findingedge

What is the goal of trading and active portfolio management? It’s not just to make money or to get rich. The goal is to generate wealth for yourself and/or your clients at an above-average risk-adjusted return.

With respect to trading and investing, there are two major markets used for wealth creation – the stock market and the bond market. Each market represents an arena where thousands, or even millions, of competitors battle to enhance returns.

Figure 1 shows the annualized returns for U.S. stocks, bonds, T-bills (as a benchmark for cash) and inflation since 1926.1 The annualized standard deviation of returns is used as a measure of risk (there are many other risk measures to choose from).

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Figure 1. Historical returns of stocks, bonds, T-bills and inflation for the United States from 1926 – 2014.1

Considering all stock, bond and currency markets from countries around the world, along with commodities and derivatives markets, there are many financial arenas in which traders attempt to add value every day.

Most participants in the stock and bond markets make money over the long-term because stocks and bonds generally trend higher over time and produce a return that is better than inflation (see Figure 1). That is the win-win associated with capitalism working for the providers and users of capital. However, with respect to risk-adjusted performance, there are winners and losers. Many participants don’t realize they are losers or don’t necessarily care. If you’re trading for a living, then you need to be a winner.

You would think that winning is crucial for professional money managers, where “beating the market” is the cornerstone of their value proposition. There’s no question that superior performance can ignite rapid growth of a money management business. Yet the enduring professional money managers realize that sales and product development teams are just as important as the portfolio managers to weather the eventual periods of underperformance.

What does enhanced risk-adjusted performance look like? Figure 2 shows a hypothetical realized annualized return versus risk plot for stocks, bonds and cash (the blue squares). One of the core tenets of finance is that the higher the expected returns, the higher the risk of loss (see above in Figure 1). Over short time periods (such as a year), this relation may not hold, but over long periods (such as 25 years), we expect returns to be related to risk. The line connecting these points represents the performance of a mixture of stocks and bonds or bonds and cash with periodic rebalancing.

The chart also shows hypothetical realized returns and standard deviations for various trading strategies. Strategies A, B and C are clearly adding value. Strategy A could be that of a successful day trader, strategy B that of a diversified hedge fund seeking to deliver equity-like returns at bond-like risk, and strategy C that of a talented stock-picker.

In the financial world, this sort of risk-adjusted outperformance is called alpha. You can roughly think of alpha as being a measure of the gap between the strategy return and the stock-bond-cash line at the same risk level.

Strategies D, E and F are not adding value. With the benefit of hindsight, investors in these strategies would have been better off just buying a diversified portfolio of stocks and bonds. Strategy D could be that of a pension fund that unsuccessfully chases returns, strategy E could be the returns associated with an individual investor who flips among investment advisors, and strategy F could be a leveraged trading strategy that turns out to be riskier than holding stocks without adding additional return.

All participant returns in each market must aggregate to the total market return. In other words, with respect to the stock-bond-cash line, there are winners and losers. The alphas among all participants don’t have to add up to zero, but the dollar-weighted alphas do. For instance, the pension fund at point D that manages billions of dollars with the small negative alpha, can perhaps support large alphas produced by many hedge funds (B) and hundreds of day traders (A) – if these groups were talented enough to exploit the pension fund. It may also take thousands of small retail investors producing a return/risk point at E to support a small amount of alpha for a single large hedge fund. Of course, among the tens of thousands of active mutual funds and hedge funds, each trying to produce a positive alpha every year, there will be many winners and losers.

 

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Figure 2. Hypothetical return-risk chart illustrating the concept of value-added performance.2

Three Keys to Trading Success

In the trading literature, there’s a general consensus around the three keys to successful trading. These keys are psychology, portfolio management, and trading edge as illustrated in Figure 3. Like a three-legged stool, trading success will not be achieved if one of the legs is too weak. Conceptually I agree, but in practice, one leg of the stool is far more important and difficult to master – the trading edge leg. Let’s talk about the three keys (or legs) in a little more detail.

Figure3FindEdge

Figure 3:  Three keys to successful trading.

Psychology

Go to Amazon.com and search for “trading psychology” in Books. There are dozens of books on the psychology of trading. It probably makes sense for a budding trader to read a couple of these books, since competitors in many arenas use psychologists and mental preparation to enhance performance. And certainly, without mental preparation and focus, it’s hard to expect results to be optimal.

For myself, I’m a pretty analytical and even-keeled guy. I’ll occasionally see emotions creep into my trading. It might be timidity with position sizing or entering a trade where I know myself to be a weak holder. Yet I think I’m pretty self-aware in these moments, and I try to avoid these situations as much as possible. Each year we perform a lessons learned and attribution analysis of our performance. In it, I’ll makes notes of when my head was not quite in the game or if I made any emotional decisions. This process has helped me to minimize the impact of emotions over the years.

The psychology leg can also be made much stronger when you find the investment style or discipline that best suits your personality. Are you a trend-follower? Or a stock picker, day trader, value investor, market-neutral investor, etc.? Everyone’s psychological make-up is different, and there’s no right answer. Some investment disciplines are obviously better than others. The efficient market proponents suggest that a buy and hold portfolio of index funds is best. Yet, if this approach is a dramatic mismatch to your investing personality, then it’s only a matter of time before you give up on a great investment approach at the worst possible time.

Having a trading/investing discipline does not deliver enhanced risk-adjusted returns. That would be too easy. However, finding an investment discipline that is a good personality fit can put your long-term returns on the stock-bond-cash line shown in Figure 2 and provide a framework for finding alpha sources.

For our wealth management clients, getting the psychology right is the most important leg because many have not spent the time to fully explore their investment personality. It takes time, and a few bear markets, to figure this out. Investors chasing returns and jumping from one approach to another seldom figure out what works for them, and their investment results are typically poor.

Also, doing a good job on the other legs of the “stool” can help with the psychology. Controlled use of leverage, diversification and position sizing can all help with the psychology leg by avoiding the highly emotional state associated with a massive loss. Similarly, the stronger the trading edge, and the more consistent the results, the easier it is to psychologically weather portfolio volatility and periods of underperformance.

Is psychology the most important leg? I say no. Too many of your competitors have figured this out. Many have automated trading and investment programs that perhaps eliminate the impact of emotions. Strengthening your emotional resolve and finding the trading/investment discipline that best suits you can be learned over time. The best you can hope for is to join thousands of your fellow competitors on the same psychological “top shelf.”

Portfolio Management

There’s no question – portfolio management is an important leg. Searching on Amazon.com for books on portfolio management, modern portfolio theory, risk management, position sizing, Kelly criteria and financial mathematics leads to hundreds of books from which to learn about this subject. See also Wikipedia.com.

Ideally, a trader/investor at any time has a number of asset classes, securities, trading ideas and edges to choose from with various degrees of conviction. Designing a portfolio of these positions to maximize risk-adjusted returns and avoid risk of ruin is extremely important.

Every day, a portfolio manager should be thinking about how to structure a portfolio to deliver the best absolute return within the risk tolerance band. Understanding all the risks and how they correlate with each other is critical in trading and investing. It’s hard to understand how anyone can successfully set up a trade without knowing all the risks, especially the risks that don’t show up in back-testing. The same goes with making a long-term investments’ in equities, real estate and private equity.

Lots of math and formulas are thrown at this leg of the trading stool. For myself, an engineer who has taken many graduate-level applied math courses, you’d think that would be very appealing to me. While the math can be helpful, I find that rules of thumb work best. Unfortunately, the formulas are very sensitive to inputs that are not well known. Using mean-variance optimization, Monte Carlo analysis, value at risk or the Kelly Criteria to design a portfolio or size trades have been mostly unhelpful to me.

Just like with the psychology key, the portfolio management key can’t get you above the stock-bond-cash line shown in Figure 2. The best that optimal portfolio management can deliver is to move expected returns along the stock-bond-cash line as the risk level goes up or down. This is analogous to professional gambling, where no bet-sizing scheme can make money over the long term if the house has the edge.

To summarize, we spend a lot of time each day setting up our portfolio factoring in expected returns, risks and correlations. That’s the job of portfolio management and I find that rules of thumb work much better than formulas. I’ll devote a future blog post to the rules of thumb I use. We spend much more of our time searching for trading edges than researching portfolio optimization strategies.

Trading Edge

Having a trading edge is by far the most important leg if the goal is generating alpha. It’s also the toughest leg to master and maintain over time. Most trading edges are ephemeral. A trader must continually search for new edges to exploit to be successful over the long-term.3 A good trader knows everything about the strengths and weaknesses associated with an edge, in part to identify as soon as possible when it becomes ineffective. Even trading edges considered enduring require innovation and creativity when applied to modern markets.

The psychology gets easier when you have an edge and an understanding of how it works. With an edge, it’s easier to stick with a trade when it moves against you, or even better, to add to the trade.

Understanding the edge helps build confidence around a trade, which helps with position sizing. I generally follow the rule that the stronger the edge, the better the trading opportunity, the more asymmetric the payoff, the more money I put into the trade. Understanding trading edges provides the conviction to step on the gas when the planets align.

As you get better at searching for trading edges, you’ll become a better investor and get very good at rejecting sales pitches from money managers who claim they have an edge, but really don’t.

What makes this game so hard (and humbling) is the intense competition among all participants in finding the next trade, investment or trading edge. At times, I’ve been asked about the difference between engineering and trading the markets. Both are cerebral, challenging and analytical, but there is one glaring difference. The “rules” change in the trading business. In the engineering business, once a technical problem is solved, we are confident that the laws of nature will not change.

Much like the natural sciences, once you’ve generally mastered the psychological and portfolio management legs, the rules don’t change over time – you can rely on your skills to work in the future. This is not the case for the trading edge leg, which makes finding a trading edge much more difficult and is what distinguishes the exceptional traders and investors from the rest.

The focus of this blog will be my humble search for a better understanding of trading edges, finding better ways to search for new edges and seeking truth in assessing the trading edges everyone knows about. I hope this blog can help my readers in their own search for improvement.


 

Notes

  1. Data from Morningstar and Ibbotson.
  2. Strategies A, B, and C may not be suitable for all investors based on their risk tolerance.  For some, Strategy D may be a better fit than Strategy C.  Strategies A, B, and C will also be impossible to achieve consistently over time. 
  3. Certainly an easier recipe for some investment managers is to serially roll out investment funds, hope to get lucky with good returns, close those strategies with poor returns and pick up fees from managing other people’s money along the way. A different set of skills is needed to follow this path.

Disclosure

The content contained within this blog reflects the personal views and opinions of Dennis Tilley, and not necessarily those of Merriman Wealth Management, LLC. This website is for educational and/or entertainment purposes only. Use this information at your own risk and the content should not be considered legal, tax, or investment advice. The views contained in this blog may change at any time without notice, and may be inappropriate for an individual’s investment portfolio. There is no guarantee that securities and/or the techniques mentioned in this blog will make money or enhance risk-adjusted returns. The information contained in this blog may use views, estimates, assumptions, facts, and information from other sources that are believed to be accurate and reliable as of the date of each blog entry. The content provided within this blog is the property of Dennis Tilley & Merriman Wealth Management, LLC (“Merriman”). For more details, please consult the Important Disclosure link here.

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