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Tharp's Thoughts Weekly Newsletter

December 10, 2008 — Issue #402
  
Trading Education

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Article

Ten Thousand Hours by Van K. Tharp

Workshops

Free Teleconference Download on How to Develop a Winning Trading System

Trading Tip

Volatility: The Real “Back Story” in Today’s Market, Part II by D.R. Barton, Jr.

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Feature

Ten Thousand Hours

by 
Van K. Tharp, Ph.D.

 

A common notion that many people have is “I’m just an average investor.”  This deeply concerns me.  That notion implies two things:

1. They probably have all of the biases that the average person has about investing, which are killing them financially right now.

2. They are not really committed to doing what it takes to be a good investor.

The average investor simply opens up an account at his/her brokerage company and has no training in successful principles. Unfortunately, he or she has probably read a few books filled with a lot of misinformation and also listens to the talking heads on the television give out more information.  Let’s contrast that with what Malcolm Gladwell says is essential for real success in his new book, The Outliers.

This book is all about success.  As a modeler, I was drawn to it because he asks the question, “What do hugely successful people have in common?”  However, he asks the question differently than I ever have.  I have always asked, “What do successful people do in common, and for each of the common tasks, what are the three ingredients?” I concluded that those three ingredients are beliefs, mental states, and mental strategies. Gladwell asks a different question: “What is common about their background?”  And when you ask a different question, you get a different answer.

I’m going to be addressing a few of these common elements in my next articles in Tharp’s Thoughts, and the first common element is absolutely fascinating.  It also fits into my pet peeve of people saying, “I’m just an average investor.”  It turns out that really successful people seem to have a common denominator of 10,000 hours of practice.  And Gladwell gives some really interesting examples.

In the computer industry Bill Joy is a legend.  He almost single- handedly programmed the Internet.  But Bill had an opportunity that few others have.  In the late 1960s, he went to the University of Michigan.  The university center there was one of the first centers to have a remote terminal where you could actually interact with the computer and program online.  In graduate school in 1975, I didn’t have that opportunity; I had to travel 30 miles to the computer center to turn in my punch cards and then return the next day to see if there were any errors.  But Bill Joy had a terminal where he got immediate feedback for anything he did.  Furthermore, Bill probably had more access to that terminal than anyone else.  He estimated that he’d spend about 10,000 hours programming on that terminal.  Thus, when the opportunity was thrust upon him to start working on the Internet, he was one of the few people in the world who was ready.

Gladwell goes on to give several other examples in the computer industry, including Bill Gates who had a similar access to a programming terminal when he was about 13 and acquired his 10,000 hours when no one else would be likely to compete.  Gates, of course, went on to found Microsoft and become one of the world’s richest men.

Another study cited was an examination of musicians coming out of a major music institute.  They classified their musicians into three groups.  The first group consisted of the outstanding musicians who could be soloists.  The second group consisted of good musicians who could earn a living playing, but were not outstanding.  And the third group consisted of average musicians who would probably end up being music teachers.  When they compared their background, one outstanding fact stood out.  And it seems to go against the notion that some people are just purely talented.  Those who were great had put in 10,000+ hours of practice.  Those who were good had put in about 8,000 hours of practice.  And those who were at best average had put in about 4,000 hours of practice.

Gladwell goes on to give several other music examples, including Mozart, whose best compositions probably happened after he’d put in 10,000 hours.  Mozart probably had help from his father with his earliest compositions, which were good but by no means his best.

Another music example was the Beatles.  The Beatles were not just another band.  They had the Hamburg experience.  In Hamburg they got to play in the red light district, and they were expected to play for 12 hours at a time.  At first, they weren’t very good, but they got lots and lots of practice.  So by the time they suddenly burst on the scene in 1964, they had racked up 10,000 hours of practice together—an experience that few bands achieve even in a lifetime of playing together.

Gladwell goes on to give other examples from other professions, but at this point I was hooked.  It probably applies to the best traders and investors too.  My guess is that they all have about 10,000 hours of the right sort of practice.  While I never explored this area in my initial modeling work, I know enough about some of today’s great traders to realize that it applies to them as well.

However, there is a caveat here. I suspect that you need more than just 10,000 hours of trading to be really good.  You need 10,000 hours of the right sort of practice. If you don’t get training in the right principles that will be the key to your success, then much of the practice may be useless.  However, this doesn’t mean to say that the Beatles were good when they first started playing in Hamburg or that Bill Joy was that good when he first started programming on a live terminal.  But these people all had the practice plus feedback to realize what was good and what wasn’t, so that they improved.

Let’s look at Paul Tudor Jones as an example of an outstanding trader.  While I don’t know a lot about his early background, I do know enough to make an educated guess.  Paul Tudor Jones started out as a clerk on various exchanges, he was also a broker for E.F. Hutton, and he followed that by two profitable years of trading on his own.  That’s a lot of practice and since he was profitable, it was probably good practice.  Jones then mentored under Eli Tulis at the NY Cotton Exchange.  All of this occurred before he founded his own firm, Tudor Investments.  He also had some exposure to Commodities Corp, which no longer exists but seemed to be essential in the background of so many great traders’ futures.  Is it likely that Jones got his 10,000 hours in before he started Tudor Investments?  Absolutely!  And did he get the right sort of trading?  Well, he was profitable even before his tutelage under Tulis.

I have several other examples of traders that also fit, but let’s shift directions to a successful investor. Warren Buffett, the world’s richest investor.  There is a lot of information on his early background, since a lot of books have been written about him.  When Buffett was six he bought and sold bottles of Cola making an easy 5 cent profit on each six pack. He worked paper routes and saved $1,200.  And then he used that money to buy and rent out farmland when he was around 16 years old.  His other childhood business ventures included pinball machines, horse racing tip sheets, and buying and selling stock.  Thus, by the time he went to college, he was already a successful investor.  He also did number crunching for his father who worked for an investment firm.

Buffett went to school at Columbia where Benjamin Graham was a professor.  He studied under Graham, and they became great friends.  Buffett then spent two years working for Graham, until Graham retired.  So did Buffett get his 10,000 hours in?  When you ask Buffett what it takes to become successful, you get a clue to how he may have put in his 10,000 hours.  He says that you should know every daily about every listed stock.  And if you were to protest that there are over 7,000 listed stocks, he’d tell you to start with the As.

Buffett’s skill level is in understanding the fundamentals and cash flow of companies.  He understands value, which he certainly learned in his apprenticeship with Graham.  You could easily guess that he had 1,000 hours of exposure in business school and another 4,000 plus hours working for Graham.  However, if Buffett used Graham’s methods to analyze every listed stock, you have to assume that he spent at least an hour on each stock, totaling another 5,000 or so hours.  His training was different from Paul Tudor Jones, but I have no doubt that he put in his 10,000 hours and that those hours were the right sort of training for what he does.

What if you just went to work trading at a bank?  After about five years as a trader, wouldn’t you have 10,000 hours in place?  Yes, but those hours have to be practicing the right skills.  Bankers don’t understand position sizing, so you would have zero hours at that skill.  Most of their trading is done by committee and you are expected to trade each day whether you have good ideas or not.  Thus, their 10,000 hours does not involve understanding high reward to risk ideas.  And it certainly has nothing to do with value investing, since most of bank traders trades are closed out at the end of the day.  The key to the 10,000 hours has to be spending them doing fruitful things and learning.

What are the right things?  Well, for traders it amounts to the following:

  • Accepting personal responsibility, so that you can correct your mistakes.
  • Understanding and looking for high reward to risk trades.  This is why I emphasize the importance of R-multiples.
  • Understanding that position sizing is the key to meeting your objectives.
  • Working on yourself so that you can continually lessen the impact of mistakes. 
  • Realizing that high reward to risk trades are different under different market conditions, so that you can adapt your thinking to different conditions.  In my opinion, if all of your training is under one condition, you are not likely to succeed.

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

Volatility: The Real “Back Story” in Today’s Market, Part II

by
D. R. Barton, Jr. 

Last week, we talked about the de facto investment standard for volatility, called “beta.  We looked at the pros and cons of that measurement.  The main problem with beta is that it covers five years of monthly data, so it really tells us very little about what’s happening today and is very slow to react.

So today, we’ll look at a volatility measure that is much more useful to traders and investors.  Specifically, we’ll look at Wilder’s Average True Range (ATR).  In short, ATR tells us the average daily range of price, taking into account gaps.  The default duration for this measurement is 14 bars (therefore, 14 days on a daily chart, 14 minutes on a one minute bar chart, etc.).

Why ATR Is So Useful

ATR helps us because it is very responsive to current conditions.  Take a look at the S&P chart below to see the how ATR reacted leading up to and during the market dive in September.

Bear in mind that the beta of stocks didn’t have a chance to change during this time since it is only updated once per month.

Let’s now return to last week’s assignment where your great aunt calls.  She’d like five low-risk stocks on the NASDAQ to add to her portfolio, and wants you to give her five names to discuss with her husband.

Remember that we did a quick stock screen on the Internet.  You know that high volume stocks are best for your great aunt, since they’ll have the liquidity to help her get into and out of positions with no problem.  You screen for all stocks on the NASDAQ with volume greater than two million shares per day and then rank them from highest to lowest beta.

You pick stocks with a low beta and with names that your great aunt will recognize: JetBlue Airways, Direct TV, Huntington Bancshares, Comcast and Staples.  That was easy.  You figure that by picking stocks from the bottom of a list ranked according to beta, you’d be picking low volatility, low risk stocks.

And you’d be dead wrong.

Remember how beta is interpreted.  Here’s the explanation found on almost every financial dictionary site on the web:  The beta of a stock that exactly matches the S&P 500 would be 1.0 while a stock that has 50% more volatility than the S&P 500 would be 1.5.   A stock with a volatility of 50% less than the S&P 500 would be 0.50.

Then we looked at the stocks you chose and their current beta measurements:

Stock Beta
Comcast (CMCSA) 0.81
DirecTV (DTV) 0.80
Staples (SPLS) 0.76
Huntington Bancshares (HBAN) 0.24
JetBlue Airways (JBLU) 0.16

Based on their beta measurements, this looks like a good low risk list. The stocks are all below the volatility of the S&P 500 (at least according to their beta measurements and the traditional definition of Beta).  But as we shall see, beta doesn’t tell the whole story.  In fact it can be very misleading, as is the case with the five stocks that were chosen for your great aunt.

Stock 
(Data from 12/1/08)
Beta ATR Price ATR 
as % of Price
Range vs S&P
Comcast (CMCSA) 0.81 1.36 15.45 8.80% 147.70%
DirecTV (DTV) 0.8 1.8 19.39 9.28% 155.80%
Staples (SPLS) 0.76 1.56 15.11 10.32% 173.30%
Huntington Bancshares (HBAN) 0.24 0.86 6.6 13.03% 218.70%
JetBlue Airways (JBLU) 0.16 0.63 4.76 13.24% 222.10%
           
S&P 500 Cash Index ($INX) 1 51.88 870.74 5.96% 100.00%

Wow!  Five stocks with very low beta measurements.  They should all have volatilities below the S&P, based on the traditional interpretation of Beta.  Yet all of them have 50% to 120% more volatility than the daily volatility of the S&P 500. And this is at a time when the S&P 500 has been around its highest all time volatility.  In more normal times, a stock with a beta of 1.0 could have a daily range volatility that is five times higher than the S&P!

Obviously beta doesn’t tell the whole story on volatility.

Use More Than One Volatility Measuring Tool

The beta measurement has two major flaws:  it looks at price movement only once per month, and it compares everything to a fairly broad index that might not be a good relative benchmark.  Let’s look at each of those issues and what we can do to make better volatility calculations.

1. Beta uses five years of data, and only checks prices once per month.  Since beta looks back through five years of data, it may contain data that is not very relative to the stock’s current performance.  In addition, beta only uses one data point each month; so it doesn’t capture potentially wild gyrations that could occur in between those month-end times!  Because of this, beta is really only useful for people with very long term time horizons (those who hold positions for many years).  For anyone who is going to hold a stock less than a year, beta becomes a much less useful indicator.  Using ATR should prove to be a much better volatility indicator for short and intermediate term traders and investors (and even most long term investors, if they use a longer ATR period).  And even for those people who hold stocks for longer periods, beta can give misleading data, as we’ll see in the next paragraph.

2. Beta is only useful for stocks that are highly correlated to the S&P 500.  If a stock has a “best fit” line (as described last week) that is very different from the S&P 500, then the usefulness of the beta calculation degrades rapidly.  For beta to work well, the stock in question must be correlated to the S&P 500.  For example, gold, pharmaceutical and biotech stocks are usually very poorly correlated to the S&P 500.  Because of this, the betas for stocks in the those sector are not useful in determining their volatility.  There are several ways to determine if stocks are correlated to the S&P 500.  For those who want to dig into the math, one widely used correlation measure is called “R-squared”.  It measures how much of the movement in a stock can be explained by movements in a benchmark index (like the S&P 500).

Next week we’ll look at some other volatility measuring tools that can help build our understanding of this mega-important concept.  Until then…

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”. 

D.R. is presenting the upcoming How to Develop a Winning Trading System That Fits You Workshop, January '09.

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