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