Being right is overrated
Joe Weisenthal at Clusterstock points out today an interesting (long) piece by Holman Jenkins at Hoover.org on the financial crisis. The gist of the article is that the financial crisis was by and large a massive financial accident that was unforeseeable.
Jenkins notes that even investors like John Paulson, who many claim to have foreseen the meltdown of the global financial system, did not in fact foresee the crisis. If they had they would have invested quite differently:
But those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes. Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less.
The point of the above quote is not whether the crisis was foreseeable, nor is it a criticism of Paulson. In today’s financial markets traders can express their viewpoints about the future through derivatives and structured products in a very precise manner. If Paulson had foreseen the collapse of the global financial system there were much easier ways to profit from (and express) that viewpoint. (Not that he is complaining.)
Much too much is made in the media about who is right, and who is wrong. (Not that these thing are well tracked.) On television, in print and on the Internet we are inundated with pundits who crow about their prescience, while omitting their missed forecasts. The funny thing is that for investors, being right is greatly overrated.
Investors and traders need only worry about one thing: profitability. Are you generating requisite profits from your portfolio for the risks assumed? Everything else is just noise.
The need to be right is a common error for beginning investors. Any one who has ridden a stock down for a large loss can attest to this. Behavioral finance experts have a term for this: the disposition effect. Investors tend to sell winners too soon, and losers too late. You could even think of this as ‘get-even-it is.’ Investors do not want to admit that they made a mistake.
The fact of the matter is that all investors make mistakes. It is simply a part of doing business. One way traders look at their profitability is expectancy. In a vintage post, Trader Mike does a nice job describing the components of expectancy. The take away is that the percentage of times you are right is only one component in your profitability. In theory, a trader could be wrong much more that 50% of the time and still be profitable, if the profits from their winning trades far exceed the losses on their losing trades. As he writes:
Expectancy, position-sizing and other aspects of money management are far more important than discovering the holy grail entry system or indicator(s).
Stated another way: For traders, being right is overrated. It is far more important knowing when you are right, and when you are wrong, and acting accordingly.
In summary, being right may be a necessary component of trader profitability, but it is not sufficient. Proper money management techniques are required to turn trading decisions into trading profits. While it is difficult some times to take, being wrong is a part of being a trader. Don’t let the need to be right prevent you from becoming a beter trader.
Update 6/5/09: Found in my bookmarks a piece over at CXO Advisory Group. Researchers find that traders are affected more by their win-loss ratio than their actual profitability. Stephen writes:
Individual traders may want to consider whether they are motivated more by being right than by making money.
Filed under: Behavioral Finance, Portfolio Management | 18 Comments
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great stuff, you should write pieces more often!
Excellent point. The most overlooked point in the tortured debate about investing and trading.
To manage money successfully is to understand the difference between process and outcomes, and to know that added value comes from experience and the ability to incorporate factors that distort human judgment in your process – to contain the mistakes.
“Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.” -David Sklansky, The Theory of Poker
The best long-term, enduring performers all must emphasize process over outcome.
Thanks for the post.
I’d add another component to this argument. All we see are outcomes, but we make decisions based upon probability distributions. Building the right portfolio means constructing your portfolio to best match your forecasted probability distribution. Paulson may have thought that there would be a significant chance for banks to fail, but he may not have thought that being short bank stocks was the best way to articulate his view and manage risk. By focusing on subprime indexes that were reflecting crazily tight spread, he had limited downside and enormous upside, especially if he employed leverage. Therefore, that was the best trade in the best trading vehicle, regardless on his view of the banks.
shorting those stocks would not have given you the same returns as paulson…the maximum return from a short is 100 percent, he received returns almost 3 fold that on his puts.
Jenkins knows not of what he speaks. There’s no real leverage in a straight short-position. Paulson was leveraged up the wazoo through credit default swaps. That’s why he was up 1000%+ in one year. Try doing that by shorting –uh-uh.
Your main point about making money vs. being right aside, many foresaw trouble but almost no one could have predicted the severity. Even Panzner who wrote a book with “Armageddon” in the title was shocked by both the intensity and speed of the crisis.
My hunch is that Paulson saw some storm clouds and wanted to profit from it but he never really predicted the exact $hitstorm that we went through. Also, people like Paulson are moving billions, using CDS and other OTC derivatives leaves a much smaller footprint than going into equities.
I’m going to take the other side of this one. This is a bear/choppy market argument. During a sustained bull market, being right makes lots of money.
When I choose stocks, I do all that I can to have the odds tipped in my favor — industry analysis, earnings quality analysis, valuation analysis, balance sheet analysis, free cash flow use, and even a review of the anomalies like momentum, volatility, balance sheet growth, etc.
It’s not perfect, but I typically have 70% winners, and my winners are larger than my losers. Being right helps make money… does anyone doubt that? But hubris destroys.
Does that mean I give up my risk control disciplines? No. I get things wrong, and when I am wrong, I cut my losses. Every 20% move down requires a review — if the thesis is intact, I buy enough to rebalance. If not, I sell.
Also, my methods continually improve my portfolio, selling things with less potential to buy things with greater potential.
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I’ll give you this — I knew a fellow for whom every position was a holy crusade. The regret level was high. He always wanted to win, and win big. Risk control took a back seat. If his staff had not been correct with a high level of frequency, his asset management firm would have died. As it was, they were constantly dealing with shorts running against them, with the pain of increase, cover some, go flat. Usually it went first increase, increase a little more, then cover some, some more, some more, until the momentum broke, and they would scale out with modest losses. And, the opposite with longs going down, but they wouldn’t rebalance like I do; they would double the position.
Toward money management of this sort, I would say, “Do you want to make money, or do you want to be proud?” Pride goeth before a fall. It’s fine to want to be right, and to aim for it, but it is wrong to not be modest, and realize that we will be wrong, and methods must be employed to limit losses when we are wrong.
No one can forsee the future. Yet walking across a busy street while blindfolded is not a wise idea. Prudence “used to be” a concept that people understood. It is rooted in common sense. Risks should only been taken when necessary, and then in proportion to the benefit associated with the risks. This is not foreseeing the future, it is maximizing the possibility of success in a future that cannot be foreseen. It is the lack of prudence that has caused our financial ills. Attempting to confuse prudence with “seeing the future” is just a ruse to divert blame.
As Soros says “It doesn’t matter if you are right or wrong.What matters is how much money you made when you are right and how much money you have lost when are wrong.”
Excellent points and never emphasised enough. Indeed, extremely few – even amongst the best and most battle-hardened traders – manage to escape the 80-20 Pareto Law in terms of the number of trades accounting for 80% of one’s profits, so on the remaining 80% of trades the performance is expected to be mediocre at best in terms of payoff. That’s where money management becomes critical.
To elaborate further on the poker analogy raised earlier, it is also useful to point out the confusion between probability and payoff to which many traders succumb, namely, most prefer betting on high-prob/low-payoff outcomes. The minority a la Taleb, position themselves the other way around. For the latter category, since you expect to be wrong more than 50% of the times, money management becomes once again critical, since you want out capital to outlast the expected drawdown streak.
No argument with your underlying thesis. Still, I wonder if Jenkins is right in suggesting Paulson et al would have positioned themselves differently if they’d known the whole financial system was going to implode.
As best I recall, Paulson started positioning himself back in 2005, probably because he could clearly see the structural setup but was unsure when things would actually start to unravel. Had he shorted financials, there was no way to know how insanely overpriced the financial stocks could eventually get. And, as it happens, it would have been a pretty painful couple of years. Equally, buying puts for an anticipated eventual meltdown can be a mighty expensive business if it takes longer than you hope.
Given how compressed credit spreads were back then (and the timing uncertainty) going short sub-prime may well have offered a better risk reward profile.
But those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes. Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less
This statement is not correct. The maximum profit a short investor can make on an equity is 100% (maybe a little higher if the investor can use some margin.) Credit default swaps have enormous leverage, and the potential profit from buying a CDS is far higher than 100%.
(Your point about process vs. outcome is still valid, though.)
I have found that the tendency to hang on to losing positions for many is perversely correlated to the speed and size of the loss. Even if there is a “soft” stop-loss in place, or a generally accepted dollar loss level, outliers and gaps tend to bypass these figures by a larger magnitude than ever expected. This forces the position to cross from the realm of “trade” to “investment”. Original motivations for what could be a short-term, attractive risk-reward profile are abandoned for agruments of “market mispricings” and exaggerations. These positions are then tucked away until the market becomes more “rational”. It is always tough to take a loss; the key is to recognize that opportunities did not die with the last missed trade. Pride is an admirable quality in most, and those in our field have more than their fair share. Unfortunately, more often than not, this characteristic leads to cancerous positions. The best of our breed have learned that it’s best to take our medicine, swallow that huge horse pill, and wake up to a new day of possibilities.
I like the work you’ve done on your site – are you having fun with it? It’s interesting and well worth the time to visit.
You make a huge error that is similar to the errors that caused the housing bubble: “Investors and traders need only worry about one thing: profitability. Are you generating requisite profits from your portfolio for the risks assumed?”
You say investors need only worry about one thing, then list two things – profits and RISKS. By your own sentence, investors need only worry about at least TWO things – profit and RISK. RISK was ignored until it couldn’t be anymore.
Many of the loans written and then bought by Wall St. to securitize were not risky, they were duds. Jumping out of an airplane without a parachute isn’t taking a risk, it’s committing suicide.
Early last winter I was driving from Baltimore to DC during the afternoon commute. It was only snowing lightly, but the road was full of black ice. At first there was a bit of traffic until we passed a car that was flipped over. Then everyone sped back up. Then there was a car stranded on the side of the road, it had done a 180 & was facing traffic. I must have passed over 10 accidents that afternoon – & all different ones, ranging from side-swipes & fender-benders to a 5- or 6-car collision, it was like a museum exhibiting all the different types of car collisions. Everyone around me was going slowly but at every highway entrance these idiots would come on at full speed & honking at us…until they were able to pass a good couple accidents.
Well put. But from the macroeconomic perspective you have to add a corollary to the being right piece, which is that error – assumed to be randomly distributed in normal times – becomes systematic in a downturn or depression. If anyone could’ve seen the depression coming, it wouldn’t have occurred, practically by definition. The puzzling part however is not that the crash occurred & huge companies went under. It’s why the market wasn’t able to compensate.
Actually, Paulson shorted bank equities too…and made a lot of money off of that…Sorry to disappoint Holman Jenkins