All posts for the month August, 2012

The Averaging Down Clown

We have all been there. You do your research and your due diligence.  You check the valuations and the charts. You calculate the risk/reward. You maybe even get all patient and wait for a catalyst. For all sorts of good and clever reasons, you decide to buy 100 shares of company XYZ, paying, let’s say, $50 per share.

A few weeks later, you recheck your portfolio. Company XYZ has fallen to $45. After cursing a bit, you recheck your valuations and research, and conclude that nothing about your original view has changed. In fact, the trade looks like an even better deal, since you can now buy shares for only $45. You pay $45 for another 100 shares.

Time passes, seasons change, you grow a beard and the stock falls to $40. Again, there has been no material news or change in your analysis of value. You decide to buy another 100 shares: after all, if you liked the trade at $50, you must love it at $40! Even better, the stock only has to rally back to $45 for you to break even. If it gets back to your original purchase price, you are in the money!

This logic seems common for professional and amateurs alike. It is psychologically very tempting, not least because it means that you do not really have to admit that you are wrong. It is strongly encouraged by a fundamental analysis/valuation mindset: without new information, trades that go against you simply look like even better opportunities. At the very least, this encourages you to not exit your losing trade, and even to commit more capital.

This is very dangerous.

The reason that it is dangerous is not that it does not work. It does work, quite often. Doubling down pays off, you make even more money than you originally thought, and you feel like a champion. That positive feedback encourages you to do it again next time.

The danger comes from what happens when it does not work. When you keep adding to a trade that keeps going against you, you will eventually lose. Perhaps the fundamental situation changed, and you were not aware of it yet. Perhaps the market simply has a different idea of valuation than you. Perhaps the market is being manipulated. It really does not matter why: at some point you will lose. And by using a strategy of averaging down, you are guaranteeing that your biggest positions will be in your worst trades.

Let that sink in, and I will say it again.

You are guaranteeing that your biggest positions will be in your worst trades.

 Averaging down feels great. It fits in with our popular acclaim for those who “have the courage of their convictions”, who “stick with it when the going is tough”. Unfortunately it also sets you up for a massive fall.

In contrast, a strategy of averaging up into winning trades puts your largest positions in your winning trades. If you pyramid up, your average price rises slower than the market price i.e. you are effectively buying at a discount to the current market. For example, if I buy 100 shares paying $50, 100 paying $55 and 100 paying $60, my average price will be $55: $5 below the market price of $60. Contrast that with the earlier example of averaging down, where my average price was $45, $5 below the market price of $40.

Another way to consider it is to examine the four possible basic outcomes to any trade:

1) Wins initially, and keeps winning.

2) Wins initially, but then reverses to become a loss.

3) Loses initially, and keeps losing.

4) Loses initially, but then reverses to become a win.

If you average down, you only get the chance to add to trade types 2, 3 and 4.

If you average up, you only get the chance to add to trade types 1, 2 and 4.

Averaging down tends to be attractive to people, since it allows the possibility of trade type 4 i.e. a trade that goes against you, but then reverses to recover your losses and more. However, that comes at the material risk of trade type 3 i.e. the trade that never recovers.

Averaging down virtually guarantees that your biggest positions will be in trade type 3 i.e. the trades that never win. Pyramiding up avoids this risk, and also allows you to add to trade type 1 i.e. the trades that start off winning and keep winning.

To be clear, there is a legitimate strategy of picking a range of entry into a trade. Rather than picking a particular price point, you may choose to scale into a position over a range of entries. The distinction here is that you must decide this plan before the first entry is made, rather than in response to a trade going against you.

Averaging down is psychologically easy, and feels good. The market tends not to reward behavior that feels good and easy. It might not punish you straight away, but averaging down losing trades is a great way to end up owning a lot of shares in the next Enron or Lehman Brothers. I prefer my biggest positions to be in my winners.

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by thezikomoletter on August 28, 2012  •  Permalink
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Posted by thezikomoletter on August 28, 2012

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The Drawdown Curse

A few years ago, I was reading a reputable financial newspaper*, when I nearly choked on my doughnut. I have lost the link to the article, but it said something along the lines of:

Stockholders will be happy: Shares in XYZ Bank have soared by 40% this year, more than making up for the 30% loss suffered last year.

Sounds reasonable, doesn’t it? 40% is bigger than 30%, isn’t it?

Like hell it is.

This is surprisingly often misunderstood. Consider owning a share costing $100. It falls 30%. How much is it worth now?

$100 x (1 – 0.3) = $70.

Cue sad face, and perhaps even a violin. Except that it now rallies 40%. How much is it worth now?

$70 x (1 + .4) = $98.

Hold the smiley face and the trumpets. WTF happened here?

It is basic math: the order matters. The 30% decline was calculated on the original price of $100, whereas the 40% gain was calculated on the new price of $70. In fact, you needed a rally of about 43% to make up for a 30% loss.

Consider this table:

Drawdown Return needed to get back to even
0% 0%
10% 11%
20% 25%
30% 43%
40% 67%
50% 100%
60% 150%
70% 233%
80% 400%
90% 900%
100% n/a

Somewhere around a 30-50% drawdown, getting back to even becomes a real problem. Once you have lost half your money, you need to double it again just to get back to even. Doubling your money is hard to do.

That is why many hedge funds that lose 50% simply close down rather than try and work back to even. That is why Buy and Hold sucks: the stock market has suffered multiple large drawdowns over time. That is why low vol. investing seems to work: not losing money in bad times is more important than making it in good times.

So how to translate this into the real world? It is one of the main reasons that I try to discipline myself to get out of losing trades quickly. I hate being in positions that are losing money. Part of it is psychological: making money is a happy experience, and I’d rather spend more time  having happy experiences. But the main reasons is mathematical: it is very difficult to recover from large draw-downs in capital. You need to actively protect yourself against the Drawdown Curse.

It sounds silly, but I have a calendar alarm that goes off at 11am every trading day. It says,

If you are losing money, then stop it.

It certainly does not always work. But it helps focus the mind. Rule Number One: Don’t Lose Money.

 

* On a tangent, I have considered writing a blog called “Grumpy Young Man Yells At The Newspapers” because I so often get mad at what I read in the press. I am not even talking about the “political opinion disguised as news and facts” sort of thing that plagues everything from the New York Times to the Wall Street Journal. I’m talking about the financial illiteracy that seems to pervade. Two of my favorite examples are:

$25m plantation estate sells for just $11m

from the WSJ, no less.

and then,

Ireland’s richest man declared bankrupt

from the Sydney Morning Herald.

I would love to believe that the errors were deliberate, but I suspect they were not.

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by thezikomoletter on August 20, 2012  •  Permalink
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Posted by thezikomoletter on August 20, 2012

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The Number One Job Of A Trader

Thank you for your replies to my question: What is the number one job of a trader?

Your answers tended to revolve around making money, managing risk, protecting capital and making positive risk-adjusted returns. Those are all good suggestions that make sense. I would add that in professional trading firms, acting in compliance with the law and regulations is an explicit focus as well.

I think the real answer is deeper. For me, the number one job of a trader is to be allowed to play the game again tomorrow.

Why? Because it is a probability game, and the only people who are right every time deserve to be in jail. Even when you have a good edge, the odds are that there will be reasonably long streaks when the dice simply do not land your way. It is important to develop an edge (a positive expectancy), but it is equally important to be in business long enough to capitalize on that edge.

Take the example of a weighted coin, where you win 2x your stake if it comes up heads, and lose your stake if it comes up tails. You have $100 to play with, and the game will be played multiple times. How much should you bet on each coin flip?

The answer is clearly not $0: this game has an edge (a positive expectancy), so you should be willing to play it. However, the answer is clearly not $100  either: there is a reasonable chance that you will lose on any given coin toss, and so you should not risk your entire stake on one flip.

Smarter people than me can work out the math of what the “optimal” bet size is for this game. In the real world, the game is murkier since you do not know what the odds are: you can only make educated guesses or rely on historical back testing. The important point is that you need to act so that you can play the game again. Betting too big so that you blow up before the positive expectancy can play out in your favor is a fatal mistake.

Acting in a way that stops you being able to play a positive expectancy game again means that you have failed as a trader. This covers everything from losing so much money that you blow up/get fired, breaking any laws or codes that get you banned, or sleeping with the boss’s wife: anything that stops you being allowed to play the game again tomorrow. It doesn’t matter how good your trade idea is, or how much money the trade is going to make next week, or how good your average win/average loss ratio is: your swipey badge thingy has to open the door to the trading floor tomorrow.

You need an edge to make money over time. But if you have an edge, and you act in such a way that you cannot exploit that edge, you have failed.

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by thezikomoletter on August 13, 2012  •  Permalink
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Posted by thezikomoletter on August 13, 2012

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The Difference Between Trading and Investing Is Liquidity Risk, Not The Time Frame

Sometimes when I try to engage with people about what I do, I get the response, “That’s great for you, but I’m an investor not a trader.” Normally they follow-up with something like, “I don’t trade. I invest in value stocks for the long haul.”

The difference between trading and investing is a murky continuum. A common approach is to focus on the time frame: investors focus on positioning themselves for the long haul, looking to earn a return over many months or years, whereas traders are hyperactive chipmunks who can’t hold a position for more than a minute without seeing another nut to chase. Trading is short-term, investing is long-term.

I think that this approach takes attention away from a crucial and often forgotten part of the process: The need for someone to take you out of your transaction. I think that if your plan involves eventually selling your asset to someone else, whether that is in 8 seconds or 30 years, then you are trading not investing.

Why is this so important? Because once you need someone else to take the asset off your hands, you cannot ignore considerations of what that person is thinking, how they might value the asset, and how they are financially and psychologically positioned. Those are considerations and risks that are better handled in a trading methodology than an investing one. Investing methodologies tend to assume that asset prices will revert to “true value” over time. Trading methodologies know that markets can stay apparently disconnected from fundamentals for long periods of time due to the needs, position and psychology of market participants.

My definition of trading is broad, and encompasses many things typically regarded as investing by most people, e.g. buying equities under a 401k. If you “invest” in the stock market this way, you do not eat the stock certificates in retirement. Instead, you plan on selling those stocks to someone else i.e. you need another monkey to be willing to acquire your portfolio when you want to extract your money. The price at which they are willing to acquire your portfolio from you will materially depend on their circumstances.

There are things that still count as investing by my definition, and they typically involve coupon-like cashflow. Buying a bond to hold to maturity, for example, is an investment: provided that no-one defaults, you get your money back plus interest i.e you do not require someone else to buy the bond from you. The cash-flows do not have to be guaranteed:  building a factory to manufacture widgets is an investment (building a factory to sell to someone else is a trade). Buying an oil field to pump the oil out is an investment (buying oil futures is a trade). Buying an equity solely for a dividend payment might be an investment, but hardly anyone buys an equity and holds it in perpetuity solely for the dividend: most people assume they can count on getting their capital out at some stage as well.

You can also consider this as liquidity risk. If you need someone to “take you out” of a position in order to make a return, then you are exposed to liquidity risk i.e. the risk that the market may not be able to buy at the time you wish to sell, and vice versa. Different asset types have different liquidity risks: holding a bond to maturity has all sorts of risks (e.g. credit risk) but does not have liquidity risk. Buying stocks for capital gains does entail liquidity risk even if you do not need someone to sell to until 2062.

I am aware that most people are not going to consider a retirement portfolio held for 30 years as a “trade”. However, defining the difference between trading and investment in terms of liquidity risk can focus attention on a crucial and often forgotten part of the process: the need to have someone to buy or sell whenever you want or need to liquidate. There is a considerable risk that the market may not want to transact with you when you want to, and certainly not at the price you might want to transact at. And certainly not if you happen to be part of a larger than usual generation that is all liquidating a similar portfolio at a similar time…. cough baby boomers cough cough.

For my next post, I would like some audience participation please. What is The Number One Job Of A Trader? Please post your answers below, or using the Contact form. Thanks.

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by thezikomoletter on August 8, 2012  •  Permalink
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Posted by thezikomoletter on August 8, 2012

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