A Canadian on Wall Street

A thought just occurred to me — you know how people often denigrate paper-trading because it lacks the pressures and tensions that come from trading real money? I don’t dispute that, but my thought is that the best way to trade real money is to trade, at least emotionally, like you’re paper-trading. Maybe that’s why people often seem to do so well paper-trading; when there’s nothing at stake, it seems easy. Losses don’t hurt, gains don’t really matter that much, and strategies are much more easily followed without the weight of emotion bearing down on you. Who would revenge trade in a paper-trading environment? It’d be silly, right? I think the same thing is true in a real money situation.

I’ve been following a lot of trading and investing blogs as my professional life has moved more into this realm, and I find that it’s solidified my own philosophy about the markets, especially in the past several months. One of the things I still find fascinating is the incredible faith people have in systems trading, “technical indicators” and algorithms they’ve created for themselves, that they stick to rigidly. It seems like such a strange thing to be wedded to, especially when the only thing that is clear about the markets is that they are often unclear, changing, mutable.

When their system points them to some trade that they don’t take, these people grumble that they should “always be following the system” and it’s their lack of discipline in doing so that causes the issue. When their system starts to put them in harm’s way, they get defensive and stop using it and begin to doubt themselves. When the system puts them in a bad trade, they often blame their mistaken reading of their system: “it needs tweaking”, “I’m misusing it”. In some way, it seems almost religious, the need to devote oneself to a rule-set and the self-flagellation that happens when one fails to follow it.

In fact, for me, the need for discipline is not in following a system, but in money/risk/bankroll management, which all refer to the same concept. One, don’t take outsized risks and two, cut your losses. It’s the simplest thing in the world, but also the hardest thing in the world; saying it is one thing, but following it is a whole ‘nother story… and where human behaviour lies. In Vancouver’s frozen property market, with its record level of homes for sale, I’m sure there are more than a few people who aren’t willing to take their losses and will wonder why they weren’t able to, in retrospect. Everything seems so obvious until you add in human nature. People have been doing the same thing for years; they haven’t changed in aggregate, and they probably won’t in any of our lifetimes.

I try to bite my tongue around people who advocate a system that doesn’t revolve around the mechanics of defensive trading — it’s bound to encounter a market that’ll teach it a few lessons. These people are cultivating the wrong thing, I believe. They want, like good religious folk, to subsume their wills to something they feel is bigger than them, that they can abdicate their responsibility to. I think being open-minded towards the markets will be much more profitable in the long run than being close-minded; if you can learn adaptation, you’re much better served when the environment starts to turn.

In these “interesting times” (not sure if there really is a Chinese curse about that — it sounds made up to me), my take on things is to stay defensive, cautious and aware of the volatility. But be opportunistic.

Also, I’ve learned more in the past two weeks than I have in the past decade (that might be a bit of hyperbole, but I’m thankful for the experience), in terms of my personality and the markets.

I suppose the following analogies have been used to describe the different kinds of personalities that are involved with the market, but I do like how they capture some of the essential philosophical differences and timeframes. I lump them into three general categories: the surfers, the fishermen and the farmers.

There are numerous day-traders or people who came up in the business scalping profits and several of the ones I’ve seen blog are avid surfers; I think of the short-termers as the most like surfers: looking for waves, patterns, breaks, occasionally caught up in the churn or dragged under and, if lucky and with a bit of intuitive skill, they might catch a big move and ride it for a glorious gain. But it’s all “of the moment,” and often depends on prevailing factors and a fair amount of reaction. The older surfers still enjoy it but they aren’t quite as flashy on their boards.

The mid-termers aren’t looking for the small fry but set up with a general idea, much like the fisherman who heads to particular waters at a particular time of day and waits. They don’t catch a ton of fish but the ones that they do are good eating and sometimes there’s even one for the record books. Sometimes they don’t catch anything, though, but it still is enjoyable enough to fish, provided it’s just for sport and not their livelihood.

Then there are those that aren’t really interested in the vacillations of the market, like the farmer who plants seeds when the soil is fertile and then lets nature sort itself out. This kind keeps an eye on their crop, but for the most part just remains patient and hopes for excellent weather. Pretty consistently, there’s a nice crop to harvest, but some years there’s too much rain and conditions are bad and the farmer can’t do much but wait till next year and hunker down for the winter.

I was at a public library sale the other day and picked up a few decent investing related books for a buck a piece — one on commodity futures trading from the 60s, and the other a decent overview of the strategies and issues of Long Term Capital Management, aka LTCM, aka the fund that last broke the financial system until a huge round of bailouts. Basically, like Ecclesiastes says, ain’t nothing new under the sun. I’m paraphrasing.

One of the things that was really clear from the latter book was that LTCM was using massive amounts of leverage to get their returns. They’d borrow money very cheaply, and throw it behind trades that would normally return about 2% or so, but due to the scale of their bets, they’d get a massive return on equity (if a piddling return on assets). It’s only when those “sure bets” started to fail — once again, the problem of induction rearing its ugly head, and in fact, this book went into a fair bit of detail on it for a book from 2000, before the recent success of the Black Swan — that everything went to pot.

This is essentially how hedge funds do their business, and make their spectacular returns, and equally gigantic flameouts. It really makes you wonder if the party line being sold to people, that you just sock away your money in a well-diversified fund and cross your fingers that everything does about the same as it always has (for the last hundred years), is really all that effective. It works until it doesn’t. I just find it asinine how people will recommend this strategy over learning about individual stocks, like it’s getting your teeth cleaned or grocery shopping — I don’t think it’s ever really possible to make it as staid as all that.

In any case, it also reminds me of ideal betting strategy, except in the case of blackjack you tend to have a better sense of the odds (as some people have described it, the known unknown) versus investing (the unknown unknown) and can feel comfortable raising your bet accordingly. Of course, this’ll get you thrown out of the casino if you do it enough times and start winning big, and in investing it’s all but impossible to get that level of comfort, without applying a little judicious ignorance. Sort of like creating a “pseudo-known unknown” by having a myriad of blind spots.