Sunday, July 19, 2009

Faith, Inside the Mind of the Turtles

Curtis M. Faith’s Inside the Mind of the Turtles: How the World’s Best Traders Master Risk (McGraw-Hill, 2009) is the perfect beach book for traders. It’s a fast read, it doesn’t strain the brain, yet it addresses questions that haunt all traders and investors—how to proceed in the face of uncertainty and how to deal with risk.

This book is only tangentially about the famous Turtles; the reader looking for more information about Richard Dennis’s experiment will be disappointed (although Faith does pepper his book with autobiographical snippets). Moreover, Faith ventures beyond the world of trading to look at risk management in business and medicine. In brief, the title of the book is misleading. More appropriate would have been the title of the first part of the book, “The Seven Rules for Managing Risk,” though it wouldn’t have marketed nearly as well.

The seven rules, stated in their simplest form, are: overcome fear, remain flexible, take reasoned risks, prepare to be wrong, actively seek reality, respond quickly to change, and focus on decisions not outcomes. Faith devotes a chapter to each of these rules. In the second part of the book he applies these rules to societal issues such as education and transportation.

There are many takeaways for traders from Faith’s book, but here I’ll highlight only one—outcome bias—because it is so seductive. If a trade turns out well, the decision to make that trade must have been good; if it turns out poorly, the decision was bad. Sounds reasonable, doesn’t it? The problem is that it doesn’t account for, among other things, randomness and just dumb luck. This, by the way, reminds me of a quotation from a piece written in 2000 about the hugely successful James Simons of Renaissance Technologies. “‘Luck,’ he told a gathering of potential investors . . . , ‘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?’” Simons, himself a brilliant mathematician, and his staff of mostly scientists and mathematicians mine the markets for best trading ideas, but like all the rest of us they have no control over the outcome of their decisions.

Faith contends that although it is important to learn from the past, if you focus on outcomes rather than decisions “you may end up learning the wrong things as you make mistakes.” (p. 157) Furthermore, you may start making really bad decisions. After a series of losing trades, for instance, a person may begin to tinker with a vibrant strategy or abandon it altogether. Plagued by recency bias and a belief in the law of small numbers, the trader becomes crippled with self-doubt. Risk becomes an enemy. The trader, on the other hand, who embraces reasoned risk and makes peace with uncertainty may, with a little luck, become a new “turtle.”

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