The Hindrance of Human Instinct
Rob: ...So I’m genuinely interested in educating people and trying to explain to them that they need to be more realistic. That’s a completely different market place from where you are trying to compete with people who are trying to make the most outlandish claims to stand out from the pack of people making similar outlandish claims.
Niels: I agree with that completely. I think it is evident from reading your book that, that is the fundamental motivation. Now you touched already upon the point about the flawed human brain in your book, and you end up talking a little bit about some of the temptation of taking profits early and letting our losses run, and that’s really how we as human beings are wired. Tell me a little bit more about that and what it really means when it comes to trading if you get this balance the wrong way around so to speak, and what you found when you test this kind of human behavior if I can call it that.
Rob: So the natural human instinct when you see a position rise in price and you're long, is to say… is to want to take a profit. And this comes down to essentially that kind of strong feeling and you want to kind of lock that in. And the reason you want to lock that in is that you want to prove that you are right. It’s the overwhelming human emotion to prove that you are doing the right thing and it’s called confirmation bias in the literature. Now when its stocks falling, if you sell a loss, then you’re going to be proving that you are wrong and nobody wants to do that. So what you actually then want to do is hang onto that position and hope it goes up in value. And as it keeps falling of course you have the same conversation with yourself until you’re forced to sell and perhaps because you’ve run out of money.
So it’s really about the way the human brain is treating unrealized losses and unrealized losses differently. We are thinking about them differently. Even though they’re exactly the same. And you know this kind of mindset that it’s not a profit until you’ve sold it and it’s not a loss until you’ve taken the loss. It’s completely wrong.
Now it’s very easy to think about a sort of pattern of price where it would actually make sense to buy on a small profit, and that would be if the market was trading in a small range. Now the problem is that most of the time markets don’t do that they trend. This isn’t the time for that kind of theological argument about whether trend following is a good thing or a bad thing.
…even in the large institutions that trade systematically, you still have debates about whether we should override the system, or cut the system's risk because of something that is going on in the world.
—Rob Carver
Certainly in the past people like Winton have done tests over hundreds of years of data where it is available, and markets have in the past exhibited a behavior where they’re trending. So if markets are going to trend and this behavior where you’re going to sell at a small profit and cut only when you’ve got a huge loss is exactly the wrong thing to do. You should do exactly the opposite of that, which is what a trend following system will do. So this is a really good example of where there is a human bias in our brains creating exactly the wrong kind of behavior. You can then write the really simple rule that will not only correct for that bias but will actually exploit it. If other people are doing this, then this trend following system will effectively taking money off them.
Niels: Now of course it kind of goes into the debate there’s also been about different kinds of strategies: convergent strategies versus divergent strategies. We know trend following is a divergent strategy. Then you have a lot of relative value strategies on the convergent side. I guess, I mean I guess part of your conclusion is that you should have a little bit of everything and that’s probably true, but when you did your test… from memory you did a test with these two different rules on 31 futures contracts, well what did you find in that? If you don’t remember I have the finding in front of me.
Rob: Okay well I did find, I think it was 26 out of 31 markets, or 27 out of 31 markets, a very simple rule which took losses early and let profits run. So it wasn’t actually a classical trend following rule. It was something much simpler than that. And it did better in 27 out of 31 markets. You know that’s not a huge surprise because firms that have been trend following futures have been profitable for many decades so it’s not a big surprise. As you say I’m not saying that trend following is the only way to trade. It’s just that this is a really nice example of where a human bias produces a behavior in the market. Which can be exploited by a simple trading rule. There are others on the convergent side as well.
Niels: Yeah, true. Actually you use the phrase simple trading rules. There are two things you highlight also early on in the book, and that’s the importance of having simple trading rules but also the importance of sticking to a plan. Tell me why this is crucial in your opinion.
Rob: Well if you’re not sticking to a plan then you aren’t really trading systematically. The whole point of having a system whether it be the full on what I call the staunch system trader where your running with systematic trading rules and a position management framework or the more qualitative semi-automatic way of your making your own forecasts then putting them kind of binding yourself into this systematic framework to actually trade and manage those positions. The whole point of that is that you gain the benefits you can get from doing that. Which you know you are going to lose if you start meddling with your system and making changes, and this is something that everyone does.
From the guys, the retail trader who is using an off the shelf charting package; he’s looking at the signals that are coming off of it, saying well I don’t really like that signal, I’ll ignore that one, I’ll do this one, I won’t do that one. But even in the large institutions like AHL, I’m not criticizing them specifically because it happens in all institutions that trade systematically, you still have debates about whether we should override the system or cut the systems risk because of something that is going on in the world.
Now the key point, of course is, if you’ve got a purely systematic trading system, that you’ve backtested. In the back test all kinds of stuff happened, and no one was there in the backtest to override it, the system just ran and did what it did. Assuming you are comfortable with the backtest and comfortable with its behavior and what trading it was doing in the backtest, then you should really be comfortable with letting that thing run now
without interfering with it. Because that’s exactly what happened in the backtest. So there are actually a very, very small number of circumstances in which I believe it’s right to meddle with a trading system and to override it. Unfortunately, this is something comes about with long experience. I think the danger is if you are ever in a situation where you are spending too much time looking at what your system is doing and following the financial news and all this kind of stuff, all these things feed into an environment in which you are more likely to try and second guess the system and override it.
That’s why I don’t sit on my computer all day and watching it trade. I spend a lot of time setting it up so that it’s fully automated and just reports to me when things look like they might be going wrong. But in an institutional setting it’s much harder when you’re trading with other people’s money because you have this fiduciary duty to look after their money, and as you know yourself, and if something happens and you don’t override the system then there’s always that question of what was the right thing to do. So it’s a culture in which it is much hard to stick exactly to what the system is doing.
Niels: True, I mean it is interesting when you or I were talking in November of 2015, and actually I would say the things you just touched upon is very real right now in the debate of investors, which obviously I spend a lot of time talking to. People are worried that the coming changes in interest rate environment - meaning we’ve gone from a bull market in bonds to a bear market, at some point, when the interest rate cycle turns - which of course we know the U.S. Central Bank has alluded to now a few times this year already and at some point it probably will come.
There is definitely fear out there that all these track records that we have been able to produce and can document and show, they’re not going to be worth a lot when interest rates suddenly start going up because not many CTAs have traded through a rising interest rate environment. So there is this fear, that oh it’s going to stop working and of course there is a point to it because most testing will have been done on data from the last thirty years, three decades. Not a lot of people and not a lot of data is available going further back. I want to talk about something related to this in a second, but I just want to hear your initial reaction to this kind of concern that investors clearly have.
We did a lot of simulations and tests looking at different interest rate environments, and came to the conclusion that they weren't as much of a problem as you might think.
—Rob CarverRob: So my last job at AHL was managing the fixed income portfolio. I spent an awful lot of time thinking about exactly this problem. And I came to a number of conclusions. The first conclusion is people often forget that what makes… we say we are looking at prices and we assume that if a bond price falls that we are going to lose money, but actually what we are exposed to is total return.
So if you’re owning bonds, then your total return is going to come (actually this applies to all futures,) is going to come from both the movement in the spot price and also any carry or roll down that you’re getting. On the carrier roll down, essentially, is sort of telling you what the market expects will happen to the spot price over whatever period it is. So what that means in practice, if you are in an environment where interest rates are very low but expected to go up then the interest rate curve and yield curve will be quite steeply upward sloping. And that means that the carry that you’d get on earning Bonds further out in the maturity space will be relatively high.
So in a nutshell if the interest rate moves in the way that the forward price is expected it will move you won’t actually make or lose any money. It’s only if the rates change unexpectedly, so if they rise too early or too fast, that you will lose money. So that’s the first thing to say. Certain people kind of think, a lot of people miss that. We did a lot of simulations and tests and looking at different interest rate environments and came to the conclusion that there wasn’t as much of a problem as you might think.
The second thing is diversify - diversification - If you’re running a CTA and 40% of your assets are in U.S. bond futures then you are some kind of crazy guy. This is true regardless of what you think Janet Yellen is going to do. You should have a diversified portfolio. So probably, when I look at my own portfolio, perhaps 20-25% is in bond futures. And if it was more than 30% I’d be sort of thinking well that seems a bit high. Regardless of what I think is going to happen to interest rates, it just seems quite high given all the asset classes that are out there in the CTA space. Why do you have so much money in just one county? Of course, all bond prices will react to what happens in the U.S. What happens in the U.S. will be the most significant thing, so if you have a reasonably diverse portfolio then your exposure to anything unexpected happening in the U.S. should be relative small.
The third thing to say is we were having this debate for the best part of three years, before I left AHL. It’s now 2015 so this is a debate we’ve been having for five years. And if you’d done any kind of meddling in that period like reducing your exposure to fixed income you would have been hurt, because being long fixed income and also trend following fixed income has been one of the greatest traits over the last five years.
I agree with Cliff Asness to the extent that I don’t think that I am a genius, and therefore sticking to a simple plan is the right thing for me to do.
—Rob CarverFor example, last year was an excellent year for CTA’s and most of them made most of their money in bonds, actually mostly in European bonds. If you cut your exposure in bonds too much to say just 10% you’d have seriously missed a lot of that return. So my message really is don’t panic.
You can go back to probably the last time we had an interest rate rise that kind of panicked the markets in a similar way was in 1994. For example, Orange County happened; a lot of people really got caught short. So you can kind of go back and look at CTAs trading back then or look at backtests simulations, in as much as they can be trusted and look at what happened then. So it’s not like there isn’t any data at all. You’ll see losses, of course, but they shouldn't be too large. It’s obvious you haven’t exposed yourself too much to one asset class in one country.
Niels: And the other thing I would add, I feel all your points are very good and of course one can add one more and that is systematic traders today can be short the bonds as easy as they can be long, so there should be no bias there. What is interesting to me is that there are a few, maybe a handful, of these managers who were around in the last interest rate hiking cycle. From 1977 to 1981, for example, interest rates went up dramatically and I can see in the firm I worked for, which happened to be around back then, it was a very profitable period for this kind of trading.
So to me at least, it looks to me that when the bigger interest rate cycle is up then I think there should be good opportunities. But when people refer to the period as you may mention, 1994, which was a difficult year for the CTA space, well actually what it was it was a correction in interest rates going up in a much bigger down move. To me it was more of a counter trend situation then it was the fact that the interest rate cycle had turned it hadn’t really turned it was just correcting against the bigger turn.
Anyway, let that be for a minute. I’m going to give you a little bit of a pause to drink some tea because I want you to… I want to point out something that related to what you mentioned earlier which was the importance of sticking to a plan. I happen just to be sent, the other day, a link to an article where AQRs - for those that don’t know is one of the very big firms in our business. The founder of AQR, Cliff Asness, was recently interviewed by Bloomberg and this is what he said about investment success and also in relation to Warren Buffett.
He basically said that genius is still good, but more and more I think about doing something reasonable that makes sense and then sticking to it with incredible fortitude through the tough times. Maybe I muddled that up a bit in my reading of it, but basically what he is saying is sticking to plan is possibly more important than just being a genius.
Now the other thing he goes on to say when talking about “greatest investor in the world” Warren Buffett he says that (this is about a study that was done about him), of course they found he was fantastic, but not quite as fantastic. His track record was phenomenal but human phenomenal what was beyond human was him sticking with it for 35 years and rarely if ever, rarely retreating from it.
So it goes very much to the point you made before now of course at this stage I have to do a little bit of selfless promotion and that is to put things into perspective a little bit and mention that, the founder of the firm I work for Bill Dunn, who has essentially been running his investment strategy for 41 years with an annual return of more than 15%, which puts him, along with our new ownership of Marty Bergin right up with Warren Buffett. Yet you will never hear these kind of rosy descriptions in the media like they describe Buffett’s achievements. Anyway that’s a little bit of us being sidetracked. The sticking to a plan and being exceptionally disciplined over the long run I think it is such an important point to for people to realize.
Rob: Absolutely and I think I completely agree with Cliff to the extent that I don’t think that I am a genius, and therefore sticking to a simple plan is absolutely the right thing for me to do.
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