Posted by

(Photo: .pst)

Getting your investment process right can be really tricky.


If you look for material on the subject you’ll likely find ideal practices (discipline, intellectual independence etc.) but no explanation of how to achieve them. Or if not you’ll probably stumble upon tactics that are so specific to the advice-giver’s circumstances that they’re unintelligible to everybody else (e.g. “always cut your losses at X%” … why X% and not X+1%?).


Often you’ll find contradictory advice. The BBC’s interpretation of one of Warren Buffet’s rules of investing for example:


Break your own rules


Hmm, thanks BBC… I think…


It doesn’t have to be this confusing.


Here we’ll explore a process of selecting and managing trades with asymmetric risk/reward profiles. By the end of this article the anxiety you might feel about those ideal practices will be replaced by excitement because you will have gained a deep understanding of how they lead to excellent risk-adjusted returns.


The Basic Principle Behind the Asymmetric Trade


Jack Schwager: You are one of the most successful traders in the world. There are only a small number of traders of your caliber. What makes you different from the average guy?


Bruce Kovner: I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen. Second, I stay rational and disciplined under pressure.

Market Wizards: Interviews with Top Traders by Jack D. Schwager (1988)


Asymmetric trades (i.e. trades where potential gains are large relative to possible losses) are found where radical viewpoints can become commonplace over time. Caxton Associates founder Bruce Kovner put together a multi-decade annualized return of 21% on his flagship fund by pursuing and sticking with unconventional viewpoints. Later in the interview quoted above Kovner was asked about what separates his more successful trainees from the less successful ones. He replied as follows:


They are strong, independent, and contrary in the extreme. They are able to take positions others are unwilling to take. They are disciplined enough to take the right size positions.


Prerequisites to Widespread Radical Trade Adoption


If the widespread adoption of your radical investment viewpoint is the goal, then investment process is about finding and managing the positions that correspond to them. Let’s get clear on the prerequisites to the transformation of a contrary position into a consensus one. Then we can put a process together.


Prerequisite #1: Room For Opinion Change


The early-1980s was a crazy time in the financial markets. The price of gold spiked to nearly $900 / ounce (a price that wouldn’t be surpassed for 25 years), the yield on US Treasury bonds (or “certificates of confiscation” as they used to call them) was in the mid-teens, and Federal Reserve chairman, Paul Volcker, was not beyond hiking the fed funds rate by a few hundred basis points over the weekend. In the midst of this hair-raising period, Michael Steinhardt, stocks guy of Steinhardt Partners, charged into the one asset that everyone thought would continue to fall: The US Treasury bond.


In 1981 he put on a $250 million leveraged long position in Treasury bonds. His firm, which managed $75 million at the time, borrowed a whopping $200 million to put on the trade. As soon as the position was significant enough to be in his monthly report to investors the complaints poured in:


Some clients grew so worried that they sent in redemption notices to withdraw their capital at the next available period. McKinsey & Company, the management consulting firm, was one such client. As soon as my monthly letter arrived, detailing my move into bonds, I was asked to meet with McKinsey’s investment committee. Chosen from among the senior management of the firm, the committee was impressive and articulate, reflecting the fact that they had achieved their success by impressing other business leaders with their acumen.


When I explained why I thought bonds were attractive, they blasted me. “But you’re an equity investor,” the committee members kept saying. “We have you allocated as an equity manager. You cannot buy bonds.” They redeemed their investment immediately following the meeting.


One Canadian investor went so far as to threaten to sue me over my bond position. “What do you know about bonds?” were the first words he yelled at me when he called one day. “You’re an equity investor. You’re supposed to be focused on the stock market. That’s why I pay you these outrageous fees!”

No Bull: My Life In and Out of Markets by Michael Steinhardt


In spite of repeated objections and gut-wrenching drawdowns he stuck to his conviction, eventually finishing the year up 10% (a fine achievement since the S&P 500 was down 3.5%). Before picking up for the next year he took a holiday, first to Israel and then to a favored location in the south of France. Upon arriving at the hotel in France he received a phone call from the office. He soon discovered he was already up 60% for the new fiscal year. His contrary stance had paid off handsomely.




It is not possible to hold a radical investment position until it’s commonplace if it was never radical to begin with. What we’re trying to do is precede the crowd; the first prerequisite is therefore to start with a viewpoint that the crowd can embrace.


Learn from Michael Steinhardt, seek opportunities where popular opinion is strongly against (or apathetic towards) a far-reaching possible future.


Prerequisite #2: A Footing in External Reality


In 1979, a sprightly 25 year-old Paul Tudor Jones was three and a half years into his career and working as a broker for E. F. Hutton. At one point he was heavily long July cotton for several client accounts. He was confident that the price would rise some 7¢ to 89¢, and couldn’t help but imagine all the money he was going to make. So much so that one day, “in an act of bravado, [he] told [his] floor broker to bid 82.90 for 100 July, which at the time was a very big order.” The instant the order was filled he realized his mistake; cotton was headed down and he needed to be short… not heavily long. The market went limit down and he couldn’t liquidate his position. He had to wait until the following day. That one trade wiped out well over half the equity in his clients’ accounts and he was so distraught that he almost quit. Eventually though, he resolved to continue… only now with a businessman-like sense of discipline.


Every day I assume every position I have is wrong.

Paul Tudor Jones in Market Wizards by Jack Schwager


His process evolved. It became about consistent and impartial probing; testing small, staying with what fits and dispassionately discarding what doesn’t. He was transforming himself into what he would later call a “premier market opportunist”.


Fast forward to the middle of 1986 and he’s six years into managing the Tudor Investment Corporation and convinced that the markets are going to crash. The market only started to top out a year after this, but Tudor Jones often stayed long in spite of his strong longer-term bearish view. [You can view the degree of intellectual flexibility he had developed by this time by watching the fantastic documentary: The Trader. Google "the trader documentary", filtering for recent results, and you might be able to find it. It pops up here and there but usually gets taken down quite quickly. We'll tweet about it next time it shows up so you might want to follow us.] By October 1987, they knew it was time:


Paul Tudor Jones: When we came in on Monday, October 19, we knew that the market was going to crash that day.


Jack Schwager: What made you so sure?


Paul Tudor Jones: Because the previous Friday was a record volume day on the downside. The exact same thing happened in 1929, two days before the crash. Our analog model to 1929 had the collapse perfectly nailed.


While the investment community squirmed, the Tudor Futures Fund registered a 62% return for the month.




You don’t have to know exactly how your idea will germinate, but seek external evidence before plunging.


Recognize the prudence of Paul Tudor Jones’ approach: probe the market, expect to be wrong and plan accordingly. Do not imagine that your viewpoint can materialize without that first iota of energy in the marketplace.


Prerequisite #3: Internal Growth Vectors that get it to Spread


Michael Marcus on trading in the early-1970s:


In those days, you watched the board, and you would buy corn when it moved above a key chart point. An hour later the grain elevator operator would get a call from his broker and he might buy. The next day, the brokerage house would recommend the trade, pushing the market up some more. On the third day, we would get short covering from the people that were wrong, and then some fresh buying from the dentists of the world, who finally got the word that it was the right time to buy. At that time, I was one of the first ones to buy because I was one of the few professional traders playing the game. I would wind up selling out to the dentists several days later.




Times may change, but principles do not. The third and final prerequisite for the widespread adoption of your radical viewpoint is the internal growth vectors that get it to spread. As is said in Michael Marcus’s quote above, an optimally infectious mechanism used to be inbuilt into the speculation business. News would spread slowly over time and professionals could trade effectively even with conventional mechanisms. Today’s markets are densely populated with professionals, so a different approach is needed. Hugh Hendry of Eclectica Asset Management has articulated this problem well:


I meet a lot of inquisitive and extremely intelligent people in this business and I have come to think that maybe this is something of a problem. Perhaps they are just too smart. Perhaps they just try too hard. Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money. So it is entirely rational (especially if you have never met a hedge fund manager) to assume the industry attracts the brightest, smartest minds. The beautiful mind, if you will. But I am not aiming to outsmart George, Stan, Julian, Bruce or the others. I do not think it is logical to try and outsmart the smartest people. Instead, my weapons are irony and paradox. The joy of life is partly in the strange and unexpected. It is in the constant exclamation “Who would have thought it?”


Ensure your idea has the legs to spread. Better yet, do not invest like it’s 1974; develop a seemingly bizarre viewpoint and you have a better chance of being early.



If these three prerequisites are present you’re onto a contrary position that can be held until its commonplace.


The Process: Selection and Management


So now it’s just a matter of setting up a process to find and manage trades that meet the prerequisites. The aim is to find them quickly and cheaply, only holding the ones with good risk/reward.


Step 1: Pre-trade Prerequisite Checking


The first step is to find an asset which has (or is about to have) the three prerequisites.


It doesn’t matter if you base your decisions on technical, fundamental or even astrological information. The process is the same; it is analysis-agnostic. The first step is to establish that your proposed trade is:


  1. Contrary,
  2. confirmed by external market reality,
  3. subject to growth vectors that will get it to spread.


For example, you might have something like this:

  • Anecdotal and sentiment information confirming a contrary stance,
  • A technical breakout suggesting a concrete footing,
  • Economic data suggesting excessive leverage in the economy.


Step 2: Pre-trade Asymmetry Checking


Now that you’re convinced that your proposed trade has the prerequisites, it’s time to check the risk / reward situation.


  1. Make a conservative estimate of the rewards available should your view turn out to be correct.
  2. Figure out the price which disproves one or more of the prerequisites. Typically this will relate to a key technical level.


If the potential rewards are a large multiple of the amount at risk then your trade moves on to the next step.


Step 3: Hypothesis Formulation, Sizing & Execution


Now you have a trade with the asymmetry and prerequisites to make it a success, it’s time to crystallize and record the hypothesis.


We suggest making notes on a piece of card with the following layout (or similar):


Click here to download in a format suitable for printing on A4


[Note: the card above has a time stop. This is the nearest time at which you are sure that you will have misjudged the behavior of the market. The reason is to ensure that you're not holding a position that can lose for unclear reasons.]


Your stop should be at the price of first invalidation. The position size should then be chosen inline with your loss tolerance. As a rule be prepared to be wrong several times before expecting a workable hypothesis.


Step 4: Evidence Gathering


The evidence gathering stage is aimed at squeezing both of your stops to a minimum. The question is; what can you find to invalidate your idea (i.e. the stuff on your hypothesis card)? Or, how can you preempt the time and price stops so that the learning is cheaper and quicker? The quicker and cheaper you can do this, the greater the opportunity to train your mind to internalize the market. It’s also a matter of efficient capital allocation; if it’s cheaper and quicker then you’ll have more time and money left for your profitable positions.


Step 5: Asymmetry & Growth Vector Monitoring


Nine out of ten times your trade will be stopped. That’s ok since you’re looking for asymmetric opportunities. If your trade has made it to this stage then it’s a winner, and insofar as its growth vectors remain intact and you’re comfortable with the risk/reward it’s worth keeping. Here the point is to monitor the growth vector invalidation points (typically trend invalidation points) and compare it to the potential upside. Normally the longer you hold a trade (i.e. the more people speculating on the same side as you), the greater the potential drawdown relative to the potential upside. This step ensures that you’re comfortable with the risk/reward profiles on your current positions.



Why does this work?


Gustave Le Bon (1841 – 1931) – Renaissance man extraordinaire


The reason why this works is because you are dealing with a fundamentally different being when investing: The crowd.


Under certain given circumstances, and only under those circumstances, an agglomeration of men presents new characteristics very distinct from those of the individuals composing it. The sentiments and ideas of all the persons in the gathering take one and the same direction, and their conscious personality vanishes.

The Crowd: A Study of the Popular Mind


Just as individual cells display different characteristics when they’re part of an organism, people change when they become part of a psychological crowd. These crowds are dominant on the investment landscape.


The Good News:


The good news is that the crowd generates extremes that will surpass your wildest guesses (including your upside estimates). Also, it has an inbuilt propagation mechanism that can get your worldview spread far and wide.


The improbable does not exist for a crowd, and it is necessary to bear this circumstance well in mind to understand the facility with which are created and propagated the most improbable legends and stories.

The Crowd: A Study of the Popular Mind


The Bad News:


The bad news, however, is that you are built to join the crowd, and it is an eternal struggle to avoid it. Particularly in the face of an uncertain future, the allure of a crowd is very strong:


The first is that the individual forming part of a crowd acquires, solely from numerical considerations, a sentiment of invincible power which allows him to yield to instincts which, had he been alone, he would perforce have kept under restraint…

The Crowd: A Study of the Popular Mind


The Solution:


The solution lies in proper process. It doesn’t have to be exactly the one described above, but you have to accept that you are dealing with something which you cannot understand from within. It is by correct process that you create cycles of learning which, over time, lead to improvements in the quality and efficiency of your hypotheses.



If you found this piece useful you might consider subscribing for occasional email updates from this blog.