The Four Dirtiest Words in Trading

Brian Hunt, writing in the Growth Stock Wire, gives some very important advice: use stop losses!

I heard the four dirty words of trading last week…

My friend had recently purchased stock in a small oil company for around $20 per share. Things weren’t going well for the company, so its share value was down to $8 – a 60% loss for my friend.

Here’s what he said: “It will come back.”

I shuddered at his analysis of the situation. I shuddered at those four dirty words.

This is the mantra of stock market losers. If you catch yourself making this statement, immediately sell all your stocks and stick the cash in the bank.

You’ll be much better off financially if you do. You’ll also have a lot less stress in your life.

“It will come back” is a common reaction investors and traders have after seeing a stock fall 30%… 50%… or 70%. Most folks just can’t stand to admit they’re wrong. Saying “it will come back” allows them to convince themselves they aren’t wrong… just “early.”

It allows them to keep hope alive… and to ignore the elephant in the room: They need an absolutely huge, highly improbable gain just to break even.

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John Mauldin on MPT

How Did We Get It So Wrong:

So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50^th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the whole concept of correlation and assets. Correlations change.”

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”

And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

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Are You Smarter than a CFA’er?

SSRN Working Paper:

Several studies have examined whether a manager having an MBA or CFA leads to superior portfolio performance. However, these studies have yielded mixed conclusions. A possible reason is that most have considered only MBA or CFA alone, and most have not controlled for managers’ style targets. We examine MBAs and CFAs together, controlling for market conditions and style targets. We find that the CFAs do add value, but even more significantly (especially in light of events in recent months) – CFAs reduce and MBAs increase Tracking Error.

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