The financial crisis back in 2008 is slowly fading from the memories of investors. But for those of us who lived and traded through it, many important lessons were learned, and usually the hard way. For many investors, it was a period that can be best described as an Emotional Roller-Coaster, where billions of dollars were lost by investment decisions which were primarily driven by emotions. In my hope to make sure that these lessons are not forgotten and wasted, I wanted to share a story that I think many of us can relate to. So I looked through my list of guests to pull a few Golden Nuggets from on this topic, and I thought that Robert Carver, who spent many years at AHL before deciding to share his knowledge about Systematic Trading through his books and blog, would be ideal for this. So enjoy these unique takeaways from my conversation with Robert, and if you would like to listen to the conversation in full, you can go to Top Traders Unplugged Episode 89.
A Solution For Avoiding Irrational Decisions
Niels: I can’t think of a better way to kick things off then by setting the scene, and you reading a little bit of the book in order for people to get a sense of your writing style which I very much enjoy. So I would kindly ask you maybe to read a little bit of the preface and then a little bit of the introduction to the book, if you don’t mind.
Rob: Sure. “I’m very bad at making financial decisions. Like most people I find it difficult to manage my investments without becoming emotional and behaving irrationally. This is deeply irritating, as I consider myself to be very knowledgeable about finance. I’ve voraciously read the academic literature, done my own detailed research, spent 20 years investing my own money, and nearly a decade managing funds for large institutions. So in theory, I know what I’m doing. In practice, when faced with a decision to buy or sell a stock, things go wrong. Fear and greed wash through my mind, clouding my judgement. Even if I spend weeks researching a company, it’s still hard to click the trade button on my broker’s website. I have to stop myself buying or selling on a whim. Based on nothing more than random newspaper articles or an anonymous blogger's opinion, but then, like you, I’m only human.
Fortunately, there is a solution. The answer is to fully, or partly, systematize your financial decision making. Creating a trading system removes the emotion and makes it easier to commit to a consistent strategy. I spent many years managing a large portfolio of trading strategies for a systematic hedge fund. Unfortunately, I didn’t have the opportunity to develop and trade systems to look after my personal portfolio. But after leaving the industry, I’ve been able to make my own trading process entirely systematic resulting in significantly better performance.”
I will now read from the Introduction.
"But I hesitated, everything had happened as expected. I should go ahead and buy, but what if this was wrong, what if the financial industry really was imploding as everyone else seemed to think?"
“It was the 23rd of January in 2009 and I was in my London office. Although I had a desk overlooking the Thames, I was usually too busy to appreciate the view. My day job was managing a portfolio of systematic trading strategies for a large hedge fund. But right now I was focusing on my own bank balance. Data was about to be released indicating how the UK colony had performed in the last three months of 2008. It would be bad news, the official confirmation that we were in recession, but nobody knew how bad. This didn’t mean extra work for me however, since a bank of computers would adjust our clients’ portfolios automatically when the news arrived.
So I decided to devote some rare free time to trade my own money. With a stressful fulltime job, I was not a particularly active trader. But very occasionally, an opportunity came up that was too good to miss, this was one of them. In my research, I’d found historically, when people’s fears were confirmed by terrible economic numbers it was often the best time to buy and this was potentially the worst news I’d seen in my lifetime.
Careful analysis showed the banks, hardest hit by the financial crises, should rebound the most if things improved. I was particularly attracted to Barclays. I had traded for their investment bank a few years before and their balance sheet was in relatively good condition. But I also looked at investing in the other major UK banks. In all, I was prepared to risk 10% of my portfolio on the four banking stocks. Then the figures came out - they were worse than expected, with GDP falling by 1.5%. Barclays dropped 15% almost immediately. Taking it to the lowest level I had ever seen. I waited for the market to stabilize and prepared to trade.
But I hesitated, everything had happened as expected. I should go ahead and buy, but what if this was wrong, what if the financial industry really was imploding as everyone else seemed to think? Panicking I quickly changed my orders, knocking a zero off each one, so that only 1% of my portfolio was at risk. It was one of the biggest mistakes of my investing career.”
Niels: Thanks very much Rob. It’s funny when you read that, it really does take you back to that time of 2009 which was a scary time to be in the investment world.
Now you’ve written a book about Systematic Trading which normally involves a lot of math and equations in the real world. But you’ve managed to write a book with very little math. Being you, why was this important to you to do it that way?
Rob: The credit for this really has to go to my publisher. When I sent the first draft of my first chapter to my publisher and he came back saying, this is great but by the third sentence you lost me. If you want to write a book that only perhaps a few thousand people in the world can understand, then that’s fine, we are prepared to do that. Obviously, there is kind of an equation that publishers use to do with size of audience, cost of book, length of book, publication costs and there are all these things kind of get factored in together. So at one extreme you would have a highly specialized option pricing book that might sell, in a good day, a thousand copies over its whole lifetime.
That will cost you over three figures to buy. At the other end you might have Investing for Dummies, which is probably going to be ten dollars and could well sell hundreds of thousands or even millions of copies. So he said you have to think about where in the spectrum you want to pitch your book.
I very much felt that I wanted to speak to as large an audience as possible. Then the publisher came back again and said you are going to struggle I think to bring your ideas down to the level where anyone on the street could understand them. Let’s try and pitch it somewhere in the middle and that’s where I tried to do it.
I’m not sure how successful I’ve been because there is a couple of reviews in Amazon.com. One says, “This is the first book you should buy when you’re thinking about systematic trading.” Another one says, “You should probably read at least ten other books before opening this one.” Opinion differs as to whether it’s as straightforward as you say. I certainly did try to make it as accessible as I could and incorporate maths only when I felt it was absolutely necessary.
Niels: I think you did a great job. By the way, having also put myself into the public light with this podcast, comments and opinions and reviews, they are what they are and completely uncontrollable and whatever people have in their mind when they wrote them, that is how it comes out. I would focus on the good ones. Even though you could have a hundred good ones and one bad one, it’s the one bad one you focus on isn’t it?
Rob: Well that’s true, but in fairness both of those reviews were good reviews. It’s just that they disagreed about how accessible the book was. I am going to just take those as a sampling error issue and assume that on average I’m in the middle which is something that I’m comfortable with.
Niels: Yeah, it’s a great book, absolutely. Now, I want to start sort of digging into the book a little bit and in the beginning you start out by defining three types of investors, namely the Asset Allocating Investor, the Semi-Automatic Trader and the Staunch Systems Trader. I want you to tell me a little bit about each of them and why it’s important to define them. But I just want to be completely open here and say I actually, I’m not English by background, so I didn’t know what the word staunch meant and so I looked it up. There may be other people on the show today listening and who have no idea. So it comes out as saying “very loyal and committed in attitude.” It has all these things so now at least I learned something new very early on in the book which is what staunch means that you are very committed to your strategies. Anyway, that was a digression here. Let’s go back and you explain a little bit about the three types of investors as you see them.
'I believe that if you have a good position managing framework in place, then how good your Systematic Trading rules are, become much less important.'
Rob: Okay so, again in the interest of making the book more accessible I didn’t want the book to be read about people who just purely wanted to do what was normally thought of as systematic trading. In other words, you have some rules that look at normally technical price patterns, and then in a completely quantitative way decide what positions you should have as a result of looking at those prices and then make the trades, often, automatically. So that is what a Staunch Systems Trader is.
It is someone that has an end to end process with trading rules at the beginning that are completely systematic, and then a position management framework that translates those into positions and trades and does all the risk management which again which is completely systematic. Then the trading at the end can be automated but the point is that you follow those trades religiously and you never deviate from them. It’s a system that could be completely automated.
Now that is quite a narrow set of people and not everyone is in a setup where, or a kind of place themselves, where they're comfortable with that. And it depends on whether you’re comfortable with the idea that a relatively simple, hopefully, set of trading rules can actually predict what will happen to prices in the financial markets. Not everyone signs up for that. I kind of identified two other groups of people who are out there.
The first group are people who think that humans are better than computers at predicting price movements. To be more specific, they think that they personally are better at predicting price movements than simple rules are. This is what I described as the Semi-Automatic Trader.
The idea behind the Semi-Automatic Trader is someone who still wants the freedom to say, I think that Apple is a good buy, but I should be short Google. But who then wants to take that opinion and put into a systematic position management framework; that will then decide how big their position should be, what size their stops should be, when they should open positions, when they should close positions, how many positions they should have open, how to manage holistically the risk of that.
I believe that if you have a good position managing framework in place then how good your ability to forecast or how good your systematic trading rules are, if you’re the first kind of investor, is much less important. To the extent that you can actually run the simulations with completely random entries.
You basically simulate a trader who is no better than flipping a coin. If you then think that into a position management risk framework, and set up correctly, that guy will still make money. That’s partly because in the past we’ve seen trends in markets and if you’re setting up a system where you’ve got fixed stop losses then they will naturally tend to pick up on trends. It’s still an interesting finding. If you then add in trading rules that do a good job of predicting where the market is going to go that does outperformance your system but not as much as you might expect. And so that is the second kind of person.
Now the third kind of person, is a very miserable cynical kind of person who thinks that no one can predict what will happen to prices in financial markets. I call them the Asset Allocating Investor because of a kind of long term buy and hold mentality. They often say you can’t pick stocks. The best portfolio is to buy a selection of ETFs that give you exposure to different asset classes. Then you basically say, “you know what, I’ve got no idea what these things are going to do I’m just going to buy all of them.” So that’s that perfectly valid point of view. I’ve run part of my own portfolio on that basis.
Then again, I still think there is value in using a position management framework to say well that’s fine but how should you account for the different risks of the different assets you are buying, how should you account for the correlations? How should you trade that portfolio, how should you rebalance that portfolio given you’ve got a set of costs? So the challenge for me was to create what I call the framework which is the sort of thing in the middle, between either a trading rule, or a qualitative opinion, or a stubborn buy and hold mentality. That takes all of those opinions and kind of processes them the same way and produces sort of positions. That’s what I’ve tried to do.