Today's commentary is by Jack Crooks, The Sovereign Society's Currency Director and Editor of The Money Trader.
Dear A-Letter Reader:
"The market can remain irrational longer than you can remain solvent."
-John Maynard Keynes
The other day Eric Roseman commented on the latest hedge fund
debacle involving a fund named Amaranth. They specialized in energy
trading and their main focus was natural gas. The fund blew up after
losing, in the course of a week or two, an estimated 65% of total
assets, which were sitting at a cool $9.5 billion. Definitely
not chump change. Had the fund's top trading guru,. Brian Hunter,
heeded the time-tested sage advice of Mr. Keynes, he may have saved his
clients a few billion dollars here or there, and the major fund might
be sailing along with eight figures.
The Amaranth debacle shows us once again that no matter how smart we
are, or think we are, we will fooled by Mr. Market. All of us are
fooled, but the key to surviving the bad times and positioning for
success is a deep respect for risk- something Amaranth clearly lacked.
Granted, few of us will ever have access to $9.5 billion dollars in our
trading accounts, but the principles that should have been applied at
Amaranth should be applied by all of us, no matter how much we've
committed to the market.
What a Fool?
In hindsight, it's easy to say that Mr. Hunter was foolish. "Didn't
he see that natural gas prices were plummeting?" seems the lament of
the financial press. Well, sure he did. But instead of taking proper
action, he displayed "the traits of the acute successful randomness
fool," as defined by Nassim Taleb, author of the excellent book, "Fooled by Randomness
." It's these common traits that we will examine below.
If you can identify and recognize the traits of fool, and apply some
simple principles, you will have your own built-in risk management
system in place.
Keep in mind, the mistakes. Mr. Hunter made have been committed
again and again by some very smart people over the years. And they will
continue to be made by top traders in the future. So, if can happen to
the pros, it can happen to us.
Learn From the Smartest of the Foolish
Below is a list of some common traits traders and investors display.
After each of the traits of market fools (I admit to displaying all
more than once throughout my investment career), I have tried to
provide an example that you can all relate to, and a reality byte to
show the proper perspective and simple ways to avoid these mistakes.
1. An overestimation of how accurate your beliefs are, either economic or statistical.
Example:
The U.S. dollar MUST fall because the U.S. current account deficit is rising. Reality:
Well, no it doesn't have to fall. If money pours into the United
States from international investors for what ever reason (stocks, high
yield deposits, real property, etc.) the dollar will rise regardless of
what the current account deficit does. Develop reasons, but don't be
dogmatic.
2. A tendency to get married to positions.
Example:
The dollar sold off even though the jobs report said employment is strong. I'm right, the market is wrong. Reality:
It's always about price action. There is a lot going on in the market,
including a lot we will never know about. Price action tells us that
our reasons may be wrong, no matter how much evidence we gather. Listen
to the market. The market is your only master.
3. The tendency to change your story
. Example:
You are a short-term trader and the market just moved against you on a
key daily report. You rationalize that it's okay, because "I'm in this
trade for the long haul, and sooner or later I will be right." Reality:
If you develop reasons and time frames stick with them. If the market
gives you information that says your view is wrong, get out. You can
always re-enter. Getting out will at least give you an opportunity to
more objectively evaluate new information.
4. No precise contingency plan for what to do in the event of losses.
Example:
You enter the trade thinking you are going to make big money-all you think about is your reward. Reality:
You should always think of your risk before you enter a position-that
is what professional traders and speculators do. You must consider your
risk beforehand because if you wait until you have already taken a
position you tend to lose your objectivity.
5. Absence of critical thinking when you revise your stance on a "stop loss."
Example:
You liked owning the euro when it was at $1.2700 against the
dollar, you will love at $1.2500-the average down mentality. Reality:
This goes to point number 4 above, set your risk parameters
ahead of time by establishing a stop-loss level to exit a trade and
stick with it-don't rationalize. The euro at $1.2500 may indeed prove
to be a bargain. But it may also be the start of a major decline that
can significantly damage your capital or wipe you out if you are
trading with high leverage.
6. Denial.
Example:
Well I really got hosed on that trade-it was bad luck. Reality:
There is usually a very good reason why you lose money. Take the time
to try to understand it. You learn more by objectively analyzing your
investment mistakes than you do by studying your winners.
We can never keep from being fooled by the market. But we can
control our risk. And if we can control our risk and stay in the game
to fight another day, our chances of winning will increase
dramatically. It's up to you.
JACK CROOKS, Currency Director
on behalf of The Sovereign Society
EDITOR'S NOTE: Jack Crooks applies all these
principles to his currency picks so he can hedge against disasters of
Amaranth proportions...and on Tuesday, October 3rd at 4:00pm (EST)
he'll be sharing more of them in greater detail on a special
teleconference. He'll even reveal his choice for best currency pick for
the last quarter of this year, plus tell you exactly how you can build
and protect your portfolio in the currency markets. There are only a
few spots left on the call...so click here now if you'd like to learn more.
