s lame attempt to bluster his way through what is clearly a hemorrhaging Eurozone economy, I was convinced the euro should fall. It did initially, but the drop was shallow and I was stopped on the rebound. Pissed, I re-shorted again but price refused to buckle. That’s when I decided to take Esther’s advice to trade reflectively rather than reactively. One of my oldest and truest trading rules is that if funda points one way and price goes the other trust price. Much as it pained me to do so at that moment, I reversed the trades in the late afternoon NY session even though I saw no reason for why the pair should rally. Of course, rally it did, because sellers ran out of orders and dealers were able to squeeze the late shorts for 20 pips into the close. Thank you very much. Acting reflectively beats acting reactively anytime.

As traders we spend all our time looking at some logical construct to beat the market, forgetting that at the core trading is a psychological rather than a logical enterprise. Our relationship with the market is a kind of marriage. In some cases that relationship may be even more durable and more intense than with our spouse. To trade well we all need Esther Perel’s therapy from time to time in order to keep the spark alive.

What Google’s Mistake Can Teach Us About Trading

Boris Schlossberg

The other day Google discovered that it was wrong. Yes the brainy we-are-smarter-than-all-of-you-combined Google, the we-will-be-the-first-trillion-dollar-company Google was wrong.

For the longest time Google assumed that the only the smartest, best pedigreed talent was worthy of hire. Even if you were 40. Google would ask you for your GPA and your SAT scores since they thought these would be quantifiable measures of your potential success.

WRONG.

Fortunately for Google, the company records everything and much to their credit they went back to analyse their employee interview records and manager evaluation forms and here is what they discovered. It did not matter whether you graduated summa cum laude from Stanford or MIT. What mattered, what made the best managers was just one quality – consistency.

You see it doesn’t matter if you are brilliant, but a mercurial grump. Other people cannot function well in an environment where you are running hot or cold every 5 minutes micromanaging every decision. To achieve long term success in an organization employees need a consistent environment with clear goals and tasks in order to perform well.

After looking at this analysis, Google changed its hiring structure and stopped looking only for geniuses and started to hire managers with strong interpersonal skills and a disciplined mindset.

So what does this mean to us as traders? Quite a lot actually. When talking about markets it is laughable to entertain the notion of consistency. After all markets are the very definition of mercurial. If they weren’t there would be no risk to trading and also no reward.

Yet while markets can wild and volatile, our reaction to them must be as consistent as possible. I am sure that when you think about your trading mistakes most of them come not from the flaw of your setup but from the fact that you DEVIATE from your own rules all the time. You take trades that are impulsive, you change the stops and limits on your original positions, you decide that the EXACT OPPOSITE of your setup is what you should really trade. Certainly I do all those things and the results inevitable erode performance.

That is actually the very nature of the markets. They are meant to destabilize you not just financially but psychologically as well. Last night my son and I were arguing about some obscure fact regarding President Obama. He was certain he was right and wanted to bet money. I was only mildly confident in my position, but since I am the money and thus the market I said to him, “OK, If you are right, I will pay you double your weekly allowance, if wrong you get no money this week.” Even though he had better information than me he backed off the bet. At which point, I told him that he learned his first lesson in trading.

Try our Trade Ideas for just $1

So that is the Google lesson for us all. It doesn’t matter how smart you are. It doesn’t matter how well tested you ideas. It doesn’t matter how statistically robust your setup is. If you cannot maintain consistency of performance in the face of constant market mind games, you cannot succeed.

Key Forex Trade Levels Daily Technicals 12.4.13

Video

BK Forex Guide to Top 10 Most Tradable Events in the Forex Market

Download Boris and Kathy’s Free News Trading Guide

This Guide Will Teach You:

+ Which Economic Reports are Possibly Tradable

+ How Frequently the Reports are Released

+ Why we Believe these Releases are Important

+ Key Takeaways for the Forex Trader

Download the BK Forex Guide to Top 10 Most Tradable Events in the Forex Market Now!

Fill out the form and the Guide will be sent to you via email.


What Stock Traders Can Teach Currency Traders

Boris Schlossberg

All of my investment money is run by @HedgeFundGirl – not only because she the best stock picker I have ever seen, but because she knows how to put together an intelligent portfolio. Whenever I check the statements I am always surprised at how many losing positions there are on the books and yet how she is able to make money and beat my FX returns every single month and every year that we’ve been married.

Try our Forex Trading Signals and Trading Club for:

button

Portfolio management is one the best lessons that stock traders can teach currency traders. Most of us in the FX land are used to basically following the prop model – one trade at a time win or lose – then count your pips at the end of the month. But constructing a portfolio of trades to diversify your bets can open up a whole new way of looking at the market.

A recent New York Times article about diversification put it best – if you are not perpetually pissed off, you are doing it wrong. The portfolio approach to trading basically assumes that you will always be losing on part of your positions. The underlying philosophy of the portfolio approach is based on humility.

The portfolio trader assumes at the outset that he does not know which bets will pay off and therefore makes a multitude of them, hoping that when the dust settles the winners will outrun the losers. Instead of serially picking his trades, the portfolio manager will spread the risk (and yes possibly dilute the return) in order to dampen drawdown.

For forex traders the portfolio approach is especially interesting when applied to algorithmic trading. If you are running the same strategy on multiple pairs then you are in fact practicing the portfolio method. However, quantitatively based currency traders often commit a very serious sin. They love to over-optimize their strategies creating very different entry and exit parameters for each currency pair.

But portfolio trading is not like prop trading. It’s kind of like the difference between team and individual sports. ( I can still hear my football coach yelling, “There is no “I” in team boys!”)
What may in retrospect be good for one currency pair may not be good for the portfolio as a whole.

The truth of the matter is that if you change the strategy parameters on one currency pair you are in fact over or under weighting that pair relative to all others and that creates a whole set of risk factors that you may not have anticipated. That’s why when trading algorithmically, its best to give equal weight (i.e. same entry/exit rules) for all the currency pairs – because after all you really don’t know which ones will succeed and which will fail.

What Ray Dalio Can Teach Us About Reality of Trading

Boris Schlossberg

Ray Dalio the founder of Bridgewater Associates – the world’s most profitable hedge fund in terms of dollar volume is known as a proponent of radical honesty. Some critics view the whole Bridgewater culture as bordering on a cult, but the more I read Dalio’s writings the more I am convinced that he is right.

In one of his writings Dalio notes, “In pursuing my goals I encountered realities, often in the form of problems, and I had to make decisions. I found that if I accepted the realities rather than wished that they didn’t exist and if I learned how to work with them rather than fight them, I could figure out how to get to my goals. It might take repeated tries, and seeking the input of others, but I could eventually get there. As a result, I have become someone who believes that we need to deeply understand, accept, and work with reality in order to get what we want
out of life. Whether it is knowing how people really think and behave when dealing with them, or how things really work on a material level—so that if we do X then Y will happen – understanding reality gives us the power to get what we want out of life, or at least to dramatically improve our odds of success. In other words, I have become a “hyperrealist.”

When I say I’m a hyperrealist, people sometimes think I don’t believe in making dreams happen. This couldn’t be further from the truth. In fact, I believe that without pursuing dreams, life is mundane. I am just saying that I believe hyperrealism is the best way to choose and achieve one’s dreams. The people who really change the world are the ones who see what’s possible and figure out how to make that happen. I believe that dreamers who simply imagine things that would be nice but are not possible don’t sufficiently appreciate the laws of the universe to understand the true implications of their desires, much less how to
achieve them.”

When it comes to our little world of trading accepting reality can mean the difference between winning and losing and one of the hardest realities to accept is that it is almost impossible to make a million dollars from a $5,000 or $10,000 or even a $50,000 base. This is the dream that so many individual traders have and ironically enough its is fueled by guys like Dalio and Paul Tudor Jones and all the other great hedge fund legends who “started with nothing” and are now multi-billionaires. The reality however is that their wealth came from two very important factors – their ability to trade well and more critically their ability to attract outside capital so that they could operate on a larger base.

It’s true, in my time I have seen a few incredibly talented traders take $10,000-$20,000 and run it to a quarter of a million in a matter of months, but I have seen many, many, many more traders take a $250,000 and run it into $10,000 over the same time frame. The fact of the matter is that is you are able to produce 20%-40% annual returns on a moderately levered account you are doing unbelievably well and your trading returns as equal to the titans of finance. That may not get you to million tomorrow, but a $25,000 account making 40%/year grows to $700,000 in just one decade. That won’t make a you millionaire overnight but its not chump change either. That’s the reality of trading.

Try our Forex Trading Signals and Trading Club for:

button