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Tharp's Thoughts Weekly Newsletter

March 19, 2008 — Issue #364
  
From Van

A Message from Van Tharp about System Quality Number

Article

Thinking about Systems Thinking by Ken Long

Workshops

Many of Our North Carolina Workshops Include a Dinner at Dr. Tharp's Home

Trading Tip

The Inside Scoop on the Bear Stearns Deal by D.R. Barton, Jr.

Special

How to Develop a Winning Trading System that Fits You

Melita's Corner

Brake before You Break by Melita Hunt

Workshop

A Message from Van Tharp

As some of you may know, we've now developed a method to objectively measure the quality of a system. I call it the System Quality Number (SM) or SQN (SM)  for short. It's a measure of telling just how good your system is. When I first taught the SQN formula to Ken Long (our ETF instructor), he calculated the SQN for each of the systems he was presenting in that ETF workshop. And here is the amazing thing -- all of them, had SQNs above 3.0. And Ken had some systems that were what I have to call "Holy Grail" systems with SQNs above 5.0!

The systems that Ken shares in the ETF workshop are so good that many of my Super Traders are adapting Ken's systems to fit them, which become the basic systems that they trade. In fact, one of the top funds in Austria has basically adapted Ken's work to fit the Austrian markets. 

Even in today's harsh markets, Ken's systems work. So unless you are a genius at trading today's markets, you should be doing everything you can to attend his workshop.  It’s coming up soon, so I encourage you to enroll now. --Van K. Tharp

ETF and Mutual Fund Techniques 101 March 29-31
Excel and XLQ Programming  April 1
How to Develop a Winning Trading System April 4-6

 

 

Feature

Thinking about Systems Thinking

by Ken Long

The purpose of this article is to review some of the highlights of systems thinking.  My focus will be on practical applications and rules of thumb, rather than trying to develop a scholarly article, which would only be of interest to … well, scholars! I will make every effort to do you no intellectual harm, and leave you with an appreciation for what systems and systems thinking are all about.

My background in systems management dates to 1991 when I began my graduate studies in the University of Southern California’s Systems Management Program, which had developed in the 60s as a way to respond to the difficulties in managing large manufacturing programs, which required managers and engineers from many different disciplines to coordinate their efforts to create complex weapons systems like the Polaris class submarine and B-1 bomber.  These projects were so complex that no one discipline knew how to go about building one, nor how to man a diverse project team encompassing and managing finance, weapons, propulsion, safety, automation, materials, electronics, and human factors.  Computers only seemed to complicate matters.  No one knew how to get the projects done on time and under budget, or how to handle the myriad of changes and learning moments that inevitably arose in a long-complex project.

It also turned out that the senior leader’s background had an undue influence on the outcome of the project, with weapons engineers building big guns with little-to-no living space for the crew, while an accountant would bring the project in under budget but without the capabilities sought in the original specification.

Tackling this problem, USC and the government developed a program that taught managers the skills to act as the middlemen between disparate work groups. These managers looked to develop optimal end-products by integrating the efforts of the different disciplines. The program quickly adapted much of the knowledge about systems that was simultaneously emerging from the natural sciences, anthropology and physics.

Systems thinking as an approach to problem solving manifests in many different fields these days.  Hard systems include mechanical and automation systems that are often modeled in simulations to examine complex interactions and the dynamics of change.  Soft systems include complex social organizations and can include many qualitative components that are not easily modeled with cause and effect rules and linear relationships. Evolutionary systems are thought of as complex open systems that have the capacity of learning, adapting and changing over time in response to interactions with and feedback from other systems and the environment.

In general, systems are usually defined as a complex and dynamic whole, which acts as an organized entity for a purpose, and which needs all of its elements to function.

Regardless of the domain, there seem to be general considerations and implications from systems thinking with broad applicability. Here are a few:

1. Systems are more than the sum of their parts, and include the relationships and interactions that are possible, which can combine in many unforeseen ways to produce surprising results.

2. Complex behaviors and outcomes will often emerge from the interactions of a few simple elements and processes in ways that are not predictable.

3. Systems thinking almost always incorporates the building of a model or a description of the system under study, during which opportunities for learning, insight and communication emerge to the amazement of participants who come from different points of view. In fact, this learning moment can be the paradigm shift that enables breakthrough thinking with lasting consequences.

4. The best modeling efforts seem to be iterative, interactive, and integrative. The group spirals around the issue or the system in multiple loops, coming back to add details and insights that emerged in the group’s travels around the systems boundaries and through its depths. There is learning and feedback between participants and the model. which we learn as we go.  Finally, points of view are incorporated

5. A useful model for systems building treats the system as a collection of inputs-processes-outputs that co-exist for a purpose and in an environment that has both direct and indirect effects on the system and which will provide feedback in different ways to the systems actions.

6. A system can be a seen as a sub-system of a larger system, and is itself composed of smaller systems. For this reason, it is usually important to specify scope and time constraints as boundaries lest the effort never get out of the definition phase!

7. Feedback loops and mechanisms turn out to be crucial to understanding processes of adaption and growth and for understanding the phenomenon of 2nd and 3rd order effects.

8. Friction, timelags, resistance and non-linear relationships are generally found in all complex systems, which helps to explain and understand situations where simple cause and effect rules don’t seem to work well.

In practical terms, in my roles as a trader, an educator, a manager and leader of large organizations, or as a member of a work team, I have seen the systems thinking approach provide a way to get started with the process of understanding, visualizing, describing and directing efforts to achieve our goals in complex, uncertain environments. It is an effective way to engage with complexity, when simple rational analysis proves to be inadequate for the job at hand. But beware! As my professor Dr. Jones (lead engineer in the B-1 bomber program) often said, “Once you start down the path of systems thinking, you will never be satisfied with simple answers again.” 

With these thoughts in mind, what can a trader do with systems thinking?  Where would one begin?  Here are 5 things to consider:

1.   Start with a systems map of your own trading process.  Identify those inputs-processes-outputs that are directly involved in your strategy.  Then identify those environmental elements beyond your control that have the greatest impact on your performance.  This formal systems definition process is sure to help you focus on those areas you can control or change directly and those that you must endure, and it is a great basecamp in your journey of self-mastery and trading excellence.

2.   Engage with a master mind group to help you examine the assumptions and implications of your beliefs and procedures.  Adding new perspectives and points of view will reveal blind spots and insights that you might never find on your own.

3.   Look for the feedback loops from the trades you take and the trades you pass on in order to examine what is being learned and what else might be learned through self-examination.

4.   Look for dynamic relationships in your trading that may not have direct causal effects, but rather look for connections that bring your actions home to roost.  Try to imagine how 2nd and 3rd order effects can arise from a chain of events triggered by your trading decisions.

5.   Look for ways that your system can evolve and grow in your chosen environment. Seek for ways you can adapt your systems to new environments.

Cheers!

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  ETF 101 Techniques Workshop, our new ETF 202 Techniques Workshop and a co-presenter with Van at our Blueprint for Trading Success Workshop. Ken is founder of Tortoise Capital Management, www.tortoisecapital.com.  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. 

IITM Third Party Clause

 

Workshop Schedule

Many of Our North Carolina Workshops Include a Dinner at Dr. Tharp's Home

Attendees enjoy a relaxing break between workshops 
with time to talk and get to know each other. 

View Fun Photos from One of These Dinners

 

ETF and Mutual Fund Techniques 101 March 29-31 Cary, North Carolina 

Dinner at Dr. Tharp's Home, Monday, March 31st

Excel and XLQ Programming (one-day) April 1 Cary, North Carolina 
How to Develop a Winning Trading System April 4-6 Cary, North Carolina 
-
Peak Performance 101 April 19-21 Cary, North Carolina 

Dinner at Dr. Tharp's Home, Monday, April 21st

Peak Performance 202 April 23-25 Cary, North Carolina 
-
Advanced ETF 202 May 17-19 Cary, North Carolina 

Dinner at Dr. Tharp's Home, Monday, May 19th

Excel and XLQ Programming (one-day) May 20 Cary, North Carolina 
Blue Print for Trading Success May 21-23 Cary, North Carolina 

 

Click Here for More Details

 

Trading Tip

The Inside Scoop on the Bear Stearns Deal 

by D. R. Barton, Jr.

This is not another plain vanilla summary about the Bear Stearns collapse.

I figured we can all find decent summaries in lots of places. Instead, I thought it might be useful and interesting to hear from a former Bear Stearns partner (who had the good sense to get out a decade before the collapse!).

So I called my good friend and business partner Christopher Castroviejo, who was a partner at Bear Stearns for four years. I’ve written about Christopher many times before; he is a veritable fount of market knowledge and insight. And though he’s been away from Bear Stearns for a while, you can imagine that his understanding of the situation is a bit more in depth than almost anyone else out there. Here are some of his insights from our conversation/interview:

What are the ongoing issues with the Bear Stearns buyout by JP Morgan? 

As with any very large magnitude deal, there are always people with competing interests. Shareholders want the highest price possible, JP Morgan wants to pay the lowest price possible – that’s pretty straightforward. Less apparent are the folks behind the scenes who would like the deal to completely unravel. There are multiple groups who would benefit if the deal fell through and JP Morgan and the Fed ended up not backstopping the Bear Stearns liabilities and the company instead went into bankruptcy. Those rooting for this outcome include bond holders and those who have taken the other side of Bear’s derivative trades who could get fire sale prices.

Are there broader reaching issues with the Bear Stearns buyout by JP Morgan? 

This signals the de facto dismantling of the Glass-Steagall Act, and making the Federal Reserve not only the lender of last resort for commercial banks, but now for investment banks as well. It is also clear that this whole credit crisis is going to winnow out weaker institutions and we are going to end up with fewer banks in general before all is said and done. Much more disturbing is the “creeping nationalization” of the U.S. banking system. With the Fed stepping in to backstop deals, it’s a very small step to actually having the fed buy up the assets of weak/failing institutions.

Are there deeper financial issues with the credit crisis that this deal is just postponing – meaning is a meltdown inevitable? 

There are deeper issues that deal with the flawed model that investment banks are using and the flawed assumptions that have led to significant over-extensions of leverage. But financial Armageddon does seem avoidable. First let’s look at the model problems. Investment banks use a “Value at Risk” model to determine the amount of exposure their portfolios have. This model is a cousin to Van’s and my friend Ed Seykota’s portfolio heat model. And the amount of exposure or risk in a portfolio is directly related to the amount of leverage one can use in a position. A big problem is that the “Value at Risk” model uses the assumption that the underlying price series is continuous and liquid. As we’ve all seen, this is a faulty assumption and the model breaks down when liquidity dries up or price action becomes discontinuous.

The more basic and even more problematic assumption that was made is that “all real estate is local.” Meaning that if a portfolio of mortgage-backed securities had sufficient geographic diversification, then it was a super high quality AAA rated product. After all, there had not been a decline in national real estate prices since the Great Depression. With this thought process, firms were able to take very small spreads in their mortgage backed securities and various derivatives thereof and then leverage them way up so that returns were really spectacular. Once again, the problem of extreme leverage reared its ugly head when the underlying assumption that real estate prices could not go down proved very wrong.

In short, Bear Stearns didn’t follow Van’s principles of using proper position sizing. And they paid for that mistake by taking down one of Wall Street’s grand old institutions. But it’s not safe to assume that all investment banks are in this same boat. Other institutions have much lower mortgage exposure as a percentage of assets and are better hedged to deal with further degradation of credit instruments. 

What should traders and investors be doing in light of the current credit situation? First of all, check your assumptions! The first one to check is whether or not your cash reserves are really safe. If you have cash in a money market fund, does that fund have any elements that are at risk? Money market funds can and do chase after a few extra basis points of interest by investing in higher yield products. Make sure your fund doesn’t have exposure to items that could slash your cash if broader trouble does hit the credit markets.

Secondly, if you get the itch to try to pick up some financial stocks as value picks, do it wisely. If you get the itch, you’re in good company since Warren Buffett and Bill Miller of Legg Mason have already jumped into “value” purchases in the financial area (both are suffering some short-term pain for being early). The easiest way to limit risk is to use Exchange Traded Funds (ETFs), spreading your risk across the sector instead of taking on single stock risk. For example, if you’re trying to decide whether Lehman will make a rebound, you may be better playing the sector ETF. You’ll note that the XLF, the heavily traded financial sector ETF, lost only 10% of its value while Bear Stearns was losing 95% of theirs. And XLF is higher now than when the Bear Stearns crisis hit.

These are only excerpts from my discussions with Christopher this morning. As always, I find these sessions very enlightening. There’s a chance we might be able to share a recording of these conversations with you if we can get them to an easily accessible place. If you’d be interested in listening to these very rough recordings, let me know by sending and e-mail to info@iitm.com. 

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.  He is a regularly featured guest on both Report on Business TV,  and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

 

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Melita's Inspirational Corner

Brake before You Break

by Melita Hunt

This week I worked the Blueprint for Trading Success Workshop with Van in my home town of Sydney and it was the closest I have come to working at a full time capacity for the last six months (hasn’t that time flown?). My diagnosis was on September 19th, which was exactly 6 months ago. Wow.

Anyway, I am actually in a bit of recovery mode this week and needing more downtime and rest than usual, so I kept away from my computer as much as possible. Therefore, instead of taking the time to write an article I decided that I could just give myself a break. Then it dawned on me that perhaps it is a good reminder for all of you folks out there as well. Are you due to give yourself a break? And which type of break do you need? Physically or emotionally?

We all seem to recognize when we need a physical break because our bodies clearly give us the aches and pains or we just run out of energy. But do you recognize the internal aches and pains too?

When we need an emotional break, our bodies are telling us that too, but we rarely listen. Instead, we just keep plugging along and ignore the signs. Usually it shows up in the form of stress, headaches, sleepless nights, or that incessant voice that never seems to shut up in our heads. It nags away because sometimes it just wants to be heard. So this week, please be really conscious of taking a couple of extra breaks and really giving yourself a break, in whatever form makes you feel good.

Take a nap when you feel like it, take a day off from studying and reading about the markets and give your brain time to digest the information that it has already taken in. Allow some space in your life rather than constantly filling your head with new stuff.

Give the forgotten child within you a bit of attention this week, whether it is through doing something playful or remembering something fun that you used to do or would like to do. Perhaps you can have some quiet time and listen to yourself without judgment. When was the last time that you listed your accomplishments and gave yourself a pat on the back? If you are like most of us, you can list all of the things that you haven’t done and need to do! But what about the things that you have done?

There is an array of ways to give yourself a break.  So try one today! And then do another one tomorrow, and the day after that…. it might just become a habit. 

As for me, I said I needed a break, so I’m off to bed with a good book. 

Have a great Easter everyone.

 

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita’s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com.

You can contact Melita at mel@iitm.com

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