We Are Traders - A tribute to all those trading the markets

Niels Jensen’s Confessions of an Investor

The problems with Modern Portfolio Theory (MPT)

“..I would like to spend a moment on MPT, as I believe it is important to understand the shortcomings of the prevailing approach to investment and risk management. [..] Let’s take a closer look at three of the most important assumptions behind MPT (there are many more assumptions behind Modern Portfolio Theory. Wikipedia is a good place to start should you wish to read more about it):

1. Risk-free investments exist and every rational investor invests at least some of his savings in such assets, which pay a risk-free rate of return.

2. Returns are independently and identically-distributed random variables (returns are trendless and follow a normal distribution, in plain English).

3. Investors can establish objective and accurate forecasts of future returns by observing historical return patterns. Strictly speaking, this assumption was relaxed by Fischer Black in 1972 when he demonstrated that MPT doesn’t require the presence of a risk-free asset; an asset with a beta of zero to the market would suffice.

Well, if these assumptions are meant to stand the test of time, then good old Markowitz (the father of MPT) is in trouble. Truth be told, none of the three stand up to closer scrutiny. The concept of risk-free investing no longer exists, post 2008. Banks are giant hedge funds which cannot be trusted and even government bonds look dicey in today’s world. Secondly, returns are clearly not random. If you have any doubts, just look at how the trend-following managed futures funds make their money. Thirdly, from 26 years of investment experience, I can testify to the fact that historical returns provide little or no guidance as to the direction of future returns.

A new approach is required.

So what does all of this mean? First of all it means that universities and business schools all over the world should clear up their acts. Two generations of so-called financial experts have been indoctrinated to believe that MPT is how you should approach the management of investments and risk whereas, in reality, nothing could be further from the truth. It also means that investors should kick some old habits and re-think how they do their portfolio construction. Specifically, it means that: [..]

i. the notion of the “market portfolio” being an appropriate performance benchmark should be discarded;

ii. there is in reality no meaningful distinction between strategic and tactical asset allocation – the difference is illusory;

iii. investors should once and for all reject the notion that there is an optimal portfolio for each investor from which he or she should only deviate “tactically” in the shorter run;

iv. market timing deserves more credit than it is given;

v. MPT is a straitjacket preventing investors from rotating between different classes of risky assets (with vastly different risk/return profiles) as market conditions change.

Please note that this does not imply that asset allocation is irrelevant. Far from it. However, it does mean that a bespoke approach to asset allocation, where individual circumstances drive portfolio construction, is likely to be superior to a more generic approach based on a strategic core and a tactical overlay.

[..]

A solution to the problem

Here is what I would do in terms of applying his thinking into a modern day investment approach:

1. Do what you do best. Some investors are made for short-term trading. Others are much more suited for long-term investing (like me). Don’t be shy to utilize whatever edge you may have. MPT suggests that markets are efficient. Nothing could be further from the truth. If you have spent your entire career in the medical device industry, the chances are that you understand this industry better than most. Use it when managing your own assets. Insider trading is illegal; utilizing a life time of experience is not.

2. Take advantage of mean reversion. Mean reversion is one of the most powerful mechanisms in the world of investments. At the highest of levels, wealth has a long term ‘equilibrium’ value of about 3.5 times GDP. As recently as 2007, wealth was well above the long term equilibrium value and signaled overvaluation in many asset classes. But be careful with the timing aspect of mean reversion. The fact that an asset class is over - or undervalued relative to its long term average tells you nothing in terms of when the trend will reverse. A good rule of thumb is to buy into asset classes when they are at least a couple of standard deviations below their mean value.

3. Be cognizant of herding. We are all guilty of keeping at least one eye on other investors, and we are certainly guilty of letting it influence our own investment decisions. This is how investment trends become investment bubbles and fortunes are wiped out. Herding is relatively easy to spot despite the fact that former Fed chairman Alan Greenspan argued otherwise – probably because it was a convenient argument at the time. But herding is also subject to the greater fool theory. You can make a lot of money investing in fundamentally unsound assets, as long as you can find a greater fool to whom you can sell it at a higher price. It works fine but only to a point.

4. Think outside-the-box. All those millions of baby boomers all over the western world who will retire in the next 10-15 years have been told by the MPT-trained financial advisers that they need to lighten up on equities and fill their portfolios with bonds, because they need the income to live on in old age. STOP! Who says that bonds can’t be riskier investments than equities? When circumstances change, you should change your investment approach accordingly and not rely on historical norms. Given the state of fiscal affairs in Europe and North America, it does not seem unreasonable to suggest that circumstances have indeed changed.

5. Bring non-correlated asset classes into the frame. One should consider having a core allocation to non-correlated assets. Traditionally, many non-correlated asset classes have not met the liquidity terms required by the majority of investors [..], but there are exceptions, the most obvious one being managed futures. The asset class proved its worth in 2008 with managed futures funds typically up in the range of 20-30% that year.

6. Take advantage of investor constraints and biases. The classic, but by no means only, example is the outsized impact a downgrade to below investment grade (i.e. a credit rating below BBB) may have on corporate bonds, as some institutional investors are not permitted to own high yield bonds and are thus forced to sell regardless of price when the downgrade takes place.”

Source: Birthdays and Investment Risk.

George Soros Bloomberg Interview

On stimulus vs. austerity and whether U.S. debt impacts the world:

"If you have a growing economy, you can tolerate a higher level of debt. And if you have too much debt and you have a recession, you get into what they called debt check. This is the big issue. "

"I am afraid it is overshadowed by political considerations. You have a financial crisis in Europe. There is the pressure of Spain and Portugal and so on. But debt is a different problem. Those countries are part of the European bloc and they are not in a position to issue their own currency. We can issue our own currency. In fact, the dollar is quite strong. It is really a matter of political judgment. That is where you have different opinions."

"There is very a strong push to tighten the budget as a way to reduce government spending. It's a resistance to any kind of tax increase and tightening, particularly the budget of the states. The [U.S.] states cannot issue their own currency. They are in a similar situation to Spain and Portugal. There is a danger that by pushing this too far, you could abort the very fragile economic recovery that you are currently enjoying and push the economy once again into a slowdown or a recession."

"I rather fear these political forces will push it into a recession. In my opinion, the country could actually absorb some more debt in order to get the economy going."

On the ECB vs. the Fed – who is doing it right?:

"Two different directives govern the European Central bank and the U.S. Federal Reserve. In the case of Europe, it's a one-sided directive. Their only job is to prevent inflation, and in the case of the U.S., it is more balanced, to maintain employment and financial stability."

On whether the U.S. dollar is still a safe asset:

"There's a big question is whether the U.S. dollar should be the main reserve currency and in fact it no longer is because it maybe accounts for two-thirds of the monetary reserves. The euro is an alternative and there's a lot of diversification into other currencies and even more into commodities. Not only gold, but actually oil is now an asset class for investors. That has put some upward pressure on the commodities."

On whether the sovereign debt crisis has diminished euro's chances of becoming a reserve currency:

"The euro is under a cloud, but that is exactly because there are some inflationary pressures from the price of commodities, particularly now oil and also food prices have risen. That is what has induced the European Central Bank to raise interest rates at a time which is, in my opinion, quite inappropriate…It is not appropriate in current circumstances when you have a number of countries that are suffering from too much debt and high interest rates that they have to pay."

On China's economy:

"China has really stimulated its economy full force very successfully and now it is trying to rein in the rate of growth, and is exercising very strong constraints on the banking system. But because of that constraint, and because of the big demand for money, a shadow banking system has arisen and is growing very rapidly. So while the big banks under direct central control are in fact refusing to lend, there is a shadow banking system that is growing out of control. There is a real danger there of wage price inflation because prices have gone up, particularly real estate prices have gone up because there was a real estate boom."

"Therefore, wage demands have risen, and we now have 20%, 30% wage increases. The Chinese government has made a mistake not allowing its currency to appreciate, which would have controlled the price of inflation. Instead of that, we now have this wage pressure, which is a little bit out of their control."

On the Chinese economic approach and whether they did something right:

"[The Chinese] were the major beneficiaries of globalization. They were the big winners in the financial crash because their economy was largely isolated because they have capital controls on their currency. They have a two-tiered currency system, whereas the rest of the world allows free movement for capital, and you had a runaway expansion of credit and leverage which then resulted in the financial crash, and China was largely immune. So, they benefited tremendously."

"Their system, which really stands in contrast to the international system, international capitalism with free movement of capital, and then there is a system where the state controls the economy. That system actually has performed significantly better than the international system. So now it is beginning to be imitated by others, but I think it is a tremendous mistake, because that was just one particular set of circumstances when it worked better. They had an advantage because they were the only ones that were controlling capital flows. So as a result, they not only control their own currency, they effectively controlled the world currency system. Now other countries, defensively, are beginning to follow them. For instance, Brazil just doubled the surcharge on capital inflows. That is not good for Brazil, and it is not good for the global economy."

Source: Soros - ECB Rate Hike “Inappropriate” in Debt Crisis

Second Biggest Weekly VIX Drop In History

"With the VIX closing the day and the week at approximately a 17.70 level, it marks a 40% decline from its closing print recorded on March 16, when it hit 29.4, just as the Nikkei was about to flash crash to the high 7,000 range. This represents the 2nd largest closing drop in the history of the volatility index, beaten only by the weekly VIX drop from November 4, 2008 (when the VIX dropped from 80 to 47.7). And stunningly, on an intraday basis, when the VIX dropped to the day's lows of just over 17, it briefly represented the biggest weekly drop in the VIX ever."

Source: Zero Hedge - Second Biggest Weekly VIX Drop In History

Cicada-Like Synchronized Traders Have Fewer Losses

"Traders who align their transactions much like cicadas synchronize their chirping make a profit more of the time, according to a study of market behaviors.

The more often traders acted within the same one-second window, the more money they made at the end of the day, according to a study in the Proceedings of the National Academy of Sciences. Traders make a profit 60 percent of the time when they're in sync, more than the overall average of 55 percent profitable trades, said study author Brian Uzzi, who is the co-director of the Northwestern Institute in Complex Systems at Northwestern University in Evanston.

Synchronized behavior benefits individuals and groups in a variety of animals, Uzzi said. Cicadas who chirp at the same time are less likely to be spotted by a predator, according to previous research. The cicada chorus, works like the trading patterns, arising spontaneously through local interactions, without a central leadership.

"If you go to animal behavior, synchronicity usually occurs when animals are faced by complex information problems, and any individual in a school of fish or flock of birds is overwhelmed," Uzzi, who also teaches at the Kellogg School of Management, said today in a telephone interview. "So it gave me the hunch that where humans are likely to be overwhelmed by the pace or volume of information, we might be able to find synchronicity."

Not 'Groupthink'

Unlike groupthink, synchronicity arises from multiple people solving the same problem separately. Groupthink, which is comparable to herding in animals, happens when traders see others trading and join. Syncing doesn't always lead to herding, and when it does, it usually takes place before the herd behavior, Uzzi said.

Uzzi's study followed 66 traders over a year and a half. The traders are talking to a few people at once, ignoring what's going on in the larger market, he said. Multiple traders are looking at different parts of the market and when they begin to process masses of information, such as IMs, RSS feeds, and news from various sources, they begin to act in concert. Trade after the sync, and the "solution" will be priced into the stock, Uzzi said.

The trades and the cicada chirps are examples of how complex systems emerge out of simple interactions. Although neither the cicadas nor the traders are centrally organized, their behavior isn't random. Trading houses may wish to design software that notices moments of sync, enabling traders to wager more money during that time, Uzzi said."

This article reminds me of the website motto: "So, what about the stock market? The universe of numbers that represents the global economy. Millions of hands at work, billions of minds. A vast network, screaming with life. An organism. A natural organism."

Source: Cicada-Like Synchronized Traders Have Fewer Losses, Study Shows

Secret of Film Success

GoldNomics - Cash or Gold Bullion?

Source: GoldNomics - Cash or Gold Bullion?

Total Market Cycle

Sources: The Big Picture and Alpha Scanner

PIIGS ? suck! suck! suck!

Source: Investment Postcards

The Day the Dollar Died

Source: A chilling look at the future

Ugly Chart..

Source:

Chart of the Day

Fibonacci, Fractals and Financial Markets

New Year’s Resolutions for Traders

An investor’s New Year’s resolutions..

Resolved, that in the coming year:

• I will not alienate my friends and antagonize my family by reminding the world on every possible occasion how right I was about the upturn – or downturn – in steels, motors, airlines, or whatever.

• When I buy a stock I will not mobilize all the good news to make it look pretty. I will try to consider both the favorable and unfavorable angles as impartially as I know how.

• I will not close out a stock position that is doing well by me for no other reason than that I have a profit. I will not cut short my gains in a good situation.

• I will not hang on to a stock that is persistently going against me. I will limit my loss, and close out any position that seems to have gone really bad before I am in danger of serious trouble.

• I will not be swayed or panicked by news flashes, rumors, tips, or well-meant advice.

• I will not put all my eggs in one basket, nor will I be swept off my feet to plunge into some unknown or low-priced stock on a purely emotional basis.

• I will not attempt to tell the market what a stock ought to be worth. I will try to understand what the market has to tell me about what people are willing to pay for it.

• I will never forget that I am not in the market primarily to prove – to my broker, my friends, my wife, etc. – that I am smarter than everybody else, but to protect and if possible to augment my capital.

Source:

New Year’s Resolutions for Traders

The Big Picture

Sarbatori fericite - Happy Holidays !!!

Craciun fericit si un an nou sanatos si bogat in trenduri si profituri !!!

Merry Christmas and a Healthy New Year full of trends and profits !!!

Romania si Leul

Romania si leul ei devin vizibile si peste Ocean, fiind descoperite intr-un post pe un blog american, e adevarat, in spiritul altui post legat de Pakistan:))

"In the spirit of my post last night about Pakistan, here is a PDF about Romania which is trying to get into the EU and then the EMU further down the road. The report notes some genuine obstacles to overcome with various imbalances and inflation but what it interesting is that the currency, the Leu (which is difficult to chart), is up 23% against the US dollar in the last two and half years. Oops."

Problema autorului legata de reprezentarea grafica a evolutiei Leului se rezolva insa..

"Yesterday I had a post about Romania and said I could not find a chart of the Romanian leu currency. Well, with a hat tip to Trader Mike, the new Google Finance has it.As I said yesterday, Romania has some clear and obvious obstacles to economic health yet YTD the dollar is down a lot against the leu.Chances are you don't care about the leu but the important thing is that it is becoming easier to access tools that used to only be available through a Bloomberg or some other expensive means. This evolution, although obvious, is very empowering for the do-it-yourselfer. And some bad video to go with this... "

Ceea ce nu stie autorul este ca acel "bad video" (de acord cu el..) de prezentare a Google Finance de mai sus este facut de un roman angajat la Google, Vivi Costache :)) Probabil acesta este motivul pentru care a gasit si graficul USDRON..:))

Sursa:
Random Roger

Warren Buffett..

Enjoy the guru..it's a pretty long recording but it's worth watching it!

Source:
Warren Buffett at The University of Florida
by Daily Dose of Optimism

The eighth wonder of our world..

I don't know what the seven wonders of the world are, but I do know the eighth - compound interest.

Baron Rothschild

Source:
Trading Quotes

About Risk Taking

A ship in the harbor is safe, but that is not what ships are built for.

William Shedd

Quote of the Day

What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?

Adam Smith

Steve Jobs introduces Macintosh in 1984

On the 3rd of January 1984, Steve Jobs introduced Macintosh. It was only 22 years ago, damn it..!:)