Trader’s Narrative

Here’s an interesting video from the recent The New Yorker Summit featuring Malcolm Gladwell talking about the financial crisis:

After Gladwell’s recent book “Outliers: The Story of Success” which inspired the Definitive Guide to Trading Mastery & Success - I was hoping that he would turn his considerable attention to the current financial crisis. What are the underlying forces behind it, how did it happen, why did so many things go wrong in a cascade effect?

We get a glimpse of that in his brief talk but I’m rather disappointed at his shallow take on things. He suggests three possible reasons why things happened as they did:

1. Regulatory Failure: A lack of rules or the absence of their enforcement
2. Cognitive Failure: Dumb people making dumb mistakes
3. Psychological Failure: Overconfidence

He brushes aside the first option and then the second, saying that the players on Wall St. are anything but dumb. Then he zeroes in on the third, concluding that overconfidence is the real culprit.

Gladwell defines overconfidence as “certainty in the presence of expertise” which leads to two main fallacies: miscalibration and illusion of control. Referring heavily to William D. Cohan’s book House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, Gladwell builds his case that at the root of the financial crisis is the culture of overconfidence on Wall St.

While I don’t doubt that this is the prevalent culture of finance today, I think Gladwell has missed the mark and in doing so, perhaps inadvertently, treated the guilty parties with undeserved deference.

The weakening of the regulatory framework, such as the repealing of the Glass Steagles Act, as well as regulators who were for the most part, incompetent, ineffective and chummy with the financial industry played a major role. It was the frayed fabric of regulation that failed to keep the ‘cowboy’ culture of Wall St. from running roughshod over Main St.

Believe it or not, there was a time when banking was a staid, boring job. There was no way you could pick up a hot chick by flaunting your job as an investment banker. Of course, that was before you could leverage your equity 40 times or more and pretend you were running a hedge fund, instead of a vital service for society.

The failure of government to properly guard the industry from rot created a “tails I win, heads you lose” game. Who wouldn’t be overconfident to play such a rigged game? If you can nuke a whole industry and take the global financial system to the precipice… and then still walk away with hundreds of millions of dollars in salary and bonuses… would you be overconfident? Of course!

If every time you got into a jam, you knew from precedent (S&L crisis, LTCM, etc) that the government would always be there to socialize your losses, wouldn’t you want to take as much risk to gain the maximum private profits? Of course! You would be an idiot not to. So it clearly isn’t a case of ‘overconfidence’ but rather a rigged game from the get go.

Here’s a more substantive take on things from Prof. Shiller and the enfant terrible of this bear market, Nassim Taleb, author of The Black Swan:

Shiller mentions his recent book: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism which dovetails nicely with Gladwell’s thesis but unfortunately it is only Roubini who ends up making real sense. As always, Roubini is unapologetically abrasive. If we want our progeny to avoid a similar fate down the line we need more Roubinis making decisions and fewer insiders like Paulson and Geithner.

Lincoln said it best 172 years ago:

These capitalists generally act harmoniously, and in concert, to fleece the people, and now, that they have got into a quarrel with themselves, we are called upon to appropriate the people’s money to settle the quarrel.

Finally I’ll leave you with this ditty which was written by Colin Negrych:

Yea though I walk through the Valley of the Shadow of Debt
I shall fear no default rates; for thou art with me
Thy printing presses and thy stress tests comfort me
Thou preparest a bull market for me in the presence of Roubini, Taleb, and Grant
Thou anointest my portfolio with liquidity; my wallet runneth over

Surely bonuses and bailouts shall follow me all the days of my life
And I will dwell in the house in Greenwich forever.
A-Ben

I’m going to tell you exactly how you can become a successful trader. But a word of caution. You are probably not going to like the answer. I’m not going to sell you a course or a ’system’ or anything like that. So if that disappoints you, simply skip this and go read something else.

For the few who will actually read on, here is the definitive guide to trading mastery & success:

Most people approach this subject by looking for certain types of skills, qualities or personalities that would allow someone to excel at trading. We know that analytical, as well as, critical thinking skills are important, so is a competitive streak and a friendly relationship with numbers and probabilities helps of course. Many successful traders also excel at games which involve patterns and probabilities like poker and chess. But obviously, not everyone who has these characteristics or all who are great poker players, for example, are in turn successful traders.

So what is really the key to performance?

Although I knew the answer intuitively, it wasn’t until I read Malcolm Gladwell’s book, Outliers: The Story of Success that it was spelled out for me. By the way, I highly recommend you add this to your reading list because it will explain many seemingly disparate questions: the North, South cultural divide in the US, why Asians are much better at math, why the school year doesn’t last 12 months, etc. Anyway, getting back on point, most relevant to us, in Outliers, Gladwell explores the 10,000 hour principle: to achieve world class success in any field requires an investment of at least 10,000 hours of your time.

Of course, Gladwell didn’t invent this, as a gifted writer he brings to life the dry, academic insights gleaned by others. In essence, the 10,000 hour principle is a confirmation of the maxim made famous by Edison: genius is 1% inspiration, 99% perspiration. If you’re interested in the research, you should check out The Cambridge Handbook of Expertise and Expert Performance edited by Dr. K. Anders Ericsson, from Florida State University.

Think of a person who is considered a ‘genius’ in their field. Let’s take Mozart or Picasso. If you explore each of their lives, you soon realize that talent and practice become so enmeshed that it is impossible to separate the two. Both masters were engaged in their art at a very young age and practiced feverishly. By the time they were young adults they had done more work in their field than the average composer or artist does in a lifetime. When they hit their stride as adults, they were just warming up! They then went on to heights of accomplishment which dazzle us to this day.

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So putting it plainly, to become a successful trader, you need to invest at least 10,000 hours of your time doing just that… trading. Of course, that means that you’ll also have to think about trading to come up with ideas, read about the current market, learn about market history to put the present in context, learn different ways of analyzing the market like technical analysis, tape reading, sentiment, etc. There’s a lot there but you need to put in those hours before you can expect success.

It might help to think about this in another way. Do you expect a thoracic surgeon to saunter through one seminar on biology then flip through Gray’s Anatomy casually and then pick up a scalpel and save people’s lives? would you want yourself or your loved ones to be his patient?

So do you then see the fallacy in assuming that simply by taking one trading course and reading a few books on trading you will make money from trading next month?

What does 10,000 hours look like?

There are 250 trading days in a year and 7.5 hours in a regular trading day, so in a year there are 1,875 potential trading hours. But you also have to consider that it isn’t possible to stay glued to the screen for the whole day (nor advisable!) and that beyond the market hours, you need to do homework both before and after.

But assuming that you put in 8 hours, either trading or thinking and analyzing… then in a year you’ve got 2,000 hours. Which means that in 5 years you’ll have 10,000 hours.

What if you were really dedicated and put in 10 hours a day? and your Saturdays? then it would only take you 3 years to get to 10,000 hours.

And here’s the problem. Most people don’t want to do this. It is hard. It is frustrating. It is grueling. The average person doesn’t want to work hard, they don’t want to put in the hours, so not surprisingly, the results they get are also average (or below average). Extraordinary achievement requires extraordinary effort, fueled by passion and a smattering of innate talent.

In Jack Schwager’s must read “Market Wizard” series of books, he profiles extraordinary traders. Read their stories and you’ll soon find the thread that runs through all of them. These are traders that work hard. They think about the market, they are so creative that they actually come up with novel indicators that often bear their names. These are not your average traders because their dedication to the craft is anything but average.

Even if they start out putting in some hours, most people give up. They quit well before the 10,000 hours have accumulated. That’s why you need passion. For without it, can you imagine doing anything for 10,000 hours?

Let’s face it, if you don’t like something, you have trouble getting yourself motivated for 30 minutes. You procrastinate, negotiate and come up with all sorts of tricks to not do it. So obviously the prerequisite is that you have a passion for trading. Going through 10,000 hours is the best way to discover if you do. If you do, those 10,000 hours will fly by but if you hate it, they’ll seem like a century.

There are other variables: luck and talent. By luck I mean, when you have finished putting in your hours, are you trading in an easy environment where the wind is at your back? or in a devastating market condition that grinds even hardened professionals to a nub?

Imagine if you started trading in the early 1990’s just as ECNs and more open market regulations allowed for all sorts of easy arbitrage, or if you entered trading during the bull market in the mid 1990’s. You might think that this would be a disadvantage since it would make trading appear too easy but that is only true for those that approach it with that mindset. To you, who put in 10,000 hours, that is not the case, in fact, just as you hit your stride and flex your new found skills, there is an amazingly lucrative market condition ready for you.

And by talent I mean an innate skill. What people call those who are a ‘natural’. Although they do exist, the only way it can be leveraged to leapfrog the rest is through consistent practice. Even if you have a ‘gift’, unless you develop it, others who simply put in more effort will over take you, eventually.

Let’s take an example so I can illustrate what I mean exactly. The name Steve A. Cohen should be familiar to you. If not, he is probably one of the most successful traders in modern times. There is very little known about him or his eponymous firm, SAC Capital Advisors, except that it is a force to be reckoned with. SAC regularly trades ~3% of the NYSE volume and since inception in 1992, has returned 40% to investors. This is even more astounding when you consider that SAC now manages billions of dollars in assets and that its performance fee is 50% with a 3% fixed management fee (as opposed to the standard 2/20 structure in the industry).

So how did Cohen get so good? Was he just a natural? is he a trading genius? To try to answer that, let’s rewind to 1956 when he was born in Great Neck, NY and then go forward a few years to find him as a young boy at the dinner table.

Cohen’s father, who worked in the garment industry was passionate about sports and he shared this with his son, poring over the scores and highlights after dinner. You could say that Steve’s love for the stock market was stoked by his father’s love for sports and especially sports scores. Steve was fascinated to discovered that there was another section in the paper with similar rows of numbers that changed daily and that they represented prices. Soon these new set of numbers became much more fascinating to him than sports score. By the time he was 13 he would regularly drop by the local brokerage office and watch the tape. In the few interviews he has given, he has mentioned again and again that what he does today has its roots in the simple act of watching the tape scroll by when he was a teenager.

Later Cohen attended Wharton, graduating with a degree in economics. While there, he was so taken with stocks that he traded between classes. Also, like many other master traders, Cohen was a great poker player. The story of Cohen’s first day at his first ‘real job’ is well known as it has been told and retold so many times it has gained a folkloric status: when Cohen was 22 he was hired by Gruntal & Co. and on his first day he made $8,000. Soon he was clearing $100,000 a day for the firm and in 1984 was given his own trading group, which he ran until he started his own firm.

Now, when most people hear the story of Cohen’s first day, their eyebrows shoot up and they attribute it to pure talent. But when you consider that Cohen was watching the tape since he was 13 and that he was trading throughout his teenage years and college, then it isn’t that surprising, is it? This by no means discounts his accomplishment but rather it puts it in the proper context.

By the time he started trading on Wall St. with Gruntal, he had approximately 9 years of experience (from 13 to 22). He quickly ramped up the hours - you can just imagine how many he racked up as a professional trader running his own group! - and within a few years had double or triple the requisite 10,000 hours.

When he started SAC Capital with $25 million in 1992, Cohen was 36 - which means that he had been trading almost continuously for 13 years. And a large proportion of those years was spent in such an intense and concerted effort, day in and day out, that it bordered on a fanatical zeal to perfect his craft. Is it surprising then, that he is one of the best?

As you’d expect, Cohen is not motivated by money but trades because it is what he loves. If he were motivated by wealth, he would have been able to stop and enjoy a life of leisure a long, long time ago.

What is Your Plan?
Because of the obvious realities of life for most, it is much easier to go through your 10,000 hours when you are young. You don’t have other responsibilities which can get in the way, you have lots of mental and physical energy and stamina, you are able to concentrate and learn very fast, and you have an open and inquisitive mind that hasn’t been polluted by dogmas.

But other than those advantages, there is nothing really that can stop you, no matter how old you are, from becoming a master trader… if you have the passion for it. Because that is what will motivate you to put in the requisite 10,000+ hours of apprenticeship. Add to that a favorable market environment and maybe a little talent, and a pinch of luck and who knows? Maybe the next generation will be reading about your accomplishments in the next series of Market Wizard books.

If you enjoyed this, then you might also enjoy:

• Two Most Powerful Principles of Personal Development
• How to Fail As a Trader in 10 Easy Steps
• Psychology of Risk