Dec

29

CBOTI probably have enough info gleaned from old-time pit traders to write a large book. I loved to hear the stories and teachings those old guys had to share, and sought out as much of it as they were willing to tell me. However, much of that information is anecdotal and it would be hard to apply the scientific method to most of it. I did learn a whole bag of tricks for extracting extra cash while trading in the pit, but most of the tricks are either mechanical in nature, or educated guesses (such as estimating how much wheat is for sale in the pit at any given time).

I did learn one slam-dunk way of pulling out money out of the pit. I worked hard at identifying new, inexperienced traders who were certain losers, and fading all their trades. This technique worked out very well for me. However, identifying certain losers is a skill in itself and takes time to develop. Pit traders can have a special insight/feel for the market, but only the net winners have that feel. A majority of those who step up to the plate to trade don't make money, and fade into oblivion.

Steve Leslie responds:

In poker, the professionals are sharks; they prey on the weak, in poker vernacular, the dead money. That is why they are called fishes or pigeons. Professionals avoid tangling with each other — it is far easier to exploit the weakness of the youthful or inexperienced rather than the wizened veteran. Therefore the professional uses time to his advantage by patiently waiting for the amateur to venture out into the waters and make a mistake. It is similar to the Highlander television show from some years back. For the Highlander to gain more power, he must kill his adversary by taking off his head. Same in poker, by destroying your opponent you assume his chips and as a result, his power.

Larry Williams extends:

While the gummint guys say, and rightfully so, "Past performance is no assurance of future success" there is one exception to this I have found and isolated: Advisors, funds, newsletters, etc., that have not done well in the past will not do well in the future. Jeff's pit wisdom does spill over to outside the pits as well.

Phil McDonnell adds:

I performed an analysis a year ago that showed that among mutual funds the worst performers were predictably among the worst in the next time period as well. The results were statistically significant for the worst group. However among the best performing funds there was no correlation. Superior performance did not persist probably because many people  mimic the trading styles of the most successful traders of the last time period. It is a bit like the generals who are always fighting the last war.

Steve Leslie writes:

Ken HeebnerI hope this complements Dr. McDonnell's work since I am sure he did some deep research on this. With respect to his comments a few points can be made.

First, I assume that he is talking about open-ended mutual funds. There are significant differences between open-ended funds and close-ended funds. And even open-ended funds who no longer accept new accounts but only money from existing shareholders. This is a very complex field, evaluating performance of mutual funds because there are so many variables that exist in the arena. Fund managers change, inflow of capital, hot markets such as large cap growth, value, international, etc. With respect to performance my first question would be how performance was measured. Was it against an index or against a peer group? For example if a fund were a midcap growth fund, was the evaluation against other midcap funds or against the Russell 1000, S&P, etc. In short, were these absolute performance or relative performance comparisons?

When I was a broker, I know that if a fund had exceptional performance the prior year, the sales rep for the company would come in and push performance. Then the brokers would take the literature and push it to the clients. Money would flow into the fund, making it more difficult for the manager to manage. Therefore the fund was a victim of its own success and performance would suffer. The most startling examples of this were in the late 1990s and 2000 when tech funds had great absolute numbers. Every sales rep who came into the office was pushing these funds. Dramatic amounts of money would flow into the funds thus putting tremendous pressure on the managers. All the clients wanted to buy were the hot funds. Nobody would buy value funds, which over the next several years would have been the proper investment.

Next is, what style does the manager employ, growth vs value, largecap vs midcap vs smallcap vs international? One year may be too short a time to evaluate superior performance of mutual funds — 3, 5, 10 year numbers are much better barometers of perfomance. Trends in the market can last longer than just one year. For example over the last 3-4 years international funds have had their day in the sun. I am confident the worm will turn and they will begin to tire. The next hot sector may be largecap U.S. growth, or other sectors. The jury is out on this. In fact, the Morningstar five-star ratings system is based on 3 year past performance. I believe the highest-rated Morningstar funds for the past three years tend to be worse absolute performers the next three. Conversely, the worst performers the last three years, the one stars, can be the best performance group. Once again the dynamics are in place for things to change.

Finally there are some fund managers who have withstood the test of time. Ralph Wanger, Kenneth Heebner, Bob Olstein, Bill Miller, to name a few, all have had stellar long term results but even they have had bad years.

Ken Smith remarks:

Performance in youth does not predict performance in aged. Performance in pre-marital bed does not predict marriage results. Performance in school does not predict performance at work. And so on.

Dr. McDonnell worked on performance of top mutual funds, found we can't predict future from present results.  I have looked at charts for many years, in fact I began at age 22.  Now just short of age 79.  Of course there was a hiatus when charts were not available.  Overall my experience determined a squiggle on a chart from five years ago will not correlate with a squiggle I will find when the market opens next year.

Marion Dreyfus agrees:

What Ken says in regard to former performance not being valid for future success should be received doctrine, and yet seems not to be. In terms of financial investments, people extrapolate out as if the law is concrete: If it returned 8% in the past 10 years, it will continue to run that way in the future. We take a lifetime to unlearn easy mistakes.


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