10 Insights from Abnormal Returns – The Book

When two amateurs play tennis, the one that makes the least amount of mistakes usually wins. The same rule often applies to investing except that what matters more is not the number of mistakes, but their size. While Tadas Vishkanta doesn’t necessarily teach his readers what to do in his first book – Abnormal Returns; he does an even more important job by highlighting what not to do.

Tadas looks at investing from all perspectives imaginable and paints a rich portrait of the market reality, without saving the uncomfortable truth. While Abnormal Returns reads like a textbook at times, it provides deep market understanding of the common hurdles each market participant faces in this enormously challenging field. Unbiased, with no issue that could blind his objectiveness, Vishkanta summarizes and explains a ton of practical investment wisdom from some of the best financial minds of our time.

Abnormal Returns is really informative reading that will enrich your understanding of financial markets. Certainly a worthwhile addition to your investing library.

Here are ten insights I was reminded of by reading the book:

1. Opportunity cost is often overlooked, not only in terms of return, but also in terms of time:

The time and effort spent in trying to become an accomplished trader, by definition, come at the expense of other activities. The biggest cost to the 90% or so of traders who fail is not necessarily the financial costs, but rather the time lost to other opportunities. Money can be made in a number ways, trading only being one of them. However, time is not something any of us can get back.

2. Know your limits:

Great investors recognize that once they make an investment decision, the results are largely out of their control. They can have a plan about when to sell, but the market will ultimately dictate how that investment works out over time.

3. The worst forecasters are often the most confident. Once in a while, they hit the jackpot like a blind squirrel finds an acorn sometimes.

Analysts who correctly called the market crash of 1987 have been living off that call ever since then. The irony is that research shows that those forecasters who get these “big calls” correct turn out to have the worst overall track records.

4. Finding skilled money managers is one of the hardest endeavors on earth

First, we should recognize that investing is a field in which both skill and luck do play a role. Investing is often compared to gambling and most often to poker, and for good reason. Recent research also shows, contrary to what the authorities say, that poker on the whole is a game of skill. Unfortunately for investors, our ability to identify skilled investment managers is much more difficult than identifying skilled poker players.

5. Distinguish between skill and chance

Fama and French examine the performance of mutual fund managers and find that before expenses the top 5% or so of managers demonstrate some skill compared with chance.9 The performance picture worsens dramatically once you take into account expenses, which largely wipe out the benefit of skill in the best managers. You can guess what it does for the rest of the mutual fund manager crowd. Anyone looking for skilled managers needs to recognize that identifying skill isn’t enough. The challenge is identifying managers whose skill outweighs whatever fees they charge investors.

6. Different catalysts rule the market in the short-term vs the long-term

Howard Marks says it well: “In the long run, there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t.” We live in a world filled with randomness, and recognizing this is an important step in dealing with our investments in a more measured and mature fashion.

7. Confirmation bias hurts us more than we could imagine. “On a subconscious level, we simply never perceive information that may not fit with our worldview.”

8. “You may think you’re able to filter the noise. You cannot; it overwhelms you. So don’t fight the noise—block it.”

9. Momentum investing works because it is psychologically hard to apply

Momentum works because it calls on investors to do things that do not come naturally. Momentum strategies require investors to buy things that have already increased in value and are trading near their highs, not their lows. Successful momentum strategies also have strict and well-defined selling, or switching, strategies. Both these pieces of the momentum puzzle are difficult for investors to master.

10. Value investing works because it is also psychologically uncomfortable to practice:

This is a more challenging task than simply buying stocks that are statistically cheap. Swensen writes, “In many instances, value investing proves fundamentally uncomfortable, as the most attractive opportunities frequently lurk in unattractive or even frightening areas.”

Howard Marks writes: “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do.”

Source: Viskanta, Tadas (2012-03-30). Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere,  McGraw-Hill. Kindle Edition.

Market Games

Bull markets last long enough to erase the memory of most market participants of how it feels to be in a correction and what should be done.

Back in January this year, most people disbelieved the rally and were very cautious. The second half of 2011 was the definition of a trendless, high-volatility, choppy environment and over time it conditioned most of us to be very nimble and take profits quickly. Most breakouts failed, mean-reversion from overbought and oversold reading worked almost flawlessly.

As the bull market climbed a wall of worry, more and more people started to figure out that breakouts are actually working and delivering solid results.

In bull markets, corrections happen under the surface and take the form of  sector rotation. When financials and tech took a breather, biotech and consumer discretionary took the leading role and the indexes barely budged. All dips were a great buying opportunity in hindsight. Somewhere along the way, people realized that instead of jumping from a setup to setup, they might be much better off just riding three or four strong stocks.

The market has been really accommodating in the first 3 months of the year, to a point that it created complacency. Naturally, when a shift in a character came, most people were slow to react.

We entered a choppy, high volatile environment, where many breakouts will be short-lived. We will see stretches of several red days followed by a pocket of green days that will continue long enough to confuse everyone.

Recency or our tendency to  pay enormous attention to the most recent price action has huge influence on our psychology. A few red days in a row and everyone turns bearish and give up positions bought on a dip, just before the market is ready to bounce. A few green days and everyone thinks that all is well and new highs are on the horizon. Don’t judge the market based on one day of market action.

Trednless markets could be very stressful to those who don’t notice the change of market character and rethink their tactics.  Stress leads to overtrading and the latter is a really dangerous endeavor in a choppy market environment. Overtrading leads to losses and losses lead to a loss of confidence, which is the last thing you want to happen to you, because your decisions will be ruled by fear and not rules.

Greed and fear often trump experience. The choices we make every day define the quality of our  lives. We are in the business to make money, not to make trades.

Choose wisely. Do less.

Market Noise or Why Recency Bias Hurt Us

In life, there is no second chance for a first impression. First impressions are the most memorable and have the biggest impact on our thought process. They subconsciously form prejudices and mental shortcuts that define our behavior.

The trading world is different. It is an environment, where last impression is often the strongest and has the biggest impact on decision making. We put tremendous weight on the short-term price action, while it often represents just noise. Because it’s easier, we’re inclined to use our recent experience as the baseline for what will happen in the future. We project the most recent events into eternity and make unwise decisions.

We strive to know everything about everything and make sense out of every move, even when it is a garden variety of noise. Sometimes we forget to take a step back and see the big picture. Zooming out helps to curb the frustration and clear the head.

If you intend to be in this business long time, you have to find a hassle-free way to manage your portfolio. Howard Lindzon has found it by focusing on longer-term social and business trends that are confirmed by price action. Brian Shannon has found it by focusing on day trade setups and being 100% in cash at the end of the day. Joe Fahmy has found it by timing his market exposure and swing-trading stocks with solid technicals and fundamentals. There are different paths to achieve the same goal.

Not everyone is willing to put the time and the efforts needed to define himself and focus on a specific approach. One of the lines from the original Market Wizards book that has remained vividly in my head comes from Ed Seycota. On the question, what would you recommend to the average trader, he replies: “Find a superior trader to manage his money for him and then find something he loves to do.” The trouble is that it is much harder to find a superior trader who will want to manage your money than to learn how to be consistently profitable yourself. Just because someone sounds confident, doesn”t meant that he will be able to deliver.