This is my daughter's prayer of thanks for this year (note # 2 & #3!) and she even found something good to say about her brother (but don't mess with her on the soccer field, hmm, wonder where she got those competitive genes?) -

I am thankful for:

My wonderful pets: 4 cats 2 dogs

Both of my very intelligent parents

The markets that my father trades to make money

My brick houses that keeps me warm and cool

My roof that keeps me dry

The piano my dad got us

The money that buys us food

The ability to get good non-moldy food

My brother who wakes me up on weekends

My brain without which I wouldn't be alive

My ability to have the freedom of choice of who I want to be when I grow up

The ability to get clothes, more than just a pair

TSA select 96, we kick butt

My teacher and friends who like me for who I am not who they want me to be

The freedom to read books and go to school and learn

I will second all of the above and also extend my thanks to everyone on Daily Spec for the many wonderful thought provoking posts of the past year.



Polaris SLBMThe comment that "we need intelligence about a coming attack and then we will be able to stop it" shows everything that is wrong in current strategic thinking and why "Homeland Security" as envisioned by the government won't work… sure there is a policing function to counter-terrorism but you will never be able to "police" the terrorists completely away.

Enemies are always at the gates and they are planning "devastating" attacks on us 24/7. Our enemies are constantly sharpening their pencils. We lived under the threat of devastating attack from the Soviets for decades.

Historically what has prevented these attacks more than anything else is not analysis and timely intervention or "policing"… rather it has been simple game theory, the concept of deterrence, that is… a credible threat of retaliation in kind or the threat of overwhelming retaliatory force. You are unlikely to punch someone if you think that they will get up and punch you even harder.

To the extent that we allow that to slip, we will only make the world more dangerous for ourselves.

We see this "credible threat effect" in the back and forth in the financial markets everyday, what stops moves in the market is the credible "threat" of uncommitted capital to step in and take an opposite position. How many times have we sat watching the green and red ticks thinking "how extended is this". We always know that if we do something stupid, such as attack in the wrong way, the market mistress can really kick us hard in a sensitive spot.

Steve Leslie writes:

Tom's either/or scenario on deterrence to terrorism is flawed thinking.

The war on terrorism is an extremely complex endeavor and cannot be distilled into one simplified strategy as a solution. 

There is no one strategy that works with terrorism. It is true that some terrorists' view is that they will not attack if retaliation will involve broad onslaughts as were seen in Afghanistan and Iraq. Perhaps this is the view that Iran is taking right now. 

Then again there are zealots and maniacs who think nothing of strapping a bomb to their bodies or filling a vehicle with explosives and driving into a crowded marketplace.  No direct or implied threat will stop them from doing this. Look at Northern Ireland and the English.  They fought their war of terrorism for over 20 years.

It is impossible for Western culture to understand a philosophy of suicide/terrorism.  This is an extremely bizzare worldview.

Think back on Timothy McVeigh. He blew up a federal building in Oklahoma City and killed hundreds of people.  For what?  No amount of implied deterrence stopped him. 

How about the Unabomber, Ted Kazinski.  He sent out mailbombs to people to kill and dismember them.  The FBI hunted him for years before finally catching him. This never stopped him from his insane mission. 

Now, it would be nice to say that all you have to do is this, but this is not the world that we live in and the sand is ever shifting.

Terrorism is a risk of doing commerce in the world.  It is now a fact of life and will never leave.



Face of FearA talk at the November 1 Junto by Robert Higgs on the importance of fear elicits many thoughts of relevance to markets. Higgs is best knows for his theory of the ratchet effect of crises on government activities. He shows in Crisis and Leviathan that during times of crisis, government powers are increased and that these powers are never reduced.

He started his talk by saying that he wished he had realized many years ago that fear is the foundation for all such increases and that fears are manufactured according to normal production curves subject to the laws of diminishing marginal productivity and depreciation.
He views fear as the key emotion. And believes that fears are invented to create an opportunity for the Leviathan to expand . He groups fears into categories: fear from government itself, fear of real dangers from which government protects us, and spurious fears which are invented so that power can be increased. Planks in his theory deal with the origin of governments in conquest, the alliance between church and state, the tactics of stationary bandits who exert power from a fixed position, the creation of an ideology of fear, the economics of fear, the growth of fear during wartime. He ends with the hope that we can conquer our fears and thus go about our normal humdrum activities in a more productive way.

Against LeviathanI was quite critical of his theories believing for example that many other motivations of human behavior are more important than fear, including the five levels of Maslow's motivations, starting with physiological, safety, love, esteem, and self actualization. Of these hierarchical levels, only the safety level could in any sense be related in part to fear. I felt that much of the support for his theory was based on anecdotal and isolated events such as King Canute's assassination for collecting high taxes. I also questioned whether there was any predictive value in his classification, whether his theories could ever be refuted, the absence of cost benefit calculations in his condemnation of any and all government actions, including its function of providing for internal and external defense, and how it could be differentiated from other theories of power and behavior. I also disagreed with his wholesale condemnation of the use of fear including his condemnation of the United States entering the First and Second World War, after what he decries as false propaganda concerning the evil intentions of our enemies.

Neither Liberty Nor SafetyHiggs' current book Neither Liberty Nor Safety details many of these theories. And needless to say, he believes that the acts that followed 9-11 served mainly to legitimize a wish list of bureaucratic interventions that had been sitting on desks for 15 years, but never were able to see the ligth of day until crisis hit. He believes they did not increase our safety but took away our liberties, and never will vanish even when the need for extra patriotism recedes.

And yet, I found many parallels to the market's fears. There are 1.5 million conjunctions of fear and stock market on the search engines and many of them relate to maintaining the stock market citizen in a state of subjugation, and contribution to the upkeep even greater than that described by Higgs in his many anecdotes, and revision of his crisis and leviathan theory.

I would be interested in your ideas on the influence of fear on markets, the most recent being the fears of recession, the fear of no further rate cuts, the fear of the subprime crisis spreading, the fear of brokerage house bankruptcies and financial liquidations, the decline of the dollar, the spread of epidemics, the comparison to the crises of 1987 and 1998, the increase in volatility and what that portends, the declining earnings growth, et al., the role in fanning fear by former officials recently retired, as well as those who have long predicted Dow 5000 et al.

High on this list would be the typology of fears that have existed each year since the beginning of stock markets, and how this has engendered the 1 million % a century growth which Mr. Ellison has kindly updated here before.

Alston Mabry adds:

Happiness HypothesisIn The Happiness Hypothesis, author John Haidt uses an interesting image our human brain which has developed over vast amounts of time to handle so many tasks: he likens the mind to a rider on an elephant. The rider is our conscious, rational, aware mind - our neocortex. The elephant is everything else and is trained to be pessimistic, defensive, status-conscious, and many other things that might contribute to survival and success, but not necessarily be conducive to happiness. The rider can see farther and is smarter than the elephant, but the elephant often decides where both will go. Haidt then argues that many ancient traditions understand this dichotomy and know that the brain must be disciplined and trained for happiness.

In trading, I find there is a basic division: analysis versus execution. Analysis can seem so sure and easy, when the market is closed and one is simply crunching numbers - the elephant is asleep, as it were, and the rider is alone with his thoughts. But as soon as the market is popping, and one must put real money on the table - as soon as there is *risk* - the elephant awakens. The mind actually changes, perceives and processes the same data differently from the night before.

Perhaps the discipline of the ancients is the answer. Would Lao Tzu, or Bodhidharma, or the Desert Fathers have been successful in the pits?

Phil McDonnell writes:

MaslowAn alternative approach to Maslow's Hierarchy might be to consider the hormonal make-up of human beings. The two powerful hormones adrenaline and nor-adrenaline control our fight or flight response to potentially dangerous situations.

However they are much more than that. They directly or indirectly influence our heart rate, breathing, blood pressure, serum glucose levels and even our memory. They are a significant factor in motivating us to action. For example researchers have found that after receiving adrenaline human test subjects were more likely to take action in contrived circumstances which potentially involved even physical violence. Humans cannot easily distinguish between true emotions and those induced by adrenaline.

Other research has shown that rats will develop stronger memories when adrenalin is administered. There appears to be a simple physiological basis for this in the neurons. In particular rats that lacked the particular receptor did not develop the stronger memories in the presence of adrenaline. The important point is that memories which are formed or reinforced in the presence of higher adrenaline levels are much stronger that those which are not.

Charles Darwin was the first to study the evolution of emotions in: The Expression of the Emotions in Man and Animals with Photographic and other Illustrations (J. Murray, London, 1872).

Emotions originally developed as a way of avoiding dangerous situations as well as signaling to others the state of a particular individual. For example when an individual is in an emotional state such as extreme anger others may be warned away and learn to avoid confrontation. But when the irrationality of anger is not present others may attempt to reason with the individual. In effect the perception of an emotional state signals to others how an individual might respond in a given situation.

As traders we can turn this knowledge around. Large movements in the markets can induce an emotional reaction in other traders. In particular these movements induce an adrenaline response associated with the fight or flight syndrome. In turn the adrenaline reinforces the memory of the particular gyration in the market. So the memory is stronger and has more immediacy and in a sense more recency. So when a similar event happens again the memory is stronger, generates more adrenaline and is reinforced again.

Each time the effect of the adrenaline is to predispose the trader to action. Traders are more likely to act and act irrationally. Trading volume tends to increase. In effect the market begins to control the emotional actions of traders causing them to think with the more primitive portions of their mind. In the logic of the primitive mind losing money is equated to loss of food and ultimately loss of life. Every drop in the market is met by selling at the worst possible time. Market rises are greeted with herd like buying after the rise has occurred. It is all an emotional dance orchestrated by our own chemistry. orchestrated by our own chemistry.

Micheal Cook remarks:

Yin & YangIt is commonplace to say that two principal drivers of the market are fear and greed. I agree that there are many other higher level motivators, such as Maslow's hierarchy of needs, but the market exhibits crowd behavior, and the crowd is the lowest common denominator of human emotions. The "masses" don't seem to have a hierarchy of needs.

In the context of the market there seem to be two basic fears: fear of loss, and fear of missing out. This latter fear is a form of greed, so maybe fear and greed are two sides of the same coin, the yin and yang of markets.  

I heard a talk recently in which it was said that the market is driven by the irrational emotions of fear and greed, and that rationality consisted in finding the right balance. I found that amusing and ironic, the idea that rationality was finding the optimal mixture of two irrational emotions.
I also find that people seem to spend a lot of time worrying about things that in no way impact any current decision they might make. Things like "will there be a recession," "will the subprime crisis spread?" This strikes me as an expression of free floating anxiety, a channel, a displacement, a sublimation… 

Russ Sears augments:

Perhaps the widest and the true foundation to build on is not "fear" but "pride". Pride that is turned into "us vs them".

Granted that this "patriotism" is often used to create fears to expand powers. When used with fear this can be the most evil and complete expansion.

However, pride or "we are smarter than them" also creates a very stable base to expand love/family to create a counterfeit charitable hand.

That is: the Maslow hierarchy is built upside down to expand government.

Self actualization: what separates "We" from "Them" is "we" are the only ones with a true "need to know" the truth. We here is defined broad, to include all but "them"

Esteem: "We are smart enough to rule everybody's life". "We" here is defined narrowly as those of "us" that are in the government. Everybody else should follow the yellow brick road to see the wizard.

Love/family: "It takes a village" government will replace the dysfunctional family, which is all of "them"

Finally, the expansion into safety: government will protect "us" from "them".

From this view fear is the roof, or exterior, not the foundation. The expansion of government occurs with each level, not simply fear.

This can of course can be seen as a clear pattern in doomsdayist prophecies. "We" are the only ones smart enough to seek the truth, at all cost. Tomorrow is bleak without "us" to warn you and turn bad on its head and into good.

It is a good exercise for the reader to read many of the recent credit crunch articles with this view,  as current propaganda. This of course can be expanded beyond the markets and political readings, even into such areas as religion and popular pseudo science such as Dawkins for instance.

Tom Ryan enumerates:

The influence of fear:

1. The reliance on social proof rather than logic (looking to the herd for confirmation)

2. The tendency to extrapolate past events out into the future

3. The tendency to respond to contrasts more than absolutes

4. The tendency to non-linear weighting of probability (Kahneman & Tversky)

6. Emotional reaction to loss tends to exceed that of gain (Prospect Theory)

7. The tendency towards being consistent in one's behavior despite the financial pain in order to avoid the mental pain (fear of regret)

8. Overreaction to scarcity (scarcity programming - as one who has gone bust before I have this in full measure)

9. Strategic conventionality ("no one ever got fired for buying IBM")

Larry Williams contributes:

Fear is the greatest enemy of long term investors as it kicks them off track, off their game plan… that, coupled with short term 'gain-greed' seems to be why there are few truly long term investors.

Where does the fear come from?

Deep within our hearts and minds I postulate there is a fear mechanism—for our survival—but those fires are fanned, now, twenty four hours a day by media. Media= Negativity (fear)= Subscribers/Viewers.

Solution? Best I've heard comes from John Prine, "Blow up your TV, eat a lot of peaches, ya gotta find Jesus on your own"



Anyone remember how we used to fight for three-point moves earlier this year?

Ah, the good ole days
Of high volatility
Don't seem so good, now



BakedReceived my vehicle registration in the mail last week. This time around the State of Arizona (aka California II) is letting people pay for two years instead of just the one.

Why would anyone pay for an extra year?  No worries — the state has put a nice little flyer in there to explain why you should pay an extra year in advance. There are five reasons. four of them are of the "less hassle — that way you won't forget" variety.  But number four struck me: "protect yourself from future tax increases."


Ok, here's the punch line..

The state has a surplus this year. 

Get the joke.  



The longest winning streak in baseball since 1920! I follow the NL West very closely, and even I can't seem to get my head around what is going on with the Colorado Rockies. They have gone from fifth place to the World Series in five weeks, winning 21 out of their last 22 games. Honestly, I just don't think they are the best team in the NL West. I don't even think they are the second or third best team in the NL West. But they are on one heck of a win streak. It's like a commodity contract opening limit up 22 days in a row. Have no clue as to how Vegas can handicap this coming World Series. By my calculations the probability of my getting hit by a meteor tonight is higher than the Rockies' winning 21 out of 22 and 19 in a row. Depending on what probability you assign their winning a game, the probability that they would win 21 out of 22 is somewhere between 1e-06 and 1e-07.



PoohAmazing Bear Rescue

A bear was walking across Rainbow Bridge (Old Hwy 40 at Donner Summit, Truckee) on Saturday when two cars also crossing the bridge scared the bear into jumping off the bridge. Somehow the bear caught himself on a ledge and was able to pull itself to safety. Authorities decided that nothing could be done…

There is a distribution of intelligence in wild animals, just as in humans, and increasingly there is evidence intelligence is partly inherited. Now in this case the authorities gave the bear a night to either fall off the bridge and perish or figure his own way out. It wasn't until the next day that for public safety reasons (onlookers) they decided to rescue the bear. And I don't have a problem with that. However, if we rescue every whale that swims up the Sacramento River or every bear that walks onto a bridge then we circumvent the natural order of things — which is that in the wild, the stupid animals perish and the smart ones propagate. The net effect of protecting the animals from every dumb move they make is Eloi-like wild animal populations. They are wild animals and not domesticated pets and they have to be allowed to fail. Otherwise as a species they will not be able to learn and adapt to the changing circumstances of the world in which they live.

Alston Mabry haikus:

Bridge-bound bear is saved.
Sunbaked berates bold rescue.
Which is more foolish?

Having been stuck on
a few high bridges myself,
I feel for the bear.

Dean Parisian extends:

I am a waterfowl hunter. Geese and ducks. I have killed lots of smart geese and lots of dumb geese. What kills the smart ones is their relationship with their life-long mates, causing them to fly back into the goose decoy spreads looking for the mate that just dropped out of the sky. Most geese killed over decoys are responding to the greed factor that the geese on the ground (the decoys) are feeding on food the geese in the air want.

These two basic goose-killing methodologies have significant lessons for market players. One, don’t fall in love with your positions because you can be gunned down at any time if they get you into strange territory. Two, don’t get yourself into situations where you “need” to be in the trade with everyone else who is feeding at the trough. That will get you killed faster than anything. One more thing, when you exit a position where shots were fired and you escaped, don’t come back and visit any time soon. There are lots of greenbacks in other places. Just keep looking until you find them.



Triage TagOverheard at the deli last week, paraphrased to give you the gist of the conversation. Two local hospital administrators:

Hospital admin #1 "No, it's good these people are coming to us"
Hospital admin #2 "What are you talking about — they have no insurance"
Hospital admin #1 "Right, so AHCS picks up the tab"
Hospital admin #2 "Oh yeah, right"
Hospital admin #1 "And the state pays faster and never argues unlike those a$$h&les at Aetna, United and Pacificare"
Hospital admin #2 "Great"
Hospital admin #1 "You just triage them a little lower in the ER to keep the paying customers happy"

J.T. Holley responds:

Here's my neighbor's response; he's a ER doc here in a Richmond, VA hospital commonly referred to as the "Gun and Knife Club of Richmond."

Probably goes on, but it is illegal and if anyone had good data that this happens, then that hospital is at risk of losing every last Medicare/Medicaid dollar. Usually not worth that big of risk. EMTALA law forbids the ER triaging based on insurance status.

There are pretty straightforward criteria to triage patients based on vital signs, chief complaint, etc. It really isn't worth the risk to get you're a$$ sued or have an EMTALA violation for one or two "satisfied" customers.

Don't know who those admins were, but they sound like dumba$$es as well as unethical — both no big surprise.

Tom Ryan extends:

RaytheonIt's not about the healthcare, it's about the money. Healthcare is just a small microcosm of the bigger picture problem which basically boils down to this: Once you create a system where a substantially large portion of your population derives their paycheck either directly from the government (in my community that would be the University, the Air Force base, the Border Patrol, the list is endless) or say one degree removed (again, in my community one of our biggest employers is Raytheon), once that group gets large enough as a proportion of the total population, you reach a turning point from which there is no going back. That group will simply just keep voting in their economic interest and expand like a virus. More programs, more jobs, more money, bigger budgets, larger departments, War on Drugs, War on Immigration, War in Iraq, War on Terror — Now we will have a war on healthcare and a government sponsored healthcare industrial complex - the list is endless and expanding. It will never stop until we are bankrupted and have to show ID just to get across town. My friends who call themselves "conservative" are just as responsible for this expansion of government as the liberals. They may be "conservative" in a gods-guns-gays way of thinking, but in my book they are proponents of big nanny government just like the liberals.

Gary Humbert explains:

Rent-seekers become successful by rewarding special interests at the expense of the general public, since the amounts are huge to the special interests, but the costs are spread around over the general public.

Hillary's mistake the first time was to take on the healthcare industry as a whole.  She will not make the same mistake again. She will simply raise taxes to spend on a nationwide health insurance program, getting industry to agree by promising to spend a ton of money on them.



 A History of the Vikings, by Gwyn Jones, is a keeper. It was originally published in 1968. This is not a history-light book that is all too common these days, but rather a comprehensive and thorough disposition on a rather complex society over the course of five or six centuries.

The book, if nothing else, dispels many of the negative stereotypes of the culture as being hell-bent on raping and pillaging everything they came into contact with (note the current movie Pathfinder). That's not to say that the Vikings did not raid their neighbors, fight wars against other cultures and take slaves. They did. But so did the Gauls, Angles, Saxons and Jutes, and the Goths, Vandals, and Celts before them.

Primarily the story of the Vikings is a story about trade; these people were first and foremost traders, and their expansion was driven by economics. Rather than raiding and relying on plunder, the Vikings set up a system of trading outposts where they traded for goods with the local populations. The Vikings had what was at the time the most sophisticated and sound monetary system in Europe. It utilized silver and gold coinage as well as precious metal and base metal beads. They had insurance contracts. They provided security and protection to shippers to protect goods from piracy.

At the pinnacle of Viking culture in the 9th and 10th centuries, the Viking trade system extended from Iceland all the way to Persia, which is why some of the most important information we have about the Viking culture comes from accounts from other cultures including Arabic and Byzantine traders. The Byzantine emperor hired the Vikings for his personal bodyguard (the Varangian Guard) and they used this position to further extend their trade network. The geographic span of this culture (Greenland to Byzantium, Portugal to the Urals) is amazing given the period and especially when you consider the state of technology at the time.

Clearly this was a risk-taking culture and it just goes to show how a bit of egalitarian politics (the Vikings although feudal, were not as hierarchical as the other tribal groups at the time), a sound monetary system, a focus on technology (Viking weaponry and ships were at the time the best in Europe by far), can create a potent cultural force.



 Last night while swimming laps I was thinking about efficiency of movement through the water. Actually this started last Friday happy hour when I took a pile of people from here to the pub and they happened to have the America's cup on TV. Several of the folks here are part-time sailors and while watching the kiwis fend off Italy through tack after tack a seed of a thought started germinating in my mind.

Efficiency is a critical component of all kinds of systems involving movement. In fluids for example we know that flow can be steady or unsteady, laminar or turbulent, and uniform or non-uniform. The more the fluid flow is steady, laminar, and uniform, the less energy per unit mass it takes to move the fluid. Unlike solids, however, elements of a fluid mass may move at different velocities and be subject to different accelerations. Still, we have three fundamental anchors: the conservation of mass (continuity), the principle of kinetic energy (flow equations), and the principle of momentum (from which the forces exerted by fluids can be established). What I am most concerned with however in this gedanken is efficiency, therefore energy relations. The most basic energy equation for flow in a fluid mass with boundary constraints, say in a channel or a pipe is (Energy at point 1) + (energy added) - (energy lost) - (energy extracted) = (energy at point 2).

In swimming, energy is added via the muscles, energy is lost due to drag, and there can be a slight effect of energy being extracted depending on the movement of water in the pool. For example, in racing at elite levels measurements have shown that the racers who are lagging behind the others can get slowed ever so slightly as they approach the wall if the wave front generated by the lead swimmers hits the wall and is already bouncing back into them. But in any event the main concern here is with drag.

We know based on the Froude relations that drag of a body or vessel through water is a function of the ratio of the length of the body to its width and depth. In general experiments show that the higher the ratio of length to width, the less drag that is exerted, which is why racing hulls tend to be long and narrow.

In swimming the practical example of this is the use of the method of front quadrant swimming, which was popularized in the 1980s and has recently come back into vogue as people examine Ian Thorpe's technique. (At least as a term or methodology.) It's beyond the scope of this post to discuss all of the minor details of FQS (you can Google it) and there is always some controversy when it comes to swimming technique but the main gist is to maximize and maintain the ratio of your body's L/w in the water in order to lessen drag. This is accomplished by swimming mainly on the sides of your body, using rapid but fluid transitions from one hip to the other, with a long body position in the water that is created by keeping one hand out in front at all times (not straight out in front of the surface of the water but in the front quad in front of your head).

I can say from experience that working with FQS can drastically reduce the number of strokes required to cross the pool, in my case by about 15-20% (3,4).

This leads me to contemplate trading efficiency. To me trading efficiency is not the same as volatility of p/l that is really what is captured by Sharpe, but rather is using the least number of contracts to capture a given level of profit. We know that in trading, as in swimming there is considerable drag in commissions, account fees, and the bid/ask spread which has to be overcome.

Also, as with swimming, I have noticed as I get older that it is not so much the losses that annoy me (although they can definitely hurt at times) but rather the periods where I am churning and getting nowhere. As daytraders we have terms we use to describe this annoying feeling, like "not in gear," "last to get the joke," "the broker is my best friend this week," etc, all of which capture that feeling of trading inefficiency.

It also begs the question as to whether trading efficiency as a metric has any predictive value, at least for traders following a systematic approach to positions. Or, conversely, is there a metric that might be developed for the market movements as whole, say over the course of the week, to assess the degree of market efficiency or the degree of market efficiency as it moves between certain goal posts (1500-1520, 1520-1540, etc)?

We have discussed before how the market often has a tendency to turbulent behavior during the course of the week only to finish nearly unchanged on the week and Victor has proposed that this is one way the system maintains itself, by enticing people to do the wrong thing at the wrong time and thereby make a contribution to the upkeep.

Jim Sogi adds: 

Here are a few additional considerations: Swimming underwater creates less drag, so there are some rules limiting the time, say one stroke, underwater in swim racing. I have a lot of experience swimming underwater trading and in the ocean when I wipe out surfing, but it seems to be part of the game and is a necessary component that might be factored in to your equations.

I like spending only the optimum time underwater, ideally none, but only a breath or two. A two-wave hold down is serious and approaches drowning. Some time underwater is necessary to pop through waves, but also to build a position, as it's impossible to get a full boat on the bottom tick every time.

The second consideration in water is planning. At a certain speed and with certain hull designs the boat starts to plane up on the surface with a break out from the limitations of the hull length/width speed formula into a new equation. When surfing, the commencement of the plane from paddling through the water is the start of the 'ride'. The length of time in a trade getting to the profit ride part seems very important in efficiency terms.

The longer and faster profit/ride, the less time underwater slogging, the greater efficiency, especially tallied over a large number. Paddling a surfboard through the water, getting onto a plane, and jumping up, while at the same time not missing the wave, takes incredible timing and strength. This is a key to trading as well, to time the opportunity, to have the strength to plow through water, sometimes under water, and get to the plane, and ride the ride, maneuvering through the changing face of the wave. Maneuvering around the sections, under the curl, until the wave ends and before hitting the reef takes skill.

Just like every trade requires such strength and courage to enter with the risk of going underwater, skill to read the changing market turns and getting the maximum distance. These things could be quantified in performance stats, but lost opportunity must also be added in as a variable, and lost opportunity has been the key variable in the recent cycle.

From Vincent Andres: 

Here is a humble suggestion. Let each trade be evaluated automatically by your computer according to some criteria (many have been given here). There may well be around 10 criteria. Evaluation may be a note between [-100, +100].

After enough trades, have a look in the criteria space to see if there is some clustering or if the distribution is random or not. Also, this is nothing else than an alike computerized version of Chair's "keep in a notebook" recent advice. 



 The average child spends 34 hours watching television a week.

A recent poll indicated that over 90 percent of the population of the United States never reads a newspaper. Fewer read more than one book a year.

There are 1440 minutes in a day. If one spends 15 minutes reading, one can read a 300 page book in a month.

Question: What is the difference between someone who can't read and someone who won't?
Answer: Nothing!

Alan Millhone asks:

 I had not heard these terrible statistics before. The United Negro College Fund coined the slogan "a mind is a terrible thing to waste." Children today sit endlessly in front of the boob tube, which serves as a babysitter for many parents. Thirty-four hours per week is staggering.

Recently my daughter took her cable TV back to "basic" and has no Internet for her two young sons. Solomon makes all A's and Forest is a B student. She is conscious of the time they spend on video games and TV, and she makes sure they are involved in school and after-school sports (currently soccer). They also have to do their homework as soon as they are home from school.

Pizza Hut and Tim Hortons in our area have a book program once a month for students, where they read and have their reading certified by a parent. My daughter says Pizza Hut is under fire for this because they are, in a way, encouraging bad eating habits for children. I suppose Tim Hortons will come under the axe next for selling donuts!

I am lucky that my parents encouraged me to read and I enjoy learning new words to this day. I wonder what can be done to change the terrible trend amongst our nation's youth?

Tom Ryan replies:

I really hate to be the park ranger, but is there really a study that actually has data about kids and 34 hours of TV a week, and what poll was it that indicates less than 10% read one book a year? Can we get back to numbers on the table?

Conversations on how "things are going to heck these days" only bring us all down and serve no purpose, not to mention that I don't believe in the premise in the first place. I, for one, am very encouraged by what I see going on with young kids these days. 

George Zachar offers:

When technology permitted advertisers to study viewership with greater detail than the old Nielsen diaries, they discovered that having a TV on counted as watching, whether there was anyone in front of the box or not. Cooking, chatting, copulating, sleeping all counted as viewing, as long as the tube was clicked on. 

Stefan Jovanovich adds:

The periodic release of alarming statistics about the decline and fall of literacy in America is one of our country's most enduring traditions. It usually coincides with the discovery by publishers that they are losing market share to another medium. Forty-five years ago the new scandalous fact of America's illiteracy (prompted by the rise of color television) was that Americans were now spending more on pet food than on books. When I told my father the book publisher of this alarming fact, his comment was that it confirmed the obvious: dogs and cats eat more than they read. I think that (yet again) the apocalypse may be a bit farther off than the New York Times fears.

Jim Sogi writes: 

As our esteemed resident philosopher states, "happiness is the end that alone meets all the requirements for the ultimate end of human action." The distinction between wants and needs makes it harder to make a concrete rule for action. For example the desire for honor is not something that is needed, but is a worthy aspiration. The more concrete way to frame the dichotomy is to put it terms of "stuff". If the goal is to get a lot of stuff, the wants never end. If the goal is to get rid of stuff, and end up with a wooden bowl and a robe, there is a finite goal. Once the stuff is gone, only the needs are left and true happiness is possible.

Regarding television: it is evil and promotes the acquisition of stuff, thus fostering unhappiness. Those who seek happiness in stuff are never happy, for there is always more. Eliminating television will improve life. The least benefit is the added 14 hours per week available for self-improvement; the greatest is the freedom from incessant exhortations to feed a desire for more stuff. For children, it avoids the frenetic programming of the brain into 3-second sound bites, which can destroy the ability to concentrate and focus.



 Paul Buchheit , creator and lead developer of Gmail, writes in his blog:

The secret to making things easy is to avoid hard problems.

That may seem obvious, but in my experience most engineers prefer to focus on the hard problems. Working on hard problems is impressive to other engineers, but it's not a great way to build successful products. In fact, this is one of several reasons why YouTube beat Google Video: Google spent a lot of time solving technically challenging problems, while YouTube built a product that people actually used. For me, the most effective method of getting things done quickly is to cheat (technically), take a lot of shortcuts, and find an easier way around the problem.

Like most aphorisms of this sort there is a grain of truth and also some fallacy. We have found that there definitely is value to having a few slower-moving deep thinkers in the group as well as a few very detail-oriented stick-to-the-process types. Obviously you must have people who are results-oriented and who can get the job done and the work out the door and the profits in the door. But I can tell you from experience that organizations that are purely results-oriented, always taking the shortest path to the dollar and which are entirely focused on efficiency don't last long term.

For example, we have two particular people who have a knack for finding all of the bugs and minefields in the programs we write. It's just uncanny; if there is a path to a program blowup they will find it. I believe it has to do with an ability to think in terms of what-if. The purely results-oriented work-smarter types never find these problems because they can't be bothered with what-if. So we need the creative what-if people in order to improve things long term.

Art Cooper remarks:

Work smarter, not harder. Taking shortcuts whenever possible, doing what's practicable instead of more intellectually satisfying, is to work smarter, not lazier.

Russell Sears replies:

It occurs to me that often when people say work lazier, what they are really saying is work relaxed. Go for a run at the height of a frustrating math problem, and often you'll find the answer immediately on returning. Likewise when suffering from writer's block, or when debugging computer code. Perhaps this is why military training helps in trading. After you learn to relax as someone shoots at you, trading is a piece of cake. 



 The musical scale that Pythagoras invented and that forms the foundation for all Western music is based on relationships between small integers. Both the frequencies of musical notes and the intervals between them are ratios of certain integers, as follows:

Scale of Just Intonation

Note            C    D    E    F    G    A     B    C'

Frequency  1/1  9/8  5/4  4/3  3/2  5/3  15/8  2/1

Interval      9/8 10/9 16/15 9/8 10/9  9/8  16/15

How could similar relationships be uncovered for the S&P? As a first step we might force all S&P daily moves into bins one point wide, that is we could call all moves of 1.0 to 1.9 points "one point moves," and so forth.

We calculated the number of occurrences of each integer move, and also the number that would be expected if we assumed a normal distribution having the same mean and standard deviation. The result may be familiar to some readers but new to others, so we show it here:

S&P Daily moves in increments of 1 point

1999 to 2007/2/28

 LO HI Cases ExpCases  
-500 -40.1 10 2.46
-40 -39.1 1 0.63
-39 -38.1 0 0.79
-38 -37.1 1 0.98
-37 -36.1 2 1.21
-36 -35.1 3 1.49
-35 -34.1 3 1.83
-34 -33.1 1 2.22
-33 -32.1 4 2.68
-32 -31.1 7 3.22
-31 -30.1 3 3.85
-30 -29.1 9 4.58
-29 -28.1 2 5.41
-28 -27.1 9 6.35
-27 -26.1 8 7.42
-26 -25.1 6 8.62
-25 -24.1 5 9.95
-24 -23.1 13 11.42
-23 -22.1 13 13.03
-22 -21.1 20 14.79
-21 -20.1 16 16.69
-20 -19.1 13 18.73
-19 -18.1 15 20.89
-18 -17.1 16 23.17
-17 -16.1 17 25.55
-16 -15.1 19 28.01
-15 -14.1 24 30.54
-14 -13.1 28 33.10
-13 -12.1 29 35.67
-12 -11.1 39 38.23
-11 -10.1 43 40.73
-10 -9.1 53 43.15
-9 -8.1 46 45.45
-8 -7.1 55 47.59
-7 -6.1 52 49.56
-6 -5.1 52 51.31
-5 -4.1 54 52.82
-4 -3.1 60 54.06
-3 -2.1 70 55.01
-2 -1.1 79 55.66
-1 -0.1 76 56.00
0 0.9 94 56.02
1 1.9 85 55.71
2 2.9 91 55.09
3 3.9 89 54.17
4 4.9 74 52.95
5 5.9 69 51.47
6 6.9 54 49.74
7 7.9 52 47.80
8 8.9 59 45.67
9 9.9 53 43.38
10 10.9 35 40.98
11 11.9 43 38.48
12 12.9 38 35.93
13 13.9 28 33.36
14 14.9 26 30.79
15 15.9 25 28.26
16 16.9 17 25.79
17 17.9 18 23.40
18 18.9 14 21.11
19 19.9 14 18.94
20 20.9 10 16.89
21 21.9 7 14.98
22 22.9 6 13.20
23 23.9 5 11.57
24 24.9 6 10.09
25 25.9 15 8.74
26 26.9 4 7.53
27 27.9 8 6.45
28 28.9 7 5.50
29 29.9 2 4.66
30 30.9 2 3.92
31 31.9 3 3.28
32 32.9 2 2.73
33 33.9 2 2.26
34 34.9 1 1.86
35 35.9 2 1.52
36 36.9 3 1.24
37 37.9 0 1.00
38 38.9 2 0.81
39 39.9 4 0.65
40 500 16 2.52

The main features of the distribution as compared to the normal are: an excess of small changes (say from -6 to +6 points), a deficit of medium sized moves (of about +-16 points) and a modest excess of very large moves (+-35 points or more). A description in terms of these three features is a better one, in my opinion, than simply focusing on the size of the negative tail (as too many people do). 

From Laurel Kenner:

In mathematics, Dr. Castaldo is on Parnassus and I am on the "Gradus ad." I do know a little about music and writing, and so I will nevertheless venture to observe that Pythagoras did not actually invent the musical scale. As Stuart Isacoff puts it in his masterful book "Temperament":

"Pythagoras's discovery was that the most 'agreeable' harmonies [e.g., the octave, fifth and fourth] are formed by the simplest kind of mathematical relationships. If the vibrations of one tone are twice as fast as the vibrations of another's, for example, the two will blend so smoothly the result will sound almost like a single entity [he is referring to an octave]. The separate constituents of this musical marriage are oscillating in the proportion 2:1."

Closer to our day, Helmholz wrote that consonant tonal relationships are embedded in the essential physical structure of notes — the sound waves. Look at a graph, and you'll see greater spikes in intensity around the octave, fifth, fourth, etc. These spikes are known as harmonics. Their intensity levels depend on the shape of the instrument that produces the sound, and the resulting mixture contributes to the distinctive sound of each instrument.

(Hold a bass note on the piano down and strike the same note, stacatto, a few octaves higher and listen closely — you'll hear sonorities of tones still higher. Or experiment with harmonics on a vibrating guitar string.)

The market's ever-changing significant levels might be viewed (heard) as harmonics of past turning points. The Chair's insights on the continuing psychological impact of catastrophic events would seem to be in this genre.

The mathematical relations found in music are tempting to apply to the physical structure of the universe, and people have done that at least since Pythagoras. But I will leave that to the physicists.

Todd Tracy adds: 

We might be socialized to market intervals in much the same way as to musical intervals. I found this interesting.

Evolutionary Effects by Robert Fink, 2004

General human evolution has provided us with voices that are acoustically musical, and with ear receptors that are appreciative of, or attracted to, acoustically-musical sounds (i.e., not noisy). Why this evolution?

Without these physiological capacities, then:

* Mothers would not coo to their babies; nor would the babies love the sound of it;

* Nor would evolution of language and the socializing sounds of the voice have been as possible;

* Nor would the noisy (i.e., not-acoustically musical) sounds from any nearby destructive event or attack, or of the sounds of breakage, screams or cries of pain, have served as a noisy warning [unattractive or repelling] to alarm or alert us — Some sounds make us come, others make us run….

And, as a result, our collectivized survival might not have been as efficient, and we could have gone the way of the extinct Dodo.

All those same capacities [regarding being able to distinguish noise from "musical" sound] also served to allow the development of musical systems to arise and evolve wherever there were curious people with time to play or experiment with the stimuli around them.

Tom Ryan extends:

I find this Pythagorean scale discussion fascinating and have thought about various applications of musical scales and notes to market prices often over the years. Pythagoras believed the universe was an immense monochord and many of the Pythagorean teachings at Crotona are remarkable insights, especially with respect to what we now call string theory.

Pythagoras believed that by studying music mathematically, one could develop an understanding of structures in nature. One of the more interesting aspects that I have found in this is the lambdoma table, which is a 16×16 dimensional matrix of ratios starting with 1/1 and ending with 16/16,

1/1 1/2 1/3 1/4 1/5 1/6 1/7…….1/16
2/1 2/2 2/3 2/4 2/5 2/6 2/7…….2/16
3/1 3/2 ………..
16/1 16/2 16/3……………….16/16

The lambdoma is composed of two series. The first represents the divisions of a string which represent frequencies or tones. The second level represents harmonics. For example the first 16 harmonics of C are 256 hz (C), 512 hz (C), 768 hz(G) 1024 hz(C) 1280 (E) 1536 (G) 1792(B-) 2048(C) 2304(D) 2560(E) 2816(F#) 3072(G) 3328(A-) 3584(Bb-) 3840(B) and finally 4096 hz (C again since 4096/256 =16/1). This series represents the overtones or partial and whole harmonics of C and are represented by ratios in the table

Through the ratios one can study other types of natural structures as well. Botanists in particular have studied geometrical structure and many plant structures (leaves, flowers) have been noted to be geometrically developed in consistent ways where the key geometric ratios fall into a contiguous grouping or overtones of a fundamental, i.e. a pattern of squares within the lambdoma matrix. Leaves for instance often have simultaneous ratios of thirds (5:4) and fifths (3:2). The Renaissance studies including Da Vinci's notebooks note that the human body develops along particular lines as well, namely an abundance of major sixths (3:5) and minor sixths (5:8).

These whole number ratios or pattern of harmonics, as Laurel noted, form the basis for musical scales,

Octave 1:2
Fifth  2:3
Fourth  3:4
Major sixth     3:5
Major third     4:5
Minor sixth     5:8
Minor seventh   5:9
Major second    8:9
Major seventh   8:15
Minor second    15:16
Tritone 32:45

The question is whether specific harmonic patterns occur at times in the market and whether these can be quantified in some way. Victor discusses market prices as music in his book EdSpec.

One way would be to classify movements as ratios, and see the patterns of ratios as they unfold, classifying movements in price as patterns on a scale or within the lambdoma. From that one might be able to find a few meager predictable patterns. But there is a problem with this: to calculate ratios in a contiguous strip of real time prices one must arbitrarily choose reference points in order to calculate the ratios.

This means that there is a substantial level of subjectivity in developing the ratios from which the patterns can be studied. But one could arbitrarily divide the day into segments and look at ranges or deltas within those segments (say 30 minutes) and then calculate ratios of adjacent periods. There are probably an infinite variety of ways to segment and calculate ratios and therein lies the dilemma.




 I just recently finished the book The Design of Everyday Things, by Donald Norman and found it a treasure trove of useful advice for designing and maintaining all types of systems. The book contains chapters on feedback, mappings between thoughts and actions, human logic patterns, and the psychology of choice. There are many examples of really bad design and what not to do (what to avoid). But at the end of the book there is a summary of seven basic principles involved in good design. The book is a bit deeper than these seven principles, but I have been mulling these over and will try here to briefly relate these principles to trading.

1. Use both knowledge "in the world" and knowledge "in the head."

Patterns and back testing are fine but they cannot tell you that tomorrow is the unemployment day, or that Bernanke is speaking at 10 today. Therefore, a trader needs both the knowledge contained within the numbers, and knowledge outside of the numbers.

2. Simplify the structure of tasks.

Trade the anticipated move in your market in the most direct way possible with the fewest instruments possible.

3. Make things visible.

Know your position at all times. Have the p/l updating in real time. Know where you are relative to your margin 24/7/365.

4. Get the mappings right.

Keep the rudder steady. If you trade reversals stick with that. If you trade momentum stick with that. Don't go back and forth simply because of recent p/l. Don't flop back and forth during the day between long and short. Don't completely reverse course because of a loss. Nothing is worse than taking a loss in both directions on the same day. Know the 1000% per century drift. Trade with it as much as possible.

5. Exploit the power of constraints.

Know when the big announcements are coming. Know how volatility changes as you get close to the end of the trading day, the trading week, and the fiscal quarter. Know where the shoals are and account for them in your trading and placing of orders

6. Design for error.

We all have placed shorts when we meant to place longs. We all have put in orders for 1000 when we meant 100. Have a system in place to catch these mistakes before they kill you. Set your limits in your trading platform. Check your position frequently. Have a backup source of capital ready for the margin call. Diversify. Train the spouse in methods of dealing with the inevitable "rough day at the terminal."

7. When all else fails, standardize.

If you are having trouble initiating positions, buy and sell on a scale. Use limit orders. Be consistent in your scales; don't change them day-to-day. It's hard enough making a judgment whether things are bearish or bullish, where to be placing orders, let alone monkeying around with the structure of the scale. Trade based on the system, not whether you had great romance the night before or too much coffee this morning.



 One of the 10 million things that the Specs have said either on Daily Spec or to me personally in the past five years that made complete sense is how the first priority for the evildoers is to get you to question not your facts or even your beliefs but your own version of reality.

They do this by attacking you on a very personal level such that you begin to question your own ability to think clearly about an issue, to use your abilities to reason. This is accomplished generally by intimidation, by peer pressure, or by insinuating that they have access to knowledge that you don't, thereby denigrating your intellect. Then into that vacuum of logic they can insert their own ideology. 

J. T. Holley adds:

 A very good example of this is shown in the movie, "A Bug's Life," by Disney via Pixar. The following is the logline from Yahoo! Movies:

"A colony of ants is threatened by a gang of grasshoppers led by the evil Hopper. Flik, a common ant and a misfit, has an uncommon vision when he tries to rise to heroic proportions by enlisting a band of circus fleas to help him defend his colony from the grasshoppers."

The amazing story is how the libertarian heroic Flik utilizes individualism and technology to bring about change in the ant colony and helps them realize they have the strength and the numbers to stand up against the evil Hopper and his grasshoppers. Up until then the way the psychological edge was maintained by Hopper and Tom's "questioning your own ability" was wonderfully demonstrated. No one single ant ever challenged Hopper due to this very thing.

Nice to see Heroes and Individualism rising above "Colonies" thoughts and overcomes in the end and is a great lesson for children! That is one movie my kids love to watch over and over!

Incredibles! is another also Pixar! I know Jobs is high up the food chain there at Pixar, but there has to be some other Libertarian, Rand-loving someone who keeps cranking these brilliant movies out every five years? Anyone know who?

Tons of hypothesis and good speculating questions are espoused during the film as well by the way.

Ken Smith adds:

Propaganda is the mechanism of the market also. Money seeping away from investors at a higher rate than should occur is the consequence of the media's flooding the public mind with anodyne.

Investors can ameliorate the losing process by cancelling the Wall Street Journal, Financial Times, Money Magazine, and so on; additionally cancelling all subscriptions to advisory letters.

What's more put a block on emails from services that recommend stock picks, ETFs, puts and calls, and those that promote trading platforms such as Metastock and Tradestation.



We had a "Sharif" moment this past weekend in the Fort Lowell shootout. It was a tie game of 1-1 in the last minute of the second half, and we were pressing up on the opposing team constantly, yet the ball wasn't going out of bounds such that the other team could substitute … suddenly not one, but two of the opposing team players on their offense, who were nearest to their side of the field right near their coach and completely away from the play and any of our players, were "hurt" and play stopped before we could execute our corner kick. Of course two larger players (including their goalie from the first half of the game) were put in place of the offensive players who came out and ran into the box to defend against the corner kick. Of course only minutes later after the end of the game, the "hurt" players ran through the parent tunnel with no apparent after effects from the "injuries." Nice acting job and it is amazing just how competitive certain coaches/parents/players can get even at U10 level. The reason this worked was that it was so far away from the ball that no one saw anything. I am sure there are market analogies such as news releases intended to take attention away from earnings or vice versa. Although Sid took the line drive kick on her knee, punching it straight at the goal, their goal keeper made a great save and the game ended with a tie. Sunbaked!



I think I have a solution, something I ‘knew’ about before but the memory of which got buried beneath the rust. The problem with achieving mere ‘expertise’ is that it doesn’t necessarily give you an edge, an area of your game or field where you are a world leader. Some ‘experts’ got their reputations by being a leader at one time, but didn’t maintain this edge. Others got their reputations by being reputed to be leaders, but in fact they just talked a good game. I liked Larsen’s honesty in ‘How to Open a Chess Game’ that he was never the ‘expert’ he was reputed to be in openings like Alekhine’s Defence. But he was the only GM who was playing them, so relatively speaking he was the best.

This is not my idea, in fact I know of three sources in the chess world and one in investment. Tony Miles once advised me that it didn’t matter too much what someone played as long as they knew more than anyone else. This echoed Lev Alburt’s advice in ‘Test and Improve Your Chess’ in which he advised studying a few positions in great depth. It’s even there in Kotov’s ‘Think Like a Grandmaster’ in which we are advised to know ’something about everything and everything about one thing’ in the openings.

In the field of investment Jim Slater’s ‘Zulu Principle’ was based around knowing more than anyone else about a particular company, but there’s no reason it should be restricted just to that. There are plenty of niche areas and approaches in markets, but the ‘trick’ is to know one of them better than anybody rather than be able to do nothing more than be able to hold a conversation about them. Of course if you do know them better than anyone then it’s probably wise to keep your mouth shut. Knowledge shared can mean an edge gone, unless of course you share with those who will help you to maintain and improve your edge.

So now I realize my mistake, I’m an ‘expert’ without an edge on a gradually descending plateau. How can I get off? Well to be a leader it’s not enough to read books.

Tom Ryan counters:

With all due respect I suggest you are confusing expertise with competitiveness. Last night for example while swimming, despite the fact that it doesn’t really matter -I am just swimming for my health, but you know how these things go - I did notice this guy two lanes over who was lapping me while I was chopping away for 2000m. Subconsciously you always wind up trying to synchronize yourself with the faster swimmer in those situations but I couldn’t keep up with him. When I got up out of the water at the end of my workout I found that I was swimming mentally against a 22 year old. Now I may be an “expert” in freestyle after 30 years but that doesn’t mean I can compete with a 22 year old who is in great shape. I could do two sessions a day in the pool for six months and still never out swim that guy, I am in my mid-40s for pete’s sake! FOC Ming Vandenberg tried to get me to race her in the pool two years ago and I just laughed, as if I could stuff myself silly at Tony’s place, then eat like a horse at Vic and Susan’s for two days and go out with FOC Tim Melvin and Wiz on Saturday night then the next day jump in the pool and race someone 25 years my junior. How would we handicap that one? But compared to you, in the pool I am the “expert”.

On the other side of the equation, we have all experienced people who are competitive, but yet, are not experts. For example in martial arts it is possible, and I have seen, people who perform well in competition, at least in the initial rounds, because they have honed a small “bag of tricks”. But of course once the trick is observed and they run up against someone who has more knowledge and skill they lose, because they have nothing to fall back on.

Not being a chess GM, I can’t comment on aging and competitiveness in chess. However the problem with the analogies between chess and trading is that chess is a head-to-head competition, whereas trading is a statistical game against a huge field of players where you have to be better than a certain % of the field, not every single other person. And in trading you can walk away when you are one piece up, whereas in chess the only way out is to withdraw or win. 0 or 1. There is a lot of money in trading between the 0 and the 1. Trading is not a single elimination tournament, well it needn’t be anyway unless you get carried away with margin. Good discussion!

GM Davies clarifies:

Maybe I am ‘confusing’ or ‘melding’ the two, but are you very sure I’m wrong to do so in fields such as chess and short term futures trading? The number of people who are ’successful’ (i.e. win money overall) is so small that most experts, by your broader definition, will be losers. I also disagree with your definition of chess success being defined as a simple win/loss - it is similar to trading in that there are a certain number of prizes and you need to finish in the top few places to get one of them. Then deduct the frictional costs of getting to the tournament and you need to be really good to have a chance to make money overall.

How does one get really good? This is where I maintain that the goal must be to do ’something’ better than anyone else as a way of bootstrapping oneself above the mere ‘experts’.

Tom Ryan adds:

I think the more relevant point which you have already alluded to is that in a competitive environment you have to find, and constantly be searching for ways (plural) of staying sharp and developing your ‘edge’ or your ‘focus’ or your ’shape’. That’s a tough one although I think there is certainly value in practice, practice and more practice. But that’s not exactly the same as being knowledgeable above and beyond others in a subject. For example, we have all manner of really bright, smart, engineers and geologists on the Spec List who are experts on various facets of the work, statistical analysis of data, 3-d modeling etc., but who can’t pull it all together to make a decision about where to drill or what slope angle to use or how far apart the pillars should be.

In the posts between you, me and Spec List member Scott that didn’t make it to the this website, I was trying to make a distinction between ‘expertise’ and ‘mastery’…sure its syntax but it’s a subtle and I think important difference. Expert is sort of a relational context whereas mastery goes beyond and supersedes that. Really, anyone who knows more than me in a certain field and who can impart that wisdom to me so that my game improves, that person is an expert to me…even if they are not to you. But that doesn’t mean they have mastered anything. To me mastery is where something gets to the point where the art/skill just simply becomes a part of you - there is no longer any notion of doing/not doing, achieve/not achieve, as there is no peak to stand on top of. You just walk the path and keep walking and keep walking and keep … It just simply internalizes to the point that it’s part of who you are.



I received a book recommendation from Stefan Jovanovich who, like Jim Sogi, utters something of profundity whenever he speaks. He recommends historical books by Peter Green and J. S. Holliday as models of good scholarship. I call on him and others for some good historical books that I can read and augment my library with and share with my children, who are studying history in school, and regrettably have been brainwashed by politically correct curricula, starting with Squanto as the archetypical American hero.

I recommend the book Lessons of History by Will Durant as well worth reading for its lessons on markets as well as a honest attempt to review the lessons from a life long study of the sweep of history in conjunction with this request.

Alston Mabry replies:

Inventing America is a textbook that has an interesting approach and might be an alternative for homeschoolers:

Book Description; W. W. Norton presents Inventing America, a balanced new survey of American history by four outstanding historians. The text uses the theme of innovation–the impulse in American history to “make it new”–to integrate the political, economic, social, and cultural dimensions of the American story. From the creation of a new nation and the invention of the corporation in the eighteenth century, through the vast changes wrought by early industry and the rise of cities in the nineteenth century, to the culture of jazz and the new nation-state of the twentieth century, the text draws together the many ways in which innovation-and its limits-have marked American history.

Check out the TOC or get the second edition here or get a used copy of the first edition for a nominal amount.

Some other longtime favorites are The Making of the Atomic Bomb by Richard Rhodes, The Devil’s Horsemen: The Mongol Invasion of Europe by James Chambers, and King Harald’s Saga: Harald Hardradi of Norway: From Snorri Sturluson’s Heimskringla by Snorri Sturluson. You can get the wiki overview here, but the saga itself is a quick read and an amazing story.

Another audio book I have thoroughly enjoyed listening to on cross-country drives is Simon Schama’s A History of Britain. The audio book is in 3 volumes. Schama, a professor at Columbia, is such an excellent storyteller that I would pick up anything he has written. The television series of the same name is also available on DVD and is outstanding.

Schama’s most recent work, Rough Crossings, is about the British and slavery during the Revolutionary War: You can hear Schama talk about Rough Crossings on Book TV.

Stefan Jovanovich replies:

Simon Schama has the gift of charisma. When you watch his narration of the video documentary of the History of Britain, you are instantly aware of it. The trouble is that his histories are not to be trusted. At their worst they are little more than royalist propaganda. Too often he writes the story that the Queen would like to read, not the one that happened. Even though Cromwell was the first head of the United Kingdom to allow Jews to openly practice their religion, Schama finds the Great Protector to be a far greater villain than any of the crowned heads who so routinely persecuted the children of Israel. He is equally severe in his criticisms of those greedy speculators of the Dutch Republic who left Spinoza free to grind his lenses; in Schama’s eyes, those Dutch Reform bigots were guilty not only of inventing capital markets but also of buying too much stuff. The common thread in Schama’s works is the notion that sectarian Christians, with their notions of free markets, are to be feared as dangerous, greedy fanatics who will upset the natural order of the world. The meme continues with Rough Crossings. Schama makes a great deal of the fact that the British offered freedom to slaves who would join the Royalist forces in fighting Washington’s Army while failing to note that the Confederates ended their struggle with the same concession to the dire necessities of war. In general, Schama finds the Christian deism of the slave owning signers of the Declaration of Independence proof of their hypocrisy and, by extension, that of the American nation as a whole. The fact that, for another half century, neither the Archbishops of Canterbury nor the Kings of England had any problem with sanctioning and enforcing slavery in their remaining territories is somehow put aside. So are the origins of the anti-slavery movement in both England and America (those dreadful Methodists). The nearly two centuries old Anglo-American naval alliance (the longest-lived military confederation between democracies in recorded history) had its origins in the anti-slavery patrols off West Africa by both fleets that began in the 1820s. Those were initiated as a political concession in both countries to those same cross-bearing nutballs who thought that the “common” people should have the right to vote even if they did not own a carriage. Ain’t history grand?

Tom Ryan suggests:

Daniel Boorstin’s three books, The Americans, written before 1973, provide a refreshing take on American history in my opinion. I recommend the third in the series, “The Democratic Experience”, which covers the 1870-1970 period in American History. It is unconventional in the sense that it focuses on the stories of the individuals who built, invented, and created this country, the untold stories of the individuals as it were, rather than the typical history of Washington political leadership that is regularly fed to children in grades 4-12.

Steve Ellison adds:

I highly recommend British historian Paul Johnson’s A History of the American People, which goes into detail on many topics, including the relentless economic growth that occurred almost from the outset. A small sample:

By the third quarter of the 18th century America already had a society which was predominantly middle class. The shortage of labor meant artisans did not need to form guilds to protect jobs. It was rare to find restriction on entry to any trade. Few skilled men remained hired employees beyond the age of twenty-five. If they did not acquire their own farm they ran their own business.

Rodger Bastien responds:

I just completed Rubicon: The Last Years of the Roman Empire by Tom Holland. I highly recommend this historical narrative of the final days of the Republic which deals with primarily the years 100 B.C. to 14 A.D. For me, the book brought to life this period which I knew little about but was arguably as important to subsequent civilizations as any period before or since. Caesar, Marc Antony and Cleopatra may have existed centuries ago, but to me those centuries somehow feel a little shorter.

Gibbons Burke replies:

I am finding I am enjoying first-person narrative accounts of historical events and times, so, with that in mind:

and one that’s not a first person, but which is fascinating and has many meals:

John O’Sullivan replies:

I recommend two books by Anthony Beevor: Stalingrad and The Fall of Berlin 1945. Both mesh grand strategy with individual detail and amazing narrative momentum. I also like three Middle & Far Eastern travelogue/history/biographies by William Dalrymple : Xanadu, From the Holy Mountain and White Mughals. Dalrymple has created his own genre and its a rich mix.

MacNeil Curry replies:

I would have to recommend Bury My Heart at Wounded Knee: An Indian History of the American West. Not only is it a fascinating account of the West from a different perspective, but it highlights quite well that there are two sides to every story and that both must be carefully studied before one can truly come to there own conclusion.

Tyler McClellan replies:

Speaking of John Wesley Powell, Beyond the Hundredth Meridian: John Wesley Powell and the Second Opening of the West by Wallace Stegner is a book with many practical lessons for investing and life that used to be required reading for the history of the American West.

Craig Cuyler replies:

My favourite historical novels are without doubt the three part trilogy by Neil Stevenson called the Baroque Cycle. This body of work, over 2500 pages long, covers life in 17th-century in England, Europe, Russia with special reference to natural philosophy & science. Stevenson weaves in his ideas about currency, calculus in speculation which took place around the central characters like Isaac Newton, Huygens, Hook, Leibniz. The courts of Louis XIV in the battle for the monarchy in England feature strongly. The Baroque Cycle is to science what the Lord of the Rings is to fantasy. Fantastic read!



The American Heritage Dictionary lists the following four options for the definition of the word gamble:

1. To bet on an uncertain outcome, as of a contest.
2. To play a game of chance for stakes.
3. To take a risk in the hope of gaining an advantage or a benefit.
4. To engage in reckless or hazardous behavior: You are gambling with your health by continuing to smoke.

Certainly, according to definitions 1 and 3, and depending on your semantic leaning definition 2, we, as market participants seem to fit the bill of "gambler." It is the fourth definition listed above, however, that is really at the heart of this matter. Somewhere along the line, many centuries before any of us were born, the word "gambler," came not only to define one who takes on risk, possibly involving money, but one who does so in a crazed, irresponsible and, yes, reckless way. The image conjured by the word is always one of an old bum, living on the streets, who having been disowned by his family, and happens across a large monetary note, heads straight to the local casino or race track to lose it all. A helpless loser. A man or woman who could never raise a family or provide for anyone, even themselves. Gambling is seen as a type of disease, not unlike obsessive compulsive disorder, or alcoholism. There are twelve step programs and group therapies available. ! However this has never been the denotation of the word, but rather the connotation.

"Gambling is a serious addiction that undermines the family, dashes dreams, and frays the fabric of society." Thus spoke Bill Frist after the passing of his Unlawful Internet Gambling Enforcement Act this October second. The bill was due to be blocked for lack of parliamentary time, so Frist sneaked it into a Homeland Security bill, the "Port Security Improvement Act," which was guaranteed to pass based on its content. But can gambling only be done in a casino, online or otherwise? I wonder just how many people in the US have had their dreams dashed by online poker playing? Could it be more than 90% of those who play? That is the exact amount of new businesses that fail within their first year, an event that also dashes quite a bit of dreams, not to mention capital. Shouldn't First, according to his own logic, move to illegalize new business? Why is it that no one considers entrepreneurs gamblers?

A term usually approved of by more in our profession is that of "Speculator," which has the following strange definition:

A person who is willing to take large risks and sacrifice the safety of principal in return for potentially large gains. Certain decisions regarding securities clearly characterize a speculator. For example, purchasing a very volatile stock in hopes of making a half a point in profit is speculation, but buying a U.S. Treasury bond to hold for retirement is an investment. It must be added, however, that there is a big gray area in which speculation and investment are difficult to differentiate. Also called punter."

I wonder how this writer would characterize one who held a stock until retirement, or one who day traded bonds? Regardless, a speculator seems to be more respected than a mere gambler. No where does the word "reckless" appear in this definition, and indeed we start to see the immergence of respectability here. Even more respect is given to the "investor.":

1. A person who puts (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.
2. A person who purchases income-producing assets. An investor as opposed to a speculator usually considers safety of principal to be of primary importance. In addition, investors frequently purchase assets with the expectation of holding them for a longer period of time than speculators."

Here we have the penultimate description of the respectable way to wager. Now we are "putting money to use," "consider[ing] safety of principal to be of primary importance." The word "risk" is not mentioned even once, much less "chance," and certainly not "game." It is interesting to note that the Unlawful Internet Gambling Enforcement Act act had to have special langauge which permitted "any activity governed by the securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 for the purchase or sale of securities (as that term is defined in section 3(a)(10) of that Act)." It is also interesting to note the harsh 57% crash PartyGaming took on the London Stock Exchange after the US law was passed, a movement that was sure to reward many who were "gambling," and short the stock.

I just wondered what everyone else thought of these terms. Do they object to them? Do they feel offended when they are called as such? Do they prefer one over the other? My mind runs briskly to the top poker players in the world, how consistently they are at the top of the money lists, making hundreds of thousands of dollars each year. Any gambling book worth its salt informs the reader of how important it is to preserve capital, and of how much one must go out of their way to avoid gambler's ruin. It seems to me only logical to regard the top poker players as investors. In fact, maybe this is the crux. Could it be that one who takes chance and succeeds is an investor, while one who takes chance and fails is a gambler? Not unlike one who kills a household of people is regarded as a mass murderer, while one who kills the majority of the army of another nation is hailed as a conqueror?

Tom Ryan responds:

In the main, it seems to me that there are several distinct differences between gambling and speculating/investing, and this ties into the discussion on fractals and markets which has been dissected many times on the list before.

The first point is that diversification tends to help reduce risk in speculating but does little for you in gambling. Why? Because the pieces of paper we trade in the capital markets are actually legal claims on the economic engine of commerce, via either a rate of interest or a claim on future assets/profits/dividends. Provided that economic growth and health continues in the aggregate and nuclear winter is not coming, in the aggregate the value of these claims will rise over time, and therefore the more you diversify the higher the odds that you will participate in this rising tide. In gambling, playing more casinos, tracks, or playing different types of games does not increase your probability of success.

Secondly, in speculating/investing, one can usually reverse out of a position or decision…even though there is a cost to that, it is not 100%. In gambling you can't take a portion of your money back after the ball is in play on the wheel or the horses are on the back stretch. So in speculating there is far more potential to adapt to changing circumstances

Finally, increasing your significant time horizon helps reduce risk in speculating/investing but actually works against you in gambling as in the long run all gamblers go broke because of the combination of the odds and the vig that you pay to play. It has to be that way of course as the casinos have to take a net rake from the gambling public in the aggregate to have a business in the long run.

One of the issues with infinite variance is that it leads one to theologically consider that the game ending event could happen at any time, therefore the statements I made above about risk management would be false. However, one of the (many) problems with infinite variance in a social environment (capital market) is that it ignores the ability of people and groups of people, to learn, adjust, adapt, and evolve over time as circumstances change. For example, although we may not have the ability to avert a major disaster from a large asteroid hitting the earth today, we as a species are more aware of the danger today than 500 years ago, and 500 years from now maybe we will have the technology/capability to avert such a catastrophe. This adaptation and learning process is always ongoing in the markets due to competition. This is simply a long winded way of saying, markets are not snowflakes.

GM Nigel Davies Replies:

Perhaps one of the most interesting aspects of this question may be that those who object the most may be the ones who are most at risk. Life is inevitably a speculative game in which the line between calculated risk and gambling is often going to be quite blurred.

In any case it's better to know that you're playing a game. As a topical example I doubt that many people who take on large mortgages to buy property consider themselves to be 'speculators' (gamblers?) on property prices and interest rates, but that's exactly what they are.

Gibbons Burke responds:

Being called a gambler shouldn't bother a speculator one iota. He is not a gambler; being so called merely establishes the ignorance of the caller.

A gambler is one who willingly places his capital at risk in a game where the odds are ineluctably, mathematically or mechanically, set against the player by his counter-party, known as the 'house'. The house sets the odds to its own advantage, and, if, by some wrinkle of skill or fate the gambler wins consistently, the house will summarily eject him from the game as a cheat. The payoff for gamblers is not necessarily the win, because they inevitably lose, but the play - the rush of the occasional win, the diversion, the community of like minded others. For some, it is a desire to dispose of money in a socially acceptable way without incurring the obligations and responsibilities incurred by giving the money away to others. For some, having some "skin in the game" increases their enjoyment of the event. Sadly, for many, the variable reward on a variable schedule is a form of operant conditioning which reinforces a compulsive addiction to the game.

That said, there are many 'gamblers' who are really speculators, because they participate in games where they develop real edges based on skill, or inside knowledge, and they are not booted for winning. I would include in this number blackjack counters who get away with it, or poker games, where the pot is returned to the players in full, minus a fee to the house for its hospitality*.

Speculators risk their capital in bets with other speculators in a marketplace. The odds are not foreordained by formula or design - for the most part the speculator is in full control of his own destiny, and takes full responsibility for the inevitable losses and misfortunes which he may incur. Speculators pay a 'vig' to the market — real work always involves friction. Someone must pay the light bill. The marketplace does not kick him out of the game for winning, though others may attempt to adapt to or adopt his winning strategies, and the game may change over time requiring the speculator to suss out new rules and regimes.

That said, there are many who are engaged in the pursuit of speculative profits who, by their own lack of skill are really gambling; they are knowingly trading without an identifiable edge. Like gamblers, their utility function is not necessarily to based on growth of their capital. They willingly lose their capital for many reasons, among them: they enjoy the diversion of trading, or the society of other traders, or perhaps they have a psychological need to get rid of lucre obtained by disreputable means.

Reduced to the bare elements: Gamblers are willing losers who occasionally win; speculators are willing winners who occasionally lose.

There is no shame in being called a gambler, either, unless one has succumbed to the play as a compulsion which becomes a destructive vice. Gambling serves a worthwhile function in society: it provides an efficient means to separate valuable capital from those who have no desire to steward it into the hands of those who do, and it often provides the player excellent entertainment and fun in exchange. It's a fair and voluntary trade.

*A sub-category of the speculative gambler: Playing poker with a corrupt official can be an untrace-able means to curry favor by "losing" bribes in a game of "chance." The 'loss' is really a stake in a position where the "gambler" is really seeking a payoff in a much bigger game, and the poker game is his means to a speculative edge. An example of this is Rhett Butler in "Gone with the Wind", who played cards with his jailers in order to obtain special privileges. Mayor Royce in "The Wire" is another literary example, but this may have been modeled the real-life bribe-taking tactics of former Louisiana Governor Edwin Edwards (whose 'house' is now Oakdale Federal Penitentiary - the Feds kicked him out of the game for winning too much.)



One of the problems that I see repeatedly in my work is the confusion over probability regarding a single event, vs. the probability of a sequence or continuum of events. A good example would be Steve Irwin's show stopping stunts, or a question recently posed to us by one of our clients regarding mining safety, or trading, or the topic of this morning's coffee … which was bicycle commuting. Although most people can easily think in terms of probability for a single event (e.g. there is a 50% chance of the roulette wheel hitting black or a .00000001% probability of being hit by a car on my commute) they have a difficult time integrating this probability over a long period of continuous exposure. To do that you have to do a Pulaski/Feynman "invert, always invert" and look at the probability of an event not happening given a certain long period of continuous exposure. Continuing with the bicycling analogy, as long as bikes and cars are sharing the road, and given some basic newtonian physics (F=ma), the mass differential between a car and a human on a bicycle, there is a finite, albeit low probability (lets say 1e-08?) of being hit by a car and getting killed as it goes past you. No matter the speed limit, size of bike lane, cell phone laws etc, there is a chance you will get mowed down from behind, as a good friend of mine found out last year (he survived, barely).

So lets say your exposure is 1e-08 to any one car, and 100 cars pass you on your commute. The probability of being hit by a car for the total exposure must be evaluated by looking at the probability of surviving which can be approximated by (1.0-[1e-08])^100. Which means that for that exposure you have a .999999 probability of survival or a 1e-06 probability of getting hit. This can be expanded for longer and longer periods of exposure. Lets stick with a single event probability of 1e-08 for now, and 100 cars per commute to keep it simple.

1 commute, 1-e06 (.0001%)
10 commutes 1e-05 (.001%)
100 commutes 1e-04 (0.01%)
1000 commutes 1e-03 (0.1%)
10000 commutes 1e-02 (1%)
100000 commutes 1e-01 (10%)

The point is that any one ride is not that risky, but if you look at the risk for longer and longer time periods or more and more continuous exposure the behavior can start to look a bit risky.

This gets back to Steve Irwin, why people should wear their seat belts, and why when you get the 30 year term life insurance there are three pages of fine print about what behaviors are not covered. What can seem responsible behavior for a single event can start to look a bit dangerous given a long enough exposure to the hazard. This is where the media tends to fall down when reporting on things like Steve Irwin's unfortunate incident.

Recently we were examining a mining safety situation and looking at PDI (prob. of individual death) and PDG,n (probability of death for a group of size n). There are no mining industry standards, but some general ranges that are well accepted. Generally PDIs for a one year exposure of less than 3e-05 are considered 'low' risk, 3e-05 to 1e-03 'moderate' risk and anything above 1e-03 'high' risk. People's risk acceptance however tends to vary between voluntary (surfing) and involuntary (my job) tasks. For example when we looked at traffic safety records for the highway between Safford Arizona and the mine at Morenci, we found PDI's (based on miles traveled annually commuting to/from home/work) between 2e-04 and 6e-04. A panel, of which I was a member, could not find any job related position at the mine which had a PDI exceeding 3e-05. Yet both regulatory personnel and the workers considered working "more dangerous" than commuting.

How this relates back to the market is that the markets are in many ways a "perfect trap" for the fund investing public to make poor risk taking decisions over long time horizons. You have relatively low barriers to entry which results in a high level of competition, ever changing cycles which makes it hard to predict long term effectiveness of strategies, and a lack of control which lends itself to an involuntary risk perception. This is a long winded way of saying "stay out of the switches" and focus on the longer term but that is why I think passive index funds are so valuable to the layperson investing for long term horizons … because they allow anyone with a bit of math background to estimate risk in a quantitative fashion, which then allows one to set their own risk levels and create a portfolio that meets their long term goals.



I consider myself lucky that my studies of the markets began with Investments by Bodie, Kane, and Marcus. Then before I could be corrupted, I started reading Vic and Laurel's books. The study of "Investments" begins by reading the difference between "real assets" and "financial assets". Then it explains their relationship to each other. How financial assets are used to transfer real wealth. This foundational underpinning often will clarify the fallacy in the arguments of the prophets of doom.

When the doomdayist is the photographer, one of the most common deceptions is to magnify the problem, then focus on only one side of the picture completely blurring the other side. He artistically crafts this clear snapshot of one side of the current state. Then he imagines a future world with both sides, but doomed to failure because of its imbalance.

Being interested in demographics, I often will read articles about the impending boomers retirement. This also is one of the doomsdayist most fertile grounds. The USA's boomers, the most productive generation in history will go from being a net producer of wealth to a net consumer. Transfers of this wealth will occur, either through boomers life or at their death. Because many in this generation have amassed a fortune, framing such pictures to imply your prophetic ability is a rich field. Also boomers want to know how this transfer will occur, to determine how to position their wealth. Do you hold "real assets" or "financial IOU's"?

Because of this great wealth, it is the rare author that will take a balanced look at how this transfer of wealth will occur. Often I find articles that will use the actuarial approach to the boomer's problem, that is taking the present value of future benefits then look at the current US debt and add it on to this social security present value and perhaps throw in a the present value of other future government debts.

All of this is put in fiscal terms, with mind numbingly large numbers even the most numerically literate has trouble understanding. The real wealth currently held by the US and the boomers is an ignorable blur. The conclusion is that the only solution is to devalue this debt by inflating your way out of it. Therefore you hold "real assets" such as gold, a doomsdayist favorite. This is of course what every generation X, Y, and Z'er will want; gold, hard assets.

This perhaps shows the brilliance of Mr. Gross's recent article No Cuts, No Butts, No Coconuts. He, like a good doomsdayist photographer, magnifies the problem. But unlike the fiscal doomsdayist, he focuses on the real imbalance. That is that the boomers have the real wealth, and the demand for that wealth will decrease. He uses housing as the basis for every real assets. He insist there will be a slowing of demand for housing therefore implies a slowing of demand for everything real. He implies that you especially do not want to hold a real company producing real wealth. He implies you certainly do not want to bet on the US, the current largest holder of the world's real wealth.

The intended message of this deflation is of course you want to hold bonds, or fiscal assets. Remember he is the biggest bond salesman around.

I would suggest that the truth lies somewhere in between. Boomers will have to transfer that wealth to someone. Generation X, Y and Z'ers clearly will not have to work as hard to obtain that wealth as the boomers did.

However, much of this ease in effort to meet needs will be due to increases in productivity, not totally inflation. There will be a slowing of demand for some assets, and a growth in demand for others. The more we look to the emerging markets to make up the shortfall in human capital, the more basis goods will be in demand. The more we look inward the more scientific discovery, quality and artistic expression, the human element, will be valued.

The younger generation will not lose an interest in obtaining wealth once their survival needs are meet. The US will not suddenly lose its real wealth advantage to motivate others. Neither will it loses its foundational ability to through creative destruction and nurturing of the individual spirit to produce wealth.

There will always be problems to solve and people reaching for the stars. In fact I would argue that, in a world where the fundamental shortage is human capital, in this world the wealthiest nations will be those that give the individual spirit the most freedom, not just the nations with the most humans.

Scott Brooks adds:

I have said this before, and I will say it again (even thought I am resoundingly ridiculed for saying it); losses hurt you more than gains help you.

If the premise of the long term positive drift of the market is true (which I believe it is), then getting good returns is simply a function of "showing up at the party". All one has to do is be there to get good returns. Unfortunately, getting good returns is not good enough.

Human beings are ruled by a two sided coin: greed and fear. When things are going well, we and forget the adage that "things are not as good as they seem", or worse yet, we think we are smarter than we really are. So we get greedy. "Hey, look at my returns, I'm pretty smart…so If I'm smart enough to get these returns, then why not go on margin, leverage the money and double, triple, quadruple my returns!"

And of course, you remain a genius, and/or your intelligence increases in direct proportionality to the acceleration or momentum of the "positive drift of the market" until the momentum or positive drift stops. Then you find out, in a very painful manner, what a margin call is.

Maybe you are not leveraged, maybe you just bought into the "safe stocks", argument, or the "new economy" stocks argument, or the "positive earnings" argument. And your newly acquired personal genius told you to hold onto to Cisco at 50 because it was recently up at 80 and it should be worth at least that much. Or Coca Cola, because it had positive earnings growth all thru '00, '01, '02. Or because the long term positive drift of the S&P 500 said keep being "long" even though the 1550 high ('00) is where it should be and not at 755 ('02) it got down to or even the approximately 1300 it is at now.

You see, it is during these times that the other side of the human nature coin rears it ugly head. Fear! Fear leads to rationalization. It leads some to be afraid to sell for fear of missing out on a big run … and thus they ride Cisco down to 12, or Enron to pennies, or Global Crossing to zero! Or maybe you sell after losing half your stake, and you become fearful and indecisive as to when to buy ever again, and the first time the market hiccups, you panic and have sleepless nights, and ulcers.

It does not matter how well you do when times are good. It does not matter how much you make during the market that has such a "positive drift" that tow truck drivers can buy an island, or dot com companies can advertise a monkey playing around in a suburban home garage for 30 seconds during the Super bowl and not even mention their name or what they do (or when tulip bulbs go from $1 to $600 and someone named Newton who missed out on the rise from 1 - 600 finally decided to jump on the tulip bandwagon). It does not matter during those times. What matters is how good you are during the bad times!

It does not matter what you make, it matters what you keep. It doesn't matter if you get 10,000% return, if you lose it all during a market hurricane.

The beaches of Florida may have long term positive effects on human beings (sunny days, warm weather, refreshing water), but you better get your butt off that beach when a hurricane is coming. Why? Because its hard to enjoy the beach if you are dead.

It is hard to enjoy the long term positive drift of the market if you have lost your nest egg, seed money, portfolio, clients, etc. Therefore, I submit to the site that the most important activity for any of us, is to become absolute experts at determining what is the likelihood that the markets are likely to decline. Therefore we should discuss what are appropriate courses of actions to take during those times. How do we recognize them? How do we know that the risk levels in the market are elevated?

What I am saying has nothing to do with being a bear, or discussing fear. It has to do with reality. How do we achieve good solid returns during the good times, and then preserve those gains during the bad times so that when the bad times are over, we have our portfolio intact and we can ride the new long term positive drift (the next wave) of the market again.

Why do I suggest this? Because losses hurt you more than gains help you!

Steve Leslie comments:

Nietzsche said that which does not destroy you makes you stronger. I say that depends on a person's evaluation of the experience. It hurts more when it is personalized.

Behavioral psychologists tell me that people avoid pain more than they seek pleasure. Or more importantly perceived pain. I am not a behavioral psychologist so I will allow some others to chime in.

After a plane crash people are reluctant to fly in a plane even though they stand a far greater chance of being killed driving to the airport. From personal experience I know that losses stay longer in your memory than wins. I can tell you every bad hand that has knocked me out of a major tournament. Or the putt I missed that cost me the club championship.

Everyone says they want the ball at crunch time but only a few of them really mean it. The rest hope that they are not called upon to face Mariano Rivera with the game on the line. Or having to make a knee knocker to go into a playoff with tiger Woods. (See Chris Dimarco at the Masters).

How about this one. Get a 50 percent return for 2005 receive your industries highest award CTA of the year, and then have a few months of drawdowns. Now you are a heel. It goes with the territory. Schadenfreude is ubiquitous.

It is a lot easier to be average or above average than it is to be exceptional or superior. It takes different wiring. Most analysts and all Re-elected politicians understand this, at least those who have long careers.

Dr. Kim Zussman contributes:

One hypothesis is that bull and bear markets have some correlation with the investment lifetimes of generations living through various markets.

For example my parents, who lived through the depression, did not own stocks when they were young because (besides not having much money) they had directly witnessed ruin. It was not until a close family friend did well in the bull of the early 1960's that they bought in the late 60's, and held down through the mid-70's. Thus from then on they eschewed stocks, pronouncing the mantra "Lost $20,000 in the stock market".

Undoubtedly there were many families burned like ours who got and stayed out by the end of the 1970's. By then, boomers only vicariously touched by the bad market of the 70's were becoming flush enough to buy stocks and help fuel the great bull that ensued.

So if painful memory of investment losses has lifetime effects in many people, this could explain some of the decade-length duration of bull and bear markets. And what effect, if any, the 2000-03 decline will have on the current cohort would seem to be a vital question.

Scott Brooks replies:

All good insights, but I am not talking about just having some losses, I am talking about having a methodology to measure risk and the likelihood of downturns. How does one survive 1968 - 1982, or 1939 - 1946.

It seems to me that long term secular bear markets can be devastating to the long term drift theory. Just as a hurricane can damper the Florida beach experience. Markets seem to go thru long term secular trends. The last great bull basically lasted from 1982 - 1999, the one before that from 1950 - 1967.

If one looks at a chart of the long term market one will see that the long term bull cycles are punctuated by basically smooth sailing with the wind blowing pleasantly in the direction that we want to go. All one has to do in those markets is basically index and let the markets blow you to prosperity.

But if one looks at the long term bear cycles (for the sake of this discussion, a long term bear cycle is one where the market goes down and then takes many years to get back to its past high levels…i.e. it hit a high in 1968, proceeded to go down, and then did not get back to that high until 1982), one will notice that they last a long time (usually longer than a long term secular bull cycle) and one will notice that, unlike the smooth sailing of the long term bull markets, they are punctuated with extreme volatility.

Now I know that there are/were big downturns in the last bull market (1987, 1990, 1994, 1998 just to name a few) but they were quick. They went down, and within a short period of time (less than 18 months in the case of 1987) they were back to new highs. All I am saying is that there has to be a way to preserve capital during these downturns. There has to be a way of measuring the likelihood of their occurrence.

Make no mistake about it. I am a bull. But it is my job to be realistic about the markets, asses them and figure out a way to make my clients money. I do not care if the market is going up or down. It is my job to:

  1. Preserve my clients capital
  2. Grow my clients capital
  3. Perform actions 1 & 2 with the least amount of risk necessary

So, my questions to the are simply:

How do we reliably measure risk? How do we manage the portfolio's during higher risk times? How do we make a profit when conventional methodologies (i.e. long term drift) is out of favor, or when our personal pet systems, markets, sectors, regions, investment types, are out of favor, because they are experiencing a long term secular bear market?

Abe Dunkelheit contributes:

Marcel Duchamp, the famous French artist, was sharply criticized for his attitude towards the French Resistance in WWII. Instead of fighting against the Nazis he emigrated to the United States. In an interview he explained his attitude. He said to him it appeared that in any conflict there is a third alternative besides fighting for or against a perceived evil, which is withdrawal! Of course 'withdrawal' is a highly individual response to conflict; it cannot be the strategy of a whole nation. No wonder that such an attitude must seem to be anti-patriotic from the group's point of view.

The idea of long term investment is an illusion because investors as a group cannot survive the bear market periods. (The individual can but not the investors as a group.) The paradoxical situation is that the illusion of long term investment is necessary to keep the economy going. If we look at the wealth of the nation as an aggregate we see it growing; but if we look at individual lives we see much misery. Why is that? Because the wealth of the nation comes at a price! The price is the sacrifice of personal happiness. The welfare of the group depends on behavior that is not good for the individual! For the whole nation the investment meme is good but for the individual it is not!

What can one do? One can develop extremely individual solutions. I think one must become extremely individual in order to survive bad things which tend to hit whole nations. One must totally stay away from the crowd and eradicate anything which is crowd-like in one's own bosom. A lot of unconventional thought must go into the question of 'investment' but nothing definite can be said in an email.

There are many unpleasant truths and one must look at them. "When killers stop killing they get killed." (A wise gangster in a movie.) I do not know if I can make myself understood. What I am basically saying is that 'investment' cannot work for the many, not in the way it is advocated; it works only for the few, but in order to work for the few it needs the many. The whole thing, from a humanistic point of view, is perverse. Trading is not 'human', neither is 'life'. Yet, paradoxically, the long term effect of this 'inhumanity' is economical growth and prosperity, which is good for the group, at least in theory, but comes at a price, which is the sacrifice of the individual, because the individual member of the group ('the many') must be tempted to act in ways which are, from the individual point of view, not good.

As an example for unconventional ways of thinking/acting I studied how to lose money. It is said, people hold on to losers and cut winners. Some time ago I opened an FX account and traded such a strategy: buy low, sell high, based on hunches, otherwise hold (no stops). I did 100s of trades - and broke even! I had a dozen big losers which offset the 95% small winners. Now that was a basis to work from; I gained some highly precious insights from this experience. I learned, for example, that it is not wrong by default to hold on to losers and cut winners; what is wrong is doing this without regard to the liquidity process.

Among many other things, I noticed the unhealthy tendency to increase exposure after a particular market had gone up! In my opinion that is the real reason why people lose money. They tend to do the right thing after experiencing it was the right thing - only that it is now the wrong thing.

I also noticed that trading in and out of stocks is not increasing profits; but dramatically reduces drawdowns. I further noticed that profits tend to come 'like thieves in the night' - rather unexpected. I learned I cannot predict and do not predict. 90% of what I am doing is exposure (or inventory) management. No single decision holds meaning to me; I look and think in terms of the 'whole'. My trading tended to be highly fragmented and I had to stay focused all the time which was draining. Now I am still trading very actively but with a detached attitude, rather disinterested in any particular move. I hardly ever react. Almost all of my trades (entry/exit) are placed before the markets open. I also noticed that when the markets turn busy that this does not necessarily mean I will trade more; it means I will think more!

Finally, I was surprised how small but good decisions can add up to quite substantial profits. There is more to it, like a positive attitude; also useful is following news in conjunction with particular moves. I noticed that moves in individual stocks are often explained by news that are already known to the market for a week or more (like DELL); also that stocks can go up with hardly any comments (like EBAY). I also realized that it seems to be a good time to buy a stock now and not later when people recommend to buy it not now but later (like AMD).

Tom Ryan mentions:

In reply to Scott, it seems to this rather sunbaked speculator that there is an inherent conflict in logic here in the sense that having a long term goal, in this case growing capital, but an operational plan that is geared to minimizing a negative event in the very short term (preserve capital), well this will always produce a sub-optimal solution. if a client comes to me and says five years from now I want to look back and have made a 15% CAGR (doubled my money) but I don't want to suffer more than a 25% loss in any one year, then the reply has to be that really, they do not have a five year plan, they have a one year plan for each of the next five years. In other words the short term operating constraint always overrides the long term plan. Always.

As for risk, there is absolutely no reason for anyone to hire a money manager in order to pursue below average market risk as anyone can do that by calling 1-800 VANGUARD and apportioning the appropriate %s to stock and short term bond index funds to get whatever risk level they want. The only reason to hire a money manager is, to use Tim's phrase, to "pursue alpha". Now all strategies to pursue alpha boil down to one of two things, either selective/focus of positions (hopefully into things that will do better than the market average), or increased turnover of positions (trading). Theoretically, therefore, it is not possible to pursue alpha without above average risk. And yes, before I get 15 replies to this email (including from Melvin) it is possible to show in retrospection how someone or some strategy achieved higher returns with below average volatility or risk in the past, but theoretically, from day(0), all alpha pursuing non-indexed strategies have higher than average risk.

So at the end of the day the issue of how to grow and preserve capital at the same time, or grow capital whilst minimizing risk, can not be solved without proper definitions of risk, such as target CAGR, the significant time horizon, maximum leverage allowed, and what constitutes impairment of capital. Even with these factors mathematically defined, the solution will always have to be probabilistic rather than deterministic because we can only use the past behavior to construct general distributions which can guide us as to future expected behavior. Hence we have come full circle to my first assertion that there is a logical conflict between growth and preservation of capital i.e. your items one and two.

As a postscript: I suppose the one other reason for a layperson to hire a money manager even if they are not pursuing alpha would be to avoid fraud risk as brokers are subject to fraud from time to time. but fraud risk is hard to detect beforehand even for professionals as the past 10 years has repeatedly demonstrated. You can probably achieve the same effect much easier simply by some diversification.

Russell Sears adds:

I would disagree, short term draw downs do not always out weigh the long term goals, just usually. To paraphrase a recent conversation I had with Gordon H. "Principle protection is currently the biggest scam on Wall Street." Anybody that understands indexed options could design a plan that maximizes your exposure to a market, but limits your yearly loss.

The problem is two fold. One, doing so causes you to give up tremendous potential earnings, opportunity cost is high, as you suggest. Second, most advisers on Wall Street upon hearing this their mouths will salivate, they spotted the chump at the table.

How, do you get the client to understand you cannot make money without taking risk? And how do you explain that such a "no losses allowed" strategy, is a chump strategy that those without any integrity will gladly execute at your expense?

I wish I knew the answers, to that last one especially. My current strategy is to assume that most people with money are comfortable acknowledging "business risk", and you have to take business risk to make money. So I try to present "investment" risk as diversification of their current risk… it just has solid $ figures attached to it.



I thought this article was interesting … the gist being that profit oriented prediction markets can provide a useful counterpoint to unsubstantiated claims in science that are so regularly published in the media. In other words, a prediction market could act as sort of an "open source" technical review on claims being made regarding key, unresolved scientific issues.



On Monday we experienced a substantial flood event on the Rillito River which runs east-west through the city here. Measurements of the peak flows indicate the largest ever measured for the Rillito, and the second largest based on models (the models of the 1913 flood indicate slightly higher flows). Now that the water has receded, it is clear that the end result is:U.S. Army Corps of Engineers 1, Mother Nature 0. The river did not jump the flood protection structures on the banks, and very little damage resulted, compared to the last two floods in 1983 and 1993. As a result of those two floods the feds and the county engineered the Rillito Riverbed in the 1990s, widening in places, raising banks, and soil cementing twelve feet thick on all banks, in effect ‘channelizing’ the river. Well it worked although the high water came within a few feet of topping throughout the course of the downstream section of the river and topping the nine bridges across the river (two of which were damaged enough to be closed).

There are some other interesting aspects to consider:

Leverage. Although the volume of the flow appears to be in the 50-100 year return period category, the precipitation that created the flow was in the 5-10 year category (2-3 inches in 12 hours).

Pre-conditions. The large flows resulted from a relatively small amount of rain due to the ground already being saturated by previous days of rain.

Efficiency. Rainfall was concentrated in the foothills of the Catalina Mountains, rather than the valley or high up in the range. This led to a rapid concentration, high water mark effect.

Unpredictable Consequences. The worst damage to the banks from scour and to the bridge piers is from objects (tree trunks, propane tank, Honda Civic are just a few of the items I witnessed) entrained in the flows hitting and snagging on the bridges and structures.

Market analogies left to the reader!


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