Traders and investors have made and lost some of the world’s most significant pools of wealth. It’s no coincidence that many of the wealthiest individuals in the world today (and through history) have been successful investors. Names like Warren Buffet, George Soros, John Paulson, David Einhorn, Bill Gross and Sir John Templeton have become synonymous with strategies that have created astonishing success, in many case creating a groundswell of books and analysts who study their lives with a toothcomb to understand “what” the magic formula was…
Even outside these heavyweights of the trading world, hundreds of thousands of individuals around the world attest to have ‘the best‘ strategy to generate consistent positive returns (in fact, Google alone reveals over 10.4 million results when searching for best trading strategies). At a macro-level, the long-standing efficient market hypothesis would make it notionally impossible for any trading strategy to be effective (as it asserts a level of information efficiency in the market). The past quarter century however, has seen a gradual move away from the efficient hypothesis to greater considerations of information asymmetry and behavioral biases driving inefficiencies (opportunities) in the market. So faced with this complexity, how do some traders generate such astonishing success?
To learn more, I spoke with Jack Schwager who is perhaps best known for his “Market Wizards” book series in which he has interviewed a cross section of the most successful traders and investors in the world. In May 2012 Jack released the latest book in this best-selling series, “Hedge Fund Market Wizards” (a behind-the-scenes look at the world of hedge funds, from fifteen traders who’ve consistently beaten the markets).
Jack Schwager is a recognized industry expert in futures and hedge funds and the author of a number of widely acclaimed financial books. He is currently the co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. He is also an advisor to Marketopper, an India-based quantitative trading firm, supervising a major project that will adapt their trading technology to trade a global futures portfolio. Previously, Mr. Schwager was a partner in the Fortune Group, a London-based hedge fund advisory firm, which specialized in creating customized hedge fund portfolios for institutional clients. His previous experience includes 22 years as Director of Futures research for some of Wall Street’s leading firms and ten years as the co-principal of a CTA.
Mr. Schwager has written extensively on the futures industry and great traders in all financial markets. He is perhaps best known for his best-selling series of interviews with the greatest hedge fund managers of the last two decades: Market Wizards (1989), The New Market Wizards, (1992), Stock Market Wizards (2001), and Hedge Fund Market Wizards (2012). Mr Schwager’s first book, A Complete Guide to the Futures Markets (1984) is considered to be one of the classic reference works in the field. He later revised and expanded this original work into the three-volume series, Schwager on Futures, consisting of “Fundamental Analysis” (1995), “Technical Analysis” (1996), and “Managed Trading” (1996). He is also the author of Getting Started in Technical Analysis (1999), part of John Wiley’s popular “Getting Started” series.
Q: Is there a strategy or style which is most effective at generating return?
[Jack Schwager] The diversity of strategies people use is truly remarkable, I saw people using completely different strategies to the degree that if I had set out to invent 15 different strategies for a fictional work…. I couldn’t have made the strategies more different to the ones I saw in real life! This illustrates a point I have made in all my works insofar as there really is no ‘holy grail‘ or single style that is most effective. Those people looking for a single unified strategy are not asking the right question.
It’s a matter of finding an approach that works for the individual. A person has to know whether they are comfortable with fundamental or technical, long term or short term, certain types of markets, wider risk or less risk… You can go through a whole checklist of things and find it’s different for each individual.
Even when looking at differences between asset classes we see that every market can be traded using different strategies be they fundamental, technical, or a mixture. If we take equity markets we see that traders can use strategies including fundamental, value, extreme long term, and day. If you want a microcosm that proves diversity, there it is!
It’s important to also look at the importance of doing nothing. The inspiration for this comes from something Debussy once said, “…music is the space between the notes.”
This is a great analogy as the key to successful trading really is the space between trades! It’s not just a matter of making the right trades… but also not doing anything when things aren’t right. I use one specific example in my book which I think highlights this really well, and that is a fellow called Kevin Daley (manager of the Five Corners Fund). Kevin has a hedge fund, but not in the conventional sense… It’s an account he runs from his home. If anyone wants to invest that’s fine, but fundamentally it’s a one man operation that he has never really looked to expand. He’s essentially different from many other traders by being someone who is very close to only trading long equity positions. He does go short on occasion, but these positions are contained to well under 10%. What I found particularly interesting about his track record is that over 12 years, he has a cumulative return in excess of 800%. The really interesting point is that over the same period the S&P had a return of 0%! How did he make over 800% as a near long-only when the index is flat? There are two elements… Firstly, he is a very good stock picker. The more important reason is that during the big bear markets like 2000-2 and 2008… while he may be down, he’s only down single digits. When opportunities are not good, he simply does not invest! or does so very lightly. Instead of losing money, he treads water.
Q: What are the distinctions between trades that are “Winning or Losing” vs. “Good or Bad?”
[Jack Schwager] If you asked most people to categorize good trades and bad trades, you would find the answers to be quite simple… If it makes money it’s a good trade, and if it loses money, it’s a bad trade. That’s not true at all…
Any approach will give you instances of winning or losing. If you have an effective approach, you will hopefully make more money than you lose. If you take a trade that follows your process exactly (whatever that process may be… fundamental, technical or otherwise), and if that trade loses money, that was not a bad trade. It’s only a bad trade if you deviate from your process and lose money. I would go further and say that if you deviate from your process and make money, it’s still a bad trade. People have to differentiate between trades that are consistent with a winning strategy, and trades that are inconsistent. That’s the mark of good and bad trades. There’s a very simple test to see whether something was a good or bad trade. You have to ask the question: “If I was faced with the exact same information and circumstances again, would I still make the same trade?“. If the answer is yes, then it was not a bad trade. If the answer is no, that means you did something that was wrong- and it’s a bad trade.
Q: What is the role of making mistakes in developing success as a trader?
[Jack Schwager] Ray Dalio worships at the altar of mistakes. The way he’s built his firm… everything they do… everything he’s ever done.. is based on the premise that everyone makes mistakes and you have to learn from them and improve the process. That’s how you get better!
It’s also important to make the distinction between performance and skill. There’s an old adage which states, “don’t confuse a bull market with brilliance.“. Too often, people fail to differentiate wins that come from the market and wins that come from skill. That’s why so many beginners get beguiled into thinking they know what they’re doing because they may start life in a bull market, and no matter what they’re doing they make money. They may think they’re smart, but it’s really just the market.
Q: What is the relationship between risk and volatility?
[Jack Schwager] This is one of the big misconceptions that permeates academia and the professional world. Somewhere along the line, risk and volatility have become synonymous. I suspect this is because the measure of volatility- the standard deviation- has nice mathematical properties that allow portfolio managers and financial academics to neatly define precise ways of allocating that seem comfortable. It is these neat properties that have made volatility the ‘plug in‘ for risk.
More money has been lost on the mis-measurement of risk than not having risk management at all. The battle is not won through being attuned to risk control. If your measurement of risk is completely wrong, it could be worse than having nothing in place. Imagine you have an odometer in a car that you thought was working correctly but was, in fact, giving you speed readings 30mph too low… that would be a lot worse than if it was stuck and you knew it was broken. If you knew it was broken, you’d be careful… otherwise you’re speeding along thinking you’re traveling a safe speed.
People find track-records of managers that have low volatility and make the conclusion that low volatility means low risk. Low volatility may indicate low risk, but it does not make that a certainty. There are many instances where low volatility was evidence of high risk. There are many strategies that make moderate money most of the time, giving low volatility track records. Once in a while, these strategies are prone to huge losses. They are highly left-skewed. A lot of the hedge fund world is engaged in strategies that have this property. They make money most of the time, but once in a while can lose a lot. These are strategies which are explicitly or implicitly short volatility and are long illiquidity and short credit.
Imagine you have to walk through a field that has a few land mines scattered through it. If you walk through it and nothing happens, it seems there is no danger. If you walk across it enough times, you’ll step on a landmine. Traditional risk management simply fails to account for the fact that the most dangerous risks are those which occur infrequently and don’t show up in track-records.
Q: Do successful traders share any behavioral or personality characteristics?
[Jack Schwager] I can assure you that the personalities of traders are extraordinarily diverse. You meet people who are painfully shy, overly extroverted, egocentric, academic, athletic and more. If you put the most successful traders up together, you wouldn’t find any common personality denominators.
There are however, some successful traits. People who are successful traders will have the ability to quickly admit that they’re wrong. Regardless of their personality, they will have flexibility. The worst traders in the world are those who are politically committed one way or another and don’t listen to anything else. This is really critical to trading success and a trait which has been shared by virtually every trader I’ve met.
Discipline is also important. People who are successful will do things because they have to be done. If they go on vacation, they will probably check-in… getting up in the middle of the night often. They will do things which may be uncomfortable and contrary to living a ‘happy‘ or ‘good‘ life.
Q: Have success methodologies changed much in the last 25 years?
[Jack Schwager] I once asked Ed Seykota if markets were different ‘back then‘ looking at the world 20 years ago. He told me markets are the same now as they were, they’re always changing. Markets are always different and part of the process is adapting and maintaining traits that allow you to win in any environment.
The past 25 years have seen an increase in the diversity of strategies. Going back to the beginning of this period, a lot of complex strategies we use now simply didn’t exist. There wasn’t credit arbitrage, structured products and more. Alongside this, computers have become more important meaning that simple algorithmic strategies such as trend-following don’t work as well now. As the market moved from having very few managers of scale to having a lot of single managers running $10-20 billion, you saw an environment that changed from having a few big fish and a lot of small ones to having a huge amount of big fish in the pond.
Q: How has the financial crisis impacted trading strategies?
[Jack Schwager] I don’t think it has changed things much at all.
It’s a bit like a drunk who gets into an accident and says, “I’m never going to drink and drive anymore!” He may stick to it for a while but a few years later thinks, “Gee, It’s been a while since I’ve had an accident, things must be OK… maybe I can start drinking again!”
People are going back to the same old strategies again….
What does this mean for Investors?
Jack has shown us that markets are complex and constantly evolving entities. The true measure of skill is developing a strategy that works around your own skill and information, considers the real (left-tail) risks in the marketplace, and is run with a spirit of responsiveness.
We are faced with the reality that many of our attitudes towards trading are built on antiquated precepts. Half a century ago, when markets were simpler (and slower) there is no doubt that a few successful strategies could be applied repeatedly to generate success. Now however, things are very different. Some exchanges (such as CME group) are handling over a quadrillion dollars of trade every year. The value of turnover of the Forex market alone exceeds global GDP every 15-20 days. Markets this large will require new attitudes to risk, and new methods of generating value.
As former US Treasury Secretary Lawrence Summers once said, “…global capital markets pose the same kinds of problems that jet planes do. They are faster, more comfortable, and they get you where you are going better. But the crashes are much more spectacular….”