A recent article in BusinessWeek highlights my fascination with randomness and my frustration with how to harness it for my own trading strategy.
Written by randomfool on January 23rd, 2007 with
1 comment.
Read more articles on General Folly and Randomness and Books and Business.
I am fascinated with, and torn by, two interesting ideas that I have trouble reconciling sometimes. The first is the idea that there are explanations for certain outcomes that are seemingly hidden right in front of our eyes, an example of which is the on-base percentage statistic in baseball as described by Michael Lewis in one of my favorite books of all times, Moneyball. The other is the idea, described brilliantly in Fooled by Randomness by Nassim Nicholas Taleb, that our brains are programmed to look at historical events and find patterns in what is really random data.
I found myself struggling with this tension while reading a recent article in BusinessWeek about Barclay’s Global Investors, a money management firm. Barclay’s has hired a world-class collection of very, very smart people who look for “signals” in markets that describe investment strategies that can generate alpha, or the amount of return in excess of the beta which is the market rate of return (or the return that you would get by just investing in an index fund tracking the entire stock market). Barclay’s attempts to use this alpha-hunting strategy to “consistently beat the markets”.
One example is a signal identified by Richard Sloan, a Wharton business professor. Sloan discovered the accrual anomaly which, in very simplistic terms, exists because stock market valuations have not historically distinguished between non-cash earnings (earnings that result from accruals) and cash earnings. And, companies with cash earnings tend to be stronger companies and perform better than companies that depend on non-cash earnings. The result, if you were to have invested in companies with strong cash earnings, is an alpha (or return above the market return) of an eye-popping 12% or more!
It’s hard not to read an article like this and run out and move all of your investments into funds controlled by super-smart people like this. However, there are plenty of examples of super-smart people who blow up in the stock market. The classic example is the story of Long-Term Capital Management described in another great business book, When Genius Failed. LTCM, a hedge fund, thought they had found a signal that nobody else had recognized and they had two Nobel laureates involved in the company with massive amounts of data that pointed to the success of the strategy. They leveraged themselves way beyond anything that is reasonable and, of course, the event that their models showed was so unlikely to happen as to be practically impossible did, in fact, happen. LTCM was obliterated with almost $5 billion in losses because they failed to account for skewness (a win-loss record does not matter if a single loss has the ability to lose far more than an infinite number of wins) and almost took down the entire banking system with it but for an unprecedented intervention from the Federal Reserve. The BusinessWeek article actually mentions the LTCM problem and Fooled by Randomness discusses it also.
It’s not surprising that Barclay’s does well in times of relatively rational markets and tanks when irrational markets prevail (e.g., the dot-com nonsense). The title of the BusinessWeek article is “Outsmarking the Market”, but is it really possible to do that? There seems to be so many factors that go into how the market reacts to things that even a strong signal like the accrual anomaly may not work again like the data suggested it did before. That is the limitation of historical data and the risk of the black swan. The problem that I have is that the tension between these two ideas has had me in cash for most of the recent run-up in the stock market and I am desperate for an investment strategy that takes all of this into account.
Written by randomfool on January 23rd, 2007 with
1 comment.
Read more articles on General Folly and Randomness and Books and Business.
Read the comments left by other users below, or:
If you want to leave your comment on this article, simply fill out the next form:
You have to be identified to write a comment.
#1. January 26th, 2007, at 12:52 PM.
Although I loved Moneyball, I can’t quite say I got anything from Fooled by Randomness. First of all I was really turned off by his cockiness. He is extremely pretentious in not only his writing, but in how he describes his trading style. Second of all, I did not learn anything new. Yes, I understand that the stock market is random and traders and active money managers typically falsely believe their ability to beat the market. When they do beat the market, its skill, when they dont its the markets fault. I think that is pretty well known - sorry to you out there who invest in mutual funds and are unaware of this.
I work for a start up 130-30 quant hedge fund, and as so, I was hoping there would be an argument pro or against quant investing in discovering an underlying order to the madness of the markets. I don’t recall him addressing the issue too overtly, or taking one side or the other. Yes he alluded to LTCM’s bust, but didn’t really expound on his opinion of quant investing as a whole.
All in all, the author bragged about his ability to stay conservative and not get caught up in the randomness of the stock market. But his pretentious writing style and lack of info made the book boring and uninformative. Don’t know how people saw this book as revolutionary.