This Never Happens

You know what never happens? This never happens:

Exponential acceleration in the direction of a trend is never followed by stabilization at a new plateau. It does not matter if the chart represents Gold futures, or house prices, or population levels: extreme moves are followed by collapses, not by plateaus.

The difficulty, of course, lies in picking the top. The graves are filled with the ruined balance sheets of those who tried to pick the top too early.

The Benefits And Dangers Of Correlation

Correlation can be very beneficial for a portfolio. It allows you to increase returns while keeping risk constant, or to decrease risk while keeping return constant i.e. adding positive return, non-correlated instruments or strategies to your portfolio should increase risk-adjusted returns.

That is the theory. It works in practice too, most of the time. Unfortunately, correlations are not constant. For example, the WSJ reported that

The correlation between gold and the 10-year Treasury has jumped above 0.6 at some points over the past five years and has fallen below minus-0.8 during others, changing direction several times.

It is important to understand that correlation is more than just the CORREL function in Excel. As Ray Dalio says,

People think that a thing called correlation exists. That’s wrong. What is really happening is that each market is behaving logically based on its own determinants, and as the nature of those determinants changes, what we call correlation changes. For example, when economic growth expectations are volatile, stocks and bonds will be negatively correlated… However in an environment where inflation expectations are volatile, stocks and bonds will be positively correlated.

My biggest problem with relying on correlation is that it is likely to fail you. Worse, it is likely to fail you just when you need it most. For example, during the 2008 crisis, several traditionally uncorrelated assets became highly correlated, as investors were forced to liquidate similar portfolios. Things that were previously non-correlated have an unfortunate habit of losing their non-correlation just when you need it most i.e. in periods of extreme distress and risk. Thus, to rely on non-correlation as a core part of your trading strategy strikes me as asking for trouble.

I try to structure my portfolio so that I can benefit from non-correlation, but am not dependent on it.  I try to add non-correlated trades into the portfolio, and try to avoid adding trades that are likely to be highly correlated with my existing positions. However, I never add a trade because it is non-correlated: to do so would be inviting danger.

Relying on non-correlation is like the banker who will only lend you umbrellas when it is not raining: everything looks fine until you need it. Try to include non-correlated assets in your portfolio, but you should also manage risk at a portfolio level. Stress-test your portfolio to see what happens if everything becomes perfectly correlated, and have a plan to respond if that happens.  To quote Taleb:

Anything that relies on correlation is charlatanism.

Finally, please indulge me a personal note. You will be pleased to hear that I achieved one of my great life ambitions today: I have finally won as many Tour de France titles as Lance Armstrong.

You Are Average

I once quite offended one of my good friends, a reasonably successful trader, by telling him that he was average. That is not how we are trained to think: we are conditioned to think of ourselves as high-performance alpha-type people who are a cut above the rest. Few traders have a self-image of themselves as average.

The problem is, the markets are made up of lots of people like that. Everyone has access to similar technology. Everyone can see the same charts and publicly available fundamentals. Everyone is intelligent, hard-working and highly motivated.

My friend took being called average as an insult, but it really wasn’t. My point was that everyone else in the markets has a good reason for being there, or at least they think they do. Every trade consists of a buy and a sell, and both counterparties have good reasons to think that they are going to be right.

When you do a trade, you’d better have a good reason. Because the guy on the other side does.

I Will Not Go Bankrupt Tomorrow

I cannot guarantee you many things. But I can guarantee you that I will not go bankrupt tomorrow.

I might lose money. All my trades might get stopped out. All my new trades might go against me immediately. But I will not lose so much that I am forced out of business.

How do I know this? Because staying in business is the number one job of a trader.

As a trader there are some things that you can control, and some that you cannot. You cannot control what the market will do. But you can choose the terms on which you engage the market.

You can choose

  • Which markets to trade (market selection).
  • When to enter and exit (trade selection).
  • How much to buy or sell (position size).
  • How much of your portfolio to risk at any time (portfolio heat).

Of all these, market and trade selection gets the most attention in the financial press and blogosphere. Position size gets mentioned occasionally, but nowhere near enough given its importance: far too many traders trade the same number of share, contracts or dollars per trade regardless of the underlying market conditions. And portfolio heat gets the least attention of all.

Ed Seykota talks about bet size and portfolio heat as being far more important than trade selection, or fiddling with whether to use a 20 day or 22 day moving average, or whether a 15 p/e is cheap or expensive.

Think of every trade as a bet. If you bet small every time, you are unlikely to win very much. If you bet large, you are dramatically increasing your risk of ruin i.e. the chance that an unlucky streak will take you out the game. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin.

Portfolio heat refers to the number of open positions at any one time, and the amount of open risk in those positions. Risking 10% of your portfolio on one trade is very risky. Risking 5% on two (uncorrelated) positions is less risky. Risking 1% on each of 10 different trades is much safer. Risking 1% on 5 different trades is safer still.

Portfolio heat also considers the amount of open profit in a position. Imagine buying a stock at $100, with a stop of $95, and the stock rises to $110. If you keep your stop at $95, then the $10 gain is still at risk: it could disappear tomorrow. If you use trailing stops and raise your stop to break even or $105, you can reduce the amount of your portfolio at risk. Raising stops in the direction of winning trades allows you to reduce portfolio heat while still allowing winners to run.

I control my trading risk at several different levels. I have a maximum amount of my portfolio at risk on any trade. I also have a maximum number of positions open at any one time: even if my system gives me 50 phenomenal trade entry signals, I will not take them all, since that would put too much of my portfolio at risk.

I have no idea how much I could win tomorrow, but I know exactly how much I could lose. I am not going bankrupt tomorrow, and that helps me sleep.

Making Money Feels Good; Losing Money Feels Worse

During my trading career, I have made money and I have lost money. And I can tell you that I much prefer making money. Making money feels good.

But here is the weird thing: losing money feels worse than making money feels good. Much, much worse. The pain and the pleasure are asymmetric.

Behavioral psychology offers some explanations why (see Daniel Kahneman’s “Thinking Fast And Slow“). Using proxies and measurements for pleasure and pain, they suggest that humans experience losing something they have roughly twice as severely as gaining something they did not have. Put another way, emotionally speaking, it takes twice as big a gain to make up for a loss.

This has direct applications to trading. It is another reason why I focus on strictly limiting my drawdowns: not only does the math work against you, but the emotions do too.