Via Instapundit, an interesting NYT column about how quickly, after a natural disaster, people start to over-discount the risks of future disasters, especially in advanced societies:
Communal memory of rare disasters is worse in more developed societies because knowledge now is passed on in schools, movies or the internet leaving no time for oral history or reliance on the elders to learn about the world.
Something similar to the quick-forgetting phenomenon happens in financial markets. In every market, some players prosper for a while by following trading strategies that tend to be highly profitable from day to day but that are almost guaranteed to be big long-term losers: martingales, naked out-of-the-money option writing and other short-gamma strategies. Every time there is a big market event, a lot of these players suffer large losses and go out of business. They move on to other businesses (I assume) and are no longer around to warn market newcomers to avoid the kind of risky, short-term-profitable strategies that they themselves once followed. So there is a constant stream of new traders who enter the markets and rediscover risk.
This is an oversimplification, since the better traders, by definition, somehow learn how to stay in the game for the long term. But the behavioral parallels between market traders and people who rebuild villages in flood zones — and countries that seek to appease their enemies — seem clear. The common element is lack of an adequate inter-generational feedback mechanism. I doubt that there is a remedy for this pattern of human behavior (I wouldn’t characterize it as a “problem” any more than I would say that rain is a weather problem) other than for people to study history more.
Interesting piece. I am always delighted to see Glenn citing the New York Times when in most instances he finds cause to dismiss the paper as worthless. But he reads it assiduously nonetheless.
You lost when you got to “appeasement”. When you are up against Hitler, probably better to dig in early. Churchill’s genius was seeing that Hitler was weird and unique, and was bent on war, hence not “appeaseable”. Churchill knew that Hitler was an aberration, before almost anyone else did, not that he represented a general case providing a general rule. Churchill himself said that appeasement from a position of strength is the only way to have peace. He tried hard to cut a deal with Stalin after WWII. If you are up against some threat which is not analogous to Hitler, which is most of them, it is usually better to cut a deal. There is no general rule about “appeasement”, or if there is, it is the opposite of the over-simplified “lesson” of Munich. The British Empire lasted for so long because the British were the masters of appeasement, which was not a dirty word prior to 1938. They stayed strong, and they figured out ways to cut deals with potential adversaries, to avoid open war, which is always expensive, disruptive and uncertain. Their “appeasement” of the USA in the early 20th Century was a diplomatic genius, for example.
I agree about reading history. The problem is that the “lessons” people learn are usually whatever they go looking for.
The perception of risks in business generally has a lot to do with what *other people* are doing. For example, if GM in 2004 had decided to switch its entire product line to plug-in hybrids, and had immediately started to retool its factories in that direction, this would have been perceived by almost everyone as an extreme risk.
What GM *actually* did, of course, was to bet its entire corporate future on the assumption that oil prices would remain below some level–this was perceived as a major risk by almost nobody, and indeed I wonder whether the assumption was even specifically called out as such in GM’s strategic planning. Because lots of other people were making the same assumption.
Generally, if you take the first type of risk and fail, you lose your job. Take the second kind of risk and fail, and you very often keep it.
Information passed on by schools, media, the internet or even reading, lacks the emotional impact of oral history. People ultimately make decisions based on emotion. Information transmitted orally comes in the form of a story complete with characters which the hearer either knows or can directly empathize with. The stories make people feel the horror and pain of the event and that in turn makes them take the threat of a reoccurrence much more seriously.
I know that I take the necessity for vaccinations far more seriously than other due to first hand stories I heard from my grandparents about their siblings dying from communicable diseases. People without this emotional awareness have only the emotion of seeing a child with real or imagined negative reactions to vaccination to guide their decisions. Dry statistics about the horrors of the past simply do not make much of an impact.
Oral histories can be very powerful. The Motoko, a culture of sea gypsies in the eastern Indian ocean lost no members to the Boxing day Tsunami because they had a story about the dangers poised by the sea god attempting to reach the fruit of trees on land. The story encoded the pattern of recession of the shoreline and the multiple impacts of the wave. As a result of this tale, even Motoko recognized the danger of the tsunami even though no Motoko had seen a tsunami for at least 120 years.
People “forget” past disaters and re-engage in dangerous behaviors due to the same thing that destroyed the space shuttle Discovery: normalization of risk. People do something that is dangerous, experience no harm, so they keep doing it, gradually inching back to the risky state. In the case of seaside villages, each passing generation moves a little closer to the danger zone or spends more time working there, with no harm coming to them. They wrongly conclude that the risk must be nonexistent.
I agree about reading history. The problem is that the “lessons” people learn are usually whatever they go looking for.
You can take this point too far. I’m not talking about differences of interpretation among people who are basically aware of past events. I’m talking about populations where large numbers of people don’t even know that the water recedes before a tsunami or that the place where their house is was flooded to a depth of ten feet on several occasions within the past century. My argument applies even more strongly in financial markets, where the event distribution has fat tails and wild events happen much more frequently than ordinary human experience would predict.
Jonathan,
I don’t know that I agree with you. Most of the time when strategies blow up it’s not because the strategy stopped working, it’s because that strategy was high risk all along and those risks were ignored by those implementing the strategy until they blew up. If traders are lucky enough to make money with these strategies, they believe that it’s because of they’re geniuses and not because they gambled at the casino and won. Their arrogance and sense of invincibility grows. That usually means that they take larger positions, and obviously, larger risks until they blow up. If you’ve ever tried to train a young trader, you know exactly how difficult it is to break that mentality. There’s no one more deaf to reason than a trader making money on a bad strategy.
There are plenty of trading companies that have been around for a long time and have done well because they’ve always made good decisions – although since trading is very stressful, good traders tend to retire early because they can. Just as bad decisions can sometimes have favourable outcomes, good decisions can sometimes have unfavourable outcomes. However, over thousands of trades, with good risk management and positive edge trades, a strategy will win in the long run. Examples of trading firms that have been successful in the long run following this rule include Susquehanna International Group and a bunch of smaller trading companies that you’ve probably never heard of.
One reason risks are ignored in implementing strategies is because hedging the risk would also mean hedging away all the profit. Another reason is that those implementing the strategy don’t understand it. The Yen carry trade, for example, is sold as an arbitrage but it’s really just a currency bet. Any attempt to lock in the “arbitrage profit” hedges away all potential profit. The curve trade is similar. In July hedge funds lost to the long oil, short financials trade. While they may have sold it as a single long/short trade, the correlation between the two sectors is too weak to trade. What they really had on was not a single position but two separate positions and they both went against them. A real long/short with good risk management would have been many positions of short overvalued banks against longs in undervalued banks and the same for the oil industry. You wouldn’t win on every spread, but if you’ve done your homework correctly and you diversify across many spreads, you can make positive returns and reduce the volatility of returns. Unfortunately, these types of spreads are difficult to find and often can’t absorb billions of dollars of capital. So, the gambling continues and each newbie thinks that he has stumbled on some genius way to make money every time a trade goes his way.
I don’t think a lack of history and oral tradition is the problem. My personal observation over the years is that there are too many incompetents trading and too many investors willing to give them money to trade.
Generally, if you take the first type of risk and fail, you lose your job. Take the second kind of risk and fail, and you very often keep it.
Yes, the issue I discussed appears in institutions as well as among unaffiliated individuals. Institutions have to be extremely careful to avoid creating incentive structures that exacerbate the problem.
Methinks:
Most of the time when strategies blow up it’s not because the strategy stopped working, it’s because that strategy was high risk all along and those risks were ignored by those implementing the strategy until they blew up.
Yes, this is what I meant. If you make $1/day for 1000 days, and then lose $1000 on the 1001st day, you have a bad strategy from the beginning even though it took you 1001 days to find out. Of course, if business lore had taught you to avoid such strategies you might have known better. And of course many traders who fail via such strategies draw the wrong conclusions from their experience.
Also:
Points about arbitrage are well-taken. Many so-called arbs are really pure speculations where the behavior of the composite instrument is not (yet) well understood and “arbitrage” serves mainly as a marketing term. Carry “arbs” are generally short-gamma speculations on when an interest-rate adjustment or devaluation will occur.
Also:
I don’t think a lack of history and oral tradition is the problem. My personal observation over the years is that there are too many incompetents trading and too many investors willing to give them money to trade.
There are always incompetents trading and other incompetents backing them. And there are always competent traders who take the other side of the incompetents’ trades and prosper. My point is that the majority of the incompetents fail and leave the arena and take the lessons of their experience with them, and new traders have to reinvent the wheel. (A few incompetents learn from their mistakes in time to become competent and succeed, but this fact doesn’t impeach my point.)
Jonathan,
My point is that the majority of the incompetents fail and leave the arena and take the lessons of their experience with them, and new traders have to reinvent the wheel. (A few incompetents learn from their mistakes in time to become competent and succeed, but this fact doesn’t impeach my point.)
It does sort of impeach your point.
Nobody will give a new trader money and discretion. If it’s true that traders who blow up leave the market, then the ones that remain train the newbies to have better habits and fire them if they believe they aren’t learning. Let’s not discount the fact that good traders also lived through financial disasters and good traders are those who learned from such such disasters. Unlike villagers who left the coast after a Tsunami and then returned after several generations, these traders remained in the market to teach newcomers.
Given that traders crowd each other out of profitable, low-vol trades, only the most competent survive in solid strategies while the less competent basically have to take a lot of risk to have a hope of make money. Business lore does teach traders to avoid these risky strategies. Trading floors are littered with lore (among other things). But the incentives are so skewed to risk taking that it doesn’t matter. Using hedge funds as an example: Fund managers rarely have a significant amount of their own net worth invested in the fund they manage, so they have no incentives to avoid risk – particularly, since even a failed manager will be able to raise money for a new fund after a blow up and they regularly do. The 2 & 20 compensation structure means that that managers seek to raise as much capital as possible to which they can apply the flat fee because investors pay it whether they do well or not (the fee is rarely ever just 2% because they sneak in other fees as well, btw). However, with few very profitable opportunities to deploy large amounts of capital in which there is both opportunity for large returns and a way to reduce volatility, they are forced to swing for the fences. If they fail, it’s not their money. If they win, the payout is huge. They are not responding to what they learned or didn’t learn from from business lore (after all, the good traders learned the same lore, no?) but to incentives. I call these people incompetent (and a few other names) because they sometimes believe that just because they have “alpha” in their hedge fund’s name, it somehow magically translates to real alpha in their returns. Many of the carry trade managers believed that it was an actual arbitrage even though it takes very little knowledge of financial theory to understand that it isn’t.
Similarly, I think Federal flood insurance and other socialized loss/privatized profit programs provide incentives for people to rebuild in dangerous areas in advanced societies.
Methinks, I thinks you are missing the forest for the trees. Many successful traders do not share their knowledge, at least not publicly. Long-term successful traders are a small minority. Investors throw huge amounts of money after strategies that do not make sense or that have not been around long. There is a lot of turnover in the business. A lot of investors and traders take advice from incompetents and charlatans because they don’t know better. New groups of investors, or investors pursuing new investment fads, make the same mistakes over and over. The people who succeed tend to be those who either avoid mistakes or somehow figure out how to learn from their own and others’ mistakes. Knowledge about what happened before is helpful in this regard.
I appreciate the point about flood insurance, which obviously creates incentive to build houses in the wrong places, but it doesn’t change my point. Many people ignore risks of unlikely events because they don’t know enough history to perceive the risk. Floor insurance or no, I would hesitate to live in New Orleans or to build a house on the beach, because I know some history and pay attention to low-probability risks. (As it is I live in a place that I expect will be washed away one day, but then I am not ignoring the risk.)
Floor insurance or no, I would hesitate to live in New Orleans or to build a house on the beach, because I know some history and pay attention to low-probability risks.
I completely agree with you. You’d make a good trader.
Jonathan, I agree that long term successful traders are a minority. However, good traders don’t have to share their knowledge publicly (most of the public doesn’t have the background to understand them anyway). They train their underlings as they build their business and the wisdom and the lore is passed on that way even in the face of high turnover.
A lot of investors and traders take advice from incompetents and charlatans because they don’t know better. New groups of investors, or investors pursuing new investment fads, make the same mistakes over and over.
I think maybe you’re conflating professional traders and retail investors and “day traders”. The professional trading operations I’m familiar with do exactly what you think they don’t do – choose employees wisely and train them well. The most successful traders are disciplined enough not to make catastrophic mistakes and learn from every mistake they make. They get promoted. Those resistant to learning are fired.
Perhaps your experience is different. Perhaps you include retail traders in your definition (I don’t because they are too small a group to factor heavily into markets and they don’t have any background in economics and financial theory and I wouldn’t expect most to understand much – unfortunate and another ball of wax because they have to invest their savings!). I completely agree that market participants fall victim to all of the bad habits you claim. Based on my experience, I just don’t agree that this happens due to a lack of readily available information about what happened before. Trading floors are full of stories of blow-ups and their gory details and failed strategies are dissected there and in classrooms of major institutions around the country – A fact that I have both benefited from and contributed to. I believe it happens because of either ignorance of Economic and financial theory and math, stupidity, incentives, stubbornness and/or hubris (which is just another word for stupidity), not a lack of readily available historical facts. A rehashing of a failed strategy is usually justified the way American communists justify supporting communism in America after it so clearly failed everywhere else – the strategy is fine, the others didn’t execute it properly, we’ll do better. In the end, maybe we will just have to agree to disagree on this point.
Nesim Taleb in The Black Swan ,has much to say on people being unrealistic.The question I have,Methinks,is who is paying the freight for the successful traders? Is the public big enough to do so or is banks’ trading divisions. Who is the sucker?
I traded successfully for 19 years (index futures) as an outside individual,but then the pattern changed and what had worked didn’t so I ended up having to quit,but still well ahead. As far as letting anyone in on the secret-well there was no big secret-it was a matter of putting together a number of things,but I cetainly wouldn’t want others,playing with a lot of money to crowd me out.
Renminbi,
I read Taleb’s first book, but I’m not reading the second as it seems like it’s more of the same and I think I might open a vein if I have to read one more thing about Popper or Soros.
I’m not sure what you mean by who is paying the freight for the successful traders? Is the public big enough to do so or is banks’ trading divisions. Who is the sucker?. “Sucker” implies that someone was conned. In reality, those who take the other side of my trades do so willingly and without ever knowing that I’m on the other side. They never see me and I never talk to them (and I don’t win on all my trades!). I haven’t “suckered” them into anything and both of us had the same amount of information available to us – whether we availed ourselves of it before executing a trade is different question. While there is a winner and a loser in every individual trade, the person losing on the trade my not be a loser. For example, If I sell stock XYZ and the price of XYZ subsequently declines, then by definition I win and the buyer loses on his long XYZ position. But what if that was only one leg of the other trader’s position? What if he only bought XYZ to hedge a short position in stock ABC which he believed to be overvalued and, since ABC is correlated to XYZ, the same factors that caused the price decline in XYZ also caused a price decline in ABC. In that case, even though there is a winner and a loser for the individual XYZ trade, the buyer of XYZ befitted because he was able to reduce the volatility of his short ABC position and I benefited because XYZ declined after I sold it. Once we get beyond step 1, I think you’ll see that nobody is forced to pay the freight for successful traders (if that is what you meant). Let’s also not forget the benefit of liquidity that successful traders bring to the market. Imagine how much higher the cost of capital and how much wider spreads would be if markets were less liquid.
I traded successfully for 19 years (index futures) as an outside individual,but then the pattern changed and what had worked didn’t so I ended up having to quit,but still well ahead.
Interesting. Congratulations. I’m assuming by “outside individual” you mean as a retail customer? Out of curiosity, what was this pattern you were trading (since it no longer works, I’m assuming you don’t mind talking about it)?
Ah!Suckers.People don’t have to be conned by others-they can do well enough conning themselves. I looked at Traders’ Commitments in Barron’s Online and see that usually most of the open interest is held by hedgers.They are presumably buying insurance.Are they losing net on their contract side to keep the traders in money, or are the traders picking each others pockets? I don’t know, but I suspect the latter,but do you have any idea?Futures which are centrally cleared are a great idea because the clearing house means the contract will be honored.By the way, what genius invented price limits? I have never been able to see the point in that,but they had those on Value Lines(KC) in the beginning and the Merc’s S&Ps killed them.The VL index was far more regular in its behavior than the S&P but one never knew what kind of premium to cash you would get and eventually it ended trading by appointment.
There are a number of things that used to work but don’t anymore-January effect,Value Line Rankings,pre-holiday movement etc.The trend following thingy I used I back tested to the 60s and was a moneymaker from ’84 thru 2002.And then it just sputtered.This was not something I read about anywhere,but I figure some others must have stumbled across it. My general Technical Analysis probably still works, but why aggravate myself if I am comfortable? It would be a lot of work to enrich others-the various tax parasites if successful,other traders if not.I have enough and am not hungry and excitement I don’t need.That’s just it-not hungry now,but it was fun. A retail customer.
I see no point in price limits either. Thanks for sharing. I have always believed technical analysis is unreliable as a strategy – it usually involves a great deal of data mining. Although, it seems to be popular with some people. In arbitrage, the direction of the market is completely irrelevant.
The Technical analysis I used was like nothing anyone else used.People who use charts are the brokers best friend.
It occurs to me that the i-bankers are double whammed. The losers get flushed out and are not around to share their mistakes, and the winners retire young and are not around to share their victories, or stories about the losers.