An Investor's Meditations
When I was 21 (last year), I started on writing a book about my investing experience. However, it was quickly shelved after I started on a few pages as I had other ventures on the table. I came upon it again just in time for today's bear market, and it seems more relevant than ever. Below is the unabridged version. Hope this helps you in your investing endeavors.
Origin Date: MMXVIII VII VIV
Revision Date: MMXVIV IXIV
Meditations of An Investor
(For Self Improvement)
The Investor and His Purpose
The purpose of the investor is to compound wealth, and make himself as well as others rich
Make your money work hard for you. Think hard, work little. This is the polar opposite of today’s middle class work ethic.
Yet, the most important quality for the investor to have is vigilance. Buying and holding is a fallacy, and the cemetery of the financial markets are filled those who bought stocks or bonds on the Moscow, Konigsberg, Berlin, Tokyo, Shanghai, and Buenos Aires exchanges pre 1950. All empires must eventually come to an end, the U.S. is no different. It is the investor’s duty to assess the risks, rewards, and time horizon before he commences his operation.
In the long run we are all right
Being an investor is arguably the toughest yet most rewarding job in the world (next to traders). You are your own boss; your money works for you; you trade where you want; whenever you want; and how you want. Being able to support yourself without doing deals or selling products and designing inventions is truly a remarkable experience.
The financials market is like an ocean, there are storms (news), currents (drift), tides (earnings releases), but mostly just random ebbs and flows. The purpose of the investor is to filter the first three from the latter.
The Investor and His Legacy
The investor’s legacy lies not in the wealth he helped to create for others and himself. They are but sand and dust as his the heirs of his clients pass off their wealth into the hands of the arrogant. No, the investor legacy lies in his actions, and furthermore his calm, steadfast stance in the face of panic, and his remarkable ability to say no amongst a crowd driven by greed.
The Investor and His Uncle Point:
The job of the investor, first and foremost, must be to the performance of his shares from their fundamentals. A well researched opportunity may be completely ruined by the very fact that share prices are volatile, and the investor may be knocked out of his position the price hits his arbitrary stop loss, even though he may be eventually vindicated.
The Investor and His Mentality
There will be hell, but if you are going through hell, keep going.
We need more crashes, more consequences. We live in a riskless society; can’t pay your mortgage? No problem. Lost all your money in the stock market? No problem, just sue. The stock market is down today, no problem, we’ll print more money and prop it up. Can’t pay your taxes? No problem, just declare bankruptcy. Banks are about to go under? No problem, just raise taxes and bail them out.
Wealth is about longevity and having the right mental framework for success. Buffett whizzed past a lot of early birds with his consistency.
The Investor and His Strategy
Some strategies are inherently inferior than others. A strategy which calls for the consistent scalping of ticks and rare, large drawdowns from gap risk is akin to eating like a chicken and shitting like an elephant.
The Investor and Global Macro
The helmsman of the USS Dow Jones, is global macro; interest rates, unemployment; GDP growth; inflation; all play a crucial role in the sentiment of investors. Should these sentiments take a dive for the worse so will the ship regardless of how fundamentally intact it is, at least temporarily.
The Investor and Mean Reversion
The nature of the financial markets is in one word, counterintuitive. Think of the average joe who works all day, comes home, and checks on the holdings of his portfolio. The more it goes up, the more he will expect it to go up, and the more it goes down, the more he will panic and lose hope. Humans are not mean reversion thinkers, we have been conditioned since childhood to look for patterns and expect the patterns to continue. When you are driving and come to a red light, you do not try to fade the stop by stepping on the gas pedal. When you lose weight, you don’t stop when you have become think (at all time lows) and return to your habits of midnight ice cream.
The Enterprising Investor and His Ring of Fire
There are five tests for an enterprising investor:
Test of Skill - Can the investor objectively identify discrepencies from sentiment and value?
Test of Time - Can the investor consistent execute his strategy over a span of decades
Test of Courage - Can the investor act on his idea even when hordes of others disagrees with him?
Test of Luck - Are the investor’s trade structured in a way to profit from gap risk?
Test of Character - Does the investor need to sell his stocks at his worst time possible in order to put food on the table?
The Defensive Investor and His Treasure
There are three gems for a defensive investor:
Gem #1 - Time
Gem #2 - Luck
Gem #3 - Character
The Investor and Market Efficiency
The hypothesis of market efficiency is largely irrelevant to the investor because the markets are fundamentally a game based on incomplete information. Just because a random walk can model the returns of a stock index does not mean there isn’t another deterministic process (such as speculator utility) which can model returns just as well as the random walk. Correlation does not imply causation.
The more believers there are to market efficiency, the more opportunities there are for those who disbelieve it. Herding is and always will be humanity’s bastion blocking the way to mechanistic paradigm.
The Investor and Hedging
Hedging is defined as the act of riding a bike while the brakes are still on.
One hedges when the sky is blue, and takes them off immediately when the house is burning.
Research is the best hedge available. The markets have changed dramatically since the 1970s, hedges now are expensive, and are fairly valued to both the insurance seller and the insurance buyer.
The Investor and Leverage
Many HFs blew up in 2008 not because they did not have an edge, but because they ran out of capital. There was no equity left to ride the subsequent recovery after the nadir.
The Investor and Price Quotes
The current price for a stock, on appearance, perfectly reflects all information available at the instant and future prospects discounted to the present from all market participants. In reality, they are plagued with other people’s mistakes of judgement. The onus then transfers to the investor to filter the facts from the noise.
Prices move either way due to human expectation
The Investor and His Allies
Unfortunately, the game at hand here bares no resemblance to NATO. You stand alone, as a single entity, as a lone wolf, and your objective is to beat yourself at your own game.
The Investor and His Enemy
Enemy, in this sense, is used in the singular as the investor only has one enemy. Him/herself
The Investor and Trading
In terms of time horizon, an investor seeks to lay bricks for a foundation to build the city of Rome and knows it cannot be done in a single day. A trader seeks to rapidly expand what he has; the city of Hiroshima and knows very well it could be destroyed in within a morning.
The investor seeks to profit from drift whereas the trader seeks to profit from volatility. One can say the performance of an investor is directly inverse to the VIX where as the trader cannot make big killings without it.
Any schmuck can scalp a few ticks from the markets. Few traders could hold a large position size for an extended period of time, and even fewers could sit comfortably on his winners for the same duration. A great trader can do both.
As far as 400 years of stock market history has suggested. Trading and finance are two completely different phenomena.
The Investor and His Information
The Investor and News
Buyers buy up a stock in anticipation of good news and so when the news is actually delivered, there is a lack of buyers to balance sellers, resulting in plunging of shares. Hence why buy the rumor, sell the news. The reverse is true for bad news.
Volatility often gets bid up in anticipation of more volatility after the event. The fact is, after the event, fresh information has been delivered to the hands of every investor, greatly reducing uncertainty going forward, causing volatility to plunge.
In a bull market, bad news is ignored. Whilst in a bear market, good news continue to prop up false hope until government intervention in the downward spiral.
The Investor and Financial Analysis
Of particular fascination to the financial analysis is the concept of technical analysis, where [insert brief explanation]. The author however, has a strong bias against the legitimacy of such interpretation. When a price pattern begins to form, it is available to every market participants and no two alike will interpret it in the exact same manner. A bear shoulder pattern appearing at 12:30 pm on Monday; will likely be complete by 1:30 pm, day’s end, tomorrow, next month, next two months, next quarter, next half year, next year, 2 years later or may be a bear trap, could be a sign of bullish reversal, and there is your market. We all see what we want to see when we look at a chart.
In a world where we live in 24 hour days but stocks only trade for 6 ½, overnight risk must be transferred to someone in accordance with a substantial risk premium for holding so. Here steps in the investor.
The Investor and His Financial Paradigm
Life is not a dress rehearsal because you only live once. The investor is hardly likely to ever become successful by watching every step he takes or hedging every move. It is equally important to allocate a reasonable amount of capital to take some calculated chances as it is to protect your assets and health. This results in a much better economic utility than the “go big or go home” mentality which delivers one’s fate into the hands of stupidity.
The Investor and Gambling
The only way to get rich at a blackjack table is to be complete reckless. The professional will bet small and consistently on every match, which will prevent him from losing but not while capping his profits. On the other hand, the degenerate gambler, despite his odds against him, may make a killing stalking his entire net worth on a “hit me”.
Betting against a gambler is similar to betting against a player who only calls the number 09 on a roulette table; random, volatile changes in account value coupled with large fat tails on both ends.
Here are some of my old notes - a study done by the Casino industry insiders on pro gamblers. Risk mgmt for trading was derived from pro gamblers.
Gambling and trading are two entirely different birds, although there sure are plenty of speculators/traders/investors that are compulsive gamblers.
A skilled blackjack card counter has an advantage over the house of 0.5%, the count is favorable only about 15% of the time.
They win over the long run, expecting losing days, weeks, and months. Professional gamblers rarely sustain a long term winning percentage higher than 55 percent, and it's often as low as 53 or 54 percent.
Only 1 in 500 card counters are profitable over the long run. Casino's welcomed card counters with open arms when it went mainstream - their profits soared.
Bankroll - often misunderstood by novices, you need a bankroll of 100 times your max bet.
Their bet size of 1% of the bankroll contracts and expands with their bankroll.
The measure of success is not the percentage of winning bets, but the relative amount of profit they makes over any given period of time.
Why gamblers lose:
Bankroll too small - takes $10k to avg $10 per hour over the long run.
The fail to realize how bad the losing streaks will be.
Expecting daily profits - even the best of the best have losing streaks lasting up to a few months.
Too timid to vary bet sizes enough to make any substantial gains.
The brag to their friends about their winning days while hiding their losing days - self deceit.
Generally speaking, non-professional gamblers go wrong by risking too much of their bankroll on individual bets. They don't spread their risk thin enough over a big enough number of bets. Professionals use smaller bet sizes in proportion to their bankroll over larger numbers of bets. As a matter of fact, one good way to spot a non-pro is they risk more than 1-2% of his bankroll on each bet.
The Investor and His Performance
Making money does not in itself justify the strategy, no more than someone who cheats on his wife and never gets caught.
The primary objective of the investor is to investigate the economic nature of the securities he is acquiring/deposing based with knowledge of statistics, data, and modeling on his hand. Without it, seldom do the investor realize his performance are the result of luck or skill. While knowledge of the mathematics is not required to invest per se, it helps explains to himself and potential clients what he is doing. The it is not required that you, the reader, learns medicine before treating your back pain with an analgesic, but going to a doctor will help you understand why the back pain is occuring, and if further medical intervention is required.
The bad investor isn’t one who suffers large drawdowns but one who shops around and cannot consistently act upon one strategy. i.e. One who changes one’s strategy after a material decline to switch to a profitable one.
There are three points the investor must ask himself before initiating any position. What is the price target? What is the time target? And how much am I risking to achieve the aforementioned goals? A price target set by analysts upwards of +20 pts on a 100 stock may seem attractive, but if the stock regularly endures drawdowns of -30 pts then this trade is poor in terms of risk reward, even if the upside goal was to be reached within a period of two weeks.
Averaging down and refusing to take losses is the bane of traders and the strength of investors.
Do not confuse brains with a bull market.
Good investing isn’t about being able to beat the markets, but being able to beat your former self.
The Investor and His Tuition
The longer the results are positive, the more the investor believes he is right. Subsequently, more and more he will abandon his supposed “boring strategy” to pursue more “lucrative” opportunities. The final result is a set of results completely indistinguishable from luck, and highly susceptible to any slight turn in fortune. Unfortunately, most investors only find themselves swimming naked after the tide disperses, and not without paying substantial amounts of his wealth to learn his lesson.
Anyone with assets, the ability to leverage assets, and access to cheap credit are going down the road to wealth.
In terms of secret methods, secret strategy, algorithm, there are none. It’s just good old fashioned planting trees in the hopes they will bear fruits in the not so distant future.
Whether today was a blue sky or a brewing storm, never stop learning everything you can about the markets. This business changes every day, what one learns last year is already past. History always repeats itself in the modern day, but always in a different form after tweaking a few variables here and there.
The Investor and Diversification
Diversification, if done incorrectly, is similar to taking up additional seats on the Titanic to try and survive.
The low correlation assumption of assets fails completely during times of intense market selloffs, when all risk assets have a correlation of -1.
The Investor and His Luck
There are decades where nothing happens, and then there are weeks when decades happen. Almost all gains from the market came from outlier events, heck, 50% of the returns in the SPX in the past 50 years came from just ten trading days.
If you have a strategy with a large amount of risk, sooner or later, bad luck will get you. On the contrary, if you have a strategy with huge upside potential but low probability, eventually, even if you are the worst trader on Earth, luck will get to you. There are many stories on the exchange where guys made millions on trades that were merely mistakes on their parts and they left the floor to retire.
The Investor and His Emotions
Successful Investors are successful because they are built differently than most people. They have a complete emotional detachment to money, are completely disciplined, and work very hard.
The second trait for any investor is humility, one who acknowledges we possess very little tangible resource on the markets and who does not pretend there is some secret to wealth lurking beneath the shades.
The only who can save your portfolio from doom is yourself.
The market will not solve your emotional problems, instead, it will amplify them.
The Investor and His Edge
Edge (Synonymous with arbitrage)
Most of the time, sadly, an edge is what men tend to tell their wives after going through their mutual life savings trading.
1. Technology/Commission - Being able to execute trades with faster delay or lower cost than other market participants.
2. Order flow – Big banks and guys on trading floors who have access to this information.
3. Market making – Earning a spread on OTC products. Not everyone has the ability to trade with these professionals.
4. Unique Inputs - Having non conventional knowledge of variables and their values going into a model allows it to perform predictions better than everyone else.
LTCM was able to finance over $1 Trillion in leverage with zero interest using reverse repo agreements whereas most banks needed to pay 5%, resulting in a 50 billion dollar edge.
Moreover, they had a team of people with two nobel prizes, the best resumes, and the best education in the world. A team of star traders coupled with world class PH.Ds using stat of the art of technology to perform quantitative research and build mathematical models. In the end, their edge amounted to a 0.07% arbitrage before leverage.
One can lose big time while trading with an edge just as much as one could trade profitability without an edge. A bad trader will offset any positive expectation derived from an edge to begin with. Great traders can make money without an edge the same way a great athlete can be successful in sports even if he is smaller or slower than the other guys.
One qualitative edge is the amount of capital the investor starts off. The author recommends gathering at least two times the PDT requirements as dictated by SEC ($50K at time of writing) for success. The more capital you have, the more likely you are to succeed, and raise more in your favor. Those with account equity below the said bar seldom dig themselves out of the hole.
The Investor and His Taxes
Wealthy people do not pay taxes. Their net worth is not derived from wages but from assets and asset growth. Steve Job’s wealth came from the exponential growth of the stock options awarded to him, and did not even generate capital gains tax as he never sold the stock.
On the flip side, the poor make up for the lack of assets by growing in debt. Credit card debt, auto debt, student loan debt, mortgage debt, lease debt. While the rich are financing their lifestyle from the interest earned on their securities, the poor are paying this interest per their liabilities. The vicious cycle starts here, as their debt burden begins to grow while the assets of the rich continues to growth, and with the disparity between the two widening across generations as the financial papers are inherited, this results in fundamental inequality.
The Investor and Charting
Patterns on any stock can be largely replicated using a cumulative p&L for a coin toss. This is neither to say technical analysis is worse than fundamental analysis, but one must look for various signals, indicators, and patterns that are non random (such as extraneous drifts, gap ups, gap downs, verticals, breakouts, false breakouts, peak breakouts, no breakouts, single peaks, double peaks, triple peaks, peak recovery etc.)
A deterministic move begets a deterministic move
A random move begets a random move
Resistances are non random patterns
False breakout - 1) breakout is deterministically right but overshoots 2) breakout is deterministically false but euphoric (good spot results, poor future outlook) 3) breakout is completely due to randomness
Begin every trade with the idea that the trend is wrong
Look into the fundamental story for a forward positive outcome
Look into the chart for non random patterns
Look into historical data for conditional probabilities. i.e. see if this setup has been done before, and if it led to a positive outcome. (t distribution test)
Check option implied volatility (ATM forward, volatility smile, volatility curve) for timing
Draw out the pathway
Begin a core position
As variables change, begin auxillary positions to hedge risk (overnight vs daily risk)
Your job everyday is to learn everything thing you can about the financial markets, if you do this making money will take care of itself.
Without risk management, large winning streaks begets large winning streaks
All that matters are the details and outliers
E Pluribus Unum
Go with the times
See both sides of the equation
Most traders fail because they try to do what everyone else is doing, if 99% of traders don’t make money, then your job is to do what the 1% minority does.
When the trend is right, the trend is right small, when the trend is wrong, the trend is wrong BIG. caveat. the trend is often right and only wrong for a minority of times.
zero expectations of grandeur if winning, zero expectations of utter ruin when losing
If the trend is wrong, then the correct approach is to be contrarian
Good traders get out when they are wrong, great traders bet against themselves
Don’t pay attention to historical valuations or economic data unless they are indicative of future results
Have a trading journal to analyze results
Size is everything
The best traders can both hold winners and size
If there are 16054 stocks on U.S. exchanges and the trend is wrong 1% of the time in any given day, every day, there are 161 stocks which the trend is wrong.