The two things that go hand in hand are reward and risk.
Yes simple, I know, but for some reason in all my travels and conversations it is often lost on investors.
Its natural for most people to concentrate on just the reward side in terms of return when it comes to investing, but you cannot think about reward without thinking about the cost.
For example what is more desirable, a 20% return with a 50% drawdown, or a 10% return with a 10% drawdown?
Sadly its not just the hunt for return that suffers from this one sided thinking but also when it comes to comparisons of performance.
Once again, most people if a person underperforms point out that they could’ve made 10% a year by parking their assets in an index.
To that we say all well and good, but are you willing to accept a 50% drawdown for that return?
You see you just cant think about reward without thinking about risk in any scenario.
For us we use a simple measure of gain to pain, the MAR ratio.
This ratio simply looks at your compound annual growth rate and divides it by your maximum drawdown.
It is a great tool in measuring “performance” both internally and externally.
To put it another way, I like to ask people this question, “How much did you pay for that drawdown?”
Sadly for most people when they see a manager that gets a 15% return and another that gets 11% they instinctively want to go with the manager that gets the higher return, even when they see that his drawdown is substantially larger than the other managers!
The manager with a 15% return might have exceptional skills at finding long only stocks that outperform but due to high correlation and market risk he still has 50% drawdown giving him a MAR of .3.
Compare that to the manager who gets an 11% return and only has a 20% drawdown with a MAR of .55, the less obvious choice is the better one!
Michael, I just wanted to take a moment to thank you for your work. I have read most of your books and they are exactly what I needed. You see I am a veteran of the brokerage business (30 Years) and I have always known intuitively that something about the entire business was, and is, a lie. Analysts have no skin in the game, management doesn’t care if you make money, it’s all about assets under management that’s why they will never say sell. “Just buy more.” You see I used to look at CFA’s as the smartest people in the room. Now I know that they are really just financial weathermen trying to predict the future. Something that can’t be done. I have adopted for my clients a simple trend following rules based strategy, and it amazes me how hard it is to change minds. It is so simple they somehow think it can’t work. But I will keep plugging away and I know you will to. The business needs to change even the other brokers in my office look at me like a freak when I tell them to stop listening to analyst’s and “stop buying stocks that are going down.” Old habits die very, very hard. Just wanted to say thanks.
Looks like this feedback was inspired by my recent interview here.
Michael Covel interviews Josh Hawes. Josh is the Risk Officer and Investment Manager of Hawking Alpha. He is a trend following trader now who started off at Goldman Sachs. Josh breaks apart the trading industry, highlighting many of the cons associated with the mutual fund space.
Josh has always had a passion for math. He started looking at the performance of different funds within Goldman. As soon as he started to look at returns of some, he began to see a disconnect. They would judge themselves off “beating the index” but they were still losing massive amounts of money. They would also have access to CEO’s of top companies and still not be able to make money off of the information they would share. This is when he began to transition out of the company and turn to other forms of trading, not just long only.
Josh was given many books to read while at Goldman. “Reminiscences of a Stock Operator” was one that resonated with him the most. “Trend Following” was another book that Josh had come across. “Trend Following” triggered him to reach out to some of the traders mentioned in the book. Ed Seykota and Jerry Parker were just a couple of the traders he was able to spark up a conversation with by reaching out.
Next, Michael and Josh break apart index investing. Josh says everyone should ask themselves, “Why does the market owe you anything? And if the market goes down, does that not mean that the markets can go down for a long period of time?” You can’t say that you should go long the market because for 200 years the market has gone up. There has been massive ups and downs and you have to be able to navigate the down periods. Michael then asks, “How does one become the next Warren Buffett?” Josh says that 2008 is one of the best examples of why you could never be the next Warren Buffett. There are a lot of people in the mutual fund space that try and mirror Buffett. Some of these people fail trading the exact strategy as Buffett. So does that make Buffett lucky or a genius?
Josh and his firm guarantees to always follow their stops. He guarantees his clients that he will be a trend follower and although he can not guarantee any level of return, he will always follow his stops. This sets Josh and other trend followers apart from fundamental traders. Josh then segues into what he believes are the four ways to make money: When prices move, when prices don’t move, arbitrage, and high frequency trading. He expands on these four points and gives examples. Michael and Josh end the podcast on the importance of talking directly with clients and connecting with people on a personal basis.
In this episode of Trend Following Radio:
Trading off fundamentals
Keeping up with the Jones’s
Smooth equity curve’s
Concept of an Index
Mutual fund industry
High frequency trading
“Every trading system starts with an idea. The idea is a concept that describes some aspect of the way a particular market or all markets work.” – Hawking Alpha