A Canadian on Wall Street

Actually, that title isn’t that accurate, but it sounds nice, and that’s we care about here. Obviously if we could predict the future with any accuracy, patience wouldn’t even factor in. As it stands, though, the ability to temper the natural traits of human nature is the number one priority in investing, as far as I’m concerned. I look to myself as an example of this — for the past several years my investing has been poor in the face of what, relative to the days of 2002 to 2004, is a fairly volatile market. It’s incredibly hard to stick to strategies that take ages to develop a significant margin of profit or loss, so decisive action is difficult to make.

Most recently, I made a decent profit on a front-month option play derived from an underlying stock that has had a lot of news associated with it. But the longer I held the paper profit, the more anxious I got over dips that would cut it back. There was no reason NOT to let it expire in the money, and with the lack of news, the volume was not there for significant selling. But for some odd reason I got antsy, as I do sometimes, and sold out poorly — at market price, of all things! — and though I took a profit it was soured by the poor exit that I made. Since then, more news has come out to fuel the underlying and I left a significant amount on the table — instead of a 100% return, I coulda shoulda woulda made a 300% return. Obviously this is a common regret for investors, and something that must be tempered if one is to continue investing (the natural instinct is to go back in to the same position, at a much less attractive price, much the same way people follow mutual funds that have had banner years, only to discover the fund underperforming after they put their money in). It does highlight how useful it is to be a good gambler. Poker may be the closest of the card games to the financial markets, with its multiple player psychologies/strategies and incomplete knowledge, but a lot of the techniques of gambling, like bankroll management and the ability to recognize one’s own emotional responses to success or failure and control them, are present in any form of game where money is at risk.

I guess this is just my attempt at catharsis for a newbie move. Whoever bought those options off me got a pretty nice deal.

LATER: Fund manager C Neul describes his own battle with emotion versus analysis, although not explicitly (”fretted”). The real difficulty with systems of any kind is that they generally have human overrides, i.e. people who start to see the system break down and start to change things and deviate from the original strategy. I remember an article I once read about people who were taught a specific poker strategy — the people who could stick to it with no deviation did very well, while those that insisted on overriding the strategy fared poorly or middlingly well. I don’t know if this is necessarily support for the use of systematic methods in investing — I certainly don’t adhere to anything that rigid. But it’s definitely a reminder that one must enter and exit trades with a clear idea of why you are doing so. Too often, I still have no specific entry or exit point, which may work if you have an instinctual feel for the market as some traders seem to, but it makes it very difficult to subtract emotion from the equation when you have no objective limits. I think, perhaps, that I should at least start keeping a journal of my reasons for entering and exiting positions as well as the prices I’m willing to pay and justifications for those prices, even if the justifications lie on a foundation that in itself is not absolute (i.e. discounted cash flow analysis, etc).

I find C Neul’s description of how they found a new indicator of the market direction kind of suspect, in the way that one retrofits and backtests ideas against a particular sample to use as a new indicator of future direction. Then again, I’m not a fan of any kind of technical analysis, which this clearly is. But the surety of how he describes this measure (”standard deviation of daily total returns of the index”) as a way to make predictions about future moves is what I find least appealing — for a “skeptic”, he sure seems pleased with the new measure, that happens to fit his specific sample. Still kind of amazed that professionals do this, but I suppose if everyone took my stance the shell game would fall apart.

As usual, another quality commentary from Sacha Peter, comparing the current purchasing power of dollars invested variously, 30 years ago. I have to admit that his systematic and well-argued attitude to financial decision-making is something I aspire to, but which I don’t think comes as naturally to me. There’s still an element of hunch that I use, and which I think everyone must in the end. It’s interesting that after however many years of study of economic factors, the “dismal science” has not really been able to establish anything approaching the laws in more physical sciences — in the absence of such knowledge, how practically can rational decision-making be applied to the economy and the markets? New forms of statistical analysis may help but perhaps there should be more effort toward, not back-testing theories and analysis, but “forward-testing” it, by letting it run for a period of time and seeing how well they perform. The problem is that 1. if successful, you would have lost the opportunity to benefit (which is a big deal in a wealth-driven industry) and 2. there is no guarantee that the theory will accord with future reality. Unlike hard science, where many laws and theories have held up long enough to be considered “true” to most, any theories on market behaviour tend to run into headwinds within a lifetime or two. (I realize I’m sort of vaguely conflating economics and markets, but you get the gist.)

The big news this morning seems to be Microsoft’s offer for Yahoo. I have to say, neither Microsoft or Yahoo has impressed me that much in the past few years — they both have a bit of a “chicken with its head cut off” style of deal-making to try to build a company through acquisitions. There’s something random about their strategies, almost as if they’re overdiversified, too unfocused to really make a dent. (The number of Yahoo acquisitions has never translated into real success.) Obviously, this is an attempt to bulk up enough to match Google’s strength in the online services/advertising space, but even Google has run into problems as it tries various strategies to grow outside its core search advertising market. I suppose I wonder if two mediocrities can combine to become more than the sum of their parts? Does “synergy” (and it’s questionable if there is — the cultures alone seem significantly different) have some magic that can recombine these entities into something a little more interesting?

LATER: Little did I know that this would become such a hot topic in blogworld. Here are some opinions from people I’ve enjoyed reading recently: Nicholas Carr, who never misses an opportunity to flog his “the net is turning into a vast, utility-computing blob driven by advertising” concept, which may be true but gets pretty dry the twentieth time around. Doesn’t he have anything else to talk about? C Neul, who seems fairly astute if a bit too sure of himself sometimes, has some good points regarding the offer from the viewpoint of Microsoft shareholders. I’m surprised this guy hasn’t weighed in yet, though.

LATER STILL: Ionut Alex Chitu revisits the long road to desperate measures undertaken by both Yahoo and Microsoft before the latest maneuvering, with a diverse series of excerpts of articles and reportage dating back to 2004.

It’s somewhat interesting reading to occasionally look at the Google Finance message boards on a per-stock basis. The signal-to-noise ratio is often relatively high, especially when compared to Yahoo’s morass of financial discussion. You get an insight into the mind of the average investor — often somewhat well-informed and spouting various lingo that they may have picked up much the way any of picks it up, from exposure and a hobbyist’s interest. As far as I’ve seen, there are few true professionals on these boards, which makes some sense. A top stock-picker is often leery of giving away too much of the recipe to their secret sauce, for obvious reasons.

Take for instance this thread on Lululemon’s message board. I love the exactitude, the forthright assuredness of people who declare the stock “cheap” without any real indication of how they arrived at that conclusion — by what metric is it cheap? Often, it seems the only metric they use it historical; what’s cheap is something that is priced lower than at some time in the past. Or later, “Im sure we will test support in the low 30s againn so you may get your chance.” How is this person so sure? The lack of skepticism in that statement makes me wonder if they should ban stock message boards. Or perhaps study them under the aegis of behavioural finance. Flocking behaviours, etc. It seems that people are happy to absorb a few algorithms and “rules of thumb” and arrange them just so, hoping that by doing so — like the Pacific Islanders and their cargo cults — they will achieve their desired results. The thinking almost seems like: If they look or sound like they know about investing, then they must know about investing. Or “fake it until you make it?” Although it might be a long time before some of these people make it.

I’m reminded of the need for skepticism and strong justifications for buying at a certain price from re-reading Benjamin Graham and David Dodd’s old textbook “Security Analysis”. It focuses a great deal on bonds and preferred shares, while leaving common stock investment till about the midway point, and some of the conditions that it describes (a world of high dividend common stocks, with single digit P/E ratios) don’t really exist anymore, but some of the same mistakes that people make now crop up in the text. The move from investment to speculation, the insistence on a “new era” where steady earnings don’t matter, the hope for future gains. It’s tough reading this book and figuring out how to apply it to the current climate. As value investors know, it’s been slim pickings for years, as investing and stocks have gotten so much play that the amount of interest and volume means that few stocks remain cheap for long. It’s hard doing the dirty work of finding unloved, unknown and excellent gems — is it still as possible as it used to be in 1940? Graham talks about staying out of the market for long periods of time, like a three year stretch after the Great Depression. This is a difficult thing to do, when the natural instinct is always to act. Graham is almost asking us, those who believe in his philosophy, at least, to be like philosophical Taoists, detaching ourselves from everything, removing any sign of affinity. That’s even tougher in today’s marketed and PR-ed world. I speak from experience, as I originally went predominantly into cash mid-summer last year, anticipating the current situation, but ended up watching as the market continued to creep up and visions of lost opportunities danced in my head — I ended up getting back in whole hog and consequently taking a hard hit in the current market. Of course, going into cash was the right move in hindsight, but having the mental fortitude and conviction (as well as truly analytical, skeptical and unbiased reasons for a particular move) is the harder part.

There’s still room for hunches and instinct, though. But if you’re going to follow those, they better be strong and you better be able to stick to them in the face of contrary information (but also be willing to accept the contrary information if there’s a good reason). It’s a tough game, isn’t it?