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.

Last month, Cable Glider got whipsawed pretty badly on the British retail sales number, so I’ll be watching closely this month. 

Seeing as how the FX market offers all traders fantastic opportunity to get creative with their position sizing via a smart use of leverage, I have a hard time understanding why anyone would quote their profit and loss in terms of pips.  If I invest in a stock, it would be common for me to tell you that I made 10%, not that stock XYZ went up by 326 cents.  To quote profit and loss in terms of pips is to completely ignore the least sexy, but of course, most important part of any successful trading strategy, and that is the position sizing algorithm.  It may be convenient to quote an individual trade’s profit or loss in terms of pips, but over a series of trades, the percentage return will tell the only story that is relevant for the trader;  the MARKET may have moved a certain number of pips, but my ACCOUNT‘s return depends heavily on how I vary my position size relative to my account size, market volatility, etc.  While it IS fun to speak in pips to describe price action, it’s more fun to talk about how that price action affected the account.

Part 2 is here

 There were no other actions to take that would be reasonable, given that my retirement investment horizon is 30+ years and I’m comfortable with my asset allocation. 

 But enough about me…

 You know, on days like today, when the market is down sharply, we always hear stories about computer glitches and other hocus pocus that was the ‘reason’ for a sudden break in prices.  Even more often, we’ll hear analysts parroting that nothing has fundamentally changed.  It’s BS.  Look, when the market breaks lower, the vast majority of investors feels pain and we are undeniably poorer…and fear never rides a tortoise out of town.  This may be a buying opportunity and it may be the start of a global double digit decline in prices…that part really isn’t important to me.  The thing that bothers me is that these “fundamental” cases are brought out on a day like today, and such stories imply that *yesterday’s* prices were the rational ones, not today’s lower prices…uh huh.  Could it be that the market was not rational yesterday and it isn’t rational today either? 

 Before making any changes to your portfolio, consider your alternatives.  For me, selling some stock today in my taxable account was a no brainer because I have an attractive alternative in my FX system.  Doing nothing in the 401K was also a no brainer, since I’m trying to build retirement wealth over the next few decades…in that context, checking the account even more than once per quarter is counterproductive, because it can only lead to fear-based emotional decision making that could be hazardous to my long term financial health. 

In my study of the charts last weekend, I concluded that the “Wednesday” phenomenon that I see in the backtest is probably due to triple swaps every Wednesday and NOT due to the EIA petroleum inventory release.  With that knowledge, I kept the system active on Thursday and went 0 for 2 again…again both were relatively large losses, and the last loss was an EXACT hit on a reaction low.  Put another way, if the market had retraced just one pip less, I would have been looking at a monthly profit for February in excess of 20%  Instead, I have a monthly loss of 3.9% and a paltry year to date return of 4.3%  To say that leverage is a double-edged sword is a cute understatement!

 So, despite still being up over 80% over the course of the last 5 months, I feel like crap….and NOW, cue prospect theory!  I’m currently reading “More Than You Know” by Michael Mauboussin.  This book is really thought provoking, and has re-introduced prospect theory to me.  The key learning being that a loss hurts about 2 to 2.5 times as much as a gain feels good.  With that in mind, it’s back to the drawing board for me in a sense;  I’m going to play with my position sizing algorithm such that I’m unlikely to FEEL LIKE A LOSER even when I’m winning.  There are lots of nerdly thoughts running in my head right now, but none of them are forming a coherent course of action just yet.  I’ll see what develops. 

In the meantime, the Cable Glider will be idle until Thursday, so I have a bit more time to see if I come up with any beneficial revisions to the bet sizing algorithm.  On another bright note, I re-coded the Cable Glider with Metatrader 4, which gives me more flexibility when I’m looking for forex brokers in the 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!

Here are two memory distorted bits of wisdom from one of my favorite professors at the University of Maryland, Dr. William Nickels.  Both points are entertaining and remarkably useful.

1) “Almost everybody, almost all the time, is almost always wrong.” This statement works well to counterbalance our natural tendency to believe whatever we hear.  I always like to say that beliefs rush into a vacuum.  This means that if I know nothing about a topic, I’m very likely to believe the first thing that I hear about said topic, and consciously or unconsciously begin to compare competing thoughts to the “truth” that I learned first.  What’s more, I might immediately associate the person who gave me this first glorious bit of information as an expert on the subject!  Remembering that almost everybody almost all the time is almost always wrong should help us to keep an open mind for opposing viewpoints.  This, in turn, should allow us to form opinions based on our own judgment rather than forming beliefs in the same way that mortgages are filed in the courthouse…first in time, first in line!

2) How to become an expert on any subject:  (This one fits in very nicely with the first topic.)  In order to become an expert on any subject, all you need to do is “keep a file”.  That’s it.  If you’re interested in a topic, you learn everything you can about it.  You cut out magazine articles on the subject, you bookmark relevant websites, you buy books on the subject, etc.  In this way, you can literally achieve encyclopedic knowledge on the subject.  And if whomever you’re speaking to doesn’t know about point #1, you can sell them anything.

Seriously though, it makes perfect sense.  If we want to become experts in a topic like, I don’t know…investing in stocks, it stands to reason that we have to do a lot of reading and absorbing information in order to move from a novice to an expert.  Any street fighter will tell you that book smarts ain’t common sense.  True expertise is forged when the fusion of our book smarts and battle scars allow us to succeed where others fail.