Know Your Process

It is said that the definition of insanity is doing the same thing over and over again and expecting different results. The thing is that if you do the same thing over and over again in the market, you will get very different results, because the market environment constantly changes. The same type of swing setups that have 80% success rate and average 20% returns in a healthy bull market, could have 15% success rate and 10% returns in a choppy market. The same market approach (process) could have extremely positive or extremely negative expectancy, depending on the market environment.

Expectancy is the average gain per every taken signal. Highly positive expectancy means that you have an edge.

Expectancy = %of winners * Avrg. return of winners – % of losers * Average return of losers

Let’s assume that no matter what the market environment is, we keep our losses to 6% on average. What are the results in a healthy and in a choppy market?

Healthy market

Expectancy = 0.8*0.2 – 0.2*0.06 = 14.8%, which means that if your average capital allocation per signal is 10%, the average profit per every taken trade will be 1.48% of your capital. If you take 100 trades in this environment, your return will be 148%. (not taking into account that the absolute capital allocation will change as your capital grow).

Choppy Market

Expectancy = 0.15*0.10 – 0.85*0.06 = -0.036 or -3.6%. If your average capital allocation is 10%, then your average return per every single taken trade will be -0.36% of your capital. The more active you are in this environment, the more money you are likely to lose. In this case, we basically have 4 options to help us mitigate the damage:

1) trade less

2) use smaller position size (1/3 to 1/2 of your usual)

3) sit on the sidelines

4) use another approach that has a positive expectancy in this market environment (also known as an edge)

We don’t know in advance what trade is going to work, but we could have a very good idea when we have an edge and when we don’t.

I like to repeat that sometimes being wrong in the market is not a choice, but staying wrong always is. The truth is that more often than not being wrong in the market is a choice, kind of. If you know when your bread & butter process does not deliver in certain market environment and that you are very likely to encounter a loss, don’t push it, don’t be more active.

Many people know when their market approach is not likely to deliver good results, but most don’t have the discipline to step away and watch mostly from the sidelines. I have to admit that I have been one of those people. I am very good at knowing when to trade less and cut my position size, but at the end of the day when I draw the line, it turns out that in this specific environment I would have been better off doing nothing and sitting on the sidelines.

Will Crowdfunding Turn Private Markets into the New Public Markets?

Crowdfunding has existed forever. It has recently become popular via Kickstarter, where companies could raise money by promising to deliver product or a service at a future date. This is not the type of crowdfunding I refer to in this post. By crowdfunding, I mean obtaining equity in private companies.

So, why is this subject so important to someone like me, whose entire edge is in public markets?

First, let me remind you of the main purpose of Initial Public Offerings.

Companies go public:

– to offer liquid exits for founders, employees and private investors;

– raise capital to expand;

– achieve higher valuations;

Investors buy public companies in order to:

– participate in the growth of various businesses;

– protect the purchasing power of their capital;

– diversify income stream;

– achieve higher returns than bond, real estate and cash markets offer;

– speculate.

The IPO market has changed a lot over the past decade. Companies go public at much higher valuation today for several fundamental reasons:

– they raise more money while private, while it takes less money and time to build a major company today;

– companies remain private longer, because they could raise all the money they need from private investors. It used to be that when a company reaches a 100mil valuation, the only viable exit was an I.P.O. Not any more;

– companies reach maturity a lot faster; they go public at much later stage in their growth cycle; most of the value is created while a company is private. There’s a lot less meat left on the bone for the public investors.

Hedge and Mutual Funds have long realized these trends and started to allocate capital to private markets, essentially accelerating the above mentioned developments. As a result, public investors have been in a way excluded from many high-growth opportunities

Don’t get me wrong. Public markets continue to offer incredible opportunities to investors, but today’s markets are very different than the public markets of the 90s, 80s and even before that. Back then, there were hundreds of 100-baggers. The number of 100-baggers in 21st Century could be counted on the fingers of your two hands and only if you timed your purchase properly. One could make a lot of valid arguments of why there haven’t been many gigantic public market winners in the past 15 years. The main argument is certainly the extremely high valuations at the beginning of the period, but there are also some secular trends (reasons) that are not going away.

It has become a lot easier to invest in private companies

Angel List has changed the investment universe for many accredited investors, which be latest counts are about 7 million, only in the U.S.

Each company, looking to raise money on Angel List, provides detailed description of its business – number of employees and their experience, revenues, current investors, previous funding, etc.

Angel List also provides easy and cheap access to experienced investors via Syndicates. Syndicates charge a performance fees, therefore they are only accessible to accredited investors. You could invest alongside Fred Wilson, Joanne Wilson, Brad Feld, Howard Lindzon, Jason Calacanis and many more VCs and angels with proven track record or just follow their footsteps.

The JOBS Act, Title III is about the change the investing game for non-accredited investors. It is expected to go in effect later this year. There are clear limits on how much non-accredited investors are allowed to invest in a given year:

  • For income below $100,000, invest a max of $2,000 or 5% of income or net worth
  • For income over $100,000, invest a max of 10% of income or net worth
  • Investments made in a Title III crowdfunding transaction can’t be resold for a period of one year

Every new law has its pros and cons.

The pluses:

– many people will be forced to become long-term investors; there will be no daily quotes for their investments;

– companies could raise money without the intermediation of Investment Banks, which probably means lower valuation for those companies, when there are no professional sellers to tell an intriguing story. Truth to be told, there will always be huge demand for good salesmen and the best salesmen in the world are Investment Bankers. They will probably engage in those private offering and help companies to boost valuations – just like they do today for wanna-be public companies.

– you will have the opportunity to invest in a business you understand and use at early stages of its growth cycle.  Imagine if you could invest in Uber, Twitter, HotelTonight or AirBnb when you first used them and loved them. You would be a lot richer today.

– companies will have more options for funding – instead of a few hundred VC and a couple thousands angels; they could raise money from millions of people, which should help boost valuation and foster innovation; By no means I say that good VCs and angels will go obsolete; They don’t provide just money, but also indispensable connections and advise that are essential to young companies;

– you will be able to invest in concepts that don’t have a viable alternative in public markets. For example, companies that are currently building the blockchain infrastructure;

– you could potentially enter a lot early in the growth stage of a company that could be huge 5 or 10 years from now;

The minuses:

– no liquid secondary market; this will probably partially change with time, but not being able to sell for a year will be a huge hit on liquidity; no liquid secondary market means no Technical Analysts – an indispensable tool for many investors; Valuation will matter a lot more, but then how do you value a tech company with no revenue, but huge potential. Maybe you just don’t invest in such companies. Reading and following experienced angels and VCs might be your only edge here. A few good starting points are – Fred Wilson, Marc Andreesen and his entire team at A16zHoward Lindzon. Also research sites like  Mattermark and Crowdability and Techcrunch.

– there will be a lot of zeroes, a lot of frauds. Private companies don’t have to report every quarter; people will have to learn to diversify properly and look at private companies as just one asset class in their overall portfolio. Learn position sizing and diversification – if you are only allowed to invest 10k a year in private companies, allocate 2000 to five different companies or even better – 1000 to 10 different ones.

Secondary, Public markets will continue to play an important role in traders and investors’ lives, but there’s a new asset class coming on the horizon – an asset class that hasn’t been available for the majority of investors for a very long time. This asset class will open the doors to some incredible opportunities. It will also open the doors to some incredible frauds. In public markets, being wrong is not a choice, but staying wrong is. In private markets, you might not have the choice not to stay wrong, so choose wisely, use equal position sizing and diversify.

The Difference Between You and George Soros

When asked about the most important lessons that Stan Druckenmiller learned from George Soros, he says the following:

I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

In my previous post, I talked about the incredible power of using small position sizes. I also mentioned that some of the best performing and most popular investors in the world, have made names for themselves by using ginormous position sizes. George Soros is one of those investors.

On September 16, 1992, Soros’ fund sold short more than $10 billion in pounds, profiting from the UK government’s reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency.

Finally, the UK withdrew from the European Exchange Rate Mechanism, devaluing the pound. Soros’s profit on the bet was estimated at over $1 billion. He was dubbed “the man who broke the Bank of England”.

Stanley Druckenmiller, who traded under Soros,  was the genius behind the idea. Soros just pushed him to take a bigger size. In this case, the bigger size was one of the reasons why this trade worked. What is more important here is to highlight their position size. They risked their entire YTD gain (they were up 12%).

Just to give you a perspective of how ballsy it is to risk 12% of your capital on one trade, consider the following simplified example:

Let’s assume that your trading capital is 200k and you want to buy a stock at $50 with a stop at 47; hence you risk $3 per share.

Risking 12% of your capital, means 12% * 200k = 24,000.

Divide 24,000 by the amount you risk per share ($3) to get the total number of shares you could afford to buy, which in this case is 8000 shares.

8000 shares * Current Market price of $50 = 400k. You would have to take on a 100% margin in order to risk 12% of your capital.

It is said that concentration creates wealth, diversification helps to protect it. The reality is that big returns are often just the opposite coin’s side of big drawdowns. Trading big position sizes is not for most market participants. If you still want to do it, you could learn a lot from people that have actually done it for a living. What are the four lessons from Soros’ s adventure with the British Pound:

1. Size matters.

When you manage billions of dollars, there are only a few great, high-liquid opportunities each year that will allow you to achieve substantial returns. The only way to achieve those bigger returns is to take on a bigger position size. The smaller your capital base, the more great trading opportunities you have in the market and you won’t have to risk big on any one of them.

2. Earn the “right” to trade Big first

They were up 12% for the year.  It wasn’t an incredible return, but it wasn’t bad either. In their eyes, they were able to afford the luxury to trade big. Here’s what Stanley Druckenmiller says on the subject:

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

3. Proper Timing is Everything when you Trade Big

A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

4. Have a contingency plan

They were prepared for the worse case scenario. Despite their conviction, they knew that they might lose money, so they had an exit plan.  They made sure that they could afford the loss and stay in business.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.



Schwager, Jack D. (2009-10-13). The New Market Wizards: Conversations with America’s Top Traders. HarperBusiness. Kindle Edition.

Wikipedia – George Soros