19 Notable Quotes from the Book “Hedge Fund Market Wizards”


1. As long as no one cares about it, there is no trend. Would you be short Nasdaq in 1999? You can’t be short just because you think fundamentally something is overpriced.

2. All markets look liquid during the bubble (massive uptrend), but it’s the liquidity after the bubble ends that matters.

3. Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.

4. The low-quality names tend to outperform early in the cycle, and the high-quality names tend to outperform toward the end of the cycle.

5. Traders focus almost entirely on where to enter a trade. In reality, the entry size is often more important than the entry price because if the size is too large, a trader will be more likely to exit a good trade on a meaningless adverse price move. The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience.

6. Virtually all traders experience periods when they are out of sync with the markets. When you are in a losing streak, you can’t turn the situation around by trying harder. When trading is going badly, Clark’s advice is to get out of everything and take a holiday. Liquidating positions will allow you to regain objectivity.

7. Staring at the screen all day is counterproductive. He believes that watching every tick will lead to both selling good positions prematurely and overtrading. He advises traders to find something else (preferably productive) to occupy part of their time to avoid the pitfalls of watching the market too closely.

8. When markets are trending up strongly, and there is bad news, the bad news counts for nothing. But if there is a break that reminds people what it is like to lose money in equities, then suddenly the buying is not mindless anymore. People start looking at the fundamentals, and in this case I knew the fundamentals were very ugly indeed.

9. Buying low-beta stocks is a common mistake investors make. Why would you ever want to own boring stocks? If the market goes down 40 percent for macro reasons, they’ll go down 20 percent. Wouldn’t you just rather own cash? And if the market goes up 50 percent, the boring stocks will go up only 10 percent. You have negatively asymmetric returns.

10. If a stock is extremely oversold—say, the RSI is at a three-year low—it will get me to take a closer look at it.8 Normally, if a stock is that brutalized, it means that whatever is killing it is probably already in the price. RSI doesn’t work as an overbought indicator because stocks can remain overbought for a very long time. But a stock being extremely oversold is usually an acute phenomenon that lasts for only a few weeks.

11. If you don’t understand why you are in a trade, you won’t understand when it is the right time to sell, which means you will only sell when the price action scares you. Most of the time when price action scares you, it is a buying opportunity, not a sell indicator.

12. Normally, I let winners run and cut losers. In 2009, however, as a result of the posttraumatic effects of going through the September 2008 to February 2009 period—talking to clients who are going out of business and seeing 50 percent of your fund redeemed is all very wearing—I got into the habit of snatching quick 10 to 15 percent profits in individual positions. Most of these positions then went up another 35 to 40 percent. I consider my pattern of taking quick profits in 2009 a dreadful error that I think came about because I had lost a degree of confidence due to experiencing my first down year in 2008.

13. As an equity trader, I learned the short-selling lessons relatively early. There is no high for a concept stock. It is always better to be long before they have already moved a lot than to try to figure out where to go short.

14. Do you know what happens in a bull market? Prices open up lower and then go up for the rest of the day. In a bear market, they open up higher and go down for the rest of the day. When you get to the end of a bull market, prices start opening up higher. Prices behave that way because in the first half hour it is only the fools that are trading [pause] or people who are very smart.

15. Now that you have switched from net long to net short, what would get you long again? – Buying. If all of a sudden stocks stopped going down on bad news that would be a positive sign.

16. Lots of companies screen as being “cheap.” I think that it’s easy to avoid value traps. The trick is to stay away from companies that can’t grow their cash flow and increase intrinsic value…As Buffett says, “Time is the enemy of the poor business and the friend of the great business.”

17. If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing. The fact that our value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term.

18. The institutionalization of the market has shortened time horizons—it has reduced the window of time managers have to outperform. Most managers can’t wait for two years for an investment to work. They have to perform now. Their institutional and individual clients appear to demand it through their money flows.

19. The single best-performing mutual fund for the entire decade was up 18 percent a year, on average, during a period when the market was flat, yet the average investor in that fund lost 8 percent. That is because every time the fund did well, people piled in, and every time it underperformed, people redeemed.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards. John Wiley and Sons. Kindle Edition.

Four Keys to Understanding Uncertainty

Barry Ritholtz has an interesting piece on uncertainty:

From the investor’s perspective, markets require uncertainty to function. Indeed, they thrive on doubt, imperfect information and a lack of consensus. Uncertainty drives the market’s price-discovery mechanism. Investing requires differences of opinion, for when there is broad agreement about an asset’s fair value, trading volume falls.

Without uncertainty, who would take the opposite side of your trade?

People don’t take the opposite side of your position because they are more or less certain about the future. It has nothing to do with uncertainty. It is all about differences in expectations, time frame of operation and market approach.

My take on uncertainty:

1) Uncertainty is always subjective. It is a state of mind that is derived from a mix of objective data, emotions and personal experience. To say that the market is always equally uncertain is to say that mood is always the same. It is not. It constantly changes.

If the perceived uncertainty is always the same, earnings reports would not have such huge impact on prices. We all know that this is not the case. In many cases, earnings reports provide new data that changes market expectations and therefore prices. Options premium is higher before earnings exactly because uncertainty is higher.

2) Uncertainty has become a synonym for bad mood in our everyday life.

The future is always uncertain, but our perceptions of the future vary. And perceptions define actions. Actions (supply and demand) define prices. Somehow uncertainty is used with a highly negative connotation in our everyday life. It is a game of words. Just like the weather people always say that there is a 30% chance of rain and never that there is 70% chance of sun.

3) Uncertainty is basically another word for market sentiment. High levels of perceived uncertainty (bad mood) and high levels of perceived certainty (good mood) have historically been good contrarian indicators, IF your investing horizon is long enough.

4) There are different types of uncertainty.

There is an economic uncertainty. Uncertainty leads to a decline in economic activity. Less people are hired. Old machines and software licences are used longer. Investments are cut. This is what it has been happening in Europe for 2 years.

There is market uncertainty that impacts volatility. When correlation is close to 1.0 (another way to say that stocks move together disregarding of their individual characteristics), uncertainty is perceived as high. It leads to choppy environment that market timers prefer to sit out in order to preserve monetary and mental capital. Perceptions define reality.

How Personal Biases Could Hurt Our Performance

I am constantly watching the all-time high and the 52-week high lists to get a sense of emerging trends and gauge overall risk appetite. Both lists are extremely useful equity selection tools and they have been home for all big stock market winners at some point in their history. An all-time high is not an automatic buy signal for me. I have always considered the technical characteristics of the stock (is it just breaking out from a long base) in order to minimize risk of involvement. I also pay attention to the catalyst behind the breakout and the growth prospects of the underlying company. All those requirements have proven to be good filters over time, but with the price of numerous unwanted side effects.

Here’s how overthinking has robbed me from some great market opportunities:

February 2011 – tobacco stocks are clearing major multi-year highs on strong volume. I disregarded the signal, conceptualizing that smoking is dying and that tobacco companies will only see their revenues decline. $PM, $LO and $MO gained more than 50% from that point and are still hovering near major highs.

June 2011 – I noticed that more and more utilities show up on the all-time high list. I knew that it is never a good sign when defensive stocks are on the all-time high list, but I’ve never really considered owning them, because they are not real growth stocks. Many of those same utilities went to significantly outperform during the carnage of last summer as capital went to perceived safety.

September 2011 – a bunch of REITs and home improvement stores ($HD, $LOW) are breaking out to major multi-year highs. I ignored those moves, thinking that no one wants to own those slow moving, boring stocks and besides there is no way those moves will sustain with a housing prices still under pressure. Many of them went up 30%+ over the next six months as Home Depot reported solid earnings growth and rents reached all-time highs all over U.S. Even homebuilders like $LEN emerged to new highs in early 2012.

April 2012 – airline stocks are showing up on the 52-week high list and my eyes can’t believe. My brain quickly disregarded those moves as noise, recalling that airlines have historically been terrible investments. 3 moths later, stocks like $ALGT, $LCC are 20% higher, still hitting multi-year highs and many stocks from the industry are breaking out.

As the saying goes, it doesn’t hurt you what you know, but what you think you know, because it usually ain’t so.

I realize that in hindsight, everything seems so easy and clear and in real time it is never so. The point is that we have no idea how far a stock could go after it breaks out to all-time highs from a solid base. It might go up 15% and then fizzles or it might go up 50% or 200%. We don’t know that in advance and we have no control over it. Good risk/reward technical signals have to be taken. Focusing on price action alone helps to minimize my underlying biases.

How have your biases hurt you and what have you done to cope with them?

Should You Trust Your Trading Intuition?

I’ve heard from many traders that they often take decisions based on instincts. Actually, all non-quants use intuition in some form or another. If you are not using a program that takes all signals that your system produces, how do you decide between several equally good looking trading setups with similar risk to reward? Do you take them all or do you concentrate on only a few? The odds are that you are doing the latter and your ultimate choice for capital allocation is subconscious.

Even though we are defined by our decisions, we are often completely unaware of what’s happening inside our heads during the decision-making process.

Feelings are often an accurate shortcut, a concise expression of decades’ worth of experience.

The process of thinking requires feeling, for feelings are what let us understand all the information that we can’t directly comprehend. Reason without emotion is impotent.

This is an essential aspect of decision-making. If we can’t incorporate the lessons of the past into our future decisions, then we’re destined to endlessly repeat our mistakes.

Nothing can replace personal experience:

Unless you experience the unpleasant symptoms of being wrong, your brain will never revise its models. Before your neurons can succeed, they must repeatedly fail. There are no shortcuts for this painstaking process.

This insight doesn’t apply only to fifth-graders solving puzzles; it applies to everyone. Over time, the brain’s flexible cells become the source of expertise. Although we tend to think of experts as being weighed down by information, their intelligence dependent on a vast amount of explicit knowledge, experts are actually profoundly intuitive. When an expert evaluates a situation, he doesn’t systematically compare all the available options or consciously analyze the relevant information. He doesn’t rely on elaborate spreadsheets or long lists of pros and cons. Instead, the expert naturally depends on the emotions generated by his dopamine neurons. His prediction errors have been translated into useful knowledge, which allows him to tap into a set of accurate feelings he can’t begin to explain.

The best experts embrace this intuitive style of thinking. Bill Robertie makes difficult backgammon decisions by just “looking” at the board. Thanks to his rigorous practice techniques, he’s confident that his mind has already internalized the ideal moves. Garry Kasparov, the chess grand master, obsessively studied his past matches, looking for the slightest imperfection, but when it came time to play a chess game, he said he played by instinct, “by smell, by feel.”

Our decision making depends on our expectations. Our expectations are defined by our experience, our memories in a similar situation. Intuition helps only if you have enough experience. The quantity of practice is certainly important, but the quality matters even more. The most effective way to get better at anything is to focus on your mistakes and learn from them. In other words, you need to consciously consider the errors being internalized by your dopamine neurons. This needs to become an ongoing process of constant reminding, because most of what we learn lives in our short-term memory, which by definition doesn’t last long.

WE CAN NOW begin to understand the surprising wisdom of our emotions. The activity of our dopamine neurons demonstrates that feelings aren’t simply reflections of hard-wired animal instincts. Those wild horses aren’t acting on a whim. Instead, human emotions are rooted in the predictions of highly flexible brain cells, which are constantly adjusting their connections to reflect reality. Every time you make a mistake or encounter something new, your brain cells are busy changing themselves. Our emotions are deeply empirical.

This doesn’t mean that people can coast on these cellular emotions. Dopamine neurons need to be continually trained and retrained, or else their predictive accuracy declines. Trusting one’s emotions requires constant vigilance; intelligent intuition is the result of deliberate practice. What Cervantes said about proverbs—”They are short sentences drawn from long experience”—also applies to brain cells, but only if we use them properly.

Source: Lehrer, Jonah; How We Decide – Houghton Mifflin Harcourt. Kindle Edition.

Five Things You Need to Know About Market Liquidity

It seems that liquidity is a massively misunderstood subject as I am constantly getting questions from the type “Isn’t that stock too thin to be considered”. You have to ask yourself how much liquidity do you actually need for your account and market approach. Here is what you need to know about liquidity in order to answer that question.

1) Liquidity is cyclical and it follows price. Many big winners have started with trading under 100k shares a day or even under 50k. Volume comes with price appreciation. When there is a catalyst behind the price move like strong, unexpected earnings growth or new contract or change in regulations that will lead to strong earnings down the road, liquidity and institutional interest follow.

One of this year’s best performing stock is $ELLI. It traded about 20k shares a day at the beginning of 2012. It currently trades close to 350k shares a day.

2) The needed liquidity depends on the size you trade and the amount you manage. The really big institutions cannot afford to accumulate any positions in individual small cap names that trade under 1 million shares a day. The sheer size of their capital makes it impractical to even consider buying small caps. Even if they manage to scoop some shares of a small cap and it doubles, it won’t make a difference for their overall portfolio return.

When it comes to smaller firms that manage under $250 million, things look completely different. Smaller institutions understand the power of sudden acceleration in earnings and are not afraid to nibble on relatively low liquid names. Their cumulative buying power gives a start to new price trends and price appreciation attracts more liquidity over time.

3) You need a proper exit strategy when you deal with relatively low liquid stocks, especially if the move is purely momentum driven and there is no clear catalyst to support it. Smaller market cap, lower float and lower liquidity help tremendously on the way up and exacerbate the move, but turn into a huge disadvantage on the way down. Liquidity tends to disappear just when you need it most. Partial exits onto strength is a very rational approach when dealing with a stock like $AE.

4) Stocks with lower liquidity often trade cleaner and provide “text-book”-like setups that seem too good to be true. It happens every year and they become some of the best performers. They start slow and liquidity comes gradually as unusual price appreciation attracts more attention.

5) Dollar volume is a better measure of liquidity than volume alone. $MWIV used to be a $70 stock that traded about 70k shares a day, which amounts to a 5 million dollar volume. Most people don’t pay attention to stocks trading under 100k shares a day, when in fact $MWIV’s dollar trading volume is the same as the one for a $7 dollar stock that trades 0.7 million shares a day. A lot of good setups could be found among high priced stocks trading under 100k a day.