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Tharp's Thoughts Weekly Newsletter

September 12, 2007 — Issue #338
  
New NEW Workshop Free to ETF Attendees: One Day Excel Course
Article

Managing Your Investment Strategy, by Ken Long

Trading Tip

An Iceberg Lurking Under the Surface of the Credit Markets, by D.R. Barton, Jr.

Melita's Corner

The Wise Woman’s Stone, by Melita Hunt

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October 12-14 Raleigh, NC

(NOTE: These workshop dates were changed since we mailed a printed schedule. Always double check on-line).

Feature

Managing Your Investment Strategy

By

Ken Long

In my capacity as assistant professor of logistics at the US Army Command and General Staff College, I have been doing some work with complex adaptive systems and the characteristics of learning organizations. One of the things that continually emerges from that stew is the challenge of assessing a dynamic environment in order to act with a degree of confidence under conditions of unavoidable uncertainty.   When the dimensions of change in the environment also change their frequency, intensity, duration and sequence, then you want to see that your assessment instruments adapt to the new parameters or you could be concerned that you are no longer calibrated to the new reality.

With that in mind it’s fair to ask yourself as a trader "How am I staying in touch with an evolving market?  Are my beliefs adapting and evolving in synch with the market? Do I know the limits of the usefulness of my beliefs? Do I know the conditions under which certain beliefs are more useful than others?  Do I have a way of choosing the appropriate point of view based on the current state of the market or the world?  Do I have a way of translating my current confidence level in my beliefs or indicators into a level of risk?"

A simple way to think of this dynamic in practice is the belief that price levels that were once resistance can become support, once price can break through and stay above the upper limits of a trading range. The set of behaviors to take when you think you are near support are different than those when you are near resistance, yet we are talking about price at the same level.  What evidence is required for you to change your point of view under these conditions?  Are these rules explicit or are they based on feelings?  How do you validate, update and manage these competing beliefs? How are they integrated into your overall belief structure?  These are all questions that a trader addresses either explicitly or implicitly as the trading system is defined.  Remember, you have a system whether you design one or not.  Also remember, your system is what you do, not necessarily what you have committed to paper. And in the space that distinction creates psychology enters, whether we are aware of it or not.

Just as it is useful to examine the beliefs inside a specific trading system, it can be useful to examine your investment management strategy.  For the purpose of this article, consider your investment strategy as your plan to integrate the various investment strategies you have selected as appropriate for your objectives.  You can think of your strategy management system as the rules you will use to assess the performance of individual systems and their continued suitability for inclusion in your overall strategy. Unless you are committed to flying blind, you must periodically determine if the system is still performing as designed, and then if it is still appropriate for your objectives. Finally, you need to decide how much of your portfolio should be allocated to that system. 

Try this experiment: Stand back from the daily operation of your various systems and examine how you answer these questions.  Do you have a routine for examining these questions or do you wait for a significant emotional event to examine these issues? If you wait for the emotional event, have your decisions, in retrospect, added value?  If not, is this a pattern that also occurs inside the operation of your trading systems? In other words, is your habitual response to emotional events a valuable part of your investment system or do you flit from system to system on a whim? Look for a connection between how you perform in the management of individual trades and how you manage the integration of your various strategies.

But if you are examining your investment strategy routinely, you can look to see if the review frequency occurs often enough to make decisions in time, or if your reviews tend to be too late and only produce explanations. Ideally, we want our reviews to enable effective decisions in time to make a difference.

You can also examine your criteria for making decisions to see if they truly are measuring things that matter, that the measurements are providing actionable information, and that the measurement scale somehow reflects the sensitivity required for the decision area. In other words, you may not want to have binary (Yes/No) criteria if the dimension you are measuring is best understood on a sliding scale or measured by degrees. We are cautious and humble enough to remember that, paraphrasing Einstein, not all the things that count are countable.

In the same way, he who controls the agenda, controls the outcome; he who selects the measuring device, selects the result.  If you commit to "analysis- based management" (and it's hard not to because it’s scientific!), then selecting the metric and the scale to use, and the interpretation of the result is all important because that definition produces the results that determine success or failure.

When military officers begin their training on the Military Decision Making Process (MDMP), they learn about selecting evaluation criteria, in order to fairly compare and choose among different courses of action. Early in their training, it is not unusual to observe a "check the block" mentality, with little thought given to how they will measure the criteria down the road when we are comparing between courses of action.  If the evaluation criteria are fuzzy, then the "measurement" can be spun, consciously or unconsciously, to get what you want.  Eliminating the fuzz up- front is perilous too though: if you pick the wrong "precise" measure, then you will be wrong with much greater fidelity.  Should you use a sliding scale or a Yes/No standard?  And there are categories of problems that may not be measurable or may only be assessed qualitatively (like areas that require a value judgment).

Finally, consider two management strategies: managing by walking around (MBWA) and evidence based management (also known as fact-based Management). These two management strategies are almost philosophical opposites, and are usually associated with the ongoing management of policy initiatives or business operations.

In MBWA, the driving concept is to get out of the office and into the world of live operations where plans are being implemented in real life. Proponents of this strategy argue that you need the physical confirmation of real world experience to fully grasp what’s going on. To apply this strategy to your trading, you might focus on daily after-action reviews of your trades and compare your trading decisions to your rule sets and look for problem areas or value added areas to help you amend either your rules or your behaviors.

Proponents of evidence-based management on the other hand, want to focus on measurable facts, removing emotion and “in the heat of the moment” perceptions, which may bias their judgment. Applying this strategy to your investment management might lead you to focus on the statistical performance of a population of trades and perhaps comparing different systems across different dimensions of performance that are related to your goals and values.

Is one strategy “better” than the other?  I submit that both can have their place as you manage your investment strategy. They are not mutually exclusive, and since I am a natural hedger, I have come to appreciate both the insights that can come from the intuitive “management by walking around” approach, as well as the systematic approach of evidence based management. The most important thing to me is that my strategy is intentional. I want to be an actor, not a re-actor, because I believe that is my best strategy for avoiding “meltdowns”.

Best wishes for success as you grapple with these issues!

About the Author: Ken Long, a retired Lieutenant Colonel in the U.S. Army with a Master's Degree in System Development, is currently a professor of tactics and logistics at the Army's Command and General Staff College. He has developed the Tortoise Method of mutual fund switching, a trading system that takes about five minutes each week with a goal of outperforming the S&P 500 Index. 

Ken is the instructor of our upcoming Highly Effective ETF and Mutual Fund Techniques Workshop, in Cary, NC and a co-presenter with Van at our Blueprint for Trading Success Workshop.

He is a trader and writes a daily and weekly market assessment for mutual funds and exchange traded funds. He is a proud husband, dad, and 
ju jitsu practitioner. 

 

Trading Tip

Conduits and Big Banks, Part Two

 An Iceberg Lurking Under 
the Surface of the Credit Markets

by D.R. Barton, Jr.

Last week we opened the can of worms known as conduits.  Conduits are simply companies that have been formed to turn clients’ assets into cash.  Today we’ll look at how these “behind the scenes” companies work and why they matter.  As a review here’s a short list from last week's article that illustrates why the financial solvency issue with conduit companies could have broad-ranging effects:

  • It involves staggering amounts of money (over $3 trillion).

  • It is an area of accounting alchemy that has little to no regulatory oversight.

  • The liabilities are easily hidden from investors.

  • The potential problems are big enough that they will require government bailouts if the situation in the credit markets worsen.

Why do conduit companies exist at all?  Because they provide a useful function for three groups of entities:

  • Companies who hold assets like receivables and securities and need to turn those into cash.

  • Investors looking for short-term debt to buy at attractive yields.

  • Banks that receive healthy transactions fees from the conduits they set up to match the buyer (company) with the seller (investor).

So a conduit’s role is to match up companies who need liquidity with investors looking for extra yield.  They generate fees for providing this service.  The banks collect these fees and take off-balance-sheet risk when they provide guarantees to backup the conduits.  Let’s take a look at how these conduits operate:

  • A company has assets (let’s say some receivables for products or services delivered) that it wants to turn into cash.

  • A conduit buys these assets (the receivables) at a discount.

  • The conduit either lumps a bunch of assets together (to ostensibly minimize risk) or sells them one at a time by creating short-term debt instruments known broadly as “commercial paper.”

  • The conduit sells this commercial paper to investors who buy it because of its perceived low risk and higher-than-market rate yields.

  • The cash raised from the sale of the commercial paper is used to pay for the assets bought from the company in the first step of this sequence.

So What’s the Problem?

Sounds like a reasonable transaction sequence so far.  But here’s where it can break down: if the conduit can no longer resell the commercial paper (which it typically has to do every ninety days), the bank is on the hook to provide backup funding.  Basically, the conduits are selling short-term debt (commercial paper) to fund the purchase of longer-term assets.  This means that there are multiple sales cycles for each long-term asset bought.  This is not a problem when all financial systems are strolling along at status quo or in an expanding market.  But it starts to unravel when credit tightens or risk on the purchased assets increases, or both.  And that brings us to the “off-balance-sheet” financing problem.

Part of the perceived safety of the commercial paper served up by conduits comes from the backstop guarantees provided by their associated bank.  But these backup guarantees don’t have to be disclosed on bank balance sheets.  Some well known banks are on the hook for huge amounts.  The Wall Street Journal reports that just three banks – Citigroup, J.P. Morgan Chase and Bank of America have written more than $250 billion worth of backup insurance to their conduits.  But, according to current accounting rules, this liability doesn’t have to show up on the books of the banking behemoths. 

What this means for you and me is that the credit contraction crisis is far from over.  In fact, it could be just beginning.  Sub-prime loans have found their way into the asset baskets of many conduits.  And that number “$3 trillion” is a really scary figure to be largely non-existent on bank balance sheets.

There will be a great temptation to start bottom fishing for bargains in the financial sector with the price reduction that has hit the sector.  But investors should be wary that we may have only seen the tip of the credit contraction iceberg.

Until next week…

Great Trading!

D. R.

About D. R. Barton: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena where he is one of the most widely read and followed traders and analysts in the world.

He is a regularly featured guest analyst on both Report on Business TV,  and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine.

Melita's Inspirational Corner

The Wise Woman’s Stone

by Melita Hunt

With a particularly demanding week behind me, and another one to follow (that I just happen to be in the midst of) I decided for my own sanity, to just keep things simple this week.

The following is a parable/short story that is easily found all over the web, but I thought that many of you may not have read it, so I am sharing it with you because it was inspiring for me and this is supposed to be an inspirational corner after all…

A wise woman who was traveling in the mountains found a precious stone in a stream. The next day she met another traveler who was hungry, and the wise woman opened her bag to share her food. The hungry traveler saw the precious stone and asked the woman to give it to him. She did so without hesitation.

The traveler left, rejoicing in his good fortune. He knew the stone was worth enough to give him security for a lifetime. But, a few days later, he came back to return the stone to the wise woman.

"I've been thinking," he said. "I know how valuable this stone is, but I give it back in the hope that you can give me something even more precious. Give me what you have within you that enabled you to give me this stone."

Author unknown

And that my friends, is “being-ness” in a nutshell.

Have a great week…Melita

About Melita Hunt: Melita is CEO of the Van Tharp Institute. She has had a diverse career working in the fields of telecommunications, accounting, marketing and sales, real estate investing, and ultimately speaking, coaching and writing; which are her passions. Her energy and enthusiasm is the cornerstone of her writing and speaking success and she has a special interest in inspiring people to be the best they can be. She has an innate ability to simplify complex subjects and enjoys traveling the world and sharing her experiences. She has worked throughout Australia, in London and is currently working in the USA. You can contact Melita at mel@iitm.com.

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