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Tharp's Thoughts Weekly Newsletter

April 16, 2008 — Issue #368
  
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Blueprint for Trading Success

Article

Big Financial Meltdowns Come from Dysfunctional Beliefs About the Markets by Van Tharp, Ph.D. 

Trading Education

Peak Performance Home Study

Trading Tip

The Nobel Laureate and the Rice Trader – Psychology’s Role in Trading Strategies by D.R. Barton

Melita's Corner

Expect the Worst by Melita Hunt

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Feature

Big Financial Meltdowns Come 
from Dysfunctional Beliefs About the Markets

by

Van K. Tharp, Ph.D

When I read about Nick Leeson and how his behavior led to the downfall of Barings Bank in 1995, I said that there would be many more rogue traders.  Let’s look at the record since Nick Leeson lost $1.4 billion and brought down a bank that had been around since 1762.  It’s been 13 years and the following rogue traders have made the media.

·       John Rusnak hid losses of almost $700 million at Allied Irish Bank and his total losses were nearly twice that.  To make back his losses, he secretly bet $7.5 billion on the yen rising against the dollar and the trade didn’t go in his favor.

·       Toshihide Iguchi lost $1.1 billion through unauthorized bond trading through Daiwa Bank.  He had covered up his losses for a decade and they were only discovered in 1995.

·       Yasuo Hamanaka lost $2.6 billion for Sumitomo Corporation in 1997.  He was once thought to be the king of the copper market, controlling 5% of the global copper market.  But much of his trading was a fraud, covered up for over a decade.

·        Peter Young lost about $900 million for Morgan Grenfell.  If this fund had not been part of Deutsche Bank, it would have fallen like Barings.  Peter was diagnosed as being schizophrenic.

·        Jerome Kerviel recently lost $7 billion, the largest such loss to date for Societe Generale by hiding massive losses.  He said he did it so he’d earn a big bonus on the profits he’d hoped to make.

That’s six incidences in 13 years, totaling $13.7 billion or more than a billion per year.  I guess the big banks of the world can afford to lose a billion dollars per year to rogue traders because nothing has changed.  Why? In my opinion, banks create an atmosphere that is anti-trading.

·        First, bank traders don’t know how much money they are trading and they don’t even know how much money they can lose before they lose their job.  This means they cannot practice position sizing.

·        Second, the person in charge of trading usually comes to the bank from an area other than trading.  One of them actually said to me once, “Van, I don’t want any of our traders to make more than 20%!”  I should have said, “Twenty percent of what?” because none of them had a fixed trading amount.  Instead I said, “Why?”  His response was, “Because if they make 20%, then they could lose 20%.  Furthermore, if they make 20%, they’ll want huge trading bonuses and then they’ll get paid more than me.”  I was stunned and I never forgot that comment.  This was the Treasurer at a huge New York Bank.

·        The third problem is consensus trading.  The traders have a meeting each month to decide what the markets are going to do.  And, as a trader, you are probably in trouble if you make trades against the group consensus and lose money.  Yet group consensus trading has nothing to do with good trading.

·        And last, but not least, every trader is supposed to make trades every day, even if there is nothing to do.  There is an attitude of “We pay you to trade, not to sit back and do nothing.”  So is it any wonder that I predicted many more rogue traders to come?

In my opinion, a thorough understanding of position sizing and setting up accounts that allow position sizing would do much to eliminate the possibility of such fraud.  When people can just trade for the bank through the bank’s accounts, it’s hard to have checks and balances, but if traders had their own accounts, then such fraud would be much more difficult. 

However, there is still another problem: the belief that risk and account variability are the same. This belief has the potential to produce even bigger losses. In my opinion, it's at least partially responsible for the Long Term Capital Management collapse and for the subprime crisis that is now sending shock waves throughout the system.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

 

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Trading Tip

The Nobel Laureate and the Rice Trader – 
Psychology’s Role in Trading Strategies

by

D.R. Barton

“The degree of one's emotions varies inversely with one's knowledge of the facts.” 
--Bertrand Russell

Chuck LeBeau and I had a wonderful and insightful time teaching a group of very knowledgeable attendees at the recent How to Develop a Winning Trading System workshop in Raleigh, NC.

As I have written in this space many times before, I love the systematic challenge that the market offers.  But the more I deal with the markets and those folks who invest and trade, the more I am convinced that the best traders – even the systematic ones – are the ones who can build their trading plans around an understanding of the psychological forces at work in the market.

Over the next couple of weeks, I’d like to explore this assimilation of the psychological into the technical and discuss how we can capitalize on the fear and greed in the markets regardless of time frame.

For our study, we’ll dig into something old and something new (or relatively so).  It’s interesting how the comparisons of Japanese rice traders and Nobel Prize-winning economists can give us some insights into the timeless nature of the markets.

And while I would love to talk about the systematic path to exploiting the markets, it’s clear from both the Nobel winner Kahneman and rice trader Honma that something more important for traders to learn is the psychological decision making that drives the ebb and flow of the markets.  Once we get a handle on that, then we have a chance of designing a strategy that gives us an edge.  Let’s start by looking at Daniel Kahneman’s insights. 

Interestingly, Kahneman, who won the Nobel Prize in economics largely for an article he authored with Amos Taversky, is a research psychologist who says that he never took any courses in economics!!  Maybe that explains why he seems to have a better handle on economics than most economists…

So when I read his article, imagine my surprise.  It was written right there in black and white: people don’t make decisions based on probability and statistics.  They make them based on emotions and past experiences. 

So another economic myth is busted.  Any of us who took even basic economics “learned” that modern economics is based on the assumption that people make decisions so that they will get the biggest reward.  (That’s called the “theory of expected-utility maximization”, for those of you who had the name on the tip of your tongue, but just couldn’t quite remember it…).  And remember that Kahnemen wasn’t burdened with classical economic training!

But the guys who wrote this dandy article that I’ve been reading have exploded the myth that market participants make logical decisions.  Kahneman won a Nobel Prize for his work, so I’m sure he’s a pretty smart guy.  In short, he and his co-author proved that decision-making changes for most people occur when they are faced with the combination of losing money and uncertain results.  This combination changes people from logical, math-based decision-makers to emotional experience-based decision-makers.  Using emotionally charged short cuts or so-called “rule of thumb” guidelines makes us pretty lousy decision makers.

In short, Kahneman and Taversky found that people use bad decision making short cuts (or heuristics).  We pay too much to avoid uncertainty.  Traders and investors can certainly relate to that. This is exactly why people are willing to jump on trends as they near exhaustion or hang onto losers until the worst possible moment only to bail out when things can get no worse and start to head up.

Next week we’ll look at how to incorporate these findings into a trading strategy and also take a first look at an amazing rice trader. 

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”. 

Melita's Inspirational Corner

Expect the Worst

by

 Melita Hunt

I, like all people, live my life by a set of rules and strategies based around my beliefs. Some of them are completely unconscious, but after many years of self-work, I am knowledgeable and conscious of many that work very well for me.

This week, however, I experienced a real unexpected blow (more about that later) because I didn’t follow one of my cardinal rules: go into every situation expecting the worst but hoping for the best.

Now initially that may sound like a pessimistic way to live, yet it is actually a very optimistic rule and has served me immensely in many areas of my life.

By expecting and preparing for the worst possible situation, I can psychologically deal with anything that is thrown at me. I get myself grounded and clear about how bad it would really be and usually that worst case isn’t quite so bad. Regardless of that, I can make sure that I have an action plan in place. And anything that happens, other than the worst case scenario, is cause for celebration. That’s a great way to live!

Many people do the opposite (especially where money is involved). They go into a situation with rose tinted glasses thinking that it is going to be the answer to their dreams, whether it is an investment, a new home or a business decision. Their version of the rule is that “Everything will work out great!” And they try not to think about any potential problems.

But when things don’t quite work out as they envisioned and the problems do appear, they start to panic, lose balance and often become a “victim” to the circumstances. They start to look for someone or something to blame, or worse still, they chastise and put themselves down and often find themselves in a big financial mess.

I first noticed that I followed my version of the rule when I went into the world of real estate investing. I remember going to seminars where everyone was showcasing best case scenarios. They would highlight the terrific returns, how much money you could make and how big the tax savings would be. The realtors would show the best property (and most expensive) after showing you the cheaper ones, to push you over the emotional and financial edge (“you can’t afford not to buy the best one…”) and the banks would take the borrowing capacity as far as they could, encouraging you and assuring you that you can afford those few extra dollars (welcome to the sub prime mortgage crisis).

Thankfully that ruse didn’t work with me.    

When I looked at properties, I didn’t look for how much I could make, I was always looking at how much I could lose in the deal. I would look at worst case numbers. I would price out the cost of any major damage or unexpected problems and looked at my cash flow situation if one or more of my places were unrented for a year (it happens more often than you may know). Would I be able to afford to hold onto my properties if interest rates went back to 15% (rather than imagining that THAT could never happen again)? If I could withstand those types of things and still hold onto the property in a favorable way, then it was a spectacular deal because the only way is up.

And for the record, I have bought and sold a lot of properties and I have made money on every one of my real estate deals. This included one that didn’t pay rent for 9 months, one that was burned and uninhabitable for 14 weeks and various other tenant issues, expenses and hiccups along the way. I was prepared and able to weather the storm. In fact, the only thing that I wasn’t prepared for was a murder/suicide that occurred in one of my properties, but that happened exactly 3 days after I had sold the property and actually closed it. Divine intervention perhaps? I still feel bad for the purchaser to this day – I guess neither of us saw that coming!  

So how does this apply to the non real estate investor?

Well it’s exactly the same.

If you are only going into a trade looking at the upside, you could be doomed.

Often I hear about people going into trading or business because they “need” to make a certain amount of money each year just to get by. If they are going into trading or business with that concept in mind then, nine times out of ten they are setting themselves up to lose. A far more intelligent approach is to say “I would like to make XX% per year, but I can also afford not to make it for at least XX months or years.”

Take a look at some of the worst case things that can go wrong. What would you do if you lost all of your capital? Or got caught in a margin call situation? How would you cope? What would you do if you lost your job and couldn’t get another one easily?

If you don’t know how far you can be stretched, then you may easily find yourself in one of those situations and grasping for a floating device that isn’t there to save you. And it’s all of your own making because it is easily circumvented.

As I said in the second paragraph, I broke my cardinal rule this week, and it was in the health arena. I went into the doctor’s office completely convinced that my tumor was shrinking because I was feeling so well. I was on cloud nine and ready to tell him about my plans for the summer. I was only thinking about the best case, and hadn’t thought about the worst.

However, I was completely wrong, and found out the tumor was growing again. The impact was huge and has been devastating to me over the last two days. But as usual, I will pick myself up and move on to the next step and treatment. I am simply telling you this because I didn’t follow my rules. If I had walked in preparing to hear the worst (like I did in the original diagnosis), it would still have been hard to hear, but I would have been much better prepared to cope and the fact that I am still alive, would have been cause for celebration.  

It may be a strange example to get the point across in a trading newsletter, but it is a rule that can be used in all situations – business, relationships, health, investing. Prepare for the worst and hope for the best. My wish in telling you this is that it will at least prompt some of you to think about where you could be a lot worse off. Then you may find that every day is not so bad, and you will start to feel wonder and appreciation for all of the little things, especially the things that “didn’t go wrong and weren’t so bad after all."

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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Copyright 2008 the International Institute of Trading Mastery, Inc.

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