Trading tactics of George Soros

As a follow-up to yesterday’s post here is a piece I saved, alas without a link. I have edited it slightly. My sincere apologies to the unacknowledged blogger.

One of Soros’s most useful qualities has been his ability to detach his emotions from his dealings in the financial markets. In that sense, he is something of a stoic. While others permitted their egos to get in the way of making intelligent market decisions, Soros understood that the wise investor was the dispassionate investor.

It made no sense to claim infallibility. Although it may have been difficult when a favorite stock suddenly took a plunge, it was far better, as Soros constantly did, to admit when he made mistakes.

One day in 1974, Soros was playing tennis with an acquaintance. The phone rang. It was a broker in Tokyo, letting Soros in on a secret: That year President Richard Nixon was immersed in the Watergate scandal that would eventually cause his downfall. The broker was calling to let Soros know that the Japanese were reacting poorly to Nixon’s troubles.

Having taken heavy positions in the Japanese stock market, Soros had to decide what to do--stay in, get out. His tennis partner noticed that sweat had formed on Soros’s forehead that had not been there during the match. Then and there Soros decided to sell. There was no hesitation, no feeling that he needed to consult anyone else before taking such a large step. It had taken him a fraction of a second to decide. That was all.

Allan Raphael, who worked with Soros in the 1980s, believed that Soros’s stoicism, a rare trait among investors, had served him well. “You can count them on one hand. When George is wrong, he gets the hell out. He doesn’t say, `I’m right, they’re wrong.’ He says, `I’m wrong,’ and he gets out, because if you have a bad position on, it eats you away. All you do is think about it--at night, at your home. It consumes you. Your eye is off the ball completely. This is a tough business. If it were easy, metermaids would be doing it. It takes an inordinate amount of discipline, self-confidence, and basically lack of emotion.”

Then there was the vaunted Soros self-confidence. When Soros believed he was right about an investment, nothing could stop him. No investment position was too large. Holding back was for wimps. The worst error in Soros’s book was not being too bold, but too conservative. “Why so little?” was one of his favorite questions.

Finally, there was his instinct. This was the immeasurable ability to know when to speculate heavily, when to pull out of an investment position--when, in effect, you were on the mark, and when you were not. “Basically,” said Soros, “the way I operate is I have a thesis and I test it in the market. When I’m short and the market acts a certain way, I get very nervous. I get a backache and then I cover my short and suddenly the backache goes away. I feel better. There’s where the instinct comes in.”

Summing up George Soros’s investment skills, Morgan Stanley’s Byron Wien suggested that “George’s genius is that he has a certain discipline. He views the market very practically and he understands the forces that influence stock prices. He understands there is a rational and irrational side of markets. And he understands that he isn’t right all the time. He is willing to take vigorous action when he is right and really take advantage of an opportunity, and to cut his losses when he’s wrong. He has great conviction when he’s sure that he’s right as he was in the sterling crisis in 1992.”

Part of Soros’s instinct was in detecting movement, one way or the other, in the stock market. This was not something one could learn in school; it was not part of the curriculum at the London School of Economics. This gift is one that few possess. And Soros had it.

Edgar Astaire, his London partner, had no trouble pointing out the source of Soros’s success: “His greatest key to success is his psychology. He understands the herd instinct. He understands when lots of people are going to go for something, like a good marketing man.”

By cunning and craft

Some time ago I saw a book of this title, if I recall correctly on fiction writing. I wasn’t drawn to the book, but the title stayed with me. Because, I thought, the only way to make consistent, sizable money in the markets is by cunning and craft.

Neither cunning nor craft alone is sufficient. It’s the combination that is so powerful. But first let’s define the two terms since they are often used interchangeably, which would defeat the whole point of this post.

I use the word “cunning” to encompass a range of its more positive meanings: craftiness, wiliness, keen insight. By “craft” I mean skill or proficiency.

Let’s start with the latter quality. A good craftsman learns his trade and continually hones his skills. If he’s a cabinetmaker he has to be precise in his measurements and skilled in his use of tools. He has to practice joinery over and over again. In time he may truly become a master craftsman. He’s unlikely, however, to become a billionaire.

We are often told that to become successful in trading we have to master the craft. Well, yes, but is this enough? I don’t think so. One reason is that the markets are dynamic and to a large extent random. The craftsman may occasionally be confronted with new tools and new design plans. Sometimes he even has the indecisive client who keeps changing the specs over the course of a job. But a good craftsman doesn’t normally use his saw with consistent skill and get inconsistent results. The skilled trader does.

Here’s where cunning must enter in—invoking craftiness or wiliness to find those trades or investments that will exploit market inefficiencies. What sets the likes of Paul Tudor Jones apart from the merely skilled trader? For one thing, cunning. Jones considers himself a premier market opportunist. What sets Warren Buffett apart from the skilled investor? Once again, at least in part cunning. These men are not merely master craftsmen; they are uncommonly shrewd. They leave average opportunities for average traders and investors and attempt to zero in on the best. And they believe in their own cunning because they commit wads of money to their best ideas.

This theme could be developed at much greater length, but let me cut it short and perhaps inspire some dialogue. My bold pronouncement of the day: The trader or investor who is all cunning and no craft is doomed to failure; the trader or investor who is all craft and no cunning is doomed to mediocrity.

Appel, Higher Returns from Safe Investments

Investors in search of a clear description of income investing need look no further than Marvin Appel’s Higher Returns from Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income (FT Press, 2010). He wisely spends most of the book on bonds since this is one of the most misunderstood areas of investing. He then looks at preferred stocks, dividend-oriented ETFs, and covered calls. Throughout Appel meticulously outlines the risk factors in these so-called safe investments and, where appropriate, their tax consequences. He illustrates his points with charts and tables and keeps statistics to a minimum (normally, just return and drawdown).

Appel has the rare ability to explain and analyze investing alternatives in a way that respects the intelligence of his reader. He doesn’t assume much knowledge, but he provides far more than an introductory overview. Take, for instance, his description of buying bonds from a broker. “[U]nlike stocks, there is usually no specified commission per trade for buying bonds. Rather, buying bonds more closely resembles buying a car. The price you pay includes a profit for the dealer. Like buying a car, and unlike buying a stock, you can sometimes negotiate a better price for a bond than what is posted on the broker’s Web site.” But sometimes the broker sees you, the odd-lot buyer, coming and bumps up his price. “Another way in which buying and selling bonds resembles dealing with a used car is your experience when you want to sell back to the dealer. You will frequently find when you go to sell a bond from your account before it matures that the price you are offered is much less than you think the bond is worth. Indeed, the price offered to you might be well below the value stated for your bond on your brokerage statement, just as the value a car dealer offers for your trade-in is frequently far below the Kelley Blue Book price.” (pp. 25-26)

Occasionally Appel suggests some tactical trading strategies, such as trading high-yield bond funds with 3% buy and sell stops evaluated once a month. He points out that this strategy works “only for investments where the size of the trend is significantly larger than the size of your stops,” (p. 87) which precludes most stock market investments.

Preferred stocks are a neglected area of investing and hence poorly understood. Appel explains that, unlike bonds, they are callable. So, although when preferred stock yields rise the prices of preferred stocks fall, “the converse might not be true: A drop in interest rates might not boost shares of preferred stocks if the issuer can call the shares.” (p. 119)

I seldom write about books directed at the average investor because most of them are both boring and useless. Perhaps because Appel has investing in his blood (he’s the son of Gerald Appel and left a medical/biomedical engineering career to become an asset manager) he draws on a store of knowledge that few financial planning authors could ever aspire to. As a result, he writes with fluency and authority. Will he keep your nest egg safe? Probably not, but then anyone who thinks there’s a sure path to investment success should probably read Tarot cards rather than this book.

Happy birthday to me

Well, not actually me but this blog. It’s now one year old and 352 posts strong. How does that translate into blog years? Seems as if it should be worth at least a dozen. But then, we might not want it to become a teenager.

Many thanks to all my loyal followers and to the publishers who supply me with books. You keep me disciplined, plugging along day after day trying to find insights from which we can all profit.

In the course of the year this blog has had 10,028 unique visitors (or, as Google so eloquently puts it, absolute unique visitors) from 112 countries. Some fled after a single visit, others remained faithful readers. Of course, this blog is not written for the masses, so counting heads is not important. Influencing minds is!

Who is a trading talent?

Some time ago I saved, don’t ask me why, the Mako Group’s description of its program to train options market makers in London. They claim that one reason for their success is their ability to “identify, train, and retain top trading talent.”

They identify six traits they are looking for in trainees.

First, discipline, which they consider the most critical determinant in success. This includes academic discipline, mental discipline (maintaining focus throughout long work days), the discipline to stick to a plan, and emotional discipline.

Second and perhaps surprising to many, humility—baseline humility coupled with quiet confidence.

Third, a history of success in areas outside of trading that demonstrate that “this person can make it happen.”

Fourth, preferably no previous trading experience; they want to shape their traders according to their firm’s culture.

Fifth, a gift with numbers. Remember that we are talking here about market makers in the world of options, which is more quantitatively driven than that, say, of equity futures.

Finally, an entrepreneurial spirit. The blurb states: “we find that the best traders are the ones who cannot sit at peace when there is opportunity within reach.”

Would you be a strong candidate?

Drobny, The Invisible Hands

Often a financial writer’s second book is merely a warmed-up version of the first. This is decidedly not the case with Steven Drobny’s The Invisible Hands: Hedge Funds Off the Record—Rethinking Real Money (Wiley, 2010). This is a terrific book, even better to my mind than Inside the House of Money, about which I wrote favorably, if belatedly, last summer.

The Invisible Hands is a series of interviews with two identified contributors from Drobny’s first book and ten anonymous global macro hedge fund managers whose funds collectively have over $100 billion under management and who performed well in 2008. The book’s stated goal is “to provide an understanding of how successful global macro hedge fund managers navigated the most significant financial crisis of our lifetimes and to offer suggestions for how real money managers and all investors can incorporate certain elements of the macro approach into their own investment process.” (pp. xviii-xix) With the endowment model failing during the crisis (Yale’s endowment assets, for instance, fell from almost $23 billion to $16.3 billion for fiscal year 2008-2009, a decline of nearly 30%) and global macro hedge funds returning 4.83% in 2008 and 4.03% in 2009, there’s something to be said for taking a closer look at global macro strategies.

Many of these strategies are difficult if not impossible for the individual investor to implement. But the thinking behind them and the way their risk is managed are often so compelling that everyone who is active in the markets can learn a tremendous amount from these interviews. Moreover, even though most of the contributors are anonymous their life stories are fascinating, sometimes even inspiring.

Here are just a few snippets. They are not representative of the book as a whole because it doesn’t lend itself to such piecemeal extraction.

Should a real money manager (such as a pension fund manager) who is long only and whose portfolio is primarily equities worry about long-term inflation? No. Equity indices are denominated in nominal terms, so in the long term equities and inflation are highly correlated. If a hedge fund manager wants to protect himself against the possibility of hyperinflation he can buy 10-year, 10,000 strike S&P calls for 14 basis points. (Leitner, “The Family Office Manager,” pp. 71-73)

Another contributor, “The Philosopher,” finds opportunities in our flawed attempts to understand an uncertain economic future. “The human brain,” he notes, “is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.” (pp. 118-19)

“The Predator” always wants to know what kinds of people are on the other side of his trades. “You need buyers to short against at the top of the market and sellers to buy from at the bottom. You have to identify the type of person who shorts at the bottom or the one who leverages on the way up and use the liquidity they provide to do your trades. You need to understand where other people get it wrong in order to see if their errors create an opportunity for you.” (p. 335)

And, finally, “The Plasticine Macro Trader” opines that “even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following.” (p. 364)

Statistical models and shoe leather

An article in last Friday’s New York Times profiles Carmen Reinhart and Kenneth Rogoff, authors of This Time Is Different, which I reviewed earlier on this blog. The article highlights the divide within economics between “theoretical coherence and elegance” and “investigating data” and notes that “over the last few decades . . . economists [have] glorified financial papers that were theory-rich and data-poor.” The quants made the empiricists seem mundane, perhaps even outmoded. Reinhart and Rogoff, of course, are the quintessential data collectors and maintain that although data gathering may not save us, ignorance of data is lethal.

In a series of papers collected and edited by colleagues after his death (Statistical Models and Causal Inference: A Dialogue with the Social Sciences, Cambridge University Press, 2010) David A. Freedman, a mathematical statistician and professor of statistics at the University of California, Berkeley, also defends the empiricists. Relying heavily on epidemiological examples, he argues for a “shoe-leather” methodology against increasingly technical approaches to statistical modeling.

Put in the simplest terms, Freedman claims that without “careful empirical work tailored to the subject and the research question, informed both by subject-matter knowledge and statistical principles” the opportunity for error in statistical modeling is huge. (p. xiv) The “’desire to substitute intellectual capital for labor’ by using statistical models to avoid the hard work of examining problems in their full specificity and complexity” is both pervasive and perverse. (p. xvi)

Or, as he writes in the abstract to his paper “On Types of Scientific Inquiry: The Role of Qualitative Reasoning,” “One type of scientific inquiry involves the analysis of large data sets, often using statistical models and formal tests of hypotheses. Large observational studies have, for example, led to important progress in health science. However, in fields ranging from epidemiology to political science, other types of scientific inquiry are also productive. Informal reasoning, qualitative insights, and the creation of novel data sets that require deep substantive knowledge and a great expenditure of effort and shoe leather have pivotal roles. Many breakthroughs came from recognizing anomalies and capitalizing on accidents, which require immersion in the subject. Progress means refuting old ideas if they are wrong, developing new ideas that are better, and testing both. Qualitative insights can play a key role in all three tasks. Combining the qualitative and the quantitative—and a healthy dose of skepticism—may provide the most secure results.”
(p. 337)

Hear, hear!