Well why has currency trading been stressful while investing for retirement via an IRA seems relatively easier? I think it boils down to the idea that the strategy employed in the IRA (buy and hold) would ultimately work if given enough time. That could never be said about a short term system that could fall apart at any given time…

And so, as I was drafting some guidelines for the next iteration of my active trading, I read the Ivy Portfolio and noticed the launch of the GTAA ETF….

For the record here are those guidelines:

No leverage
No intraday trading
No drama (Usually related to gun-slinging “discretionary” trades with or without high leverage)
No monthly fees
No proprietary platforms

I have decided to use GTAA as a benchmark for my own Tactical Asset Allocation model. For now, I only have an absolute returns version of my model, and GTAA is an absolute returns fund, so the benchmark is appropriate. However, I also have my eye on the model over at MarketSci, which is likely to be geekier and more elegant than my absolute return model, but nevertheless, for now, I will be using that model as a secondary benchmark. The positions for my model for November 2010 are :

VEU / VWO

The model (if it can even be called that at this point) always purchases equal parts of the top two assets, so clearly there is some room for improvement.

To reiterate, this is never investment advice.

More to come…

If market cap indexing is a good strategy domestically, it would follow that it should be a good investment internationally as well.  Interestingly, I’ve seen a few global indexes such as the one offered by Russell, but I have yet to see a single mutual fund or ETF that provides a market cap weighted portfolio of the entire world.  The products that I see are usually more along the lines of single country funds and “all world except for country X” funds.  That still makes it pretty easy to build the portfolio.  All we need are two funds, and an idea of what percentage of our money to put into each one.

 Let’s start with the funds.  While there are certainly other options, I will use Vanguard ETFs as an illustration, because they are generally recognized as low cost index fund pioneers.  We can build the portfolio with Vanguard’s Total Stock Market ETF (ticker VTI) to cover US Equities and the Vanguard FTSE All-World ex-US ETF (ticker VEU) to cover all other countries.  With just two instruments, we get low cost exposure to more than 95% of the global investable universe. 

Since we’d like to be market cap weighted, all that remains is discovering the USA’s percentage of world market cap…(insert Jeopardy theme music)…okay, this was surprisingly difficult to track down, but the World Federation of Exchanges does publish this data on a monthly basis.  Using their monthly domestic market cap figures, I have the US share of global market cap at roughly 40% as of this writing.

So that’s it!  40% goes into VTI and 60% goes into VEU.  We can check the World Federation of Exchanges data on a yearly basis to ensure that our portfolio is still representative of world market cap.  Except for the real world nuisances of adding additional capital and dividend reinvestment, the beauty of this plan is that it never needs to be rebalanced.  Remember, we are not setting some arbitrary division like 50% US and 50% rest of world.  We are simply investing in the entire world by market cap weight.  Whether the US percentage of world market cap shrinks or grows in the future, our portfolio will automatically reflect it.

  Keep in mind that this was just one example, and it’s provided for illustration only…your mileage may vary…blah blah blah…etc….I am not an investment advisor.

Now as soon as someone gives us a good All-World in One index fund option, this plan will get even simpler…100% in one fund…set it and forget it!

Financial Porn :  

“A slang term used to describe sensationalist reports of financial news and products causing irrational buying that can be detrimental to investors’ financial health. Short-term focus by the media on a financial topic can create excitement that does little to help investors make smart, long-term financial decisions, and in many cases clouds investors’ decision-making ability. ” 

The folks in the in the financial news game have a tough task.  They have to keep their viewers from tuning out, despite a multitude of evidence that suggests that investors who do not regularly watch the financial news achieve better long term results.  In order to keep viewers tuned in, the financial networks manufacture a sense of excitement by constantly making predictions about the short term direction of the markets and implying that it’s always time to DO SOMETHING.  The problem is that whatever that “something” is, it probably causes the investor to deviate from his long-term plan.

In the context of retirement saving, this means that it is prudent to plan an appropriate asset allocation and set up periodic rebalancing.  If an investor reacts to news and deviates from his retirement plan, he is injecting a potentially large new source of randomness into his returns…one that has the power to derail a good financial plan.

In the context of mechanical trading, it means that it is appropriate to follow the system’s signal on the next trade.  Whenever I have the urge to override a signal, I’m usually being influenced by something I’ve just seen on TV.  In such a case, I remind myself that it’s almost never time to deviate from the plan.  I’m always amazed at how much trouble and anxiety that I could have avoided if I had simply walked away from the screen for a day and let the system do its work.

It is wise to keep in mind that financial news networks are bankrolled to a large extent by advertising dollars from brokerage firms.  The brokers are the folks who would love nothing more than if we were all day traders, churning our accounts and generating lots and lots of commissions.  The networks create the impression that the “fast” traders are the ones who make all the money, without substantiating this claim in any way. 

I was prompted to make this post because I want to mention that CNBC is always counting down to something.  It could be a financial report, the market open, the market close, whatever.  They don’t count it down in minutes and seconds…oh no.  They count it down to hundreths of a second!  With those hundreths flying by, how could a viewer’s blood pressure not rise?

When I was in San Francisco over the summer, I did not have access to cable TV.  I disconnected from financial porn and my results did not suffer.  I’d go so far as to say that actual masturbation is more productive than the financial kind.

Short Term Trading and Randomness

My experience in the markets tells me that this is certainly not true.  Short term bars can be dominated by single large trades, and the fear, greed, and mass hysteria of fast markets that surround news events. Simply looking at a 5 minute bar chart, we will see one hell of a lot more noise…not to mention the fact that in order to trade this chart successfully, the trader must continuously execute split second decisions with consistency and clarity.  Even if possible, this method must be quite stressful, and lead to a shortened career as a trader due to burnout or blowup!

Long Term Trading

The first thing that we can do to increase the signal to noise ratio on our charts is to go to a longer time frame.  Of course, this in itself is not a cure-all, and even in fact, the distinction between short term and long term is subjective and seems to be different depending on which trading instrument we are referring to. 

As an example, Cable Glider operates on a 30-minute bar chart.  This is undeniably a short-term chart.   I have no explanation for why 30 minute bars work well in this case.  For any other instrument that I have tried to build a trading system for, it always required using a 1-hour or greater bar time in order to generate a system with positive expectancy.  I’ve sometimes heard this disparity referred to as the “personality” of a trading instrument, though I suspect it has a lot to do with the depth of liquidity in that market and the number of traders actively participating in the market.

Closed bar trading

Closed bar trading means only making decisions about entering a trade based on the previous bar, and if all conditions for entry are met, open a new position at the open of the next bar.  This is a simple concept that improves the reliability of system backtests, and also mitigates the effects of bad data (presuming that “bad” data is more likely to printed as erroneous highs and lows and not erroneous opens and closes)

Tick Chart = Random path

When I first began to code automated trading systems, I thought that I would need to run my tests on tick charts, that is, charts that record EVERY trade and price movement in the market.  This makes intuitive sense, but I now believe that that tick charts are useless at best and harmful at worst.  If we can see that 1 minute bars are entirely too noisy to make any trading decisions on, what can we gain by looking at every tick! 

It is true that a tick by tick data should allow us to reliably backtest a system that is making decisions based on the current bar, but this leaves us open to a lot more over-optimization and curve fitting.  At worst, we might presume that the way that a trading instrument moved on a tick chart in the past will repeat itself.  This is certainly pure folly, particularly in retail forex trading with a market maker, as the market maker can move the bid and ask wherever they chose, even without any trades occurring.

The bottom line is to chose a timeframe or set of timeframes that allow us to react quickly when timing entries and exits, but that also are long enough to filter out enough of the random noise so that our technical trading signals become reliable enough to generate consistent profitability.  As usual, there is no quick solution or magic formula…. this is the ART of the technician!

 

Here’s an excerpt from the article referenced above:

“

How bad does it look? You can see the figures at Henry’s own Web site, and they are astonishing. Since December 2004, his main investment fund has lost a stunning 36%. And according to a report in the May 29 Wall Street Journal Henry’s slide continues, as Merrill Lynch has redeemed $600 million from the firm.

While a simple index fund over that period would have turned each $10,000 into about $12,450, Henry’s “Strategic Allocation” fund has turned the same amount of money into a mere $6,360. Except we’re not actually talking $10,000. We’re talking hundreds of millions of dollars.

“

36% drawdown over 2 and a half years is stunning?  Was it more stunning when the S&P 500 index shed approximately 50% of its value from 2000 to 2002?  How about the fact that the NASDAQ composite index is currently at a roughly 50% drawdown that is over 7 years in duration!  Everything is relative, but only the recent is sensational…

Equity Curve Timing at its Worst

Notice that Merrill is redeeming funds.  On the surface, this may seem a prudent way to conserve capital, but now they will need to find someplace else to invest that money.  Like a trader who jumps from system to system each time one of them is in a drawdown, this tactic makes it very difficult to succeed in the long run.  All systems will have drawdowns, and while much has been said about the deep drawdowns that trend following systems experience, I’ve seen very little written on the fact that when they recover from that drawdown, they tend to do so with blinding quickness!

Value of Diversification

I don’t tend to follow the results of John W. Henry’s Strategic Allocation Fund, but I do watch the returns of the Financials and Metals portfolio with great interest.  At the time of this writing, the Financials and Metals would have turned a $1,000 investment in 1984 to over $100,000 today.  An equivalent investment in the S&P 500 index would have grown to just under $16,000.  More importantly, both the Financials and Metals and the Strategic Allocation Fund show a slight negative correlation with the S&P 500.  This is the classic “one zigs when the other zags” type of investment assets that we would want to have in a well-diversified portfolio. 

Opportunity for investing

I don’t recommend any investment products, and the primary purpose of this site is to follow the returns of my forex trading systems.  Incidentally, my systems are trend following in nature and have recently come upon hard times as well.  With all of that being said though,  the recent media attention to the Death of Trend Following smells like a bottom.  Remember, proper equity curve timing is never easy.

I realized that I’ve been taking some ignorant swings at “Random Walk” and the Efficient Market Hypothesis.  I hadn’t really read anything related to random-walk since Economics 101.  This realization, coupled with the fact that I literally live in the shadow of a wonderful public library that I have NEVER used, led me to take the short, direct walk to the library to get the book and review it.

All in all, the book is a good read and a valuable read in the sense that stock investors who take its recommendations to heart are far less likely to shoot themselves in the foot by overtrading, chasing performance, etc.

The basic premise of the book is that price movements in the stock market resemble a random walk, and that past price movements are not predictive of future price movements.  The book does make passing mention of a LONG TERM UP TREND in equity prices roughly equivalent to the long run rate of earnings growth, but rather curtly declares that transaction costs are prohibitively high, and therefore, short-term trend trading is not superior to a buy and hold approach.  In fact, it categorically goes through most widely followed methods of stock picking and explains why these are inferior to index investing.

Get it?  Two things : Future stock prices cannot be predicted, and nothing beats buying and holding a diversified portfolio that is primarily made up of US stock index funds.

Here are some important limitations to consider, however.

The conclusions about efficient pricing and long term upward bias apply to the STOCK MARKET ONLY.  Furthermore, while the book explains why fundamental and technical analysis “do not work”, it pre-supposes that an inability to predict the future movements of stock prices necessarily means that one should not be able to outperform the market over a long period of time.  Keep in mind that the book had already acknowledged the inconvenient trend phenomenon but managed to “normalize” it away.

My own evolution as a trader has taken me away from active stock investing.  In fact, the relatively small percentage of my assets that are currently held in stock funds are actually invested in index funds.  Why?  The risk-reward relationship for successful stock picking is relatively small due to the high costs and/or inavailability of high degrees of leverage.  I personally find my skill set more suited for forex trading, but this is by no means a recommendation that everyone run out and start changing their dollars for euros and pounds and whatnot.  Forex trading is purely speculative, and speculation and investing are really two entirely different animals.  Month after month, my forex trading results are convincing me that speculative, short term trend following in the forex market can and does produce returns that are not only outstanding, but also uncorrelated to the returns in my stock portfolio.  This is diversification at its best. 

Despite my rather facetious rant against index funds in a prior post, the vast majority of us will be investing in stock funds via tax advantaged accounts like IRAs and 401k’s…for this purpose, Random Walk’s advice is practical, easy to implement, and perhaps the best way to get rich slowly and enjoy a financially free future.
 

Let me be the first to say just how easy it is to actively manage your own account and do WORSE than average.  It’s so quick and easy to set up an online trading account and start buying things left and right without any real strategy.  The trader who does this sure better hope the market really is random!  I suppose that this would be the typical life cycle of a risk-taking investor:  The young maverick boldly charges into the market.  He thinks that high risk equals high returns.  On cue, the market moves in his favor, and he becomes absolutely sure that trading is fun, easy, and highly profitable!  The maverick trader will inevitably get stuck in a losing position and have no pre-determined exit strategy.  At this point, his choices are to hold on and hope that the position will recover, or sell it out at a loss and “wise up” to the fact that he cannot beat the market.  His experiences with active management and personal financial loss with likely lead him to invest in index funds, where at least he can do no worse than the average.

But wait!  You saw the title of this article…and it’s true!  100% of S&P 500 index funds underperform the S&P 500 index.  Their costs may be low, but they are not zero.  In this way, index fund investors guarantee themselves a slightly below average return because they are afraid that any attempt to do better will land them a failing grade.  This does NOT mean that actively managed mutual funds are necessarily a better choice.  Actively managed funds do charge higher fees, and give their clients’ money a little bit of a deeper hole that it has to dig itself out of before it can even think about outperforming the S&P.  And indeed, just as there are many average investors, there must be many average money managers, all of which are willing to extract fees from investors and deliver a return just close enough to the average that their investors do not cash in their shares.

I believe that the average mutual fund manager’s primary motivation is to perform well enough to keep his job for another year.  To do this, he must deliver returns that are at least similar to his peers.  This tendency to fixate on the averages results in something I like to call “average cling”.  If the average money manager is simply going to invest in a basket of stocks that will perform close to average by design, what is he doing to deserve the management fee?  Average cling is like taking an exam and knowing what the curve will be ahead of time, then deciding to stick as close to it as possible so as not to stand out on the downside and get kicked out of the class.

Perhaps the best way to achieve above average results inside of a mutual fund is to invest with a manager that completely disregards the averages and strives for absolute return.  Such managers are rare, but certainly not unheard of.

Granted, the strategies above are aimed at passive investors; that is, those of us who do not want to spend our time picking stocks or other assets to include in a portfolio.  There are certainly higher return avenues available to investors who are willing to do their own work, but understand that consistently outperforming the market requires a love of trading and investing.  Just focusing on returns will not be sufficient motivation to put in the necessary work.  The necessary work is considerable, and it might just outlast your attention span.  

Index funds are STILL a good choice for the average, risk-averse, passive investor. It’s okay to be average. Just don’t let the establishment fool you into thinking that it’s impossible to break the curve.

(This article is part of the 87th edition of the Carnival of
Personal Finance…check it out!)

Other than a few odd conversations with relatives who would claim to be making money holding various stocks, I had no source of financial education.  I’m not sure how I found the Fool, but I’m immensely glad that I did.   

The Fool is a great place for absoulte beginners to learn the basics of investing.  They publish an online guide called Our 13 Steps to Investing.

If you know nothing about trading and investing, please go there and read the first 9 steps.  Yeah, that’s right, the first 9.  The last 4 steps are marketing fluff designed to get you to subscribe to newsletters. 

It’s easy for an experienced investor to dismiss the Motley Fool, because the information presented there is rather basic and light, but for newbies, it’s a gentle and fun introduction to self-directed investing.   Maybe someday you’ll be a snobby graduate of the Motley Fool like me.

 On another, related note, I worked at the Motley Fool as a database programming intern for 2 years while I was in college.  I managed to land the internship mostly because of my enthusiasm about the company.  I really didn’t have the necessary skills at the time of the interview, but I had the drive to contribute to the company, and a man by the name of Kevin Book gave me a chance.  For those of you who watch CBNC, you might see Kevin from time to time.  He’s moved on to Friedman Billings Ramsey, and now he gives talking head analysis to CNBC.  Go Kevin!