risk


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Staying in the game, not blowing up your account, is the way to approach the markets. Your risk must always be controlled, ultimately that’s all that you can control.

This week’s trade will have a trading component to it. The risk will be defined and controlled. Just adding the last touches.

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From derekhenquist

“Gambling is taking a risk when the odds are against you. Speculating is taking a risk when the odds are in your favor.” Victor Sperandeo

This quote stuck with me since I first read Trader Vic: Methods of a Wall Street Master, still one of my favorite books. A number of stories lately have reminded me of the comparisons and contrasts between gambling and market speculation. The first was a Wealthtrack interview(HT @researchpuzzler) with Bruce Berkowitz of Fairholme Funds, recently named Morningstar Fund Manager of the Decade.

He talks of dropping out of high school as a 15 year old to run his bookie business, and the lessons learned. I can relate, as I was known to book a few bets in my teenage years. Not enough to consider dropping out of school, but enough to pick up lessons that would shape the way I later viewed financial markets. The hope, fear, and greed so influential in markets became obvious to me at a young age. Funny how the largest bets would always be on a midnight Hawaii game, and of course the Monday night NFL game. The desire to breakeven is overwhelming for those at a loss, so accepting behavioral finance was a no-brainer for me.

Another story highlighting some parallels with gambling came from Dr. Brett Steenbarger, discussing the signs of trading addiction as though he was talking about gambling. Anyone participating in trading or investing knows how easy it is to overwatch, overtrade, rationalize loss, etc. The first thing a new trader needs to do is recognize destructive behavior, and create a plan for protecting you from yourself.

Finally, a tweet from @milktrader pointed out that “the only difference between gambling and trading is that your amount at risk and amount of potential reward varies with trading.” I agree, but there’s more to it. The parallels are obvious, from the lack of control over outcome to the illusion of knowledge to the physiological effects of having a stake in the outcome. However, the differences are substantial…and mostly mathematical.

The expectancy in gambling is ALWAYS terrible, while market speculation at times offers outstanding opportunities. To get a 2:1 or 3:1 opportunity in gambling, one needs to accept incredibly low odds of victory. In financial markets, those 2:1 or above opportunities come around like clockwork and offer high enough probability that long-term positive expectancy is possible. Not only that, but the market speculator has the opportunity to adjust his or her position after the game begins…when was the last horse race where you could take a little off the table after the first turn? Or reclaim most of your bet when your horse stumbles out of the gate?

I’ll leave the neuroscience to the experts, but it seems to me that we need to coordinate our left brain(rational) and right brain(experiential) in laying out the role of each. We want to allow our intuition to shine through, but within the overall structure of positive expectancy. No matter how hard one tries, the math of gambling can’t come close to touching the opportunities for building a business out of the markets.

Gambling, is creating a risk, where none previously existed, usually for entertainment value. Speculation/Investing is however the assumption of risk that already exists and needs to be bourne by someone.

Hedge Fund Ebullio Capital: Down 86.25% In One Month

By now, many of you may have already heard the startling tale of Lars Steffensen’s hedge fund Ebullio Capital Management. For the month of February 2010, they were down a whopping 86.25%. That brought their year to date total return to -95.83%. Immediately, questions swirl in one’s head such as ‘How did this happen? What kind of risk management did they have in place? How will they recover?’ Remarkably, their investor letter had quite a calm tone to it. And even more surprisingly, the rationale for how such a travesty happened was quite vague.

No, not really. But wow – what the hell happened here?

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Ten principles for a Black Swan-proofworld
By Nassim Nicholas Taleb

Published: April 8 2009 03:00 | Last updated: April 8 2009 03:00

1. What is fragile should break early while it is still small . Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

2. No socialisation of losses and privatisation of gains . Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus . The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks . Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity . Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

8. Do not give an addict more drugs if he has withdrawal pains . Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement . Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

10. Make an omelette with the broken eggs . Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buy-outs, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.

In other words, a place more resistant to black swans.

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Someone chopped through my phone line, and down went my broadband connection and phone. The US markets open at 3.30am NZ time, neighbors don’t appreciate people banging on the door to use their phone, strange buggers these kiwi’s.

Thus, mobile phone time, just for emergencies. However, it looks like I copped a bit of luck, my positions are all a little higher, but relying on luck is a good way to blow-up-accounts.

From The Economist

THERE is such a thing as a free lunch. That, at least, is what pension funds have been told in recent years. Diversify into new asset classes and your portfolio can improve the trade-off between risk and return because you will be making uncorrelated bets.

Boy, did pension funds diversify. They bought emerging-market equities, corporate bonds, commodities and property, while giving money to hedge funds and private-equity managers with their complex strategies and high fees.

The idea was to “be like Yale”, the university endowment fund run by David Swensen, a celebrated investor, which started to diversify into hedge funds and private equity in the 1980s. Compared with other institutional investors over the past 20 years, Yale had very little exposure to conventional equities. It also produced remarkably strong returns.

But those who thought Yale had found the key to success have been disappointed. Every one of those diversified bets has turned sour this year. In retrospect, it looks like the strategy had two problems. The first was that all risky assets were boosted by the same factors: low interest rates and healthy global growth. That encouraged investors to use leverage, or borrowed money, to enhance returns. The result was what Jeremy Grantham of GMO, a fund-management group, describes as “the first truly global bubble”. As confidence has unravelled, investors have been forced to sell all those asset classes simultaneously, driving down prices across the board.

The second, and related, problem is that some of the asset classes were quite small. Initially, this illiquidity was attractive since it seemed to offer more alluring returns. And as more investors became involved, their liquidity duly improved. But they still suffer from the “rowing boat” factor. When everyone tries to exit the asset class at once, the vessel capsizes.

Furthermore, some of these asset classes were always likely to be driven by the same factors as stockmarkets. Private-equity funds, for example, give investors exposure to the same kinds of risks as quoted companies, only with added leverage.

So was the whole idea of diversification a write-off from the start? The strategy’s defenders say no. They argue that pension funds (and other institutional investors) had made too big a bet on equities in the 1990s. When the bet went wrong with the bursting of the dotcom bubble, funds went into deficit.

They accept that, in a crisis, correlations head towards one; in other words, all asset classes (except government bonds) tend to fall together. But the diversifiers have three counter-arguments. The first is that any correlation less than one is still worth having. Hedge funds may have performed badly this year but their losses have been far lower than those of equity markets.

Second, there is a difference between short-term correlations and long-term ones. If you take a five- or ten-year view, it still looks as if property, commodities and the rest offer some diversification benefits. They did so during the equity bear market of 2000-02, for example.

Third, consultants like Colin Robertson of Hewitt Associates argue that diversification does work when it is applied in a sophisticated way. There is no point in diversifying if the investment does not offer a genuinely different source of return (much of private equity falls into this category) or if the asset is already overvalued.

Yet even allowing for this, diversification has surely not offered the benefits most pension funds expected. Indeed, it may have had perverse results. In the old days, with equities trading at below-average valuations, funds would now be on a buying spree. They could afford to ignore the short-term risks because of the long-term nature of their liabilities. Pension funds thus acted as an automatic stabiliser for the market.

This time round, that does not seem to be happening. One reason may be accounting changes which make pension-fund managers more focused on the short term. Another, however, may be the strategic drive to diversification. The Wall Street Journal has reported that CalPERS, America’s largest public-pension fund, has been selling shares to meet commitments to put more money into private-equity firms.

The final problem with diversification has been the cost. Investing in quoted shares via an index fund is very cheap—a fraction of a percentage point. But diversified asset classes cost more to trade and involve higher management fees, expenses that eat into pension-fund returns.

So perhaps diversification has been a free lunch after all. Not for the pension funds, but for the fund managers.

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