The Little Book of Market Wizards

by Jack D. Schwager

  In all these cases, the action that feels good—getting a bargain, locking in a profit, holding out hope for avoiding a loss—is usually the wrong thing to do. The need for emotional satisfaction will lead most people to make decisions that are even worse than random, which is why the dart-throwing monkey will do better.

  As an empirical demonstration of how most people’s biases will lead them to make decisions that are worse than random, Eckhardt told the story of how one of Richard Dennis’s employees entered a charting contest that required predicting the year-end prices for a number of markets. This employee simply used the current prices of all the markets for his predictions. He finished in the top five among hundreds of contestants. In other words, at least 95 percent, and probably closer to 99 percent, of all the entrants’ predictions were worse than random.

  The Inadvertent Experiment

  In his book The Little Book That Beats the Market, Joel Greenblatt provided a value-based indicator for ranking stocks. He called this ranking indicator the Magic Formula, a name that poked fun at the hype normally accompanying market indicators, but also referred to the surprising efficacy of the measure. In fact, Greenblatt and his trading partner, Rob Goldstein, were so impressed with how well the Magic Formula worked that they set up an eponymous website that investors could use to pick their own stocks from a limited list of equities selected based on the value rankings of the formula. Investors were encouraged to pick at least 20 to 30 stocks from the list to get close to the average performance of these stocks, as opposed to being overly dependent on a few names. As a last-minute addition, they also included a check box that gave investors the option of having their account managed rather than picking the stocks themselves. It turned out that less 10 percent of people using the site for investment chose to do their own selection—the original concept—while the overwhelming majority chose the managed portfolio option.

  Greenblatt then tracked how the self-managed portfolios fared versus the managed portfolios. After the first two years, on average, the managed portfolios outperformed the self-managed portfolios by 25 percent, even though both were constructed from the same list of stocks. The differential between the managed and the self-managed portfolios reflected the impact of human selection and timing decisions. Letting investors make their own decisions (picking specific stocks from the list and timing the purchase and sale of these stocks) destroyed all the performance vis-à-vis investing equal-dollar amounts in a diversified portfolio of these stocks without any attempt to time the entries and exits of the holdings.

  [Investors] did much worse than random in selecting stocks from our prescreened list, probably because by avoiding the stocks that were particularly painful to own, they missed some of the biggest winners.

  Joel Greenblatt

  I asked Greenblatt why he thought the investors making their own decisions did so much worse. Greenblatt replied, “They took their exposure down when the market fell. They tended to sell when individual stocks or their portfolio as a whole underperformed. They did much worse than random in selecting stocks from our prescreened list, probably because by avoiding the stocks that were particularly painful to own, they missed some of the biggest winners.” Think about it. Don’t these sound like decisions made to seek comfort?

  Greenblatt had inadvertently created a control group experiment that demonstrated the impact of human decisions in the market vis-à-vis a well-defined benchmark—a diversified portfolio consisting of the same list of stocks without any selection or timing inputs. Investors could have achieved the same expected return (with sampling variation) if they had randomly selected their stocks, investing equal-dollar amounts in each, and applying the same timing-free buy-and-hold approach. Or, equivalently, the same expected return could have been achieved from a portfolio based on the dart throws of a monkey at the list of the selected stocks. Greenblatt’s inadvertent experiment effectively provided a real-life validation of Eckhardt’s contention that the proverbial monkey would outperform humans making their own investment decisions.

  Behavioral Economics and Trading

  Eckhardt ties in human biases to the tendency for the majority of market participants to lose. As Eckhardt explains it, “There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you’ll gravitate toward the majority and invariably lose.”

  Eckhardt’s observations are well aligned with the findings of behavioral economists whose research has demonstrated that people inherently make irrational investment decisions. For example, in one classic experiment conducted by Daniel Kahneman and Amos Tversky, pioneers in the field of prospect theory, subjects were given a hypothetical choice between a sure $3,000 gain versus an 80 percent chance of a $4,000 gain and a 20 percent chance of not getting anything.1 The vast majority of people preferred the sure $3,000 gain, even though the other alternative had a higher expected gain (0.80 × $4,000 = $3,200). Then they flipped the question around and gave people a choice between a certain loss of $3,000 versus an 80 percent chance of losing $4,000 and a 20 percent chance of not losing anything. In this case, the vast majority chose to gamble and take the 80 percent chance of a $4,000 loss, even though the expected loss would be $3,200. In both cases, people made irrational choices because they selected the alternative with the smaller expected gain or larger expected loss. Why? Because the experiment reflects a quirk in human behavior in regard to risk and gain: People are risk averse when it comes to gains, but are risk takers when it comes to avoiding a loss. This behavioral quirk relates very much to trading, as it explains why people tend to let their losses run and cut their profits short. So the old cliché (but not any less valid advice) to “let your profits run and cut your losses short” is actually the exact opposite of what most people tend to do.2

  Why Emotions Affect Even Computerized Trading

  Interestingly, the need for emotional comfort will even have a detrimental impact on systematic trading (i.e., computerized, rule-driven trading), an area of trading one might reasonably have assumed would be free of emotionally based decisions. Typically, when people approach systematic trading, they will test their system rules and then discover that there are many past instances when following the system rules would have led to uncomfortably large equity drawdowns—an observation that will be true even if the system is profitable over the long run. The natural instinct is to revise the system rules or add additional rules that mitigate these poorly performing past periods. This process can be repeated multiple times, making the simulated equity curve smoother and smoother with each iteration. In effect, the natural inclination is to optimize system rules for past price behavior. The resulting final optimized system will generate an equity curve that looks like a money machine. Such a highly optimized system will be much more comfortable to trade because, after all, look how well it would have done in the past.

  The irony, however, is that the more a system has been optimized to improve its past performance, the less likely it is to perform well in the future. The rub is that the system’s impressive simulated results are achieved with the hindsight knowledge of past prices. Future prices will be different, so the more the system rules are tweaked to fit historical prices, the less likely the system will work on future prices. Once again, the human instinct to seek emotional comfort has negative consequences in trading—even in computerized trading!

  Conclusion

  The lesson of this chapter is that most people lose money in trading not only because they lack skill (that is, they don’t have an edge), but also because their inclination to make the comfortable choices in trading (or investing) will actually lead to worse-than-random results. Awareness of this inherent human handicap to trading is the first step in resisting the temptation to make trading decisions that feel good but are wrong on balance.

  Notes

&nb
sp; 1. Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47, no. 2 (March 1979): 263–291. Prospect theory is a branch of decision theory that attempts to explain why individuals make decisions that deviate from rational decision making by examining how the expected outcomes of alternative choices are perceived (definition source: www.qfinance.com).

  2. This paragraph has been adapted from Jack D. Schwager, Market Sense and Nonsense (Hoboken, NJ: John Wiley & Sons, 2012).

  Chapter Seventeen

  Emotions and Trading

  Free solo climbing is a sport that defies belief. The free solo climber forgoes all protective equipment in making ascents. Picture an unroped climber 2,000 feet up on a sheer, vertical rock wall, and you get the idea. Any mistake is potentially fatal. You would think that any practitioner engaged in this sport would be flooded with adrenaline—and you would be wrong.

  Alex Honnold is widely acknowledged to be the best free-soloing climber in the world, whose extraordinary feats include the first free solo climb up the northwest face of Half Dome, a 2,000-foot vertical wall in Yosemite National Park. He was featured in a segment of the October 10, 2011, episode of 60 Minutes.

  At one point, the correspondent, Lara Logan, asked Honnold, “Do you feel the adrenaline at all?”

  If I get a rush, it means that something has gone horribly wrong.

  Alex Honnold

  Honnold replied, “There is no adrenaline rush. . . . If I get a rush, it means that something has gone horribly wrong. . . . The whole thing should be pretty slow and controlled.”

  Those words could just as well apply to the expert trader. The Hollywood image of trading as an adrenaline-filled, high-risk-assuming endeavor may make for good visuals, but it has nothing to do with successful trading.

  Expensive Excitement

  Larry Hite was once playing tennis with a friend who had gone broke trading futures. His friend couldn’t understand how Larry could just follow a computerized system.

  “Larry,” he asked, “how can you trade the way you do? Isn’t it boring?

  Hite replied, “I don’t trade for excitement; I trade to win.”

  Charles Faulkner, who has used his research on modeling human excellence to coach traders, told me about one of his early clients who was a very emotional trader. This client had developed a successful system but couldn’t follow it. Faulkner taught him some techniques for emotionally detaching himself from the markets. Initially, the techniques worked, and the trader was profitable as he followed the system. One day when Faulkner was working with him, the trader was up $7,000 in the first few hours. Just as Faulkner was feeling rather smug about his apparent success in helping this trader, the trader turned to him and in a monotone said, “This is boring.” The trader eventually blew up. “He knew how to go into an emotionally detached state, but he didn’t like to be there,” said Faulkner. The lesson is that the markets are an expensive place to look for excitement.

  You Can’t Win If You Have to Win

  When Stanley Druckenmiller started his money management firm, Duquesne Capital Management, in 1981, he was entirely dependent on the income stream from a consulting contract with Drysdale Securities that paid him $10,000 per month. In May 1982, Drysdale Securities abruptly went out of business. As a result, Druckenmiller had a cash flow problem. His $7 million in assets under management at the time paid $70,000 per year in fees, but his overhead was $180,000 per year. The firm’s capital on hand was only $50,000. Without the consulting income from Drysdale, the survival of his management firm was threatened.

  At the time, Druckenmiller was absolutely convinced that interest rates, which had receded from all-time-record highs a year earlier, would continue to decline. Druckenmiller took the firm’s entire $50,000 and used it to margin a highly leveraged long position in Treasury bill futures.1 He literally bet the company on the trade. In four days, Druckenmiller lost everything when interest rates began rising. The irony is that only one week later, rates hit their high for the cycle and never again remotely approached that level. Druckenmiller had bought T-bill futures within one week of a major bottom—you can’t time a position much better than that—and still lost all his money. Druckenmiller’s analysis was absolutely right, but the emotionalism that underlay the trade—excessive leverage and lack of planning in a Hail Mary attempt to save his firm—doomed it to failure. The market will seldom reward the carelessness of trades born of desperation.

  Impulsive Trades

  Impulsive trades can be dangerous. When asked to recall their most painful trades, the Market Wizards often cited impulsive trades as examples.

  The trade that Bruce Kovner considers “far and away” his most painful trade and, psychologically, his “going-bust trade” was the product of an impulsive decision. Very early in his trading career, in 1977, there was a shortage of soybeans. Given the tight supplies and persistent strong demand, Kovner anticipated there would be fears of running out of soybeans before new crop supplies became available. To profit from this situation, Kovner put on a highly leveraged spread position, going long the old crop July contract and short the new crop November contract. His expectation was that the shortage would cause the old crop July contract to rise much more steeply than the new crop November contract. Kovner’s projection was not merely right, but spectacularly right. At one point, the market entered a string of limit-up moves led by the old crop contracts. Kovner’s profits were soaring.

  One morning when the market reached new highs, Kovner received a call from his broker. “Soybeans are going to the moon!” his broker excitedly told him. “It looks like July is going limit up, and November is sure to follow. You are a fool to stay short the November contracts. Let me lift your November shorts for you, and when the market goes limit up for the next few days, you will make more money.” Kovner agreed to cover his short November position, leaving himself just outright long the July contract.

  I asked Kovner if this was a spur-of-the-moment decision. “It was a moment of insanity,” he replied.

  Just 15 minutes later, Kovner’s broker called again. This time around, he was frantic. “I don’t know how to tell you this, but the market is limit down! I don’t know if I can get you out.”

  Kovner went into shock. He yelled at his broker to get him out of the July contract. Fortunately, the market traded off the limit for a few minutes and he was able to get out. In the following days, the market went down as quickly as it had risen. If he had not gotten out immediately, Kovner could have lost more than all his money because he was heavily margined. As it was, between the moment he agreed to let his broker liquidate only the short side of his spread position and the point when the long side was liquidated later that day, his account equity was halved.

  Kovner recognized that his impulsive decision to lift the short side of his spread position in the midst of a market panic showed a complete disregard for risk. “I think what bothered me so much,” Kovner said, “was the realization that I had lost a process of rationality that I thought I had.”

  Ironically, one of the trades that Michael Marcus recalled as being among his most painful also involved an impulsive decision made in the soybean market. Marcus went long soybeans in the great bull market of 1973, which saw soybean prices triple their previous record highs. As the rally developed, Marcus impulsively took profits on his entire position. As he described it, “I was trying to be fancy instead of staying with the trend.” Ed Seykota, who worked at the same firm and served as a model for Marcus, stayed with his position, since there was no sign of a trend reversal. The soybean market then proceeded to go limit up for 12 consecutive days. During this period, Marcus dreaded going to work, knowing that soybeans would be bid limit up again and that he was out of his position while Seykota was still in his. The experience was so agonizing that one day when Marcus felt he couldn’t stand it anymore, he took Thorazine to dull the pain.

  Marty Schwartz warned against the danger of acting impulsiv
ely to recover trading losses. “Whenever you are hit,” Schwartz said, “you are very upset emotionally. Most traders try to make it back immediately; they try to play bigger. Whenever you try to get all your losses back at once, you are most often doomed to fail.”

  Based on my own personal experience, I would say there is probably no class of trades with a higher failure rate than impulsive trades. Regardless of what approach you use, once you have defined a trading strategy, you should stick with the game plan and avoid impulsive trading decisions. Some examples of impulsive trading decisions are putting on an unplanned trade, taking profits on a position before either the target objective or the stop loss is reached, and implementing a trade because a friend or some so-called market expert recommended it.

  Don’t Confuse Intuition with Impulse

  Impulsive trades should not be confused with intuitive trades. The former are almost invariably bad ideas, while the latter can be high-probability trades for experienced traders.

  There is nothing mystical or superstitious about intuition. As I see it, intuition is simply subconscious experience. When a trader has an intuition that the market will move in a given direction, it is often a subconscious recognition of similar past situations.