Thin Line Between Love and Hate
How individual biases shape our market views
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I'd like to start by making some general comments about market structure. This is my sense of what markets are made of. In future pieces I'll look to expand on these themes and tie them to specific investment ideas. I welcome your comments.
Markets are dynamic. They echo and rhyme but rarely repeat. Markets conspire against us by often reproducing a pattern long enough just to draw us in – and then change after we have made our move. Uncertainty characterizes free markets because they are a product of a wide range of human behaviors. If markets were certain they would offer no opportunities whatsoever. Markets must deceive us in order to function.
Opportunity and uncertainty go hand in hand. That's OK – as long we recognize that markets can do anything at anytime. Todd's frequent refrain: "Discipline Over Conviction" captures the essence of it all. In order to succeed, we must be decisive – but we can't be certain of anything. Live by your convictions but don't die by them.
Too frequently our analysis of the future is proven wrong by events that we could not have anticipated. Sometimes it's even worse: what we thought we knew – what we took as fact – turns out to be fiction or irrelevant. We should expect to be surprised.
Yet we all try to anticipate what happens next. It's what we do. A trade or an investment is a prediction after all. Markets are a place where we must have a fixed view of the future in order to accept risk and allocate capital. But as soon as we commit it's best to abandon our convictions. The market owes us nothing and the least likely outcome is often what we expect. This is a strange and challenging business.
Markets conspire to keep us focused on our own behaviors and not those of other – but equally important – players. If you are a short-term trader, chances are you have a decent sense of what other traders like you are thinking and feeling, but only a limited awareness of what a long-term passive investment manager is experiencing. You are biased by the type of market participant you are. Chances are the more biased you are – the degree to which your style is pure – the more successful you are. It's very difficult to be a profitable short-term trader and a winning long-term portfolio manager. We tend to pick one set of biases and go with them because that is what works. In this view biases are neither good nor bad – they just are. They define and constrain our behavior. They make us do some things and not do other things.
But what if we stepped out of our own biases and looked at the biases of other types of market participants? Maybe we can getter a better read on market structure by looking at matters from multiple perspectives. Maybe we can make more money by understanding how others make their money.
We can identify different classes of market participants primarily by Time Horizon but also other biases like Market Selection and Risk Tolerance.
Let's look at two extremes. The first is a highly leveraged day trader on a bank desk. The other is a passive investor, the Chief Investment Officer of a pension fund.
The Trader: The trader is focused on many markets and instruments, with an emphasis on the most liquid tradeables. He is agnostic about direction – he'll trade long and short – often both in the same hour. His time horizon is short – sometimes seconds. A day is an eternity for him. He lives from open to close and likes to go home flat or hedged. His risk tolerance is tight because a 5% drawdown is a complete wipe-out as he is levered 20:1. He is young and he is wired. The Trader is surrounded by multiple screens, data feeds and TVs. He may know quite a bit about markets, the economy and the psychology of human behavior – or maybe he knows nothing. It doesn't matter because he is disciplined and tries not to confuse himself with the facts. He never enters a trade without a stop. He scores himself daily. His benchmark is a high absolute return with relatively low volatility. His biggest fear is a string of consecutive small losers that add up to one big loss. The trader can barely pay the rent on his salary, but can score a seven-figure bonus when he performs.
The CIO: The CIO is middle-aged. She has spent her career constructing portfolios for the long-term. Aside from some recent and relatively modest allocations to "alternatives", namely long/short equity hedge fund and private equity, she is a buy-and-hold investor who believes that the market cannot and should not be timed. She always tries to think about the portfolio as a whole and not about individual markets. She re-balances her portfolio every six months to reflect the "optimal" weighting of her sector allocations according to long-term correlations. Concepts like Markowitz-type diversification, Modern Portfolio Theory and Efficient Frontier largely guide her decision making. She is well read and frequently attends investment conferences. Her primary focus is manager selection. She considers herself to be very risk averse, but willingly accepts a 20% or greater drawdown. Her primary benchmark is relative to the performance and volatility of the S&P 500. Her biggest fear is under-performing the market. The CIO has a low six-figure salary.
These are only two types of market participants. There are many more, including offshore and algorithmic. The point is that markets are made up of many types having very different biases and behaviors. Billions of shares don't trade on the NYSE every day because the market is truly efficient or because information is perfectly discounted. If that were the case, CNBC would have very little to talk about. Markets are bubbling with activity because they accommodate the diverse needs and expectations of very different groups.
I ask you, what are the odds that the trader and CIO will act alike? Usually quite low. This is part of the reason markets work. Often the Trader is Selling what the CIO is buying or vice versa. A "normal" market is characterized by a diversity of biases and behaviors. Markets function well – but are somewhat boring - when buyers and sellers are in balance.
What happens when the Trader and the CIO happen to behave the same way? This is when the market really moves. Markets dislocate and become volatile when different players become bullish or bearish at the same time. It doesn't matter why. It matters that behaviors temporarily converge and push the balance of buyers and sellers out of whack.
Usually this convergence of behaviors is accompanied by a sense that the market is speeding up. If we think of volatility as the path price takes over time, then increasing volatility means that the market is covering ground at a faster rate. Volatility is often the consequence of longer-term market participants changing their behavior by temporarily reducing their time horizon. Sometimes this shows up like a long-term investor temporarily adopting the behavior of a short-term trader. Everyone has a stop whether they acknowledge it or not.
During most of January long-term investors stopped buying. They did not sell, but at the margin the effect was the same as the balance of buyers and seller changed dramatically. Behaviors converged. Long-term investors "shorted" the market by not buying and short-term traders sold. One wonders what might happen if the buy-and-hold types actually start to sell. More on this later.
I believe markets can be viewed as a collection of behaviors that tie to specific biases and a "fixed" time horizon that is subject to change. We may not be able to predict the future, but we can gain an edge by anticipating how different types of investors will react to new information. This awareness may change how and when we choose to react to the inevitable surprises that await.
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