View Full Version : The Zero-sum Nature of Investing?
That is to say, I think Junkman is spot on. (Well, except I disagree with him about the zero-sum nature of some investments.)
Bae,
I’d freely concede you the point but ask this in return. “What is the consequence of assuming one is true rather than another?”
To assume that all of investing is a less-than zero-sum game, as it most certainly is for futures markets, places on an investor the burden of “getting it right” on the merits of the evidence itself, right now, as opposed to having the fall-back of ”the market will bail me out of my mistakes.”
Is all of investing, especially stock investing where, perhaps, organic growth can be argued for, really a zero-sum game? Frankly, I don’t know, nor do I care. What I do care about is that every time I buy something, I could be wrong and lose money. A good deal of the time, I AM going to be wrong about the facts, my interpretation of them, the price I paid, my timing, whatever. Not just “mistakes of math or procedure, but WRONG! for having being too Greedy, too Fearful, too Despairing, or overly Hopeful.
At bottom, investing isn’t about the numbers. It’s about the irrational human being who uses his/her rational mind to support decisions already made by the emotions, as the recent work in Behavioral Finance abundantly supports. That’s why this emotions stuff is such a make-or-break issue. Over-timidity will destroy an investing account just as fast as over-confidence. “Balance, Daniel-san. Balance. Karate (or investing) is all about balance”, as Mr. Miyagi would say.
The essence of successful investing is the willingness, and the ability, to make decisions under conditions of uncertainty. You don’t get paid for playing it being safe. You get paid for accepting risk and for managing it properly. Every time your hand is on your mouse, ready to click your acceptance of the order you’ve just written, you could be making a mistake, or you could be making a shrewd decision. And the way you score yourself isn’t by how the trade turns out but by whether you saw at the time everything you should have seen.
Same-same with playing a card game like Euchre. Almost invariably, there is only one way each hand should be played. But often enough, you’ll lose the hand because the cards weren’t in your favor. When you go back and review the play of the hand, you’ll see why your strategy failed in this instance. But that doesn’t mean you change your strategy the next time you get the same hand. That’s total insanity, because that next time, had you stuck to your strategy, you would have been right.
What a good investor develops after a while is an acute sense of self-awareness and the discipline to bench oneself when you realize you’re screwing up. “Wait a minute”, you say. “I’m not thinking clearly. Therefore, I’m done for the day before I do myself some damage.”
How does one learn the needed discip0line to make good decisions under pressure? By making decisions under pressure, day after day, week after week, year after year, hundreds of them, thousands of them, until enough of the fear dies down, until the excitement fades away, and the process of evaluating information and then buying or backing away can be done without the interference of the “monkey chatter” of the mind or the emotions (as the Buddhists might phrase it).
Why can I be so definite about this stuff? Because I live and breathe it nearly 24/7, and because the money won (or lost) is so incidental to the larger game being played, achieving excellence for its own sake in the dojo that markets can be.
Charlie
I am, among other things, a mathematician. I am a student of game theory, especially as it applies to decision making under uncertainty. I think it is very important to understand the specific structure of the game you are playing as much as you can, which is why I quibbled with your use of the phrase "zero sum".
The type of game can influence your strategy significantly.
Bae,
It's interesting to me that that you use game-theory in your investing, which is exactly how I got into junk bonds. Market returns don't distribute normally, as anyone with ten minutes, access to a time-series such as the broad market, and a spreadsheet can demonstrate to himself. But, OTOH, study after study confirms that an unearned premium of about 2% attaches itself to spec-grade debt, and across a basket of such risks (structured synchronically or diachronically) the premium should be capturable. In practice, however, decent profits (not just the premium) depend on chopping left-hand tails and gaining as much exposure as possible to right-hand ones.
But at the level of buying, it really is a less than zero-sum game due to spreads, execution costs, dearth of info, etc. Why are the bonds being severely discounted? Because the issuer is in a huge amount of trouble. So the bet you're making is a very contrarian one about which you cannot be wrong too many times or you'll get yourself thrown out of the game, as in, a busted account.
Charlie
chanterelle
4-26-11, 4:48pm
Charlie, please clarify the meaning of left/right tail thing for me... thanks
If you have a probability distribution graph, the regions on the extreme left and right are known as "tails". In the following normal graph, some of the tail regions are colored. They represent areas of reduced probability of the event occurring.
http://20bits.com/wp-content/uploads/2008/11/two-tailed.gif
I believe Junkman is saying "chop off the extreme losses, while retaining the extreme gains". Which would rock, if you could reliably do so. :-)
chanterelle,
Talab, whose insights about markets I depend on (and those of Mandelbrot), can explain the matter far easily than me.
http://www.edge.org/3rd_culture/taleb08/taleb08_index.html
http://www.fooledbyrandomness.com/fortune.pdf
http://rs.resalliance.org/2008/09/17/financial-resilience-taleb-and-mandelbrot-reflect-on-crisis/
Etc.
For an investor in high-risk/ high-yield securities, chopping left-hand tails can be done by keeping positions small, and gaining exposure to right-hands tails can be done by buying as broadly as possible instead of using a cap-weighted index. Said another way, you want to avoid nasty surprises, but you do want to receive pleasant ones. That means that Modern Portfolio Theory gets thrown in the garbage can where it belongs, as does the improper use of statistics, and "open systems" (where the odds cannot be calculated) are embraced.
So what you end up doing is using a very loose version of game theory. Give me some time to do the write up, and I'll provide a real-world example of what I mean.
Charlie
I believe Junkman is saying "chop off the extreme losses, while retaining the extreme gains". Which would rock, if you could reliably do so. :-)
Bae,
It's SOP for any trend-following trader. "Cut losses quickly, let profits run."
chanterelle
4-26-11, 5:42pm
Thank you!! ... appreciate the input, I always enjoyed your posts on the other forum.
Talab, whose insights about markets I depend on (and those of Mandelbrot), can explain the matter far easily than me.
http://www.fooledbyrandomness.com/fortune.pdf
That is a super article!
Bae,
Us liberal arts graduates find the following paper tough going, but given your math training, you'll enjoy Taleb's, "Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance"
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1142785
Thank you!! ... appreciate the input, I always enjoyed your posts on the other forum.
chanterelle,
Thanks for your kind words.
Charlie
Bae,
Us liberal arts graduates find the following paper tough going, but given your math training, you'll enjoy Taleb's, "Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance"
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1142785
You devil, you just ate my afternoon! That paper is a wonderful observation on the problems with economists/investors misusing/misunderstanding statistics, and mistaking their own models for reality. It was well worth the time reading, and I thank you!
Bae,
Thank Nassim Taleb, not me. His ideas are anchors in the storms of nonsense that pass as financial wisdom.
Next on your reading list, if you have the interest, is Mandelbrot's, The (Mis)Behavior of Markets. A used copy from Amazon is a mere $6.24 (plus $3.99 shipping) and worth ten times that. Between the pair of them, Taleb and Mandelbrot, they provide a complete refutation to Modern Portfolio Theory and a way to understand markets and investing that emphasizes staying out of the troubles caused by mistaken epistemology and worse statistics.
http://www.amazon.com/Mis-behavior-Markets-Benoit-Mandelbrot/dp/0465043550
Glory be, Mandelbrot ... fractal hero, RIP. Does he actually try to draw his fractals theory into this, or is an entirely separate theory? I have always been fascinated by the ... patterns, the search for something beyond the random when looking at ... anything. Money included.
Here's a psyche question for the both of you (and anyone else): Do you consider yourself to be "on the tails" as people? This should probably be a separate thread, but how many variables would it take to bring you down from one in seven billion to (nearly) one-of-a-kind? I for example: a woman. - now I'm, conservatively, one in four billion. Over 45. One in two billion, maybe? Left handed. One in 200 million. Of Danish orign, one in ... and so on. Add some rather more unusual facts about me ... about fouror five more things and there may only be one or two people on earth who are "just" like me. So ... I always think of myself as on the tails, and as I read over the last few financial posts, I wonder if that affects how someone invests? Identifying as "a tail" (hmm ... that doesn't sound to good somehow, lol) I refuse to throw away the long shot and it usually means I lose. So ... I don't play.
flowerseverywhere
4-27-11, 7:19am
Wow. Loved the posted articles and KIB your post is fascinating too. really started the wheels turning. I like to learn something new every day and today I hit the jackpot. I had seen the Nova fractal show about Mandelbrot however now I have the Misbehavior of markets on hold at the library.
Kib,
If I'm understanding your question correctly, then the "correct" answer is that each one of us, every human being in the world, is "on the tail", because each of us is unique. By that, I mean this. Jake Bernstein argues that "We don't trade markets. We trade our beliefs about markets. Hence, we trade ourselves." Hence, we set our own limits as to what is possible. Whether that is profits or losses, we are the ones who create them, not markets.
Most people find that hard, if not impossible, to turn into action, nor do they want to accept the responsibility that insight requires. "What do you mean I won't get rich just because I show up at the door? How dare you say that? I'm middle-class, and the stock market owes me money for my retirement. You're robbing me of my birth-right."
Well, No, that's not how things work. For all the the advantages that the "insiders" and "the big boys" do have, even the humblest of us, with even the smallest of possible accounts, can pull money out of markets provided our plan is sound and we're willing to do the work and to take the risks it requires. In 1984, my total net-worth was $2,000 and no more possessions than fit in a VW. Yesterday, a very ordinary day in markets, I pulled out $1,688 dollars, or roughly a week's wages for one day's work. A truly elite trader will pull that much out on a single trade and could be done for the day, as he or she chose.
And before anyone attempts to dismiss such gains as only accruing to traders, there is no material difference between a trader, an investor, a speculator or a gambler. All are making bets about an unknowable future. If they have a sound plan and know what they are doing, they will win, on average and over the long haul. If not, they'll lose. Any one, absolutely any one, can create a winning plan. Whether they will is another matter and, in fact, most won't, because they will find every way they can to sabotage themselves. This is why investing isn't just about the numbers. It's much more about the emotions of Fear, Greed, Hope, and Despair. Alexander Elder, another trading coach, puts it this way: Money, Mind, Market. The trilogy has to be in synch. But most people don't want to do the head work. They just want to be told what to buy, and that's why and how they lose. They want to have something they don't deserve, because they haven't done the work it requires. They know that and punish themselves by losing.
As for Mandelbrot, I, too, am sorry he died so soon before his work was done. He does apply fractals to markets to describe their structure. Turning his insights in investing plans is another matter that is an going investigation. To date, as he points out in his book, little has come of it, but he was hopeful about the work.
I've requested two of Mr. Taleb's books from the library - the article was fascinating! I've always had an uneasiness about the stock market, one that I couldn't quite put my finger on, and the personal finance books I've read so far haven't done much to help that.
I've always had an uneasiness about the stock market, one that I couldn't quite put my finger on, and the personal finance books I've read so far haven't done much to help that.
Oceanic,
Taleb's books might increase your uneasiness. But they also might offer an explanation of why you feel/think as you do, which is entirely justified. The promise of easy, risk-free profits the personal finance books make, and the inevitable disappointments that would-be investors suffer, are a good reason to stay far away from both of them. There is nothing easy, obvious, or safe about investing. But it is doable, and it is learnable in exactly the same way a game of cards is doable and learnable. So the question each person has to ask her or himself: "Is this really what I want to do with my time, compared to all the other things in my life needing attention?"
I'm just a blue-collar kid who grew up in a blue-collar family. Dad worked for the local utility company. Mon stayed home to raise us four kids. Both of my parents grew during the Depression, so frugality came easily and naturally to them, as well as the importance of saving and investing. Like many of that generation, they were patriotic, and part of their patriotism found expression in stock-ownership. They had faith in the country of which they were a part, and they wanted to be part owners of the companies whose products and services they used. Even as small kids, us kids were encouraged to save and to invest and a birthday or Christmas present was often a share of stock.
When investing is presented that way, as simply an ordinary part of one's life, then buying a stock or a bond is no more scary than buying broccoli or bell peppers. If the price is high, you back away. If the price is low, you grab a bargain. That much is easy to understand. It's when people buy because someone tells them to buy that the problems begin. The decision wasn't their own and, typically, they didn't really understand what they were told, nor didn't want to hear the other half about what to do when things didn't work out as expected.
Traders have a saying, "Amateurs look first to profits; pros look first to losses", and that's where Taleb's books become valuable, for addressing the broader issue of identifying and managing risk, i.e., staying out of trouble in the first place. Markets (and there are many more markets than just the stock market) can be scary, but they don't have to be debilitating. The risks never go away, but they can be managed, and their existence is the only reason why profits can be obtained. So, believe it or not, "risk" is your friend, provided you give it the respect it requires which means you need of theory of risk, which Taleb's insights help provide.
Another person whom I like a lot is Justin Mamis, particularly his book, The Nature of Risk: Reflection on the Stock Market and the Meaning of Life. A third book which complements these is Edwin Lefevre's, Reminiscences of a Stock Operator, a quasi-autobiography of Jesse Livermore, the greater trader ever, whose insights into the psychology of investing still ring true today and are always widely quoted. The point in reading any of these books isn't to see what someone else did and do the same, but to draw from their struggles the courage to find one's own path and the confidence to pursue it.
"There are no roads but by walking"
http://www.youtube.com/watch?v=DHQ-_bf9NFI&feature=related
Charlie
chanterelle
4-27-11, 4:54pm
I liked Mamis' work on risk..it helped me define things about myself. I have a varied stream of income/investments, but I must admit that I hedge my bets with about 6-8 months income in cash at hand plus about 18 months worth in lower interest, easily accessed accounts. I can always survive and bide my time in case of a Biggie Snafu on my part and wait until my stash is built back up. May not make alot of sense to some but given my early life, it was worth it to me to accumulate the extra funds just to sit there.
Kib,
If I'm understanding your question correctly, then the "correct" answer is that each one of us, every human being in the world, is "on the tail", because each of us is unique. By that, I mean this. Jake Bernstein argues that "We don't trade markets. We trade our beliefs about markets. Hence, we trade ourselves." Hence, we set our own limits as to what is possible. Whether that is profits or losses, we are the ones who create them, not markets.
Most people find that hard, if not impossible, to turn into action, nor do they want to accept the responsibility that insight requires. "What do you mean I won't get rich just because I show up at the door? How dare you say that? I'm middle-class, and the stock market owes me money for my retirement. You're robbing me of my birth-right.". I think what I was getting at is just that perhaps our perception of ourselves and where we stand in comparison everyone else has a lot to do with how we do or don't invest. As someone who feels unique and doesn't really identify with a group, I think it would be likely for me to go in one of two ways: assume I can manipulate the larger group or outplay them because I'm coming in with a different perspective, or wind up trampled because I'm 'different'. Unfortunately my experience has been more of the latter.
Dharma Bum
4-27-11, 5:56pm
He does apply fractals to markets to describe their structure.
What's next, the Elliott Wave theory?
What's next, the Elliott Wave theory?
Perhaps you misunderstand what "fractal" means in this context?
It's not predictive, it's cautionary. Useful for understanding volatility, and why you shouldn't bet your house on a normal distribution.
Dharma Bum
4-27-11, 6:53pm
Perhaps you misunderstand what "fractal" means in this context?
It's not predictive, it's cautionary. Useful for understanding volatility, and why you shouldn't bet your house on a normal distribution.
Doesn't stop people from trying to make a buck selling it as such:
http://www.tradingfives.com/articles/elliott-wave-fractals.html
http://marketheist.com/2010/03/24/the-stock-market-is-patterned-ralph-elliotts-fractal-analysis-of-the-markets/
http://www.elliottfractals.com/subscriber.asp
I could go on but you have Google too. I would note that anything cautionary is in at least a sense predictive though.
Sorry to interrupt, keep going, it's interesting.
I could probably write a nice book about how to use quantum phase noise from laser diodes for directing your investing, and sell it to silly people who are impressed with jargon, but that doesn't mean it is actually useful for the advertised purpose. However, it doesn't mean quantum phase noise isn't useful in other significant applications, nor that it should be thrown out because nutcases seize onto it :-)
What's next, the Elliott Wave theory?
DB,
Connie Brown, a heavy-duty and successful trader, uses EW, as do others. But introducing it in this thread serves no purpose.
Prevailing investment theory has its origins in Bachelier's 1900 dissertation that Markowitz reworked to do his own and whose adaptation onto his 1954 paper is credited with launching MTP whose underpinnings are Brownian movement and whose price charts cannot describe actual markets. Mandelbrot, using fractals, can mechanically produce charts indistinguishable from historical ones, which isn't to say, he points out, that markets are fractal, merely that fractals are a good way to visualize price changes and that risk cannot be properly managed within the MPT framework, for the reason, as Taleb lays out in his technical papers, that samples of extreme, but infrequent, events cannot be used to predict their own occurrence, whereas the Random Walk school does depend on improper sample sizes and regularly blows themselves up, whines that "their models just need a bit of tweaking", gets back-stopped by moral hazard agreements, and then goes right back to business as usual, having learned nothing. The big boys can get away with that kind of crap at tax-payer expense. A small investor can't, which is why the cautionary tales T and M tell are so vital.
To say all of the above in plain English, don't make guesses about what Mandelbrot is saying. Read his book/papers before you attempt to criticize his ideas which he himself is very careful to point out their limitations.
Thanks for the book recommendations.
I am new to this side of things, but becoming increasingly interested.
My background is such that while we were frugal and living within our means (our current debt is the remainder of my school debt; I'm on a five-year plan for that -- sooner if i can manage!), and we were frugal with our investments (401k and mutual funds that we set and forget! set rather conservatively -- managed to gain during the recession even!), I was actually quite an ostrich about finances. I hated actually doing the bills and would stress myself out over it.
Fast forward to moving to NZ and starting to run my own business, I began to create a love affair with my accounting. I"m currently using an accounting software that I enjoy watching move every day. I discovered that the accounts "breathe." I started to learn a lot about marketing strategy, market penetration, pricing, etc etc etc. In one year, we turned a profit. I was shocked. This year, we are "paying ourselves back" for the investment that brought us here -- 1/3 of our total assets (retirement and mutual fund, but the totality that we got for the house). The business is growing, and we plan on franchising it over the next few years.
I'm also running my business-within-the-business (eg, we run a holistic health collective, I run my own yoga business under that umbrella), which is really starting to take off. The money from this will be used to pay off my student loans (I'm making the monthly payment until I have the lump sum saved up). I'm very excited about this income.
DH is also starting his small business (writing) on the side, which is bringing in more income for our savings. This pays for our "extras" -- it goes into our travel/fun/entertainment budget. What we don't spend at the end of the month goes into savings.
So, we are at the point where -- or will be in the next 2-3 years -- where we'll want to start investing intelligently. We have some good financial planners (and people good at 'hiding' money (eg, tax shelters), so I'm sure we'll learn a lot from them.
But for the now, I'm excited to have some interesting (albeit thick) books to start in on. Are there any basic texts I should read first, though?
Zoebird,
If you're running growing and successful business(es), then you're gaining more knowledge and experience than the usual beginners book can offer you. Let learning about "investing" take a back seat to the more important things in your life.
But if you really, really do want a recommendation for a "basic" book, then Ben Graham's 1934 classic, The Intelligent Investor, is where you should begin. A used copy from Amazon will cost more to ship than to buy, but it is a bargain in any case. The book is an easy read, because he focuses on the broader issue of the psychology of investing rather than the tiny, technical details of the numbers.
http://www.amazon.com/Intelligent-Investor-Book-Practical-Counsel/dp/0060155477
I love an old book, Junkman. One of my weaknesses. I can put it on my gift list for July (birthday), and someone in the US will ship it to me with all of the gifts. Don't worry, I ship them stuff too!
Oh, and my biggest asset in my business is tenacity. That, and follow-through. You always have to follow-through. :)
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