Hedging Real Estate

They have been all the vogue, but many of the new markets opening up will most definitely change what we think of as a market “to trade”. The Wall Street Journal chimes in:

Once, a home was a castle. Now it is looking more like Fort Knox — a pile of money in need of protection. Amid warnings from economists that real-estate values in some parts of the country may drop eventually, there is a nascent movement to offer new investment products designed partly to hedge against falling property prices. The goal: Offer limited protection against the risk of riding real-estate prices back down again after the record run-up in recent years. In recent months, Merrill Lynch & Co. and other investment banks have started offering investment products that will rise in value if a basket of housing- related stocks declines. Already, nearly $400 million of these investments have been sold, according to Daniel Carrigan, vice president for new-product development at the Philadelphia Stock Exchange. The Chicago Mercantile Exchange also is preparing to announce plans to introduce in the second quarter of next year futures contracts based on home prices in each of 10 cities. It will also offer a composite contract covering all 10 cities. That plan follows the introduction last May by HedgeStreet Inc., based in San Mateo, Calif., of financial contracts called Hedgelets that let investors bet on a rise or a fall in home prices in six individual cities.”

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Style Drift

In doing some research I came across the following excerpt. The date of the article has no relevance for my point:

“A key failing of equity managers in 2003 had been their inability to capture the upside when markets bounced. That had happened largely because managers were still licking their wounds from 2002 and an environment that had penalised risk-taking. But managers were not being paid to hold cash; they were paid to put it to work. Getting the risk profile right meant investors understanding how drawdowns happened and being able to distinguish between “good” and “bad” drawdowns. “Style drift is a bad drawdown…Breaching limits is a bad drawdown. But an investment decision that was part of the strategy and went wrong is not a bad drawdown. You need to take on more risk without scaring the hell out of investors.”

The whole concept of style drift is very important. Put simply it means jumping from one trading strategy to the other. Kind of like chasing your tail (if you happened to have a tail).

A good drawdown is one that happens because you expect it. A good trading strategy will have drawdowns from time to time. You can’t avoid them. They are not unexpected. A bad drawdown, on the other hand, is one where the losses pile up as you chase the latest hot manager or hot investment tip. Bad drawdowns stem right from impatience and greed.

Predict v. Follow Feedback

Feedback from author of Predict v. Follow:

“Hello Michael, I just wanted to let you know that it was my quote you used. I’m glad to further the discussion on your website since it has helped me greatly. Thought I would take the opportunity to let you know what I thought of your book and comment on it. Your book has caused me to do some soul searching to what kind of trader I want to be, how I will enter markets and how and why I will exit. It forced me to define an approach to trading, to carefully pick markets to trade, and to think how I would choose risk management levels. No book can be all things to all people, but your book forced me to rethink my trading strategy and attempt to trade like a professional trader would trade. By the way, technical charts do serve a great purpose, they are the records of missed markets of most fundamentalist’s and guru technician’s. Why do they miss most markets? p. 140 of your book answers this question (I think the best concept in your book). Thank You.”

Predict v. Follow

I was forwarded this quote that addresses the idea of technical analysis and where trend following fits into the grand scheme:

“From John Murphy’s book technical analysis is defined as the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. There is the key difference. Predictive vs following. A lot of the “tools” in technical analysis books are centered around prediction v. following. A classic example of this concept would be the idea of a price target off a head and shoulders top. A true market technician would set a price target based on the size of the formation and forecast the most likely next “leg” the market would go to. A true trend follower would never set a price target, they prefer to let a trailing bar stop take them out of the market when prices start to reverse against them or some other similar method. You can use technical analysis “tools” to help you follow the price movement and act more like a follower or you can use technical analysis tools to help you predict, the choice is yours. Another important point is that if someone told you they were a trend follower, that would imply that they are that type of trader. Technical analysis is a wide concept that would need to be refined in order to generate a particular trade system.”

I agree with all except the idea that prediction may be an option. Technical analysis for so-called prediction is fool’s gold.

Intelligence Analysis

Richards J. Heuer, Jr. wrote the free online book Psychology of Intelligence Analysis for the Center for the Study of Intelligence at the United States Central Intelligence Agency. The relevance to great trading and great traders is straightforward.

Here is the table of contents:

Author’s Preface
Foreword by Douglas MacEachin
Introduction by Jack Davis
Chapter 1: Thinking About Thinking
Chapter 2: Perception: Why Can’t We See What Is There to Be Seen?
Chapter 3: Memory: How Do We Remember What We Know?
Chapter 4: Strategies for Analytical Judgment
Chapter 5: Do You Really Need More Information?
Chapter 6: Keeping an Open Mind
Chapter 7: Structuring Analytical Problems
Chapter 8: Analysis of Competing Hypotheses
Chapter 9: What Are Cognitive Biases?
Chapter 10: Biases in Evaluation of Evidence
Chapter 11: Biases in Perception of Cause and Effect
Chapter 12: Biases in Estimating Probabilities
Chapter 13: Hindsight Biases in Evaluation of Intelligence Reporting
Chapter 14: Improving Intelligence Analysis

I have noticed the CIA’s web server can be iffy so be patient.