CategoryBook review

I recently came across a book – How we decide ? This is a book about decision making and how humans make decisions under various circumstances. Although this book is not on some best seller list or by a very well known author, I found the book good and learned quite a bit from it.

Let me list some of my key learning’s from the book

– The rational brain – prefrontal cortex is involved in rational decision making and can evaluate only a limited number of variables and data elements at a time. However our emotional brain, the amygdala and other parts are the hidden supercomputers of the brain. They are able to process more pieces of information and can do so much faster. The reason is evolution. When facing an immediate danger, such as a tiger, the emotional brain had to process the information quickly and cause a fight or flight response. There was no time to sit and think in such a situation.
– The standard model of decision-making has been the rationality based model. Emotions are considered bad for decision making and corrupt our thinking process. That however is not true. Emotions can and do lead us astray, but they are crucial to decision making. The emotional brain and the rational brain are constantly communicating with each other and help us in arriving at our decisions.
– The decision process is a not a smooth process involving the rational brain alone. It is actually an argument where the emotional brain and rational brain go back and forth and based on the situation a final decision is reached.
– The learning process of the brain has a big emotional component. The dopamine system is involved in this process. Whenever we commit a mistake, the dopamine levels drop in the brain and we ‘feel’ bad about it. The emotional centers of the brain encode this memory and use it for later decision making.
– Emotions mislead us several situations. For example, the normal response to price drops in the market is fear and panic. The typical response of most of the investors is to exit the market to avoid the pain and fear. However this is often an incorrect response. A rational and calm response would be to look at the individual stocks and evaluate the expected value at the given price. A decision should then been taken based on this number, than based on emotions.

Some key learning’s for investors (my conclusions)

– Stock market investing is all about decision making under uncertainty. As investors, we can never have complete and full information. Perfect information is a myth. No one can ever know all there is to know about a company, much less an industry or the market.
– A perfectly rational investor is an incorrect model. The above book and several other books I have been reading, point out that the best investors are able to combine rational thinking with their emotions.
– Emotions are formed based on repeated experiences in a particular field. These emotions are referred to by several terms – intuition, gut feel etc. As one develops experience, the learning’s are encoded in the brain as emotions or intuitions. However one should not rely on emotions when starting out as an investor. At that time, one does not have enough experience and the emotions have not developed fully. However as one gains experience, one should learn to trust one’s instincts or at least be mindful of them.

I have personally faced this several times. When analyzing a company, all the numbers will look fine and the company looks undervalued. However some stray facts or a few points will keep troubling me. In most of the instance, where I have ignored such feelings, I have regretted later.

– Smart investing is a mix of rational thinking combined with emotional learning. As one matures as an investor, one should learn to tune in to emotions and gut feel and try to at least understand what they are telling us. You will rarely see investors talk about gut feel or emotions. They are considered too soft or not macho enough!. That is however foolish. The human brain does not work that way. Decision making is a mix of rational thought and emotions. Ignoring emotions means using only a limited power of your brain.
– Novel problems require thinking and should not be based on emotions. When analyzing a new company or business model, do not rely on emotions alone. One should think rationally and assemble all facts before making a decision.
– Embrace uncertainty – It is amazing the level of confidence most people have on their investment. Analysts writing about a company, will provide you projections for the next 3-5 years. Sometimes these projections are not even round numbers (like sales would 1244 crs in FY2010). What crap !. Nothing is absolutely certain in the stock market. There are only varying levels of certainty. To simplify it, I look at low (20-30% probability), medium (around 50%) or high level of probability (around 70-80%) for any specific scenario. In addition, I always believe in developing multiple scenarios when trying to come up with an intrinsic value number. As a result you would have noticed that my estimates are generally in a range and not a fixed number
– Entertain competing hypothesis – One should always be open to counter arguments to one’s investment idea. That allows one to accept contradictory information and weigh it properly. I try to constantly look for points, which go against my investment idea though i am not sure how successful I am at it.
– Finally think about thinking. One should constantly analyze one’s decision making and thinking process. You should be able to look at your thought process objectively and look at ways of improving it ( read this process v/s outcome article by Michael J. Mauboussin ). This blog is my approach of doing it, though in a public fashion. In addition, I always write down my investment thesis when I am looking at an idea and also how I feel about it (though I don’t publish it as they are my private thoughts).

I would strongly recommend you to read this book. It is a very good book and has several crucial points on how the human mind works and how one can improve his or her decision making.

I have just finished this book. I wrote about this book earlier here. I have also read N N Taleb’s earlier book – fooled by randomness and liked it a lot.

I will not be doing a detailed review of the book as that can be found on amazon and a lot of other website. I will however highlight some of the points, which struck me as important and how they impact me as an investor.

One of the key points, which the author makes, is about the complexity of the real world and lack of predictability. For ex: No one predicted the rise and the importance of the internet. The Internet has become one of the major forces shaping our world. It can be termed as a positive black swan. As a result all complex systems such as the economy, financial markets, which get impacted by such black swans, cannot be predicted. But that does not stop analysts and all the talking heads on TV from making predictions (predictions for 2008 etc etc)

Now one can argue that some prediction do come through. Well, you don’t have to be a guru for that. Just take some events, toss a coin and make a prediction based on the toss. You will be right 50% of the time. Analysts and TV gurus are worse than that in terms of their success rate. There are numerous studies supporting it, so you don’t have to take my word for it. Try this on your own – write down some predictions you hear this year and check back a year later.

Why are we suckers for this? because we want to resolve uncertainity and anyone who can or claims to provide visibility to the future is sought out (we do have astrologers !) . The author terms this as the narrative fallacy.

Personally, I stopped looking at predictions, analyst estimates, top picks/ hot picks etc etc long time back. If I want to be entertained I would rather watch a movie or a cricket match!

A logical question is how to invest if you do not predict. Does developing a DCF not amount to forecasting a company’s cash flow? Well it does. The difference is between a macro and a micro forecast. Forecasting a company’s cash flow is much easier than forecasting the direction of the stock market. If you know the company well, it is in your circle of competence, and you can figure out the few key variables driving the cash flow of the company then it is possible to arrive at a reasonable estimate. Will it be accurate? I don’t think so. However if you are conservative in your assumptions (don’t assume 50% growth rates) then the impact of the negative surprises would be minimal. I would not worry about positive errors (cash flow more than forecast) as I will gain from it. In addition, if you buy at a discount to the estimate of the intrinsic value (margin of safety concept), then you are protected further from errors in the forecast.

Compare this approach with macro, top down forecast. If some one says – infrastructure stocks will do well because infrastructure spending is to increase by 50%. In addition to all the stock specific factors, you thesis is also dependent on the increase in the spending which in turn depends on multiple factors. The more variables in the investment idea, the more there is a chance of something going wrong. In addition, you will also pay more for such an optimistic scenario. So if the macro forecast or something else with the company goes wrong, the losses can be severe.

I am currently reading the book – The Black swan by N N Taleb. This is a great book on low probability, high impact events which are termed as black swans.

I am still in the middle of this book. One key point which I came across is ‘confirmation bias’ on which the author has devoted a complete chapter.

The basic idea behind confirmation bias is that once we make a decision, we tend to look for evidence to confirm it. As a result we tend to ignore any negative information which could refute our decision. As a corollary to this concept, any additional information is of no use as it would only re-inforce the decision and not add any more value to the decision making process.

Like others, I am equally susceptible to this bias. My approach to reduce its impact is to write a single page thesis on an investment idea and sometimes post it on my blog. I try to gather negative information and also prefer to get negative feedback on my idea. That helps me in wieghing all negative information and arrive at a better decision (hopefully).

I am not sure if I have been entirely successfull in it, but I have rejected a few ideas after selecting them, once I was pointed out some key information (which I had missed out). In a few other cases, the negative information, which I had missed earlier resulted in reducing my estimate of intrinsic value for the stock – for ex: I missed the impact of liabilities in the case of VST. As a result I ended up taking a smaller position

Final post on my notes with my comments in italics

Earlier posts on the same book here,here, here and here

The thirteenth chapter discusses how robust systems can be developed. Systems which work in varying market situations are robust. The author gives an example from biological systems. He refers to the concept of simplicity and diversity. Simpler organisms are most resilient than complex ones which are adapted to specific environments. Also nature develops diverse organisms so that the ecosystem is shielded from the effects of a radical change in the environment. So systems or approaches built on these two concepts are more robust.

An investor following a simple and diverse approach will be more successful than others. For example, a value investor (simple approach) following a graham style approach, aribtrage and DCF based approach (diversity) can be fairly successful in varying market circumstances.

The fourteenth chapter discusses about the role of ego in investing. The simple rules discussed in the book are effective and profitable. However these simple rules do not feed the ego. When beginning traders use descretionary trading and use their own judgement, any win feeds the ego and feels good. You can now brag to your friends on how smart you are. The author mentions that this behavior is prevalent on online trading forums.

The same is applicable for value investors too. Value investing is a very effective and simple approach. However very few have the discipline to follow it consistently.

The author makes a very valid point for traders (and investors) that one should not wrap his ego around every trading win or loss. A failed trade or investment does not mean that you are an idiot or that a winning trade or investment does not mean that you are a genius. One should view failure and success in the market in the right perspective and not take it too personally (although it is easier said than done)

The last chapter discusses the Turtle trading rules in detail. It is however difficult for me to discuss them in detail here.

I received the following comment from senthil. He pointed out to a negative review on the book (see link in the comment) – Way of the turtle on which I have been posting for the past few days.

I found some review comments to be valid. However at the same time the reviewer has choosen to highlight only the negatives and not comment on the positives of the book. I think most of the books have a mix of both. I would say good books are the ones where the positives outwiegh the negatives. Ofcourse there are books which take a germ of an idea and use 250 pages to beat it to death. On the other hand there are very few books or classics which are worth reading multiple times. ‘Security analysis’ and ‘The intelligent investor’ by Benjamin graham, Common stock and uncommon profits by Phil fisher are a few which come to my mind.

The book (inspite of the title) is not a ‘how to’ book for trading. If, like me, you do not know much about trading, this book will at best give you a basic feel of what trading is all about. I have had a mental block against trading. The block was more on the lines that it is impossible to make money via trading. I am more inclined now to believe otherwise. I am more open to the idea that traders can and do make money. Does that mean that I am interested in trading? No .. I am not. I find long term buy and hold and other forms of value investing more appealing and easier to make money. I do not have the stomach to bear a drop of 40% in my portfolio.

I am planning to read a good book on real estate investing sometime next year to see what it is all about. Better to understand various forms of investing and then reject the ones which do not fit with my temprament than to have a closed mind against it.

Other books I am reading (not related to investing)

The four hour workweek – Interesting book and quite a few good ideas by the author, but goes overboard a lot of times.
Einstein: His Life and Universe – I seen a lot of good reviews on the book and wanted to read about Einstein. Also I think charlie munger has recommended this book (not sure though)

My notes on the previous chapters of the book here, here and here.

The ninth chapter discusses about the building blocks of trading such as breakouts, moving averages, volatility channels, time based exits and simple look backs in detail. The next chapter follows with a detailed discussion on various systems such as the ATR channel breakout, Bollinger breakout and Donchian trend etc. This chapter also gives the performance data for all these systems based on the historical data. For ex: donchian trend has a 10 year return of 30% p.a with a max drawdown of 38.7%.

The important point in this chapter is the author’s emphasis on backtesting. Backtesting means that every system should be evaluated with respect historical data for returns and maximum drawdown. Backtesting may not help predict the future or ensure that the system will always work, but it would help to determine which system could be profitable in the future and what conditions are needed for the success of the system.

My comment: The same approach should be applied by investors too. For ex: value investing has almost a 50 year history of performance over varying periods and business conditions. So this approach to investing has proven its ‘fitness’ over a long period of time and in varying conditions. I would say that any other approach such as momentum investing should also be evaluated in a similar manner.

The next chapter discusses in detail the pitfalls of backtesting. The key reasons why the historical test results differ from actual trading are as follows
– trader effects : As more traders use the system, the effectiveness of the system is lost
– Random effects
– Overoptimization paradox:
– Curve fitting: Fitting the system to data

The chapter then discusses how these distortions can be resolved and backtesting results improved.

The next chapter discusses how one can get better results from backtesting. One approach is by using better measures such as RAR (regressed annual return), R-cubed and a robust sharpe ratio. In addition a representative sample and appropriate sample size can help to get better results. The author also discusses about monte-carlo simulations to analyse the various systems based on historical data.

The sixth chapter discussed various trading concepts such as support and resistance. These concepts are discussed in detail in this chapter with examples.

The seventh chapter is crucial to help answer the question: How can you know if a system or a manager is a good one. I would suggest reading this chapter in detail and understanding it and applying it when selecting or evaluating a trading system. A lot of trading systems refer only to the returns and choose to ignore risk. The chapter refers to four types of risk.

Drawdown – String of losses than can reduce capital in the trading account. It is the maximum loss the trader / manager or trading strategy incurred at any point of time.

Low returns – period of small gain where the trader cannot make enough money to make a living

Price shock – sudden price change which can wipe out a trader

System death – Change in market dynamics that causes a previously profitable system to start losing money.

The chapter discusses each type of risk in detail with examples for various trading systems. I was amazed with level of volatility which a lot the trading systems show. For example the author refers to trading systems which can generate returns of almost 35%+, but incur drawdowns of 40-45%. So there would be times when your capital would drop by 40%.

How many of us have the nerve to withstand this kind of losses?. So the next time around if some one recommends a trading strategy with high returns,ask about the drawdown. If the other guy cannot tell you the drawdown of his strategy, run (he does not know about trading or is trying to fool you). If he does give you a number, try to figure if you can tolerate that level of risk. The book also indicates that the higher the level of return, higher is the volatility and higher the drawdown. So if one is a beginner, try for a system which has a lower return and lower drawdown.

The next chapter revisits risk and money management again. The author again cautions the reader from underestimating risk and blindly accepting the claims of vendors or money managers. Curtis’s advise is to go for returns at which the risk is manageable and let compounding do its magic. No point in trying for 100% to 200% returns and then blowing up (losing all the money).

The author makes a very important point in this chapter. He says that trading is simple, but not easy. He gives the example of people like dentist or doctors who are smart and under the assumption that if they are smart and successful in their profession then they should be good at trading too. The reality is that these folks are not good traders.

I find this comment interesting. I have seen this all around me. A lot of people I meet are smart and very good at their jobs. They automatically assume that they will be good at investing. Intelligence may be a necessary but not a sufficient ingredient for success at investing. It is surprising that most professionals think that they can put 1-2 hours a week into investing and be a great investor. By that analogy, all of us should be good doctors and architects too. Anyone can be a good or great investor, but like most other pursuits in life, one has to work at it.

Coming back, the author also says that most new traders underestimate the pain of a drawdown. They believe that they can live through a 50-60% drawdown, but when it hits them, they may stop trading completely or change methods at the worst possible time. I have faced a drop of almost 25% early in my life as an investor and even that was painful. When you are starting off and face this kind of drop, it is easy to question the process.

Posts on previous chapters here and here

I have been reading the book – Way of the turtle for the past few days and have found it to be a good book. It is a book on trading. I posted my notes on the first two chapters earlier.

Notes on 3rd, 4th and 5th chapters follow –

The third chapter refers to the risk of ruin. This is risk a trader faces that several of his trades will go against him and he could lose his entire capital. The way to manage this risk is via Money management. This involves putting the position in small chunks called as units which are sized based on the type of the market, volatility measure of the market etc (please refer to the book for more details).

The third chapter refers to four key points

– Trade with an edge: Find a trading strategy which can produce positive returns over the long run as it has a positive expectation (see an earlier post on edge, kelly’s formulae etc here)
– Manage risk: Control risk via money management discussed earlier
– Be consistent: execute plan consistently to achieve the positive expectation of the system.
– Keep it simple

All the above points are equally valid for an investor as it is for a trader.

The fourth chapter focuses on thinking in the present and aviod thinking of the future. Successful traders do not attempt predict the future. They do not care about being right, only about making money. A key point is that good traders are also wrong a lot of times. However they do not beat themselves over it. They are focussed on sticking to a plan and trading well and not worrying about the success of each trade or do not look at each trade as a validation of their intelligence.

One of the biases namely recency baises can impact a trader severely, especially if he is on a losing streak. People have a tendency to overwiegh recent data. Recency bias results in a trader over wieghing recent performance, especially bad performance and the trader may end up abondoning a successful system. The way to avoid this bais is to focus on probabilities and to know that every system has a certain odd of failure (A certain number of trades will go wrong). However by focussing on the process than the outcome and being confident that the system works well in the long run, one can remain rational and continue with a successful system.

The fifth chapter discusses about the concept of edge in more detail. The chapter introduces various concepts such as MAE (maximum adverse excursion – loss over the time frame) and MFE (maximum favourable execursion – gain over a time frame). The E-ratio (edge) is ratio of MFE/MAE adjusted for volatility. This ratio can calculated for various duration such as 10 days, 50 days etc.

To find an edge, you need to locate entry points and exit points where there is greater than normal probability that the market will move in particular direction within the desired time frame. The various components that make an edge for a system comprises

– portfolio selection : alogrithms which markets are valid for trading on any specific day
– Entry signals : alogrithms that determine when to buy or sell to enter a trade
– Exit signal : alogrithms that determine when to buy or sell to exit a trade

I referred in my previous post about a book on trading – Way of the turtle which I have been reading for the past few days. Now why should a guy who displays a mental block against trading, read a book on the topic? The short answer is to challenge my own biases against trading.

I can definitely say that this is a good book and anyone wanting to learn about trading or wanting to evaluate a trading system (in a book or being sold by someone) should read this book. What follows over this and the next few posts is my own summary (not review) of the book with my own thoughts and comments (which I cannot resist putting 🙂 )

The book is written by curtis faith who was one of the turtles (traders) recruited by richard dennis and william eckhardt as a part of an experiment that trading can be taught. The author was one of the original recruits (and probably one of the most successful) who made more than 30 million for Richard.

The book describes the difference between an investor and a trader. An investor buys stocks, but is really buying an underlying business. A trader in contrast is concerned only about price and is essentially buying and selling risk. The second chapter of the books talks of the turtle mind, which I think is equally relevant for an investor.

As we all know that markets are populated by individuals who are driven by fear, greed and all other cognitive biases, which create opportunities for a trader. The book refers to various biases such as loss aversion – higher preference to avoid losses over gains, sunk cost effects – tendency to treat money that has already been committed as more valuable than money to be spent in the future, disposition effect – tendency to lock in gains and ride losses, outcome bias – tendency to judge a decision by the outcome than by the quality of the decision at the time it was made and several other biases such as recency biases, anchoring etc.

The second chapter describes each of these biases in detail and how it affects a trader. The chapter continues with various trading styles such as trend following, counter-trend trading, swing trading and day trading.

One the key points I realised from the initial chapter was that each of these trading styles are valid for specific types of market. Curtis refers to various markets such as stable and quiet, stable and volatile, trending and quiet and trending and volatile. For example, trend followers love markets that are trending and quiet where they can make more money than a volatile market which is more punishing to trend followers. In contrast counter-trend traders love markets that are stable and volatile.

Another key learning for me in the chapter – successful traders never try to predict the market direction. Instead they look for indications that a market is in a particular state and trade accordingly.

I will be posting the rest of my notes over the next few posts. You can find the author’s blog here.

I am planning to read the following books in the coming months

– Way of the turtle (great book on trading)
– EINSTEIN : His life and universe (biography)
– The dhando investor – reread (book by mohnish pabrai)
– Security analysis – reread ( value investor’s bible)
– Micheal porter’s – competitive advantage

update 9-Aug
– more than you know (on investing and mental models)
– Black swan – great book by nicholas taleb – a must read