Posts tagged ‘flash crash’

The Pleasure/Pain Principle

The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.

Admitting one has a problem is half the battle of conquering a challenge.  A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).

Source: Investopedia

Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.

In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:

Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

A. A sure gain of $500

B. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with this problem:

Problem #2:  In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

A. A sure loss of $500

B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.

In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.

The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (see Pessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).

Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).

A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including fixed income ETFs), but at the time of publishing SCM had no direct position in GLD, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

May 12, 2012 at 6:13 pm Leave a comment

Time Arbitrage: Investing vs. Speculation

The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour.  Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.

What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.

Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.

Winning via Long-Term Investing

Legg Mason has a great graphical representation of time arbitrage:

Source: Legg Mason Funds Management

The first key point to realize from the chart is that in the short-run it is very difficult to distinguish between gambling/speculating and true investing. In the short-run, speculators can make money just as well as anybody, and in some cases, even make more profits than long-term investors. As famed long-term investor Benjamin Graham so astutely states, “In the short run the market is a voting machine. In the long run it’s a weighing machine.” Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform. 

Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products spontaneously stick, then the financial institutions often market the bejesus out of them to unsuspecting investors, until the strategies eventually fall off the wall.

Beware o’ Short-Termism

I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With more than 2 billion people online and 5 billion people operating mobile phones, no wonder investors are getting overwhelmed with a massive amount of short-term data. Next, trading costs have declined dramatically in recent decades, to the point that brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”).  Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, the cat is already out of the bag, and the low hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.

There is never a shortage of short-term fears, and today the 2008-09 financial crisis; “Flash Crash”; debt downgrade; European calamity; upcoming presidential elections; expiring tax cuts; and structural debts/deficits are but a few of the fear issues du jour in investors’ minds. Markets may be overbought in the short-run, and a current or unforeseen issue may derail the massive bounce from early 2009. For investors who can put on their long-term thinking caps and understand the concept of time arbitrage, buying oversold ideas and selling over-hyped ones will lead to profitable usage of investment time.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 25, 2012 at 6:09 pm Leave a comment

Sweating Your Way to Investment Success

Source: StopSweatyArmpits.com

There are many ways to make money in the financial markets, but if this was such an easy endeavor, then everybody would be trading while drinking umbrella drinks on their private islands. I mean with all the bright blinking lights, talking baby day traders, and software bells and whistles, how difficult could it actually be? 

Unfortunately, financial markets have a way of driving grown men (and women) to tears, usually when confidence is at or near a peak. The best investors leave their emotions at the door and follow a systematic disciplined process. Investing can be a meat grinder, but the good news is one does not need to have a 90% success rate to make it lucrative. Take it from Peter Lynch, who averaged a +29% return per year while managing the Magellan Fund at Fidelity Investments from 1977-1990. “If you’re terrific in this business you’re right six times out of 10,” says Lynch. 

Sweating Way to Success

If investing is so tough, then what is the recipe for investment success? As the saying goes, money management requires 10% inspiration and 90% perspiration. Or as strategist and long-time investor Don Hays notes, “You are only right on your stock purchases and sales when you are sweating.” Buying what’s working and selling what’s not, doesn’t require a lot of thinking or sweating (see Riding the Wave), just basic pattern recognition. Universally loved stocks may enjoy the inertia of upward momentum, but when the music stops for the Wall Street darlings, investors rarely can hit the escape button fast enough. Cutting corners and taking short-cuts may work in the short-run, but usually ends badly.

Real profits are made through unique insights that have not been fully discovered by market participants, or in other words, distancing oneself from the herd. Typically this means investing in reasonably priced companies with significant growth prospects, or cheap out-of-favor investments. Like dieting, this is easy to understand, but difficult to execute. Pulling the trigger on unanimously hated investments or purchasing seemingly expensive growth stocks requires a lot of blood, sweat, and tears. Eating doughnuts won’t generate the conviction necessary to justify the valuation and excess expected return for analyzed securities.

Times Have Changed

Investing in stocks is difficult enough with equity fund flows hemorrhaging out of investor accounts like the asset class is going out of style (See ICI data via The Reformed Broker). Stocks’ popularity haven’t been helped by the heightened volatility, as evidenced by the multi-year trend in the schizophrenic  volatility index (VIX) –  escalated by the “Flash Crash,” U.S. debt ceiling debate, and European financial crisis. Globalization, which has been accelerated by technology, has only increased correlations between domestic market and international markets. As we have recently experienced, the European tail can wag the U.S. dog for long periods of time. In decades past,  concerns over economic activity in Iceland, Dubai, and Greece may not even make the back pages of The Wall Street Journal. Today, news travels at the speed of a “Tweet” for every Angela Merkel  – Nicolas Sarkozy breakfast meeting or Chinese currency adjustment, and eventually results in a sprawling front page headline.   

The equity investing game may be more difficult today, but investing for retirement has never been more important. Stuffing money under the mattress in Treasuries, money market accounts, CDs, or other conservative investments may feel good in the short run, but will likely not cover inflation associated with rising fuel, food, healthcare, and leisure costs. Regardless of your investment strategy, if your goal is to earn excess returns, you may want to check the moistness of your armpits – successful long-term investing requires a lot of sweat.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in ETFC, VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 15, 2012 at 5:08 pm 3 comments

My 10 Holiday Thank You’s of 2010

Source: Photobucket

10.) I am thankful for “QE2” (Quantitative Easing) because it broadens my thesaurus with another acronym meaning “printing press.”

9.) I am thankful for the Goldilocks “-flation” fears. Not too hot inflation and not too cold deflation makes Goldy feel just right.

8.) I am thankful for weak housing prices. Who wants to pay high property taxes?!

7.) I’m thankful to have another bloody, partisan midterm election behind us resulting in gridlock. Oops, I forgot, we just started a bloody, partisan 2012 Presidential election cycle. 

6.) I am thankful for May’s “Flash Crash” because I’m an adrenaline junkie and the financial crisis did not provide enough excitement in 2008-2009.

5.) I am thankful for the Irish banking system bailout. Misery loves company.

4.) I am thankful for higher commodity prices, specifically my long wheat futures position. I’ve effectively hedged my daily breakfast bowl of Wheaties

3.) I am thankful for the Chinese…for supporting our gluttonous consumerism by purchasing all our debt.

2.) I am thankful for a record year at Sidoxia. The launch and leading performance of Fusion added  to a memorable 2010 (read more).  

1.) I am thankful for the thousands of readers and followers who stopped by my site in 2010. Not only were the compliments appreciated by the die-hards (“Caffeiners”), but also the constructive feedback from casual visitors (i.e., “Slome, you’re a moron”).

Happy New Year and best wishes for a prosperous 2011!

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in BP, wheat futures, or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

December 22, 2010 at 1:08 am Leave a comment

Doing the Opposite – Slow Frequency Trading

The business of robot trading, or so-called high-frequency trading (HFT) has grabbed a lot of headlines recently. The recent exposé released by 60 Minutes on the subject  has only fanned the flames, which have been blazing harder since the May 6th “flash crash” earlier this year. The SEC is still working through proposed rule changes and regulatory reforms in hopes of preventing a similar crash that saw the Dow Jones Industrial Index almost fall 1,000 points in fifteen minutes, only to recover much of those losses minutes later.

The debate will rage on about the fairness of HFT (read more), but let’s not confuse active day-trading with high-frequency trading. In the case of HFT, the traders are actually getting paid to trade with the assistance of “liquidity rebates.” In exchange for the service of providing liquidity, these computer-based trading companies are earning cold, hard cash. Wouldn’t that be nice if individual day traders got paid money too for trading, rather than flushing commissions down the toilet?

Rather than warn unsuspecting working class Americans of the dangers of trading, discount brokerages and other trading firms peddle talking babies, loud music, back-testing voodoo software, and the prospect of discovering a profit elixir. As it turns out, investing is like weight loss…easy to understand, but difficult to execute. There’s no such thing as a miracle drug or chocolate diet that will shed pounds off your frame, just like there is no miracle trading system that will instantaneously generate millions in profits.

Doing the Opposite

Rather than succumb to the vagaries of the market, investors would be better served by following the mantra of character George Costanza from the hit, comedic television show Seinfeld. In the classic episode, astutely captured by Josh Brown (The Reformed Broker) and also cataloged in chapter four of my book, George realizes that all his instincts are wrong and discovers the road to success can be achieved by doing everything in an opposite fashion. George goes on to flaunt his contrarian approach when he runs into a blonde bombshell at the diner. Rather than boast about his accomplishments, George fesses up to his professional shortcomings by revealing his unemployment status and admitting that he lives at home with his parents. No need to worry, this strategy captivates her and results in George immediately getting the girl. George doesn’t stop there; during the same episode he gets his way with New York Yankee owner, George Steinbrenner, by telling him off. Before long, George is generating big bucks and making key decisions for the organization.

The same contrarian instincts of George apply to the investing world. Resisting the urge to follow the herd is key. The grass is greener and the eating more abundant away from animal pack. Investor extraordinaire Warren Buffett encapsulates the  idea in the following advice, “Be fearful when others are greedy, and be greedy when others are fearful.”

There will constantly be an urge to trade frequently and chase performance, whether you’re talking about technology stocks during the boom, real estate five years ago, or the perceived safe-haven of Treasuries and gold today. The melody sounds so beautiful, until the music stops and prices come crashing back down to Earth. If you want to win in the losing game of the financial markets, do yourself a favor and become a slow frequency trader – George would be proud of you doing the opposite.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 13, 2010 at 12:39 am 3 comments

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