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Lessons From A Trading Great: Linda Bradford Raschke

I realize that I’m only human, and that I’ll always make mistakes. I just try to make them less frequently, recognize them faster, and correct them immediately!

We can thank Linda Bradford Raschke for that important bit of trading wisdom.  

Only the very best can battle the markets over the long-haul and still come out on top. Linda Bradford Raschke is one of these traders. She’s been at the game for over three decades and still manages to clean up. You probably know the name. She was featured in Schwager’s The New Market Wizards book (hers was the best chapter in your author’s opinion).

If you haven’t already I highly recommend you go and check out her latest book Trading Sardines. It’s a fantastic read, full of humor and valuable trading wisdom from a decorated veteran of the game.

Linda’s traded from all sides of the business; as a market maker in the open outcry pits, as an individual trader for her own account, as well as a fund manager for institutional investors. She’s literally done it all.

In this piece, we’re going to explore Linda’s methods, habits, and practices. We’ll breakdown how she approaches markets and the tools she’s used to make a consistent killing over the years. Let’s jump in!

Linda’s Trading Program

Linda segments her trading between four different strategies (she calls them profit centers). Each profit center has a different approach to the market so that she can diversify her revenue streams. Not all of them bring home the bacon each year, but she counts on at least one of them to make her nut for the year.

LBR Profit Center 1 — S&P Day Trading

S&P day trading is Linda’s bread and butter. 95% of this trading is in the E-mini S&P 500 futures contract as opposed to the other stock index futures like the Rut, DOW and NASDAQ. This was her original program and still to this day, her most consistent producer.

She stresses that successful day trading in the S&Ps requires contextual awareness. Do the odds favor a low to high day or a high to low day? Is it likely a trend day or a consolidation day? Getting this context right makes the trading day much easier.

Linda likes to fade the noisy fluctuations of the S&Ps as the market awaits a big economic report or FOMC release. On light volume days she likes to fade the tests of the intraday range.

But her biggest money maker is on high volume high vol trend days. Once Linda has the market by the tail she presses hard and rides her position into the close. There’s more on her big bet philosophy in the ensuing sections. Her “secret sauce” (like many of the other wizards) is knowing when to size up and “go for the jugular.”

LBR Profit Center 2 — Swing Trading

Her second profit center involves swing trading on the major futures contracts with a 1-3 day holding period. Losers get cut quickly.

For these swing trades, Linda generates entry signals based on 2-period ROCs and other momentum readings. Even with all the fancy computer equipment available, Linda still chooses to manually write down the indicator reading and closing prices for the 24+ futures markets that she tracks. Writing the data down every day helps keep her in tune with the market in a way that just following things on a screen can’t.

LBR Profit Center 3 — Daily and Weekly Classical Charting Trades

The third trading strategy generates profits using classical charting patterns with Peter Brandt style execution. Like Peter, her entry signals are discretionary but she does her best to quantify her process and patterns via ATRs, pivot points, and swing highs and lows.

To manage these trades she likes to use a trailing stop to see how much the market will give. If momentum begins to move against her, she will override the trailing stop and exit the market at the close.

She finds that her best trades come from daily swings turning up or down (false breakouts) rather than the breakouts of chart formations.

Over the course of her career, Linda has noticed that a particular market will give roughly 14-20 reasonable swings per year. Her goal is to just capture one great swing a month. If she does this then she’ll usually have a great year — provided she pulls back her aggressiveness when the market enters a period of low volume churn.

LBR Profit Center 4 — The Everything Else Bucket (Special Situations)

Linda dips into this bucket during severe market dislocations. One of her favorite trades is to fade sentiment extremes with an option structure that allows her to take the other side of consensus fear/greed while keeping her risk capped. For bullish bets she prefers the long call spread, and for bearish bets she deploys the long put spread. This keeps her risk tightly defined in the incredibly volatile market conditions that accompany extremes in sentiment.

She’ll also take seasonality trades under this bucket. Seasonality trades are generated from patterns in the commodity markets. Check out this website for more info on commodity seasonality.

The defining characteristic of this bucket is that the opportunities are rare. And because of that they are not easily modeled.

Rare opportunities usually mean fatter edges because they can’t as easily be arbitraged away by a professional quant firm that uses immense computing power to search for patterns in reams of market data.

That’s the skinny on Linda’s trading setups. But setups are only a small part of what makes a trader of Linda’s caliber. In Trading Sardines she explains how successful trading requires much more than finding a good chart pattern. It’s about having a sound process, robust research methods, solid position sizing, good market reads and a healthy lifestyle away from the trading screen.

A Strong Trading Process

In trading, a good process leads to good profits.

Linda refers to her trading as a business. She uses terms like profit centers and costs. That’s a great way to frame it because one must approach trading with the same seriousness and discipline as one would running a business.

Successful businesses keep meticulous records so they know what’s working and what isn’t. Based on this feedback the leader will adjust fire and calibrate the process appropriately.

Linda does the same for her trading.

She monitors each of her four profit centers on a quarterly basis. Her performance will come from different programs each quarter depending on market conditions. If she finds that one profit center is consistently underperforming she’ll tweak her approach until it starts producing again.

One indicator she likes to look at is trade frequency. If trade frequency for one of her programs comes in way higher or way lower than normal she knows there’s likely an execution error going on. This usually means she’s overtrading, not getting rid of losers quickly enough, or trading while sleep deprived.

We follow a similar protocol here at Macro Ops. Each quarter we review our results and segment them by market and trade strategy type. We discard what’s not working and keep what does.

Another thing all successful businesses have in place is a crisis management plan. Linda has hers for trading. If an execution error occurs she immediately corrects course, no questions asked.

Linda talks about a time where she came into the open incredibly bullish on the S&P E-minis. But instead of going long she accidentally put on a large short. Instead of monkeying around and trying to find the perfect exit to limit her losses, she immediately cut the trade and went long.

“Correct mistakes immediately” has saved Linda millions of dollars over her trading career.

On Models and System Building

Linda has her four core profit centers that work for her — but that doesn’t mean she stops refining her old edges and at the same time searching for new ones.

She is constantly scrutinizing and scouring around for new and improved approaches — the markets force you to continuously adapt or die.

Linda’s not a 100% mechanical trader but she tries to systematize as much as possible to take some mental burden off of herself so she can focus on the tape. Here’s her explaining this in Trading Sardines.

I was never a systems trader though I try to stay systematic. It is hard for me to give up the control I get with tape reading. I don’t want to give up control, period. I would like to believe my experience gives me an edge. But some people will only be able to make money following a system.

She also mentions that if you do use a system it has to be your system. This is in line with what we preach here at Macro Ops. You can’t succeed long-term blindly following somebody else’s approach. Here’s Linda again (emphasis mine).

The problem is, it’s hard to muster the necessary confidence in a system unless you develop it yourself. Systems, even ones that make 100 trades a month, can go through brutal drawdown periods. And if the system isn’t your baby, you’ll abandon it with a loss instead of adhering to it long enough to recover a drawdown.

To vet system ideas Linda is a fan of manual backtesting.

My best work came from testing by hand. I could see where a signal worked and why. I could also look at the conditions where signals failed. When testing with a computer, too much data gets lumped together. This often cancels things out and it is easy to miss the subtle nuances that lead to learning. I’ve learned more by notating signals on charts, studying when signals don’t work, looking for secondary or confirming signs, and recording seas of data by hand. There is no way I could have created my numerous nuanced tactics by backtesting and doing computer runs.

This is exactly how our resident systems trader at Macro Ops, Chris D. does his research.

He’s all about manual backtests so he can develop a feel for the signal and the underlying market. You also see ways to subtly improve things that a computer can’t catch.

Even though Linda is a discretionary trader she likes to build her trade ideas from the base of a model. Here’s why:

Most professional traders know things intuitively from experience. However, we are all subject to different cognitive biases. Models help us keep an open mind and guard against biases. They differ from mechanical systems but are an integral part of the trading process.

It’s possible to trade within the confines of a model or a framework but still allow enough flexibility so your trading is not 100% systematic. Using a model or framework to define trade ideas coupled with manual execution gives you the best of both worlds. The model keeps you from overtrading and the manual execution allows you to make adjustments depending on market conditions.

In Trading Sardines, Linda gives us some advice on how to start the modeling process. For her, it starts by asking some simple questions.

A modeling process starts out by asking simple questions. For example, what happens if you enter on a breakout of the first 15-minute bar after the opening? What is the distribution of how many ticks you can get in the next 15-minute bar? What happens if you enter on a breakout of the 15-minute bar going into the last hour and exit at MOC (market on close)? Is there a distribution pattern showing the most common time for highs and lows? The permutations are endless.

Once you discover the answers to these questions through backtesting and market research you can start to develop a real trading edge that will act as the foundation for your own profit center. Linda makes her models world-class by incorporating new information into each of her trades. This is a form of Bayesian inference — another concept we hound on again and again here at Macro Ops. Here’s Linda (emphasis mine):

Another essential step is to layer on top of our multiple model tree a form of Bayesian process. Start with the prior models and probabilities and then continuously update them as new information unfolds. One data point at a time. To go one step further, we can even weigh these new pieces of information. And as the volume of information increases exponentially, you see how easy it is to fall down a rabbit hole.

In regards to model building Linda offers up some wisdom on how to design exit criteria. She’s a fan of time-based exits.

Much of my modeling uses time-based exits. Exits on the close or the next day’s close, Exit after one hour. Exit when Europe closes. Time-based exits are not dependent on the range or volatility condition, and they are robust.

Instead of exiting based on a predetermined price target, time exits allow you to realize the full strength of the signal. Here’s more on her exit philosophy from her interview in New Market Wizards.

I’m also a firm believer in predicting price direction, but not magnitude. I don’t set price targets. I get out when the market action tells me it’s time to get out, rather than based on any consideration of how far the price has gone. You have to be willing to take what the market gives you. If it doesn’t give you very much, you can’t hesitate to get out with a small profit.

On Position Sizing and the Big Bet

At Macro Ops we’re huge proponents of the Big Bet and there’s a reason for that. All of the trading greats talk about how “going for the jugular” when the stars align with your approach to the markets.

Linda says the same thing in different words (emphasis mine).

When traders think about money management, they think about stops and trade management. But a big part of the equation is knowing when to go all in, increase the leverage and press your trading to the hilt. Load the boat. These opportunities have an increase in volume and volatility. There is no point in actively trading in a dull market. Let the market tip its hand and come to life first. And then if you are fortunate to be in the groove and know you’ve got a tiger by the tail, milk it for all it is worth. This is where the real money is made.

It’s possible to simply “get by” in trading by having an okay edge and proper risk control. But if you want to achieve market wizard status you have to know when to up size and bet big.

Linda’s first ever 7-figure day in the market came from utilizing the big bet strategy on the S&P E-mini contract (emphasis mine).

There is no more glorious feeling in the world than capturing a huge trend day. My first seven-digit day came from a short position in the S&Ps. The market was overbought, the sentiment readings showed too much bullishness, the 2-period rate of change was poised to flip down and my models lined up like a rare planetary alignment.

I had come into the day with a short side bias. When the market started selling off the opening, I added in a big way and held until the close.

I want to stress her planetary alignment comment here. Because this moment is similar to what Druck talks about when he says to go for the “whole hog” or when Warren Buffett mentions “swinging hard at the fat pitch.”

All market opportunities are not created equal which is why position size must vary depending on the expected value of the trade: EV = (Probability of Winning) x (Amount Won if Correct) – (Probability of Losing) x (Amount Lost If Wrong)

When trading a diverse set of markets like Linda it’s paramount to standardize the dollar risk of each contract so each trade risks a similar dollar amount. By not standardizing the risk between markets, the most volatile market will dominate the p&l.

Linda uses the average dollar daily range for each contract she trades in order to get all of her positions sized correctly.

Each quarter, we calculated the average daily dollar range per market. If gold had a 20-dollar average daily range over the previous 30 days, this translated into a $2,000 average daily dollar range. If the S&P e-minis had a 14-point average daily range, this is a $700 average daily dollar range. Gold sizing might be 4 contracts per million. If we had $100 million of AUM, it mean that 1 unit of gold equaled 400 contracts. In the S&P e-minis, 1 unit might be 10 contracts per million or 1000 contracts.

This is otherwise known as volatility-weighted position sizing. This ensures a trader risks similar amounts on each trade. Lower volatility instruments will need more contracts and higher volatility instruments mean fewer contracts. By sizing this way, fluctuations in highly volatile markets will equal the fluctuations in quieter markets.

In markets, there’s a time to play aggressive offense (and place the big bet), and then there’s a time to play aggressive defense. When positions move against you, Linda suggests to taking off size until you can think clearly again.

Whenever you have your back up against the wall, you have to get smaller. Reduce your size to the level where you can start trading again, because in these types of situations when there is uncertainty or unprecedented volatility, there is lots of money to be made. But you can’t do it if you are frozen or stressed, so figure out the level where you can function and trade freely again.

Taking size off when things go south will preserve mental capital and allow you to get ready to pile on again when general conditions favor your bias.

On Market Dynamics

It’s not the actual news that’s important — it’s the market’s reaction to that news that is most important to a trader.

Linda talks about this concept and gives guidance on how to best trade news driven moves.

If positive economic news is released and the market sells off on that news, this could also be perceived as an aberration. It is a divergence from what would normally be expected. But this, too, is the market’s way of imparting powerful information. In this case, it may be that there are no buyers left, or that the news has been long discounted.

Trade in the direction of the aberration. The market is never too high to buy or too low to sell.

Trading mastery requires a thorough understanding of the boom/bust process that plays out over and over again in public markets. Linda has studied the underlying dynamics of the boom/bust process to give her the confidence to trade bubbles when they are about to pop (emphasis mine).

There was a study done on price behavior when the field of behavioral finance was just coming on the scene. It simulated trading with groups of individuals who were not traders. The price of the market would always rise first. It kept inching higher until everyone had bid and there was nobody left to buy. At that point, it broke sharply with no support underneath.

To this day, this is one of the main reasons markets sell off—there is nobody left to buy.

That’s why at Macro Ops we are such huge fans of sentiment indicators. Sentiment indicators tell us when there is “no one left to buy.” Periods of extreme optimism set the stage for gut-wrenching selloffs. Linda exploits this same edge in her profit center 4 through the use of call spreads or put spreads.

On The Trifecta Approach: Combining Fundamentals and Technicals

The best traders in the game pull data and information from numerous sources to construct a trading thesis. Linda uses the “Marcus Trifecta” approach in her trading by first finding fundamental market imbalances and then entering the market via technical analysis cues.

She made tons of money trading the yen using this multi-faceted approach. Here’s an excerpt from Trading Sardines which describes the trade in more detail (emphasis mine).

The “carry trade” was a popular strategy from 2002-2007. Investors borrowed money in yen where interest rates were low and invested it in higher-yielding currencies. It was a crowded trade, meaning too many people were in this same position. What was going to happen when people needed to unwind?

I trade by technicals since I have not yet had much luck using fundamentals. But I am aware when there is a market imbalance implying a crowded trade. The yen was a ripe situation. It has left a bear trap or false downside breakout on the weekly charts. I tried twice to put on a position, both times unsuccessful. The third time I knew I got it right. It was our signal to load up. I don’t mind trying a few times if there is a basis for a position but the timing is off. The real key is to make it pay and use maximum leverage when the trade starts working. I told Judd to keep buying yen, and the ensuing rally made our year. The yen went straight up for the next five years as global interest rates came crashing down.

On Trading Lifestyle

Grinding an initial capital stake into millions of dollars takes time. Fortunes aren’t made overnight in the trading business. The big money is made by finishing the marathon, not the sprint.

Linda makes this clear and lays out many lifestyle strategies that maximize your chances of making a  real fortune from trading the markets.

She used the following three things over her long career to keep her mind and body fresh and ready to battle the markets day in and day out.

  • Gratitude practice
  • Physical fitness
  • Time off

The markets are volatile beasts which mean they will send your emotional brain into a whirlwind. In order to combat the push/pull of these emotions, Linda uses a gratitude practice to keep her grounded when things go wrong.

Gratitude is a key ingredient of success. It means that even when bad things are happening, you always have something to focus on. Just like pilots have a gauge to make sure they can still tell which way is up, gratitude keeps me from ever feeling upside down. When you are trading the markets, you have to have a separate source of happiness —- to know that there are still wonderful things all around, most of which do not require money. It is easier to take risks when you remove your personal happiness and well-being from the equation.

Gratitude leads to optimism, and a positive attitude is 90% of the game.

Linda was extremely active in the gym and even competed as a bodybuilder! The discipline required for her to compete in bodybuilding carried over into her trading program.

Trading and physical training have a lot in common. Every successful training routine requires the following:

  • A sound methodology
  • Consistent execution of that methodology through the use of daily rituals
  • Records of progress
  • Positive thinking and optimism

These are the exact same things needed to succeed in the trading grind! So if you aren’t already, get in the gym!

Finally, Linda recommends taking time away from the trading screens to refresh and recharge. A hobby helps to relieve stress. For her, this was horseback riding.

LBR has the whole package of a legendary trader — a burning desire to win, emotional fortitude to withstand the ups and downs of a trading career and the ability to “go for the jugular” when the market required it.

I want to end this piece with her advice on how to find success as a new trader (emphasis mine).

Understand that learning the markets can take years. Immerse yourself in the world of trading and give up everything else. Get as close to other successful traders as you can. Consider working for one for free. Start by finding a niche and specializing. Pick one market or pattern and leam it inside out before expanding your focus.

Finally, remember that a trader is someone who does his own work, has his own game plan, and makes his own decisions. Only by acting and thinking independently can a trader hope to know when a trade isn’t working out. If you ever find yourself tempted to seek out someone else’s opinion on a trade, that’s usually a sure sign that you should get out of your position.

Well said Linda… Now time to get to work!

If you liked this article, you will love Lessons From The Trading Greats Volume 1 which has more insight from the world’s best traders. Click here for a free copy!

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Investing in Shipping Stocks: Lessons from Walter Schloss

He knows how to identify securities that sell at considerably less than their value to a private owner; And that’s all he does … He owns many more stocks than I do and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on [him]. That is one of his strengths; No one has much influence on him.

Those words, spoken by Warren Buffett, describe one of the greatest value investors of all time. No, Buffett isn’t referring to his longtime business partner Charlie Munger nor his famed teacher Benjamin Graham.

The investor is Walter Schloss.

Schloss is a wellspring of value investing wisdom.

Over the course of this piece we’ll dive into Schloss’ principles for investing. His ideas on portfolio construction. And we’ll finish with applying these lessons learned to analyzing shipping stocks. An industry we’re particularly bullish on at the moment.

Battlefields to Balance Sheets

Schloss enlisted in the US Army Signal Corps at the end of 1945 after his stint as a runner on Wall Street. Before being shipped overseas, Benjamin Graham offered Walter the opportunity to join his firm, Graham-Newman Corporation, as a security analyst. Schloss accepted the offer after returning from service and quickly learned the ropes of value investing through real-world applications of Ben Graham’s classroom teachings.

After working under Graham for nine years, Schloss opened up a one man shop, Walter J. Schloss Associates.

As the saying goes, the rest was history.

Schloss took his original partnership money and spent the next 32 years compounding capital at 16.4% annually compared to the S&P return of 9.8%.

Schloss accomplished this impressive feat while operating out of a small room (Warren Buffett referred to it as, “a portion of a closet”) at Tweedy, Browne’s offices. He didn’t use a computer or a team of analysts. Just a monthly paper subscription to Value Line. He was the embodiment of a spartan approach to investing.

How was Schloss able to compound capital at such high rates over such a long period of time? What was his secret sauce?

Schloss kept a low profile (similar to the Chandler Brothers) and routinely shied away from press coverage or interviews with journalists for the majority of his career. However, as he got older, he started sharing his wisdom in the form of articles and speaking events. Through these sporadic public appearances we can get a better picture of just who this man is and how he invested in markets.

Investment Philosophy: Buy Stocks Like Groceries, Not Perfume

Like other successful investors, Schloss followed a simple yet robust approach to amass his fortunes. This approach can be surmised in the following bullets:

  • Start with beaten-down losers, the 52-week lows and companies with temporary issues.
  • Don’t lose money.
  • Avoid debt like the plague.
  • Try to buy stocks that manufactured products while sporting long histories of operations (20+ years).
  • Focus on assets rather than earnings, citing the claim that earnings aren’t as predictable as assets on the balance sheet.
  • Avoid talking to management.
  • Read the entire annual report and familiarize himself with the basics of each business he bought.
  • Purchase hundreds of stocks, keeping a well diversified portfolio.
  • Exhibit around 25% turnover — i.e., holding period of four years.

Above all else, Schloss didn’t want to lose money. He had a tremendous respect for his limited partners’ trust in his ability to manage their capital, and did everything in his power to limit his losses. Schloss had a tremendous grasp on the psychology of the average investor and frequently used it to his advantage. During an interview with Barron’s in 1955, Schloss said (emphasis mine),

They [stocks] tended to be ignored by the public because they didn’t have any sex appeal, there wasn’t any growth — there was always trouble with them. You were buying trouble when you bought these companies … Basically, it’s a contrarian philosophy, and people really like buying things that are doing well.

I wish Schloss was more complicated — it would help me get more pages out of the piece — but that’s really all there was to it.

He would fish in the ponds that looked like radioactive cest-pools, hold on to the ones that were the cheapest and sell when he had at least a 50% gain.

Schloss was so focused on not losing money, he often left a lot of meat on the bone — something he was perfectly fine with. In that same Barron’s article Schloss examined that,

One of the tricks of this business is to keep your losses down and then, if you have a few good breaks, the compounding works well for you.

These simple principles guided Schloss’ stellar 16.4% net annualized return.

Along with the above fundamental tenants, Schloss offered investors 16 rules, which he called Factors Needed to Make Money in the Stock Market. As with most rules / checklists, it’s not the points themselves that matter, but the individual’s ability to stick to the rules. The rules are attached at the end of this piece. I encourage you to print it out and keep it by your desk, laptop or wherever you do your investment work.

If you would like free access to my value investing checklist click here! 

Qualitative Aspects Don’t Matter

Walter Schloss didn’t care about the qualitative aspects of the business when he invested — something attributed to his inability to judge management’s acumen — and focused only on the numbers. This flies in the face of many value investors’ creeds that claim management and incentives matter amongst other areas like marketing and customer acquisition cost. There was a reason why Schloss preferred to invest this way: it helped him sleep at night.

Unlike Buffett, Schloss made a point of not talking to management or factoring them in at all. His reason was that good management would eventually show up in a higher stock price and a higher multiple

This makes sense if you’re buying the assets of a business rather than their earnings and future growth prospects. You don’t need to know how management will grow earnings and reinvest their capital if you’re investing because its asset value per share is higher than what you’re paying on the open market.

Applying Schloss’ Methodology to Shipping Stocks

Equipped with this knowledge of Schloss’ methods and criteria for investing in public companies, we can construct a framework to help us analyze shipping stocks.

Shippers represent a perfect harmony for the type of companies Schloss would be interested in buying: cyclical lows, asset heavy businesses trading at steep discounts to liquidation values. Let’s go through a few of Schloss’ 16 Rules and see how we can apply those directly to the messy, “road-kill” industry of shipping.

Rule 1: Price is the most important factor to use in relation to value

Shipping stocks are stupid cheap with prices for a majority of these companies trodding around all-time-lows. No matter how you look at shipping companies its undeniable that on a purely quantitative measure, they’re selling for pennies on the dollar.  

That’s not to say that qualitatively there are issues — i.e., bad management, low growth prospects — but on price alone, Schloss would be interested.

Rule 4: Have patience. Stocks don’t go up immediately.

I was asked via email from one of the MO members about the difference between being early vs. being wrong — and how can I tell the difference?

Schloss is frequently quoted for buying stocks “on a scale”; as share prices fell he would buy more. This is where patience comes in. Schloss reminds us that stocks don’t go up right after you buy them — especially if you’re buying the troubled, “ick” factor stocks that Schloss made his fortune on.

Having the patience to endure a short-term selloff in share prices cannot be understated. Schloss would not have generated the returns he did if he sold quickly after share prices went against him (remember his 25% turnover rate!).

Rule 6: Don’t be afraid to be a loner but be sure that you are correct in your judgement. You can’t be 100% certain but try to look for weaknesses in your thinking. Buy on a scale and sell on a scale up.”

When investing in Schloss-type stocks, you will by default be a loner. You can’t have one without the other. Shipping stocks are at all time lows because the industry isn’t experiencing that inflow of serious capital … yet.

We know the thesis for why the shipping industry will probably heat up over the next two years, but Schloss tells us that knowing our judgement isn’t enough. Schloss encourages us to look for weaknesses.

What does this look like?

Try Googling the bearish thesis for the shipping industry and compare it its bullish cousin you’ve subscribed to. This is called Red Teaming your thesis.

Is there anything you missed in your initial assessment? Can you identify major weak points to your thesis? Are there any biases possibly clouding your judgement etc…

Buying on a scale allows us to account for our inability to time when the market will become less irrational. Schloss wouldn’t take his full position all at once because he knew the stocks he bought were in trouble, and they were likely to fall further.

Selling on a scale works for the inverse reason as buying on a scale — the stock could keep going up as you unload your position, giving you incrementally higher profits as opposed to dumping the entire position at once.

Rule 10: “When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think its attractive. 3 years before, the stock sold at 20 which shows that there is some vulnerability in it.”

Following the vein of Rule 1, Rule 10 provides the investor with an increased margin of safety when making their initial investment. According to Schloss, If buying a stock at its 52-week low is good, buying a stock at its all-time low is even better.

The good news for investors is that the majority of companies in the shipping industry are trading at all time lows.

Once again, these stocks have problems (whether industry specific, company specific or a combination) they’re currently dealing with. Buying these companies at all-time lows helps us sleep at night.

Rule 11: “Try to buy assets at a discount rather than earnings. Earnings can change dramatically in a short time. Usually, assets change slowly. One has to know how much more about a company if one buys earnings.”

Schloss focused only on the balance sheet and the assets that could be liquidated for cash. Applying this to the shipping industry gives us an easier framework for analysis. We don’t have to understand management and the intricacies of the businesses if the company is selling at below half its net asset value measured by the active secondary scrap market.

Putting Words Into Action: Next Steps

How do Schloss’ principles coupled with the value opportunity in the shipping industry play out in real time? What are actionable steps to take if you want to invest in these shippers?

The plan itself is simple in theory — but like Schloss’ rules — hard to follow:

1) Find a basket of the cheapest shipping stocks with the greatest margin of safety / discount to fair value

2) Allocate a specific amount of your portfolio to this basket of stocks and

3) Forget about them for 1-3 years.

Conclusion

Walter Schloss stuck to his rules and stayed in his well-defined lane. And by doing so, he generated “super-investor” level returns.

I’m not saying you need to do a full 180 on your current strategy in order to generate Schloss-like returns, but I am advocating for an appreciation of Schloss’ tactics — and consider adding a few tools to your investment toolkit.

(** all information for this report was sourced via www.walterschloss.com **)

Walter Schloss’ 16 Rules

 

  1. PRICE IS THE MOST IMPORTANT FACTOR TO USE IN RELATION TO VALUE

 

  1. TRY TO ESTABLISH THE VALUE OF THE COMPANY. REMEMBER THAT A SHARE OF STOCK REPRESENTS A PART OF A BUSINESS AND IS NOT JUST A PIECE OF PAPER.

 

  1. USE BOOK VALUE AS A STARTING POINT TO TRY AND ESTABLISH THE VALUE OF THE ENTERPRISE. BE SURE THAT DEBT DOES NOT EQUAL 100% OF THE EQUITY. (CAPITAL AND SURPLUS FOR THE COMMON STOCK).

 

  1. HAVE PATIENCE. STOCKS DON’T GO UP IMMEDIATELY.

 

  1. DON’T BUY ON TIPS OR FOR A QUICK MOVE. LET THE PROFESSIONALS DO THAT, IF THEY CAN. DON’T SELL ON BAD NEWS.

 

  1. DON’T BE AFRAID TO BE A LONER BUT BE SURE THAT YOU ARE CORRECT IN YOUR JUDGMENT. YOU CAN’T BE 100% CERTAIN BUT TRY TO LOOK FOR THE WEAKNESSES IN YOUR THINKING. BUY ON A SCALE DOWN AND SELL ON A SCALE UP.

 

  1. HAVE THE COURAGE OF YOUR CONVICTIONS ONCE YOU HAVE MADE A DECISION.

 

  1. HAVE A PHILOSOPHY OF INVESTMENT AND TRY TO FOLLOW IT. THE ABOVE IS A WAY THAT I’VE FOUND SUCCESSFUL.

 

  1. DON’T BE IN TOO MUCH OF A HURRY TO SEE. IF THE STOCK REACHES A PRICE THAT YOU THINK IS A FAIR ONE, THEN YOU CAN SELL BUT OFTEN BECAUSE A STOCK GOES UP SAY 50%, PEOPLE SAY SELL IT AND BUTTON UP YOUR PROFIT. BEFORE SELLING TRY TO REEVALUATE THE COMPANY AGAIN AND SEE WHERE THE STOCK SELLS IN RELATION TO ITS BOOK VALUE. BE AWARE OF THE LEVEL OF THE STOCK MARKET. ARE YIELDS LOW AND P-E RATIOS HIGH. IF THE STOCK MARKET HISTORICALLY HIGH. ARE PEOPLE VERY OPTIMISTIC ETC?

 

  1. WHEN BUYING A STOCK, I FIND IT HELPFUL TO BUY NEAR THE LOW OF THE PAST FEW YEARS. A STOCK MAY GO AS HIGH AS 125 AND THEN DECLINE TO 60 AND YOU THINK IT ATTRACTIVE. 3 YEARS BEFORE THE STOCK SOLD AT 20 WHICH SHOWS THAT THERE IS SOME VULNERABILITY IN IT.

 

  1. TRY TO BUY ASSETS AT A DISCOUNT THAN TO BUY EARNINGS. EARNING CAN CHANGE DRAMATICALLY IN A SHORT TIME. USUALLY ASSETS CHANGE SLOWLY. ONE HAS TO KNOW MUCH MORE ABOUT A COMPANY IF ONE BUYS EARNINGS.

 

  1. LISTEN TO SUGGESTIONS FROM PEOPLE YOU RESPECT. THIS DOESN’T MEAN YOU HAVE TO ACCEPT THEM. REMEMBER IT’S YOUR MONEY AND GENERALLY IT IS HARDER TO KEEP MONEY THAN TO MAKE IT. ONCE YOU LOSE A LOT OF MONEY, IT IS HARD TO MAKE IT BACK.

 

  1. TRY NOT TO LET YOUR EMOTIONS AFFECT YOUR JUDGMENT. FEAR AND GREED ARE PROBABLY THE WORST EMOTIONS TO HAVE IN CONNECTION WITH PURCHASE AND SALE OF STOCKS.

 

  1. REMEMBER THE WORK COMPOUNDING. FOR EXAMPLE, IF YOU CAN MAKE 12% A YEAR AND REINVEST THE MONEY BACK, YOU WILL DOUBLE YOUR MONEY IN 6 YRS, TAXES EXCLUDED. REMEMBER THE RULE OF 72. YOUR RATE OF RETURN INTO 72 WILL TELL YOU THE NUMBER OF YEARS TO DOUBLE YOUR MONEY.

 

  1. PREFER STOCK OVER BONDS. BONDS WILL LIMIT YOUR GAINS AND INFLATION WILL REDUCE YOUR PURCHASING POWER.

 

  1. BE CAREFUL OF LEVERAGE. IT CAN GO AGAINST YOU.

 

If you want access to my personal value investing checklist click here to secure your free copy!

,

The Danger of “Vision macro” and How to Avoid It

“Our knowledge can only be finite, while our ignorance must necessarily be infinite.” ~ Karl Popper

Something that’s helped me in my trading journey is adopting the practice of multivariate critical thinking (MCT).

MCT is the application of considering multiple hypotheses and then dispassionately applying critical judgment to each. It requires updating the probabilistic weighting for each, as new information becomes available — practical Bayesian analysis.

This seems simple and easy, and on the surface it is, or at least should be. But the difficulties come in its application. Specifically concerning the “dispassionate” part.

The problem is — at least it was for me — is that we’re naturally linear thinkers inhabiting a non-linear world. And to top things off, we have a stubborn ego-sensitive brain that wants simple answers and to always “be right”.

It’s a tough circle to square for sure. But not impossible.

If you wonder if you suffer from ego dominated linear thinking (let’s call this EDLT), just think back to the last time you were wrong on a trade or a market call. And ask yourself, did you get upset? Did you not enjoy the process of “being wrong”? Did the most dangerous four-letter word in trading, “HOPE”, become a part of your thought process? If the answer is yes, and it will be for the majority of people, then you’re practicing our instinctual EDLT.

When operating in EDLT mode the brain latches onto a hypothesis and then focuses in on “being right”. It doesn’t do this through objective assessment but rather by employing a tool kit full of anchoring, confirmation biases, and heuristics to cherry-pick information that supports it in “being right”.

The irony is that by focusing on “being right”, we more often than not end up “being wrong”.

This is an important habit to break. Doing so leads to better outcomes.

Practicing MCT is invaluable because it focuses the brain on finding the errors in its own logic. Because the brain no longer has to defend a single thesis but instead is forced to continuously analyze and weight numerous possible outcomes. Which switches its focus from trying to “be right” to figuring out how it’s wrong. This makes you better at “being wrong”. And being better at “being wrong” is vital to making money.

The trader who most fully practices MCT is George Soros. He said the following about this process:

The Secret to my success is that I’m always wrong. I’m ALWAYS wrong. And I try to correct my mistakes. That’s the secret of my success.

And

My approach works not by making valid predictions, but by allowing me to correct false ones.

Most read these statements from Soros and think he’s being glib. That’s because they’re playing the “being right” game. They’re too busy looking for some “secret” that’s going to help them “be right” more. But all they need to do is “invert, always invert!” their thinking process.

Soros adopted this unnatural mode of analyzing the world from philosopher Karl Popper. Popper established the epistemological philosophy of critical rationalism. He took these ideas from David Hume, who took them from Pyrrhonian skepticism, which evolved out of the ancient school of Indian Philosophy, Carvaka. At the foundation of all of these schools of thought is that “nothing can be known for certain”.

Since nothing can be known for certain we need to be good at being uncertain. The MCT framework helps us to do do just that. The Philosopher from Drobny’s The Invisible Hands discusses how this works (emphasis mine).

I try to develop a hypothesis about how the world is working and how it could work in the future. Therefore, information to us is a collection of theories and ideas, together with evidence that either supports or falsifies these theories and ideas. Information can come from fundamental economic drivers, such as growth, inflation, and other variables, or it can come from more technical, market-based factors such as flows, liquidity, etc.

We are not engaged in what I describe as “vision macro,” whereby one tries to work out some kind of single truth about how the world works. Rather, we form a probabilistic set of hypotheses about how the world could look and what might drive markets going forward, focusing on the market impact in all scenarios and looking for good risk-versus-reward trades around these hypotheses.

“Vision macro” is standard EDLT. There’s plenty of examples of EDLT thinkers in the finance space; they are a dime a dozen on the fintwit. Their modus operandi is to lock onto a “single truth” and become a torchbearer for that narrative. They make themselves champions for their “truth”. As a result, they blind themselves stupid and end up fighting the market for LONG periods.

The old Wall St. adage that it’s not about being right but about making money is an adage for a reason. You only need to be “right” at the right time and the way to do that is by being good at “being wrong”. Critically assessing multiple hypotheses with MCT is the way you get there.

EDLT is centered around seeking out confirming evidence. MCT looks for disconfirming information. EDLT is fragile while MCT is robust. Most people utilize the former because practicing the latter is tough.

If you find yourself latched onto a “single truth”, Karl Popper would ask you “how would you disprove yourself?”

Drop the search for grand narratives and invert your thinking.

Final call for the Macro Ops Collective! After tonight at midnight we’ll be shutting enrollment down until the summer.

If you would like to receive all of our premium research, stock picks, macro trades, and be apart of the most elite macro trading community on the net sign up now before midnight.

All purchases come with a 60-day money back guarantee so there’s no risk to join. Come check it out!

Click here to enroll in the Macro Ops Collective!

2020 US Presidential Election
,

Using Political Prediction Markets For Fun And Profit

Elections are interesting to us as macro traders. High-profile political election results can move the markets in a big way, Just look at how crazy the E-mini S&P’s traded during the US’s 2016 presidential election…

They had a 5.5% crash and rally when the cash markets were closed!

The magnitude of a macro market move after a political event depends on how much the results surprise traders. It works just like a stock’s earnings announcement. If results come in way above expectations the stock will rip hard. If results come in way below everyone’s expectations the stock tanks.

Up until recently, we’ve had to rely on sub-par polling models created by people who have no real money backing their predictions. These models did not give us a good indication of the true positioning of traders in the market.

Now, prediction markets like PredicIt allow us to get a glimpse of how people around the world are judging the odds of global political events (and backing those judgments with real money).

PredicIt operates based off a simple contract priced between $0.00 and $1.00. Traders have the option to either purchase “yes” or “no” shares on any given question or event. The market operates exactly like a futures market where for every “yes” contract there exists another trader holding “no.”

At the end of the event, the winners are each paid out $1.00 a share and the losers receive $0.00 a share. Leading up to the event the prices for “yes” and “no” fluctuate depending on supply and demand of the market. This floating opinion allows us to use PredicIt to assess how various political outcomes will impact markets.

Let’s look at a quick example.

PredicIt already has a market for the 2020 US Presidential Election.

If a trader thinks Trump will win again he can purchase “yes” shares on Donald for $0.30.

  • If Trump wins the trader will receive $1.00 for a net profit of $0.70
  • If Trump loses the trader will receive $0.00 for a net loss of $0.30

Now if the trader wanted to bet against Trump he could buy “no” shares for $0.71.

  • If Trump wins the trader will receive $0.00 for a net loss of $0.71
  • If Trump loses the trader will receive $1.00 for a net gain of $0.29

How does this help us handicap the actual event? It’s easy, simply take the price of the “yes” shares and use that as the implied probability of Trump getting elected. Do the opposite if you want to calculate the implied probability that Trump will not get elected.

In the Trump example, since “yes” shares cost $0.30 there’s a 30% chance that Trump goes on for a second term. There’s also a 71% chance that he will not get elected because “no” shares cost $0.71.

Here is a rule of thumb for quickly gauging the likelihood of an event using PredicIt:

  • If the “yes” shares are expensive (close to $1.00) you know that the probability of the outcome happening is high
  • If the “no” shares are expensive (close to $1.00) you know that the probability of the outcome happening is low

As the 2020 US election nears, the price of these contracts will fluctuate based on new information that materializes similar to how stock prices fluctuate based on the most recent earnings announcement.  

Once election time comes we’ll have a more clear indication of how markets will react to another Trump victory. If Trump “yes” shares come into the event cheap, then we know another Trump victory will rattle the markets since it was priced in as a low probability event.

We prefer using prediction markets over polling or bank forecasts. Why? Because in the prediction markets participants have skin in the game, while the modelers and pundits typically don’t. Without financial downside forecasts tend to suck. You need that potential for pain to get a real price on what will likely play out in the future.

Besides using PredicIt as a trading indicator it can actually be a fun way to separate the annoying political loudmouths in your life from their money. We all know a handful of people at work, on Facebook, or at the dinner table who babble on non-stop about their favorite candidate. And no matter what you say in response they won’t waver from their conviction because they are emotionally attached.

The trick here is finding someone who’s obsessed with a polarizing candidate even though that candidate is a cheap “yes” on PredicIt.

For example, let’s say this coworker, friend, or family member is adamant about Trump winning reelection and Predict it has Trump “yes” shares offered for $0.30 (30% chance of winning).

Here’s what you need to do.

  • Buy “yes” shares for Trump on PredictIt for 30 bucks.
  • Now go to the political loudmouth and bet 50 bucks against Trump. (Most people unfamiliar with betting will always accept 1:1 odds because it’s mentally simple and intuitive.)
  • Once both bets are locked in you have guaranteed yourself a $20 (minus PredictIt fees) no matter what happens with Trump
  • If Trump wins, you lose 50 bucks to your political loudmouth, but gain 70 bucks on PredicIt
  • If Trump loses, you win 50 bucks from your political loudmouth, but lose 30 bucks on PredicIt.

You can pull this arbitrage off again and again by finding more passionate Trump supporters in your circle to wager against (assuming they have no knowledge of PredicIt).

Or if you have a whale/ultra passionate person in your circle you can 10x your bet,  $500 against him, $300 on PredicIt and lock in a nice $200 for yourself — an entire free night out for a fancy steak dinner and a show with your significant other!

I’m always on the hunt for this type of stuff, it’s fun, and it helps train your mind for trading.

Just make sure before you wager your friend at 50 you can buy for cheaper than 50 on PredicIt. The lower the number on PredicIt the better the trade!

 

 

,

How To Earn $1 Billion Dollars

The father of modern physics, Albert Einstein was unquestionably a brilliant mind. Not only did he change the world with his work in physics, but he was also an avid sailor, played the violin and shared this gem with the world:

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.

In investment circles, Warren Buffett is most credited with exploiting the benefit of compounding and, at 88 years old, has obviously figured out how to do just that!

It isn’t too challenging to understand and agree with what Einstein and Buffet have taught us: anyone in the markets understands that compounding is a powerful force. But, for fun, indulge me for just a second while I run through some good ol’ fashioned numbers to illustrate the point.

A couple of assumptions before we begin. For simplicity, I am not factoring in inflation, down years, depressions, unusual returns, time away from the markets, commissions and fees, and/or anything that would make this a more robust system than it needs to be for purposes of this exercise. The goal is to not get bogged down with details, but to take a step back and see what compounding interest can build over the long term.

I started the test out at age 30 with $10,000. Maybe you started earlier and already have $10,000 saved at age 21, or over $100,000 by age 50. If you’re one of these magic unicorns, kudos! You are already well ahead of the game and on the road to billionaire status. For the rest of us, here is what my model revealed.

The math is simple: if compounding can put 10% per year back into our accounts, then in theory, all we have to do is live longer to cross that $1 Billion threshold.

In my model, starting at age 30 with $10,000 means by 151 years of age you’ll be a billionaire.  

If you want just half a billion, then you only need to live to about 144 years old! Maybe $100 Million is more your sweet spot…that’s only to 126 years old.

Interestingly you don’t actually break the million dollar mark until your 79th year.

I’m not going to lie, it is slow going in the beginning, so it’ll be hard to keep your eyes on the prize until later in life, where the numbers really start to shoot up dramatically.

If you are 44 years old with $500,000 in assets, you reach the $100m mark on your 100th birthday! And a billion by the potentially attainable age of 124 years old.

Yes, I recognize that this simplified “all you have to do” theory may sound ridiculous, but we can all agree that if you have more time to earn, then your overall assets will grow much larger. So, it isn’t a question of whether or not the math works out (it does), but instead, how long you can live while still maintaining a high quality of life?

We need a lot of time to get to the billion dollar mark, but we also need to get there in as good as shape as possible, otherwise what’s the point? Our bodies and minds must be healthy enough to enjoy that large nest egg.

In 1955 the average life expectancy in North America was 69 years of age. In 2015, 50 years later, it was 79 years old. A nearly 15% increase. Using this metric, 50 years from now, our average life expectancy may be close to 90 years old. And it’s not crazy to think that life expectancy will exponentially increase over the next 50 years as we see rapid advances in tech and healthcare.

So there is a potential to earn a billion dollars like Charlie Munger says:

Sit on your ass. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.

And he’d know, at age 95 he’s made a lot of money just sitting on his ass and compounding.

If we want a chance to hit the $1 Billion mark we need to stay laser focused on increasing our own life expectancy.

Here are the leading causes of death in the United States from the Center for Disease Control.

And internationally it’s fairly similar according to the World Health Organization.

Generally speaking these are common worldwide:

  • Heart Disease
  • Cancer
  • Accidents
  • Stroke
  • Alzheimer and Dementia
  • Diabetes
  • Road Injury
  • Lower Respiratory Infections
  • Influenza
  • Suicide

Knowing that we don’t have cures for most of these just yet, it is a bit hard to optimize against them; however, we have lots of information regarding known causes of heart disease, cancer, diabetes, alzheimer’s and the flu. If you are living in a world where chronic disease is inevitable, we should chat more. It isn’t.

We know that diet, negative environmental factors, sleep, exercise, and sense of purpose have been directly linked to the most common causes of death.

To achieve a $1 Billion net worth we have to pour our energy into making sure our body and mind stay healthy for as long as possible.

Dr. Peter Attia is the foremost expert on the front lines of longevity. If you are interested in learning all about his work in the field of longevity, I highly recommend you go down this rabbit hole – it is well worth the read, watch the video, and then get to Googling.

If you’d rather just read an abbreviated version, here are a few of Dr. Attia’s suggestions:

  • Fast – 12-16 hours per day is good for metabolic health and weight management and something that can be practiced everyday. I’ve been doing this for about 15 years now, off and on.
  • Fast – A more challenging fast that lasts 2-3 days. It isn’t a complete fast, it is a fast mimicking diet called Prolon which increases autophagy or simply a cleaning of the bad stuff by your cells. And finally a 4-5 day Prolon fast really increases stem cell based rejuvenation. Research this before you undertake it.
  • Eat whole foods, the stuff our grandparents would recognize.
  • Drop the sugar and keep insulin low.
  • Sleep more and sleep better.
  • Drink more water.
  • Don’t Smoke.
  • Exercise, and focus on strength/resistance training above all other forms of exercise.
  • Live for something, have a mission!
  • And if you live in the United States, stay off the Opiates.

What’s the payoff?  Well, you’ll feel better almost immediately, but you also may have a shot at compounding your face off to a $1 Billion net worth!  

In summary, start purchasing cash flow producing assets, let them compound, don’t fiddle with them, eat less, exercise more, sleep more, drive safely, and live for something! Write to me when you turn 150 and cross the $1 Billion line so we can celebrate!

Age Assets

30 $10,000.00

31 $11,000.00

32 $12,100.00

33 $13,310.00

34 $14,641.00

35 $16,105.10

36 $17,715.61

37 $19,487.17

38 $21,435.89

39 $23,579.48

40 $25,937.42

41 $28,531.17

42 $31,384.28

43 $34,522.71

44 $37,974.98

45 $41,772.48

46 $45,949.73

47 $50,544.70

48 $55,599.17

49 $61,159.09

50 $67,275.00

51 $74,002.50

52 $81,402.75

53 $89,543.02

54 $98,497.33

55 $108,347.06

56 $119,181.77

57 $131,099.94

58 $144,209.94

59 $158,630.93

60 $174,494.02

61 $191,943.42

62 $211,137.77

63 $232,251.54

64 $255,476.70

65 $281,024.37

66 $309,126.81

67 $340,039.49

68 $374,043.43

69 $411,447.78

70 $452,592.56

71 $497,851.81

72 $547,636.99

73 $602,400.69

74 $662,640.76

75 $728,904.84

76 $801,795.32

77 $881,974.85

78 $970,172.34

79 $1,067,189.57

80 $1,173,908.53

81 $1,291,299.38

82 $1,420,429.32

83 $1,562,472.25

84 $1,718,719.48

85 $1,890,591.42

86 $2,079,650.57

87 $2,287,615.62

88 $2,516,377.19

89 $2,768,014.90

90 $3,044,816.40

91 $3,349,298.03

92 $3,684,227.84

93 $4,052,650.62

94 $4,457,915.68

95 $4,903,707.25

96 $5,394,077.98

97 $5,933,485.78

98 $6,526,834.35

99 $7,179,517.79

100 $7,897,469.57

101 $8,687,216.52

102 $9,555,938.18

103 $10,511,532.00

104 $11,562,685.19

105 $12,718,953.71

106 $13,990,849.09

107 $15,389,933.99

108 $16,928,927.39

109 $18,621,820.13

110 $20,484,002.15

111 $22,532,402.36

112 $24,785,642.60

113 $27,264,206.86

114 $29,990,627.54

115 $32,989,690.30

116 $36,288,659.33

117 $39,917,525.26

118 $43,909,277.78

119 $48,300,205.56

120 $53,130,226.12

121 $58,443,248.73

122 $64,287,573.60

123 $70,716,330.96

124 $77,787,964.06

125 $85,566,760.47

126 $94,123,436.51

127 $103,535,780.16

128 $113,889,358.18

129 $125,278,294.00

130 $137,806,123.40

131 $151,586,735.74

132 $166,745,409.31

133 $183,419,950.24

134 $201,761,945.27

135 $221,938,139.79

136 $244,131,953.77

137 $268,545,149.15

138 $295,399,664.07

139 $324,939,630.47

140 $357,433,593.52

141 $393,176,952.87

142 $432,494,648.16

143 $475,744,112.97

144 $523,318,524.27

145 $575,650,376.70

146 $633,215,414.37

147 $696,536,955.81

148 $766,190,651.39

149 $842,809,716.53

150 $927,090,688.18

151 $1,019,799,757.00

 

,

Emergent Properties of the Market Collective

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

One of the coolest things to watch in nature is a Starling murmuration.

If you’ve never seen one before then give this video a watch.

Starlings — which are small and not particularly intelligent birds — are somehow able to form these amazingly complex and beautiful airborne systems that are capable of extremely intricate flight patterns which shift and shape with near instantaneous coordination.

They do this apparently in response to threats; to thwart off and confuse predators.

I’m fascinated by systems that display emergent properties such as murmurations. Where a network operating off simple behavioral rules can emerge complex, seemingly intelligent, behavior.

Scientists have long been awed by the same and using the latest technology they’ve been able to gain a fuller understanding of exactly how Starlings accomplish this.

The following excerpt is from a paper on murmurations by Italian researchers. You can find the whole thing here (emphasis by me).

From bird flocks to fish schools, animal groups often seem to react to environmental perturbations as if of one mindHere we suggest that collective response in animal groups may be achieved through scale-free behavioral correlations… This result indicates that behavioral correlations are scale-free: The change in the behavioral state of one animal affects and is affected by that of all other animals in the group, no matter how large the group is. Scale-free correlations provide each animal with an effective perception range much larger than the direct interindividual interaction range, thus enhancing global response to perturbations.

Scale-free correlations mean that the noise-to-signal ratio in a Starling murmuration does not increase with the size of the flock.

It doesn’t matter what the size of the group is, or if two birds are on complete opposite ends. It’s as if every individual is linked-up to the same network.

The Starlings accomplish this feat by following very simple behavioral rules. Wired magazine notes the following:

At the individual level, the rules guiding this are relatively simple. When a neighbor moves, so do you. Depending on the flock’s size and speed and its members’ flight physiologies, the large-scale pattern changes.

It’s easy for a starling to turn when its neighbor turns – but what physiological mechanisms allow it to happen almost simultaneously in two birds separated by hundreds of feet and hundreds of other birds? That remains to be discovered, and the implications extend beyond birds. Starlings may simply be the most visible and beautiful example of a biological criticality that also seems to operate in proteins and neurons, hinting at universal principles yet to be understood.

A Starling murmuration is a system that is said to always be on the “edge”. These are systems that exist in what’s called a “critical state” and are always, at any time, susceptible to complete total change.

Wired writes that Starling murmurations are “systems that are poised to tip, to be almost instantly and completely transformed, like metals becoming magnetized or liquid turning to gas. Each starling in a flock is connected to every other. When a flock turns in unison, it’s a phase transition.”

What are the benefits of this emergent behavior?

The broader effective perception range combined with their existing in a constant state of criticality, provide Starlings with a strong competitive advantage for survival. The Italian researchers conclude that:

Being critical is a way for the system to be always ready to optimally respond to an external perturbation, such as a predator attack as in the case of flocks.

Individual Starlings operating off their own simple self-interested rules in aggregate create a vastly superior “collective mind” that broadens their perception range — and thus information intake — which enables them to operate in a continuously critical state. A state that’s optimal for responding to threats which helps raise their odds of survival.

You might be asking at this point, “Interesting stuff Alex, but what does this have to do with markets?”

Fair question…

Well, isn’t the market just one big collective mind?

Similar to a murmuration, the market is just the aggregation of individual actors operating off simple inputs (prices, data, narratives) in order to try and avert danger (ie, lose money on the way down or miss out on the way up).

Like Starlings, market participants instinctively key off one another. Robert Prechter, the popularizer of Elliott Wave Theory, writes in his book “The Socionomic Theory Of Finance” that:

Aggregate investor thought is not conscious reason but unconscious impulsion. The herding impulse is an instrument designed, however improperly for some settings, to reduce risk.

Human herding behavior results from impulsive mental activity in individuals responding to signals from the behavior of others. Impulsive thought originates in the basal ganglia and limbic system. In emotionally charged situations, the limbic system’s impulses are typically faster than the rational reflection performed by the neocortex… The interaction of many minds in a collective setting produces super-organic behavior that is patterned according to the survival-related functions of the primitive portions of the brain. As long as the human mind comprises the triune construction and its functions, patterns of herding behavior will remain immutable.

These simple inputs create a market that is collectively smarter than its individual constituents. It has a much broader perception range and exists in a critical state (always ready to phase shift from bull to bear regime) which allows it to more ably respond to changes in the environment.

When Stanley Druckenmiller first got into the game, his first mentor Speros Drelles — the person he credits with teaching him the art of investing — would always say to him that, “60 million Frenchmen can’t be wrong.”

What he meant by that is that the market is smarter than you. It knows more than you thus its message should be heeded because 60 million Frenchmen can’t be wrong…

Druckenmiller often says that “The best economist I know is the inside of the stock market. I’m not that smart, the market is much smarter than me. I look to the market for signals.”

We’ve known about the wisdom of crowds and the power of collective intelligence ever since Francis Galton — a British statistician and Charles Darwin’s cousin — discovered the phenomena while observing groups of people guess the weight of an ox at a county fair (the individual guesses were far off but the average of all guesses were spot on). There’s since been a significant amount of work done on the topic; The Wisdom of Crowds by James Surowiecki is a good summation of it.

But, there are a few key differences between markets and murmurations and the unique impact and limitations of crowd intelligence in financial markets, specifically.

The first is —  and this is a big one —  that markets are reflexive.

George Soros was the first to discover this truth. He wrote that “Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued.” This means that the act of valuing a stock, bond, or currency, actually affects the underlying fundamentals on which they are valued, thus changing participants perceptions of what their prices should be. A process that plays out in a never-ending loop…

This is why Soros says that “Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality.” And that the level of distortion is “sometimes quite insignificant, and at other times quite pronounced.”

This means that markets are efficient most of the time except for some of the times when they become wildly not so.

The key driver between low and high distortion regimes are the combined effect of (narrative adoption + price trends + time). These three inputs all work in unison. So when there’s a narrative that becomes broadly adopted, it drives steady price trends, and when these price trends last for a significant amount of time, they then drive more extreme narrative adoption. And so on and so forth…

This positive feedback loop hits at the unconscious impulsion herding tendencies of investors and drives them to focus on trending prices in the act of valuation at the near exclusion of all other factors (ie, earnings, cash flows, valuation multiples etc…).

Most of the time, there are enough competing narratives which drive price volatility and keep the market fairly balanced.

Another major difference is that Starlings aren’t aware of the broader complex system they are an integral part of. It’s all instincts… evolutionary programming… they turn when the bird next to them does.

Whereas in markets, we can be aware of the system of which we form. We can consciously separate ourselves from the herd and view the whole objectively (at least to the best of our abilities).

This is important. Because as traders, we’re in competition for alpha with the rest of the flock. We don’t just want to turn when and where the others turn. We want to get to where they’re going before them. And to do this, we need to be able to develop a sense for where they’re headed…

Which brings us to the lesson I”m trying to impart.

The reason I’ve been chatting so much about birds, collective intelligence, and reality distortion and all that jazz… is because if we understand the signaling power of certain areas of the market, whether in a low or high distortion regime, we can eschew the need to try and predict all together and instead let the market tell us where things are headed.

I was reminded of this while listening to this Knowledge Project podcast interview with Adam Robinson. Here’s Part 1 and Part 2.

For those of you who don’t know him, Adam is a prodigy who “cracked the SAT” and created The Princeton Review. He now spends his time thinking, writing, and advising hedge funds on strategy. He’s the penultimate first principles thinker. He shared some of these principles in the above interview which we’ll cover now.

To begin with here’s Adam summarizing the lens in which he views markets (emphasis by me):

The fundamental view of investing is that you can figure out something about the world that no one else has figured out. It’s a bit like prospecting, right, gold prospecting. You can go out with your pan and find something that no one else has found. Well, the difference between investing and gold prospecting is that gold prospecting, you actually find gold that you can actually go sell, right? If you find a value that no one else has found, what makes you think… If people are irrational enough to believe that the price of gold is different from what you think it is or should be, what makes you think they’re going to become rational tomorrow? There’s that great quote by John Maynard Keynes, “Markets can stay irrational longer than you can stay solvent.” Good luck with that.

So, there’s a third way, and John Maynard Keynes said, “Successful investing is anticipating the anticipation of others.”

My approach to markets is simply this, to wait for different groups of investors to express different views of the future, and to figure out which group is right. I look for differences of opinion strongly expressed, and decide which one is right.

Whatever else you may think about the world, the world is the product of our thinking. So is the economy. So are our investments. If you think about it, an investment is nothing more than the expression of a view of the future. So when you buy Facebook, or you short the dollar-yen, or you buy gold or short US Treasuries, you are expressing a view of the future. Your view of the future can be right or wrong, and your means of expression can be right or wrong, but that’s what you’re attempting to do, right?

So, if you and I were to go to Columbia Business School or Harvard Business School right now and ask the assembled MBA students, “What is a trend?” They wouldn’t be able to define it at all. In fact, I don’t know that any investor in the world can define a trend. They can define it simplistically like this: “A trend is the continuation of a price series.” Yeah, well that’s great. What’s causing the continuation? Right? And I’ll tell you what a trend is—this is an investment trend—actually it’s true for all trends. A trend is the spread of an idea. That’s all a trend is. It’s the spread of an idea.

Adam doesn’t believe in the existence of intrinsic value but rather views markets as an evolutionary narrative continuum; where stories spawn, develop, spread, only to eventually get outcompeted and then wither and die.

This is similar to what The Philosopher said in Drobny’s The Invisible Hands which I discussed in my piece on How To Be a Smart Contrarian. Here’s the Philosopher in his own words (emphasis by me):

Market prices reflect the probability of potential future outcomes at that moment, not the outcomes themselves.

One way to think about my process is to view markets in terms of the range of reasonable opinions. The opinion that we are going to have declining and low inflation for the next decade is entirely reasonable. The opinion that we are going to have inflation because central banks have printed trillions of dollars if also reasonable. While most pundits and many market participants try to decide which potential outcome will be the right one, I am much more interested in finding out where the market is mispricing the skew of probabilities. If the market is pricing that inflation will go to the moon, then I will start talking about unemployment rates, wages going down, and how we are going to have disinflation. If you tell me the markets are pricing in deflation forever, I will start talking about the quantity theory of money, explaining how this skews outcomes the other way… People tell stories to rationalize historical price action more frequently than they use potential future hypotheses to work out where prices could be.

Adam references the work done by Everett Rogers in the study of the Diffusion of Innovations (Rogers has a book by the same title which is well worth a read). This line of study is about how the adoption of technology spreads but the work really can be applied to how everything spreads: narratives, ideas, social norms etc…

Rogers breaks down the categories of adopters as: innovators, early adopters, early majority, late majority, and laggards. Well in markets there is a similar breakdown of participants who are consistently early or late to the adoption of narratives and thus trends.

Knowing which groups are which and what their signaling means has been a critical part of Druckenmiller’s process over the years. Here’s Druck in his own words:

One of my strengths over the years was having deep respect for the markets and using the markets to predict the economy, and particularly using internal groups within the market to make predictions. And I think I was always open-minded enough and had enough humility that if those signals challenged my opinion, I went back to the drawing board and made sure things weren’t changing.

Adam breaks down these groups as follows, from earliest trend spotters to later adopters:

  1. Metal traders
  2. Bond traders
  3. Equity Traders
  4. Oil Traders
  5. Currency Traders
  6. Economists
  7. Central Bankers

What does this mean in practical terms?

Well, metal traders tend to be the most farsighted of the group. They are usually right and early about changing trends in the economy.

Why is this?

Adam gives three reasons, “The first is, they [metal traders] are the Forrest Gumps of the investing world. Their view of the world is very simplistic. Are people buying copper? And if they are, thumbs up. All is good in the world’s economy. Great. I guess interest rates are going higher. That’s the way metal traders view the world. And if people are buying less copper, they go, ‘Oh, that’s bad. Economic slowdown’.”

Secondly, “People buy and sell copper. It’s used — it’s a thing. It’s not just a number on a screen, which is all currency traders look at. Right?” And third is time frame, “Commercial metal traders look months to years ahead. Because if you want to take copper out of the earth, it’s going to take years to open that mine, right? So, metal traders are the most farsighted. They have the simplest model of the world, and they are actually in touch with the world economy.”

In our November MIR, China is a Teacup, we pitched the case for buying US treasuries. One of the reasons why was because metal traders were signaling slowing economic growth ahead and slower growth means lower rates (bonds get bought). The trade was an easy layup…

The above is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

 

 

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Trading During 9/11 Attacks And Why I Became A Systems Trader

The S&P 500 was down. Really down. Down hard. Then I heard the news on CNBC behind me.

“Another plane just crashed into the World Trade Center.”

I was short the S&P 500 E-mini futures. My system had me short. I had no idea what was causing the S&P to fall so much up to this point, and it had been falling since the May highs of $1320. I had been aggressively short selling since $1209 on August 8th, 2001.

The market had been selling off since March of 2000, the dot com bubble had burst, and we were generally in a bear market, trending lower and lower. By the summer of 2001, we had already sold off about 30% from the highs, officially entering bear market territory; but the buzz from the roaring tech bubble bull market was still a star in everyone’s eye. We all wanted that big dip buying momentum to return.

Spoiler: it didn’t.

When the news hit CNBC on September 11, 2001, I was already profitable well over 100 points on my short position. Each point in the E-mini S&P 500 is worth $50 per contract (multiply that by how many contracts you have), so I was well positioned at this point, with massive profits.

When I woke up that morning I had no idea what was happening. I checked my screen’s as I did back then when I first woke up (see my post from last week about my “new” morning routine); futures were down again, my trade was working, and I was ecstatic. This was the first time I had built such a massive position and it had played out. I thought about taking some profits, but held true to course as my system kept telling me to stay in.

I had a plan, but I wasn’t really sure exactly how to navigate these waters. This was unprecedented. I was in disbelief watching what was happening on TV, watching my screen as the market went “limit down,” and watching as the entire world stopped trading.

(Note: Limit Down means that the exchanges stop trading for a period of time to let things cool off a bit before trading can commence again. This event was so big that the market continued with this closure for another four days – the longest duration in modern history.)

As anyone around during that time remembers, prior to 9/11 the market had been selling off, and was selling off hard. I kept getting more and more indicators to add to my short position, so I kept adding. I had the maximum position allowed for me at that time.

There I was: massive profits thanks to a huge short position that my technical analysis had “predicted.”

I did everything according to my trading plan. I had proper position sizing. I increased my position as new levels were breached. Everything was “by the book,” minus the World Trade Center collapsing on live TV right before my eyes.

Other planes were still in the sky., The Pentagon got hit. This was unprecedented fear and chaos.

While trading was halted, there was nothing I could do but watch, and worry.

Where would they attack next?

Were there more planes out there ready to attack?

Would my location (Los Angeles) be hit?

Was it safe to leave? Should I go get food? Was anyone working today?

All I could do was watch live news coverage and listen to people speculate as to what might happen next.

The next four days, while the markets were closed, we all just watched and waited for more information.

Traders talk to each other day in and day out about the market, market analysis, market news, and what they think will happen. We speculated when trading would resume, how far the market would plummet before it was opened again, and if the government would intervene and support the market by buying everything until it stopped selling (aka the rumored “Plunge Protection Team”).

No one knew anything.

We started building out plans for the “what if” scenarios.

What if…when trading opens they only allow single contract trades, so I can’t cover my position quickly?

What if…the market is down 1,000 points on the open? Do I cover?

What if…the market is up 1,000 points on the open and I can’t cover in time?

What if…the market is open, but no one is trading, and I can’t cover my position?

What if…they don’t open the market until 2002?

On Sept 17th, they did re-open the market. The New York Stock Exchange was so kind as to inform the public when they would open, so other markets followed suit, and things resumed some sort of normalcy.

The S&P 500 opened 50 points lower on the morning of the 17th, and traded within a 40 point range.

It was insanity, complete chaos. Volume was huge, the world was ending, then the world was saved. This cycle seemed to be on repeat for days on end.

Believe it or not, I did not cover my short position.

Having the time to think through everything during those days off, I realized that I needed to stick to my trading plan and prove my thesis.

Why? If there was no signal to cover my short position, and my trade was sized correctly, then it follows that I wouldn’t suffer enough to take me out of the game.

This outlier event, 9/11, the most dramatic event to ever happen in the United States, was actually covered in my trading plan. Not by name, but certainly the rules were broad and effective enough to keep me in winning trades.

Eventually I did cover, and for a massive profit. But, I left plenty on the table, like nearly every good trade.

I learned a lot about myself in the days that the market was closed, reflecting on what happened.

I learned that the market can give you insight before something happens. There is speculation that 9/11 was heavily shorted by certain parties that participated in the planning and execution of the attacks. I can assure you I wasn’t one of those parties, however, my trading plan identified and planned for the events that followed the terror attacks.

I learned that taking time to breath, think, and relax is usually a better tactic than immediately reacting. I started to invest a little more in my meditation practice.

I learned to imagine and consider more outcomes and new threats.  The crazier the better! Approaching the future in a reality that was entirely different and unexpected than the present resulted in my ability to create new strategies to handle the unexpected.

Trading is a job;  emotions about the current state of affairs is not. I have learned that while I can be angry, sad or any other emotion about something that is happening, not letting that interfere with decision making is a muscle that needs to be exercised often. In the markets, math generally wins over emotion.

Most importantly, what I took out of this outlier incident is what led me to become a systems trader. I now trade mechanically and algorithmically instead of subjectively and discretionarily.

In the event you find yourself in another “outlier incident,” I highly recommend to do the same.  

Focus on finding a slight edge in the market, then exploiting that edge with the most powerful tools at our disposal (position sizing and exits) in order to make meaningful and very consistent returns over time.  

Remove your emotions from trading.  Let your system do the work for you, and trust that it will do what it takes.

 

 

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Play To Win Or Go Out Like Broomcorn’s Uncle

There is a passage from a classical Chinese text, written thousands of years ago, that describes the plight of
many struggling traders today.

It’s from The Zhuangzi and translates as follows:

They are consumed with anxiety over trivial matters but remain arrogantly oblivious to the things truly worth fearing. Their words fly from their mouths like crossbow bolts, so sure are they that they know right from wrong. They cling to their positions as though they had sworn an oath, so sure are they of victory. Their gradual decline is like autumn fading into winter ­­this is how they dwindle day by day. They drown in what they do­ you cannot make them turn back. They begin to suffocate, as though sealed up in a box­­ this is how they decline into senility. And as their minds approach death, nothing can cause them to turn back to the light.

Bleak stuff indeed. So how does it apply to struggling traders?

Well, first consider there is a whole contingent of people familiar with “the rules,” yet still not satisfied with their results or where they have wound up. And when I refer to “the rules” in air quotes, I mean the stuff you will find in just about every trading book that was ever published.

Stuff like this:

● Cut your losses and let your profits run.
● The first loss is the best loss.
● Always plan your trade and trade your plan.
● Trade with the trend.

Now hold on, isn’t that stuff legitimate? Don’t all those old truisms have merit?

Sure they do. But they certainly aren’t enough ON THEIR OWN MERITS to succeed in trading. If you hang out on trading websites, or in the trading and investing section of bookstores, you will find those “truths” posted everywhere. You will hear them preached like gospel, with an implied message of profit salvation.

Yet those wise old truths sure haven’t helped the vast majority of traders who can parrot them. There are no bonus points (let alone extra profits in the trading account) for being able to recite that stuff in your sleep.

That Zhuangzhi passage reminded me of struggling traders who stick to “the old truths”… despite a perpetual track record of sub-par performance. They never do anything special, never make life ­changing profits, and never actually­­ ­­experience enough success to feel like they have truly succeeded at trading.

Let’s break down the Zhuangzhi passage sentence by sentence and see how it can apply to struggling traders.

They are consumed with anxiety over trivial matters but remain arrogantly oblivious to the things truly worth fearing.

You know the thing that is REALLY worth fearing?

Time, or rather, the loss of opportunity to learn and grow, which primarily relies on time as an input.

With time comes opportunity to learn. With opportunity to learn comes opportunity to grow… and with sufficient growth one can find the necessary breakthroughs to reach full potential.

The passage of time in the absence of real growth ­­when time is wasted spinning one’s wheels ­­is such that core lessons are never learned… core breakthroughs are never experienced… and then, time’s up!

You can always earn more capital… unless you run out of time.

That is why one might argue it is far better to blow up a few trading stakes at small recoverable levels, and learn quality lessons from the experience, than to stay at hobbyist level permanently.

By the way, regarding the strategy of blowing up early to acquire seasoning and skills — that is exactly what Paul Tudor Jones did. He understood that the point of trading small was learning the ropes in order to trade big… which meant pushing the envelope and learning from the results.

The following is from a PTJ interview in the foreword of an updated Reminiscences of a Stock Operator edition:

In the book I think [Livermore] lost his entire fortune four or five times. I did the same thing but was fortunate enough to do it all in my early twenties on very small stakes of capital. I think I lost $10,000 when I was 22, and when I was 25 I lost about $50,000, which was all I had to my name. It felt like a fortune at the time. It was then that my father flew up from Memphis and sat me down in my tiny New York City apartment and began lecturing me as lawyers do. He commanded, “Leave the gambling den behind. Come home and get a real job in a safe profession like real estate.” Of course, I did not, and the rest is history…

The thing to fear, as the young PTJ knew, was not the risk of temporary small­-stakes capital loss for the sake of a learning curve… but the danger of a boring and unfulfilling life, having turned away from the trading game before the lessons clicked.

And thus, to the degree the experienced trader continues to dabble and play footsie with markets while fearing inconsequential things, he or she might miss the thing to REALLY fear… a loss of time that means a loss of learning and a loss of breakthrough… which means never graduating to the fulfillment of one’s potential. Just being a dabbler forever… an aphorism quoter on Twitter for all time.

Continuing with the Zhuangzhi breakdown:

Their words fly from their mouths like crossbow bolts, so sure are they that they know right from wrong. They cling to their positions as though they had sworn an oath, so sure are they of victory.

These traders are “sure” they know right from wrong (in terms of what trading success consists of). They are sure it is all contained in the trading commandments they have memorized, which they then repeat dutifully and often to everyone around them. (We all know the guy who tweets the same things over and over, day after day, ad infinitum…)

These traders “cling to their positions” of “knowing” the trading rules in the sense of never examining their rigid mindset ­­never stopping and saying “Wait… perhaps I am missing something crucial here…”

They keep the faith with religious fervor. And the net result is generally as follows (Zhuangzi again):

Their gradual decline is like autumn fading into winter ­­this is how they dwindle day by day. They drown in what they do ­­you cannot make them turn back. They begin to suffocate, as though sealed up in a box­­ this is how they decline into senility. And as their minds approach death, nothing can cause them to turn back to the light.

This is not the spectacular blow­up of the short vol seller. It’s a slow churning death of small loss after small loss. The slow bleed of thousands of trades with stops placed too close… and profits too meager to move any kind of needle.

There is no graduation, no transition to meaningful size­up, no scaling to a position of strength and fulfillment… no making the light worth the candle.

There is just playing around without building… tinkering without learning… churn without growth. It’s a sort of thin­gruel persistence… a stubborn surviving, and then a fading away.

In poker there is a saying attributed to the legendary Doyle Brunson: “Going out like Broomcorn’s Uncle.”

Nobody really ever figured out who Broomcorn’s Uncle is, but the saying refers to a poker player who is so meek and conservative he simply lets himself get anted to death. He takes nick after nick and cut after cut until finally his stack is chiseled down to oblivion, like the fading dwindlers of the Zhuangzhi passage.

It’s a strange thing. If a poker player goes out like Broomcorn’s Uncle, he was playing the game ­­sitting there at the table, engaging with opponents ­­but he wasn’t actually “playing the game.”

Instead that player becomes so focused on the mere aspect of surviving… the mere angle of not losing… that he lost sight of the fact that you need courage, guts, strategic vision, and the passion to step forth and exploit victory’s bold moments ­­if you choose to play the game in the first place.

There is a sort of rigor mortis that can set in for the hobbyist trader ­­set in their ways, set in their habits and set in their permanent biases. They’ve been trading for years, so they “know” all there is to know ­­or so they think­­ because the old truths are seen as be­all end­all, and years in the saddle give them license to be cranky.

Contemplating knowledge gaps becomes a less and less palatable thing over time, because that would require admitting that knowledge gaps exist. And so they harden… but never break through… and then finally fade.

How do you avoid this fate? In a nutshell, first by remembering that taking on risk ­­at the right time and place is the whole point of trading. If you are scared to ever go for the gusto, there was no point in entering markets in the first place. It’s good to survive and not blow up… but not if the follow-­on recipe is bread and thin gruel forever!

It’s hard to do that, of course. It’s hard to control risk most of the time, then press aggressively in the opportune windows. It’s hard to scale up in windows of true opportunity, while maintaining deep patience otherwise. But this hardness is a feature not a bug, because if it wasn’t damn hard there wouldn’t be so much profit in it!

Traders who have survived but not thrived have typically learned the basics of preserving their capital. The next hard lesson is learning how to push hard when it counts… how to make the light worth the candle via size.

This is how the legends like Stan Druckenmiller produced their outsized returns. They understood the concept of the big bet and when to swing hard. Druck’s words below:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

And there is just no easy way to learn that. No easy way. It CAN be learned, yes of course. But the learning of it is hard. It is a hard thing. And again this makes sense. If learning how to make big bets at the right time, while maintaining risk control properly, was an easy thing, then lots of people would do it. The reason only a small handful of traders pull it off is precisely BECAUSE OF the hardness and challenge of the path.

But the payoff for doing this ­­ for trying and succeeding ­­is far more than money. The pursuit itself sings to the practitioner’s soul, and as such the vitality of the adventurous trader’s spirit does not fade. Hunter S. Thompson:

Turn back the pages of history and see the men who have shaped the destiny of the world. Security was never theirs, but they lived rather than existed. Where would the world be if all men had sought security and not taken risks or gambled with their lives on the chance that, if they won, life would be different and richer? It is from the bystanders (who are in the vast majority) that we receive the propaganda that life is not worth living, that life is drudgery, that the ambitions of youth must he laid aside for a life which is but a painful wait for death. These are the ones who squeeze what excitement they can from life out of the imaginations and experiences of others through books and movies. These are the insignificant and forgotten men who preach conformity because it is all they know. These are the men who dream at night of what could have been, but who wake at dawn to take their places at the now-­familiar rut and to merely exist through another day. For them, the romance of life is long dead and they are forced to go through the years on a treadmill, cursing their existence, yet afraid to die because of the unknown which faces them after death. They lacked the only true courage: the kind which enables men to face the unknown regardless of the consequences.

As an afterthought, it seems hardly proper to write of life without once mentioning happiness; so we shall let the reader answer this question for himself: who is the happier man, he who has braved the storm of life and lived or he who has stayed securely on shore and merely existed?

 

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Making Better Decisions

Hey everybody.

Chris D here.

Last September, I gave a webinar to Macro Ops Collective members about my health habits and wellness practices. It’s an important topic because sloppy life practices away from the trading screens affect trading results way more than most people realize. Most of the questions and feedback I received from that video were about building trading systems and all the health and wellness that I focus on.

In this article I hope to provide you with health and wellness ideas that will up your trading game as well as your overall well being. After all, we don’t live solely to invest. We have family, friends, hobbies, and other projects in our lives that benefit from a focus on health.

My intention here is to share what has worked for me, for you to pick and choose what would benefit you the most, and then share with our team your tips and tricks.

Focus On Yourself First

Most think that it’s selfish to focus on your well being ahead of others you care about (ie, spouse, children). But, if you continuously sacrifice yourself for others and disregard your own mental and physical health, then what happens when that catches up to you and you’re sick, injured, or burnt out?

Something I learned in the military is a great metaphor for this. When I was younger, I was a United States Marine. An infantryman no less. The Marine Corps takes great pride in being a very self sufficient group, all the way down to the individual level. We are taught to take exceptional care of our weapons, our gear, ourselves and then it expands upward to our team, our squad, platoon, company, battalion, regiment and so on.

The Marine Corps traditionally arrive by sea. With that, we need to take care of our own. I was lucky enough to go through Combat Water Safety Swimmer (CWSS) training (basically lifeguard training on steroids) as part of my training.

During this training, we operate according to the standards and intensity expected of us in combat. All CWSS is carried out in boots, trousers, two shirts, body armor, helmet and rifle along with accompanying ammunition and gear that the normal Marine would wear during an amphibious landing.

A major objective of this training is learning how to rescue a drowning swimmer. This is done in full gear, with the victim in full gear too, while getting hit by ice cold waves. The task is made more difficult since the drowning swimmer is in full on survival mode. They’re fearing for their life and trying to grab onto anything, especially the rescuer.

In order to be a capable rescuer, you need to be a good swimmer, which gives you confidence in the water and provides confidence to the troubled swimmer you are rescuing. This is the most important (and dangerous) part about a rescue; the troubled swimmer isn’t  thinking logically, they are in fight or flight mode and very often you do end up in a fight. But our job is not to fight in the water our job is to rescue. We need to bring our rescuee back to reality, we need to calm them down, we need to give them a little confidence. This can take numerous attempts before you can get the swimmer to calm down enough to be rescued, as crazy as that might sound, and requires that you, as the rescuer remain calm, as well.

Applying this concept to real life: like that troubled swimmer, you won’t be able to help your family and friends when they need you the most if you aren’t taking care of yourself.

In order to take care of others (your spouse, family, friends, community and so on),  you need to be at your best or other people’s troubles will be like that drowning swimmer. If you’re weak, tired, and/or distracted, you put both yourself and those you are helping at risk of being pulled under.

To further emphasize this point, being a good trader/investor doesn’t just happen on a whim, after reading Twitter for months and subscribing to some newsletter. I argue it takes developing a process, focus, discipline, and many other things as well, but you must take care of yourself first.

Excellent decision making is hard. Good decision making is easier. But poor decision making is the easiest of all.

This is why I believe that in order to become successful, and maintain that success as an investor, the majority of the work needs to be done on yourself before you can makegood, and then excellent, decisions with your money and your life.

Treat Yourself Like A Professional Athlete

I’ve been trading and investing for a living for nearly 20 years now. There have been some very hard lessons learned along the way but it wasn’t until I realized that the real success in the markets comes from first working on myself.

As a former semi-professional athlete and someone who still trains quite a bit, I liken my mindset to that of a professional competitor. As an investor, our minds and bodies are the tools we use to get the job done.

(Check out how LeBron James approaches taking care of himself with training, diet and a major focus on recovery. I have a very similar approach, albeit not 7 figures!)

Let’s start with the subject of sleep.

Sleep

It wasn’t until 2018 that I realized how important sleep was to my health and focus, and the opportunity I had to jump-start my performance by just sleeping better.

Back to LeBron James…On the Tim Ferriss podcast, LeBron talks about getting 10 hours of sleep per night, and how he usually nap during the day as well.

This is an athlete playing a physically challenging sport, non-stop for six months at a time, and unlike many other professional basketball players, his season goes to the very last second of the very last game, as he is always in the championship. LeBron is still in his prime and he attributes a large amount of that to sleep.

For me, I always wore my 4AM wake up as a badge of honor, thriving on low amounts of sleep, and spending hours upon hours reading (usually about 8 hours before I really got going on the other things in my life).  While this definitely gave me a huge advantage and I benefited greatly from that discipline, and consumption of information, increasing my hours of sleep has significantly improved my ability to focus and to get into a desired mindset more quickly  and far more frequently than when I was operating on less sleep.

Here’s an interesting study and something I used to start my journey down the sleep “rabbit hole.”

“Brief periods of sleep loss have long-lasting consequences such as impaired memory consolidation.“

In the past I would go to sleep whenever I felt tired and wake up at 4AM regularly. I realized that focusing on the time I woke up was the key to getting more sleep. I force myself to stay in bed longer now, generally 5AM or6AM. I occasionally even find myself sleeping until 11AM – something old Chris would have never been able to do. Once I was able to overcome my 4AM wake up habit, making sure I received eight hours of sleep per night became easy. Now, I regularly get eight to ten hours of sleep every night.

Subjective results? Since then I’ve lost a bit of stubborn weight around the midsection, blew through some physical plateau’s and have built and improved my trading systems at a much faster and, more importantly, efficient tempo than ever before. I feel better, and I’m certain I make better decisions, so I continue.

Meditation

As soon as I wake up, immediately before looking at my phone, any screens, emails, texts, Instagram, charts, news or anything else, that might cause any thoughts, I go straight to meditation.

There is a surprising amount of noise in our minds as we sleep. The activity of dreaming, then switching directly to external feedback, or someone else’s agenda (news, social etc…), means that there is no time to switch context from what our subconscious mind was doing while we were sleeping, to the immediate barrage of stimuli.

Meditating immediately after waking can help organize those crazy subliminal suggestions and enables us to better get our sh*t in order before taking on the day.

I’ve been meditating for about 30 years now, pretty much everyday.

I was lucky enough to be taught it through sports when I was young and have taken that with me throughout my life. It wasn’t until this year that I discovered how much more effective and useful meditation is when you do it first thing in the morning.

Your mind will also thank you again for doing a second session in the afternoon, which I do as well, though not everyday. This can be in the form of a dedicated meditation session or cardio routine. When I’m in a city, I like to go for long walks; when I am in nature,  I like to hike, run trails or jog on the beach. The repetitive nature of hiking/jogging/walking helps me get into a meditative state.

While this s is subjective, meditating slows the world down for me. I make better decisions and am not bothered by things I can’t control when I am in a regular meditation practice. I am able to release worry and stress over these things.

Get Challenged By Nature

Challenging the elements further toughens the mind. I spend most winters in the snowy mountains so I get opportunities to be a part of some of the most extreme things that nature can offer. The strength I get from conquering the cold really sets the stage for my day.

During the winter after my morning meditation I throw my zero drop trail running boots on, a pair of shorts, and take a little morning jog…shirtless. There is something amazing about running in fresh powder snow with no sunlight and overcoming that voice saying that there is a nice warm shower back at home waiting for you, and continuing on.

This is about strengthening my mind, right along with meditation, this gives me the power to not be a victim of things that I can’t control. The cold is relentless but I can choose to not let it bother me.

Cold showers work too if you don’t have mountain access. In urban areas I like to spend about 5 minutes under cold water in the morning after I finish my meditation practice.

Coffee

This is the first thing, outside of water, that is going into my body. I want to ensure that I reap all the benefits that coffee offers, without any of the negative aspects. This means only the highest quality, organic coffee that I can get my hands on. I like Kion Coffee.

Coffee has some amazing benefits, but the wrong type of coffee can have some less than desirable effects. Poor storage, pesticides, mold, and many other factors come into play when dealing with low quality coffee. More importantly, not so good coffee makes me feel not so great…

I hand grind with this travel grinder and run it through my travel french press. Over the years I’ve traveled with different coffee accoutrement and I’ve found this to be my preferred setup.

That is the beginning of my morning routine, and how I start my day before I look at any charts, trades, emails, texts or anything else. When I do fire up the screens and get to work, I put a lot of effort into focusing at a high intensity.

Eliminate Distractions and Achieve Flow State

When I sit down at the computer to work, all notifications are completely removed: no ringers, no pop-ups, all sounds are turned off/muted. My phone goes on Do Not Disturb mode so I will not receive any phone calls unless it’s a family emergency.

Interruptions from Instagram, Twitter, texts, and calls can crush your productivity. The reason is context switching. Anytime you respond to a message, call, or notification you have to refocus your attention. This refocusing costs brain power and precious time. Don’t believe me? Here’s some research that shows how “expensive” context switching is on productivity.

To be in a headspace to make excellent decisions, I focus on doing one task at a time and doing it well. My goal is flow.

A great defense against the distractions from the outside world is a nice set of noise cancelling headphones. I currently use these Bose and Beats and I just pre-ordered these babies – which are supposed to rival the Bose for sound quality.

To get into the flow state, I shove some Binaural Beats into my ear holes based on the chosen mindset I’m intending to achieve. Binaural beats need to be listened to with headphones to have the desired effect, where each ear is played a different musical wavelength and the difference between the two in your brain is the wavelength you are attempting to stimulate. Non-lyrical repetitive music is even easier than going down the Binaural Beat path. Try classical baroque era music; I’ve found it to be useful. Looking for something different? There’s a reason that Trance music is called Trance music. Give it all a shot!

3, 2, 1, Go…

After all of my boxes are checked, (good night’s rest, meditation, cold exposure, high quality coffee, silenced notifications, binaural beats) it’s time to check charts, update trades, and double check my risk for the day.

The first 30 minutes of trading will tell me if I have a new setup or not. If so, I put everything together, entry, exits, position size, and then send off that information to my broker.

That’s the skinny on my morning routine. It has evolved a lot in just one year, and I expect it to continuously evolve as I discover and adopt new best practices, but so far this ritual has me dialed in, focused, and ready to make the best quality trading decisions day in and day out.

The Rest of The Day

There’s a lot more that goes into my daily routine after these morning rituals, but I will save my diet, exercise routine, trading systems, geeky technology thoughts, travel methods, and much more on the soon to be released Macro Ops Podcast!  

I’m happy to chat further about this in the Comm Center Slack where I spend most of my time or Tweeting @chrisdmacro or Insta @chrisdmacro Or hit me up at chris@macro-ops.com.

 

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The Chandler Brothers: The Greatest Investors You’ve Never Heard of

Two secretive brothers from New Zealand have perhaps THE best long-term track record in the investing world. Starting in 1986, the two turned $10 million of family money into over $5 billion just 20-years later. That’s an astounding 36% CAGR.

Compare that with Buffett (19% over 50yrs), Klarman (20% over 34yrs), Lynch (29% over 13yrs),  Soros and Druckenmiller both around (30% over 30yrs).

Yet, hardly anybody has ever heard of these guys. I live and breathe markets and I just came across them for the first time this year.

This is by design.

The two brothers have gone to great lengths over the years to maintain a low profile and keep their faces out of the news. It wasn’t until 2006 that they chose to give their first and only substantial interview. It was with Institutional Investor (link here), and they only agreed to the interview so they could counteract bad press they were receiving from Korean media over a failed activist push by the two to upseat management at a Korean Chaebol.

They were amongst the first investors to plunge into emerging markets like Russia, Brazil, and the Czech Republic. They are sons of a WWII veteran who ran a beekeeping business with Edmund Hillary (yes, that Edmund Hillary), before starting what became New Zealand’s most upscale department store.

They are perhaps THE MOST INTERESTING INVESTORS IN THE WORLD.

They are the Chandler brothers: Richard and Christopher. They ran the Sovereign Global Fund for 20-years (the two have since split off to manage their own money with Legatum and Clermont Capital).

To follow is a profile of the brothers along with some of the secrets they’ve shared in how they look at and invest in markets — also, some commentary and case studies of their investments by me. (All quotes are from the Institutional Investor interview unless otherwise noted).

First, some quick background on the brothers and their unusual origin story (emphasis by me).

The Chandler’s investing background is anything but conventional. The brothers grew up in Matangi, a rural town outside the provincial city of Hamilton in the dairy farming country of New Zealand’s north island. Their Chicago-born grandfather had emigrated to New Zealand in the early 1900s, gone into advertising and married his secretary. He died of an allergic reaction when his third son, Robert, was just one year old.

Although he never knew his father, Robert was profoundly marked by the American success literature he had left behind, notably the books of Orison Swett Marden, an early-20th-century American journalist and author who inspired such proponents of “positive thinking” as Dale Carnegie and Norman Vincent Peale. Robert’s sons were deeply influenced by this worldview as well. We are great believers in the idea of having audacious goals, breaking out and doing something out of the ordinary,” says Richard. “It’s helped us turn what most people consider a mere profession into a vocation and, beyond that, an art, where we frequently put ourselves in harm’s way.”

In 1972, Robert and his wife Marija, started a department store called the Chandler House which quickly became a booming business. This is where the two brothers, Richard and Christopher, began learning the skills of business and investing.

Richard and Marija employed their two sons at the store when not away at boarding school. The two worked sales and helped their father balance the books on the weekend. They also accompanied their mother on buying trips where they learned the key principles on how to buy right (more on this below).

Richard referred to his mother as “the most brilliant business person I’ve ever met who taught us many of the key principles we follow as investors”. Two of these key principles were, “Never buy something unless you know to whom you can sell it” and “Buy as much as possible in a narrow range of hot items.” Richard said his mother “was able to identify the best opportunities and be the master of narrow and deep and that, with stocks, we do the same thing. We back our beliefs to the hilt.

The two brothers were essentially getting an MBA when they were only kids. This undoubtedly helped shaped them into the two market masters they are today.

After college, Richard and Christopher took over the family business and rapidly expanded its size. And in 1986 they sold it for $10m which they then used to launch their fund Sovereign Global. Richard remarked on the decision to the sell the family business that, “Basically, we said, ‘Let’s do something that we love to do, not just something that we are good at.” That something they loved, was investing…  

The fund’s first investment serves as a perfect example of the style that would typify the brother’s approach. And that’s contrarian to the extreme and highly concentrated. Narrow and deep just like their mother taught them.

The two poured nearly the entire family fortune into just four Hong Kong office buildings in 1987.

That year the property market in Hong Kong was in dire straights. Real estate prices were down roughly 70% from their 81’ peaks. Britain’s lease on the territory was due to lapse in the coming decade and according to Richard, “The feeling was that China was going to take over Hong Kong, so most investors said, ‘Who cares?”.

The sentiment at the time was that the island was uninvestable. Here’s a few Newspaper headlines from the year.

This pervasive negative sentiment and over extrapolation of recent trends is what drew the two brothers to the place.

They objectively studied the fundamentals and came away with a variant perception. Richard remarked on the time that, “We had read the treaty, and it promised the status quo for 50 years, and we believed it. Even more important, rents were rising, and rental yields exceeded interest rates by 5 percentage points, which guaranteed that any investment would more than pay for its financing costs.”

The brothers leveraged up and paid $27.6 million for D’Aguilar Place, a 22-story building. They then renovated the place which allowed them to triple rents over just three years, which gave them the cash to acquire more buildings.

Low and behold, Hong Kong didn’t immediately become a communist despot as many feared. The property market recovered and the brothers sold their buildings for $110m, pocketing over $40m after paying off creditors; quadrupling their fund’s NAV in just over four years time.

The brothers also invested in Hong Kong stock index futures during this time which they viewed as another way to play the recovery in the property market, as the Hang Seng was mostly made up of real estate companies. But in the middle of the the crash of 87’ their stop losses were hit and the brother’s were forced to close out the position. The following week markets crashed around the world and the brother’s narrowly escaped a major loss.

Richard said they learned from this experience that “if you get lucky once, don’t press your luck.” It also gave the brothers an aversion to using leverage. Being unlevered “enabled the Chandlers to take a long-term view of risky markets, their key competitive advantage at a time when many investors, particularly highly leveraged hedge funds, invest with a short-term horizon.” A long-view is a critical part of their philosophy, as Richard notes the brothers “like investments where the risk is time, not price.”

With their recent winnings in Hong Kong the brothers went looking in emerging markets. Richard recalled that “The fax machine was becoming very popular” and “we felt that value was moving from real estate to communications. So we researched it and found that Telebras was the cheapest telecom company in the world.”

It was here that they ran into some analysis problems which led to them developing a unique valuation method which they would use again and again throughout their careers.

At the time, Brazil’s hyperinflation had rendered earnings and P/E ratios absolutely meaningless. So they had to turn to “creative metrics — in this case, market capitalization per access line. Telebras, the nation telephone monopoly, was trading at about $200 per line, compared with $2,000 for Mexico’s Teléfono de México and an average cost of $1,600 for installing a line in Brazil. The brothers bet that the government of then president Fernando Collor de Mello would liberalize the economy and open the country up to foreign investment.”

This practice of using unique metrics to compare and discern value is an important piece of what Richard calls “the ‘delta quadrant’ — transition economies or distressed sectors where information is not easily available and standard metrics don’t apply.”

After obtaining government permission to invest in Brazilian equities (Sovereign was one of the first foreign investors in the country) the brothers put $30m —  roughly 75% of their fund — into Telebras shares in 1991 and a smaller amount into Electrobras, an electric utility.

This was an even more contrarian bet than Hong Kong was. Not only was sentiment in the dumps in Brazil (news clipping from 91’ below) but foreign investors weren’t even looking at opportunities there. The Chandler brothers were walking their own path.

Once Collor de Mello began cutting the budget deficit and opening the market to foreigners, Brazilian equities tripled. But soon “Collor de Mello was… caught in a massive kickback scheme and was impeached that April. Stocks swooned, falling 60 percent over the next eight months. Most foreign investors fled the market, but the Chandlers sat tight.”

Richard recalls the selloff saying, “As far as we were concerned, the shock was external to the fundamentals of the company… Telebras had simply gone from extremely undervalued to outrageously undervalued.”

By 93’ the market recovered and the Chandlers sold out of their position later that year. The brothers more than 5x’d their initial investment in under 3-years, boosting their fund to more than $150m. Richard said the experience of riding out the volatility helped them “build our emotional muscles, helping us to make it through major market falls and grind through the trying times without losing our equilibrium.”

The brothers continued their run of highly concentrated and extremely contrarian investing with forays into Eastern Europe, South Korea, and Russia. Always going into markets and investing in assets that no one else would touch.

Another great example of their approach is their big bet on Japanese banks in the early 2000s. Institutional Investor writes that “In November 2002, with Japan slipping back into recession after a decade of stagnation and with stocks at 20-year lows — the Nikkei 225 index was more than 78 percent below its 1989 peak — the country’s banks were wallowing in bad debt.” It was under this backdrop that the Chandlers began loading up on shares in the sector.

The two bought a $570m stake in UFJ Holdings, “which had posted a staggering loss of $9.3 billion in its latest year. The pair went on to buy more than 3 percent of Mizuho Financial Group as well as stakes in Sumitomo Mitsui Banking Corp and Mitsubishi Tokyo Financial Group… Altogether they spent about $1 billion on their spree.”

“The banks were priced for a total wipeout of equity holders,” says Sovereign’s broker at the time at Nikko Citigroup, John Nicholis. “We were advising our clients to stay away from the sector.

Here’s a few headlines from the time showing the negative consensus of the time.

Like in Brazil, the brothers had to be creative in the metrics they used to value the banks since they didn’t have any “earnings on which to base multiples, and uncertainty about the extent of bad loans made it difficult to forecast a turnaround.”

So instead, the team looked at “market capitalization as a percentage of assets; on this daily basis they determined that UFJ and other megabanks traded at about 3 percent, compared with 15 percent for Citigroup at the time. The Chandlers concluded that Japan would have to nationalize the banks or reflate the economy with low interest rates, and bet — correctly, as it turns out — on the latter scenario.”

After riding out a near 50% decline from when they began building their position the Chandler brothers rode the stock all the way back up to new multi-year highs. They were still sitting in the stock in 2006 (when the II interview was conducted).

In talking about their big win in Japan, Richard said that, “Most fund managers are focused on what can go wrong rather than on what can go right and were too afraid to make that call. We were not.

Talk about having courage in your convictions. These guys must have to push around a wheelbarrow to haul their giant cojones around.

Richard helps shed light on how he and his brother are so effectively greedy when others are fearful in sharing one of his favorite sayings from Investor Philip Carret, who said it is essential “to seek facts diligently, advice never.” Richard explains: “Money managers have to account for their actions to their shareholders, which means they have an undue fear of underperformance. We invest only our own money. Our investment decisions are driven by optimism, not fear.

Once they establish the conviction they then have the optimism and courage to buy in size. II writes:

The brothers also prize scale, believing that the way to achieve outsize returns is to make a few big bets — Sovereign usually holds fewer than ten stocks — rather than manage a diverse portfolio. The Chandlers favor large-cap stocks in big countries. “If you are invested in big companies in big countries, that means there is a ready audience of benchmark-following investors who must buy the asset,” says Richard. “By buying big — going narrow and deep, as opposed to diversifying — you maximize your success.

Sovereign usually holds fewer than ten equity positions at any one time. Though it typically holds its larger positions for two to five years, the firm regularly trades in and out of some stocks to test the waters and take advantage of price movements.

It’s very important to note that this isn’t dumb blind conviction. You’re not a smart contrarian by just buying a hated falling asset. The crowd could be correct and the underlying could be worth much less than what it’s selling for.

The Chandlers lived and breathed business from the time they were children. Richard had a degree in accounting and a masters in Commercial studies. After college he worked for a big accounting firm where a coworker recounted his “incredible intellectual capacity and enormous, almost unbelievable thirst for knowledge. He used every project we work on as an experience to learn a new business model.”

These two know businesses. They know what’s important and the things to look for in valuing them. They know how to correctly assess a prospects margin of safety in relation to its upside.

Richard said, “Our talent is to understand the long-term potential of a business” and “the market gives you the opportunity to arbitrage what the emotional investor will pay or sell at versus the fundamental value of a company, but you’ve got to pull the trigger promptly without hesitating… We’ve disciplined ourselves mentally and prepared ourselves in terms of information, as well as relationships with brokers, to do that.”

Lessons From the Chandler Brothers

To make these types of long-term outsize returns, you have to go NARROW and DEEP.

That means putting large portions of your portfolio into just a few high conviction trades, the veritable fat pitches, when they come along.

We call this Fat-Tail Exploitation Theory, or FET for short. And it flys in the face of all the conventional wisdom that espouses the wonders of diversification. Druckenmiller talked about the importance of FET when he said the following:

The first thing I heard when I got in the business, from my mentor, was bulls make money, bears make money, and pigs get slaughtered.

I’m here to tell you I was a pig.

And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

And Barton Briggs touched on it in his book Hedgehogging when writing about his friend and macro fund manager, Tim.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

A reason why FET is key to delivering outsized returns is because of the underlying power laws that are embedded in markets. Pareto’s law of 80/20, or in markets it’s more like 90/10 or 95/5 even, which means that 90% of your returns will come from 10% or fewer of your trades.

Just take a look at the profile of Sovereign’s returns. Over a 15-year period just five investments generated 90% of their returns (chart via II).

There are two keys to this.

One is that you can’t force it and you have to really really know your stuff or else you’re assuming blind risk and opening yourself up to financial ruin. The Chandler brothers understand businesses inside and out. They could cut through the fluff in laser like fashion and get to the meat of the issue when evaluating companies.

Second is time. Fat pitches like these don’t come around often. The Chandlers would go years in between big investments without risking any substantial amount of money. Michelangelo once said that, “Genius is infinite patience” well the corollary to that in investing is that infinite patience is success.

Joel Greenblatt said this about the need for patience and taking a big picture view of things:

Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

Next there is contrarianism.

The Chandler brothers made it a point to set up shop in Dubai and Singapore, far away from the financial centers of the world in New York and London. They did this because they didn’t want to fall victim to the powerful pull of groupthink and herd mentality.

Being able to look at the same situation as the market and form a variant perception lies at the heart of how they uncover highly asymmetric trades. A good way to develop a variant perception is to take a page from the Palindrome, George Soros, who said:

The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

As humans we all have the tendency to get wrapped up in the hysteria and be seduced by compelling narratives, especially when the components of fear or greed are present. But it’s in these situations where the narrative has driven the market to extrapolate trends ad infinitum, driving prices to ridiculous levels, that create the environment where amazingly asymmetric bets exist.

You need to step back, objectively sift through the data yourself, and develop a big picture view of things. This is what Templeton referred to as “the point of maximum pessimism” which Bill Miller explains here:

The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

And lastly, you need to be creative and think out of the box in order to form a variant perception and see a future different from the one in which the crowd is pricing in.

The Chandler brothers used “creative metrics” and the point is that it’s not rocket science. But it does mean you need to do the thinking, do the work, and come to your own conclusions. Great opportunities aren’t found in a simple screen or low P/E. They exist BECAUSE they are difficult to find, to comprehend, to value. Greenblatt says it like this:

Explain the big picture. Your predecessors (MBAs) failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.

Narrow and Deep. Contrarian. And think of the logic, not just the formula…