Frank, Success and Luck

In The Success Equation Michael J. Mauboussin teased apart the relative roles of skill and luck in performance and introduced the paradox of skill: “As skill improves,” he wrote, “performance becomes more consistent, and therefore luck becomes more important.” (p. 53) And, addressing a gathering of investors, James Simons of Renaissance Technologies claimed that “luck is largely responsible for my reputation for genius. I don’t walk into the office in the morning and say ‘Am I smart today?’ I walk in and wonder, ‘Am I lucky today?’” He has, of course, been both incredibly talented and “lucky” in spades.

The reality is that being talented and hardworking is not enough to guarantee success; luck also plays a critical role. Robert H. Frank, an economics professor at Cornell, expands on this point and explores its ramifications for tax policy in Success and Luck: Good Fortune and the Myth of Meritocracy (Princeton University Press, 2016).

“Chance events,” the author writes, “have always mattered, of course, but in some respects they’ve grown more important in recent decades. One reason for that has been the spread and intensification of … winner-take-all markets. These markets often arise when technology enables the most gifted performers in an arena to extend their reach.” (p. 9) In what might be viewed as a variation on Mauboussin’s paradox of skill, Frank argues that “the prodigious rewards that accrue to a handful of winners in these markets attract enormous numbers of contestants. And the more [highly competitive] contestants there are, the more luck matters.” (p. 10)

High achievers often downplay the role of luck in explaining their success. They’ll claim that they deserve what they achieved (and all the money that comes with it) because they were both skilled and dedicated, unlike their less talented, less driven colleagues. They’re right only in part. As the author argued in an earlier book, “a gifted salesperson … will be far more productive if her assignment is to sell financial securities to sovereign wealth funds than if she’s selling children’s shoes.” (p. 41) Psychologically, however, denying luck’s role in success may be a good strategy since it “may spur additional effort.” (p. 77)

Frank believes that a recognition of the pivotal role of luck in success will help to break down the resistance to raising more tax revenue to “sustain the public investment needed to support the stock of luck available to future generations,” a resistance that “has also resulted in spending patterns that poorly serve the current generation, including even its most successful members.” (p. 108)

Frank advocates a progressive consumption tax. A person’s taxable consumption would be his income minus his savings. “Under the current income tax, rates can’t rise too high without choking off savings and investment. But higher marginal tax rates on consumption would actually encourage savings and investment.” (p. 118)

Since our sense of financial well-being is relative, “doing better than one’s rivals,” “a progressive consumption tax wouldn’t alter the fact that those who earn more can also spend more.” (p. 121) They might forgo some extravagances, but so would their rivals. So they shouldn’t feel worse off.

Whether or not one buys into Frank’s proposal for a federal consumption tax, this book should stimulate debate. And that’s all one can ask, given the current situation in Washington.

Bowman, The Golden Rules

How many times does one have to read good advice before acting on it? I don’t know. I for one continue to struggle. This time the advice comes from Bob Bowman, Michael Phelps’s coach, in The Golden Rules: 10 Steps to World-Class Excellence in Your Life and Work (St. Martin’s Press, 2016), written with Charles Butler.

The rules are straightforward:

1. A champion sets a “dream big” vision
2. Adopt an “all-in!” attitude, not a “get out!” one
3. Take risks—and then enjoy the rewards
4. Short-term goals lead to long-term success
5. Live the vision every day
6. A team approach can inspire individual success
7. Stay motivated over the long haul
8. Adversity will make you stronger
9. When the time comes, perform with confidence
10. Celebrate your achievement, then decide what’s next

Following them is something else.

Bowman recommends that competitive swimmers seek to achieve, not to medal. As he says, “Gold medals are out of your control. Another swimmer may simply be better than you on race day.” But if swimmers “set their sights on breaking a record—at nailing the best time possible—then they can visualize something that’s tangible, achievable, and within their control.” That recommendation can easily be translated into the language of finance: don’t focus on profit, which is out of your control; focus on the things you can control, like risk management and your own performance. And, Bowman would add, keep a scorecard.

One of the problems I think most traders and investors struggle with is staying motivated over the long haul. But just think about how hard it must be to stay motivated when you’re swimming back and forth for 7,000 meters in the morning, all the while staring at the lane’s black line, and then doing the same thing again in the afternoon, day after day, month after month. Bowman’s advice: make every day seem not like every day and find another passion to offset the grind that comes with your primary one.

The other problem, this one ubiquitous, is dealing with adversity. Bowman suggests that you practice being uncomfortable (the famous example being the time he stepped on Phelps’s goggles and cracked them so that the swimmer’s goggles would fill with water when he was competing in an unimportant heat—something that certainly served Phelps well when the same thing happened to his goggles, this time of course not caused by his coach, in the Olympics and he nevertheless swam to gold).

Cunningham, The Buffett Essays Symposium

In 1996, as a way to launch The Essays of Warren Buffett: Lessons for Corporate America, which went on to become an international bestseller, Lawrence A. Cunningham conceived of and hosted a two-day symposium at the Cardozo School of Law in New York City. Warren Buffett and Charlie Munger were, of course, the stars of the show. The proceedings were taped, and lots of photos were taken.

For the twentieth anniversary of the event Cunningham put together a slim volume, about a hundred pages, of excerpts from the proceedings, along with a host of unfortunately grainy photos. The Buffett Essays Symposium (Harriman House) provides highlights from four panel discussions: on corporate governance, finance and investing, mergers and acquisitions, and accounting and taxation. The contributions of academics and other panelists have been, for the most part probably mercifully, excised, except where they are necessary to provide context for the responses of Buffett and Munger. Here and there Cunningham includes brief boxed commentary from current academics and market participants.

Buffett fans will appreciate this book. Buffett and Munger comment expansively on a range of topics—from getting a first class CEO to that perennial fixation, Buffett’s death, in this case how Berkshire stock price would react to his death.

Cunningham reminisces about the logistics of the symposium (like forgetting to arrange to get the Buffett family to the airport) and events surrounding the symposium (for instance, officially witnessing Warren Buffett’s signing an updated version of his will). And then there are all the pictures, which seem to indicate that rich, engaged people simply don’t age.

The book is modestly produced—a paperback with a black and grey cover, nothing glossy here. As befits the coverage of a down-home value investor.

Kurz, Economic Thought: A Brief History

If you’re looking for a short but masterful overview of the course of economic thought, Heinz Kurz’s book, translated from the German by Jeremiah Riemer (Columbia University Press, 2016), might be just the ticket. In a mere 185 pages Kurz takes the reader from ancient Babylonian clay tablets, “perhaps the first national income account in human history,” to modern developments such as game theory and behavioral economics.

The chapter titles indicate the span of this book: early economic thought; classical economics; Marx and the socialists; the rise of marginalism; Marshall and the theory of partial equilibrium; utilitarianism, welfare theory, and systems debate; imperfect competition; Schumpeter and the principle of creative destruction; Keynes and the principle of effective demand; reactions to Keynes; general equilibrium theory and welfare theory; and developments in selected fields.

Kurz’s book is dense but eminently readable. What makes it especially worthwhile is that it traces ideas, even as developed by lesser known economic theorists. It is definitely not a redux of Robert L. Heilbroner’s The Worldly Philosophers. It’s a book about ideas, not famous people. Kurz evaluates these ideas and assesses their contribution to the development of economic thought.

Khouw and Guthner, The Options Edge

If you’re just starting out in options, this is not the book for you. And for that I am grateful. There are a lot of good introductory options books but very few that address the intermediate trader or the experienced investor who wants to incorporate options into his portfolio. And fewer still that provide insights into how professional investors/traders craft and manage options trades to express their directional hypotheses or hedge their portfolios.

The Options Edge: An Intuitive Approach to Generating Consistent Profits for the Novice to the Experienced Practitioner (Wiley, 2016) by Michael C. Khouw and Mark W. Guthner starts with the basics but quickly complicates things by demonstrating their mathematical underpinnings. (The non-mathematically inclined can simply skip these sections and suffer no great loss.) It introduces the reader to trading volatility, option pricing, synthetics, and fundamental strategies. It explains how portfolios can be hedged using options to enhance returns and how to extract information from options prices. Perhaps most notably, it offers some options strategies for special situations such as potential short squeezes, skew opportunities, and dividend capture. And it explains how to analyze business opportunities as if they were options (think, for instance, of Berkshire Hathaway, which effectively sells puts and buys calls), with examples of both home runs and strike-outs.

This book is a healthy antidote to the usual fare offered to retail traders—buying single calls or puts on ostensibly fast moving stocks (often identified by questionable trading services), selling naked options in the hope that the probability gods favor you, or routinely placing non-directional trades on indexes. It challenges the reader to be creative in finding trading opportunities and structures, all the while admonishing him to thoroughly learn the intricacies of options so he won’t be blindsided.

I often say that if I get one good idea from a book I consider the read worthwhile. Well, I definitely got my one idea from The Options Edge. And even a little more. So, yes, I consider this book a winner.

Goetzmann, Money Changes Everything

It’s easy to despair over the outsize role of finance in the modern world and but a short step to the cynical question: What good is finance anyway? In his sweeping book Money Changes Everything: How Finance Made Civilization Possible (Princeton University Press, 2016) William N. Goetzmann demonstrates that although finance has often created serious problems (in part because it is “a potentially destabilizing force”), it also led to “some of civilization’s most important achievements: writing, the mathematics of probability, mechanisms for savings and investment, and the harmonization of global relations.” (pp. 8, 519)

Goetzmann, a professor of finance and management studies at the Yale School of Management, takes the reader on a fascinating intellectual adventure in time and space, from the Uruk tablets (c. 3100 BCE) to sovereign wealth funds, from China to Europe, Inc. Throughout, he points to the feedback loops between civilization and finance. For instance, he quotes the fourth-century Pythagorean philosopher Archytas: “The discovery of calculation (logismos) ended civil conflict and increased concord. For when there is calculation there is no unfair advantage, and there is equality, for it is by calculation that we come to agreement in our transactions.” Goetzmann comments: “Who might have guessed that the roots of democracy lay in financial literacy?” (pp. 94-95)

He shows how Fibonacci, in his Liber Abaci, compared the present value of two cash flow streams to devise the method of “net present value,” “the most important tool in modern finance.” (p. 243) He discusses the analysis of option prices by Henri Lefèvre (1827-1885?) and includes one of Lefèvre’s payoff diagrams that shows how to deconstruct an option position.

This book is packed with information. We learn, for instance, that Christopher Columbus’s “contract with the Spanish crown was extraordinarily complex: he received not only political favors but also 10% of future revenues from transatlantic trade. He also negotiated an option to invest up to 1/8 share of any commercial enterprise organized to exploit his discoveries.” (p. 10)

There is no way I can do justice to this book in a brief post. Let me say simply that everyone who is curious about the history of finance will be richly rewarded by reading this book. And by keeping it ready to hand for future reference.

Chishti and Barberis, The FinTech Book

Financial technology is a mushrooming field. Just ask any unemployed bank teller. Or the fixed-income trader who has been replaced by a computer programmer. And perhaps, soon enough, even currency counterfeiters.

The FinTech Book: The Financial Technology Handbook for Investors, Entrepreneurs and Visionaries, edited by Susanne Chishti and Janos Barberis (Wiley, 2016), addresses multiple aspects of this disruptive technology—or, better, technologies—in developed as well as emerging markets. It highlights the kinds of applications that can either challenge the very existence of traditional banks or be incorporated into, and thereby radically change, mainstream banking. It analyzes commerce—payment systems, B2B transactions, identity theft—and investment—crowdfunding, marketplace lending, robo advisors, crowdsourced alpha. And, of course, crypto-currencies and blockchains.

This book is not at all technical. It was written not for quants (although the next paragraph may seem to belie this claim) but for people who are either simply curious about the status and possible future course of financial technology or who might want to get aboard this trend, as entrepreneurs or investors.

One chapter that caught my fancy was “To Crowdsource a Hedge Fund” by Andrew Campbell, data analyst at Quantopian. Campbell suggests a quant crowdsourcing platform with “a robust all-in-one algorithm creation and comparison package…. When a platform for researching, writing, back-testing, deploying, and comparing trading strategies becomes an investor in its own user base, a symbiosis emerges. The quants get a free platform for researching and writing algorithms that will always remain their own intellectual property and the chance to win significant capital backing. While the rest of the world is left analyzing quarterly returns on a few dozen strategies, the platform-investor gets to build their portfolio by looking minutely at returns from hundreds of thousands of strategies. With this mass of data in hand, a fund can more accurately invest in the strong and uncorrelated algorithms needed to form an elegantly diversified portfolio.”

Social investment networks exist already, of course. Yoni Assia, the founder and CEO of the world’s largest such network, the eToro OpenBook, writes a chapter about the success of his enterprise.

The FinTech Book is at heart an idea book, which is why visionaries were included in its self-defined audience, along with investors and entrepreneurs. Financial technology might not be as world changing as DNA editing, but it will fundamentally transform the way we interact with all things economic. And that’s a big chunk of our world.

Wilson, Stopping the Noise in Your Head

Reid Wilson is director of the Anxiety Disorders Treatment Center in Chapel Hill and Durham and adjunct associate professor of psychiatry at the University of North Carolina School of Medicine. He’s the author of Don’t Panic, which went through three editions (Harper Perennial), and has spent most of his 35-year career working with anxious clients. I think it’s fair to say that his credentials are significantly above those of the average self-help guru. The question is what can he do for traders and investors. As it turns out, a lot. In this post I can only point to a few.

“Anxiety’s best strategy,” Wilson writes, “is to convince you to spend most of your energy worrying about how to protect yourself or someone else against harm. It scores points by getting you to worry and then step back instead of step forward into the action.” (p. 8) It gets you to play defense or, in the language of the markets, to focus on risk (viewed as a negative). It gets you pass on promising positions, to dump your winners too soon, to play too small.

We want security, we want to know what’s coming next, we want certainty and comfort. But this is impossible in general, and quintessentially so in the markets. And therefore, to become a winning player, “your job will be to purposely and voluntarily choose to seek out uncertainty and distress.” (p. 9)

Just as a fitness coach doesn’t put you on the elliptical machine on a steady incline at a constant pace but mixes things up because disruptive change builds strength and increases stamina, so a “mental” coach disrupts your pattern and gets you out of your comfort zone “to build your ego strength and your mental muscles and to increase your grit and resilience so you can handle distress and rebound after a loss. By doing all that, we will improve your performance.” (p. 170)

Put another way, “step toward, not away from, your challenges. … Think of the aphorism ‘When you’re in the jungle, run toward the roar.’ What you’ll discover over time is that when you run toward rather than away from what is difficult for you, you’ll arrive on the other side of your challenges because you’re not resisting them anymore.” (p. 182)

What does this thesis have to do with worry and anxiety, signal and noise? “Worry is supposed to be only a trigger for problem solving. It is not supposed to last a long time. But Anxiety’s goal is to get you confused as to what is a valid concern and what is noise and then to get you to dwell on the worry instead of solving the problem.” (p. 51)

Some of the tipoffs that we’re trying to protect ourselves instead of looking for ways in which we can grow are: stalling or procrastinating, becoming numb or feeling flat, retreating to a safer place, over-preparing, continually researching, continually seeking advice, checking repeatedly, seeking the “right answer,” detailed thinking through of all possible options, and worrying! (p. 101)

Wilson develops his thesis (and recommendations) over 350+ pages. There’s a lot of solid advice in this book, advice that, if followed with conviction, might actually improve one’s bottom line.

Peterson, Trading on Sentiment

We all know that sentiment is a critically important ingredient in the pricing of tradable assets. But it is extremely difficult to move from this general and somewhat amorphous principle to a trading/investing edge. Richard L. Peterson takes up this challenge in Trading on Sentiment: The Power of Minds Over Markets (Wiley, 2016).

Peterson is the CEO of MarketPsych, a firm that in 2011 joined forces with Thomson Reuters to produce the Thomson Reuters MarketPsych Indices (TRMI), sentiment data feed covering five asset classes and 7,500 individual companies that Thomson Reuters distributes to its clients. As the Thomson Reuters website explains, these indices use “real-time linguistic and psychological analysis of news and social media to quantify how the public regards various asset classes according to dozens of sentiments including optimism, fear, trust and uncertainty.”

Odds are that, unless you’re a bank or hedge fund employee, you won’t have access to TRMI. Peterson’s book is the next best thing, although you have to realize that if you want to incorporate sentiment (not some proxy for sentiment) into your trading decisions and can’t do big data analysis yourself, you’re working with one hand tied behind your back.

Trading on Sentiment is divided into five parts: foundations, short-term patterns, long-term patterns, complex patterns and unique assets, and managing the mind.

To give a taste of this book (and to address something that affects everyone’s investments) I’ll focus on the chapter on sentiment regimes. As Peterson writes, “Context matters in financial markets. In the academic literature, differences in context are said to be a product of market regimes. A market regime is—in its most simplistic terms—a bull or a bear market. Recent academic research demonstrates that the performance of common investment strategies differs across market regimes, and these differences may be rooted in the divergent mental states of traders in each context (e.g., optimism in a bull market versus pessimism in a bear market).” (p. 270)

Regime-dependent performance may result from shifts in liquidity available to portfolio managers. “The profitability of published market strategies rises and falls in 3- to 5-year cycles based on liquidity. … The alpha to be harvested from such price patterns exists when they are largely ignored, but as capital is attracted to them, the excess returns dry up or even reverse.” (p. 272)

Peterson summarizes “the effects of sentiment regimes on the predictable returns of several market anomalies.” For instance, high-beta stocks outperform low-beta stocks “only following months of negative news sentiment.” As for post-earnings announcement drift (“the tendency of stock prices to continue moving in the direction of an earnings surprise after the event”), such drift is “significantly greater when market sentiment is opposite the direction of the earnings surprise.” (p. 273)

Trading on Sentiment will undoubtedly be seen in time as a seminal work. Much more research remains to be done on the identification and measurement of sentiment and its impact on financial markets, both on a macro and a micro level. But, even so, investors can use whatever measures they have of sentiment as potentially profitable filters in placing and managing their trades. Peterson’s work can serve as a useful guide.