Co-founder of @AuroraSignals, quant hedge fund co-manager, financial advisor, entrepreneur, trader of equities | forex | options
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Tue 29 July 2014

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Learning to be a lion - investing rules of survival

Lion


Forget the bulls, forget the bears. Perma-bulls pray for constant upside movement while perma-bears wish for the opposite. The error that comes from associating with (admit it, we’ve all done it) either “type” is it instills emotional biases. I can’t explain how many bad investment decisions I made between the years of 2009 and 2013 simply because deep down inside I was a perma-bear. Why? I was determined not to get slaughtered in the event of another crash. I was so determined that it blinded me to many great opportunities. Renowned BridgeWater hedge fund manager Ray Dalio often talks about learning to love mistakes. This is a wonderful principle to live by, but it is important not to obsess over mistakes. Learn from them, don’t let them blind you. Often when something bad (or good) happens to us as humans we try so hard to avoid (or seek) that situation again. From this emotional bias, perma-bulls and perma-bears are born.

BearBullCartoon

On a long enough timeline, both of these investor types get taken to the woodshed in one market climate or another. Having these mindsets also cause you to see things that may not be there, and miss the things that are. One of the most important approaches I’ve learned over the years is to seek an objective understanding of markets. Understanding markets for what they are doing, rather than what we would like them to do; or what we might fear they are doing. It is this satellite view of markets that allows investors to observe change, real change for what it is. Taking such approach places you in a whole different category than most investors or traders. You become a lion, not a bear or a bull. Lions naturally are successful predators because they are opportunistic when it comes to feeding. How does this translate to investors? It means learning to see markets for what they actually are, and only investing or trading upon real opportunities.

Satellite view

How does this look for my own investment practice? Over the last few years, I’ve found myself focusing less and less on what is going on in the media and more on the big picture. Let’s face it, the simple bit to a successful system is extracting true signal from the noise. The media, in many ways, is comprised of a lot of noise -- constant commentary from analysts that have personal and institutional motives. Get away from all that! Are there opportunities to be had from following such sources? Sure, possibly, but I argue they are not the best. If you want unique investment results, invest differently than others.

Non-predictor - don’t guess where the zebra will be

Another key difference is learning not to be a predictor. Predictions fail! Bulls predict an up market for the coming quarter, bears predict a down market. Unless you have a crystal ball, how can you convince me you are correct? Successful investing is not about future predictions -- lions understand that that in terms of hunting. If a lion predicts a zebra will be a mile ahead of it in an hour, and it is wrong, the lion doesn’t eat that day. Instead, the lion acts in real-time, opportunistically. The lion only makes the choice to react, or move, when he sees what is actually going on (i.e. a zebra walking to a nearby water hole). Simply put, the lion doesn’t rely wholly on future location and timing of a zebra, just it’s current speed and direction. Start viewing markets this way, and stop trying to make future predictions! If your strategy requires you make projections or predict the future, ensure you use proper risk management and/or hedge your downside.

Avoid stupid mistakes - don’t mistake a bear for a stone

It’s taking on this mindset that allowed me to get outside the bounds of mainstream investing. There is no perfect strategy for trading the markets, but using this approach as a baseline to your decisions can drastically help you avoid making stupid, possibly ruinous, mistakes. Seek avoidance of foolish decisions and take positive opportunities as they arise. Hedge fund manager Mark Sellers says, “focus on the downside and the upside will take care of itself.” In nature we intuitively practice avoiding catastrophic risks, even when the probabilities of such risks are low. You should apply this approach to investing as well.

“Which is more dangerous, to mistake a bear for a stone, or mistake a stone for a bear? It is hard for humans to make the first mistake; our intuitions make us overreact to the smallest probability of harm and fall for a certain class of false patterns—those who overreact upon seeing what may look like a bear have had a survival advantage, those who made the opposite mistake left the gene pool.” -Antifragile, Nassim Taleb

This sounds like no-brainer advice, but even many experts fail to practice it! It is this discipline that will help many investors avoid ruin - the upside isn’t as hard to attain as many think. It’s the downside avoidance that’s the difficulty; it is what separates successful investors from those who blow up.

Systematize your strategy - stick to what you know works

Does this require you take an automated (computerized) approach? Not at all. A commonality among most successful investors or hedge fund managers is not their strategies, but that they are systematic. When it comes to investment decisions, algorithms do not suffer from emotional biases or “bad days,” whereas humans can and often do. To avoid these pitfalls, as a human trader/investor you must have rules, and stick to them -- like an algorithm. Where rules are most important is in terms of risk management. Your risk management rules are the most important of all, so keep them simple, and keep to them. Stick to what you’re familiar with, don’t get overly complicated. Historically, the investments I have lost the most on were the ones I was least familiar with. Now, if I’m not familiar with something, I don’t invest in it. Bad mistakes often arise from one of two areas: unfamiliarity with the investment, or a larger than normal position size. In both circumstances it is usually the price action that controls one’s decisions, they are based off fear, not judgment or experience:

“The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience.” -Onmi Partners’ Steve Clark

“You have to be an expert in what you invest in. You need to understand why you are invested. If you don’t understand why you are in a trade, you won’t understand when it is the right time to sell, which means you will only sell when the price action scares you. Most of the time when price action scares you, it is a buying opportunity, not a sell indicator.” -Nevsky Capital LLP's Martin Taylor

Sticking to systematic rules can help traders and investors remove a lot of the crippling emotion from the process. When you employ proper risk management and stick to pre-determined rules, you’re more likely to avoid stupid mistakes. Minimizing these mistakes over time is more powerful than you would think.

Adapt - seek optionality

Don’t be overly stiff with your rules. Like all systems in the universe, adaptation is crucial to survival. If you maintain an objective understanding of markets, you’ll be more adaptive to change than your peers - that could be the edge you’re needing. One of the most applicable rules to adaptivity is the idea of “optionality.” This term was coined by Nassim Taleb, author of Antifragile, who specializes in the fields of randomness, probability and uncertainty. What better application than in financial markets? In short, maintaining optionality is a powerful practice when applied to all types of investing or trading (as well as in life!). Don’t take on positions with few options, or no backup plan.

Look back at decisions you’ve made in your life, for example, many of those with the greatest outcomes were probably those that gave you the most options. Nature does this inherently; that’s why so many systems are naturally robust. Look for investments that have great upside potential for multiple reasons. Have clearly defined thresholds or rules for when you will exit a position, profitably or unprofitably. Early on in my trading career I suffered from laziness; I would enter a position purely on gut feeling with no defined exit strategy(ies). This practice provided me with few to no options, and I paid the price for it more often than not. Good chess players are masters of optionality. The best make moves that give many options or payouts, as they are always thinking multiple steps ahead with adaptive abilities in case one path gets shut down. Properly apply this to investing or trading, and you’ll quickly begin to see the advantages it provides. It is so intuitive but so rarely practiced by market participants. Apply it to your decision making process and you'll begin to think like the pros.

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