Decision Making

Decision making is an area of interest I frequently return to. Last week I explained how I like to work to a new starter at the firm, and thought it would be a good opportunity to share more broadly.

Building a robust process that supports decision making has been crucial throughout my trading career, but I now find it helpful more generally in many areas of my life.

I outline my approach below. To me, it is both simple and comes naturally. However, I wonder how common such an approach is, given how often confusion arises.

Before I go through the individual steps, perhaps the most important aspect to emphasize is the difference between the steps in yellow, which focus on what we should do, and those in blue which concern how we should go about it. This helps form a clear division between before and after a decision has been made.

Steps in the process

Ideas

This stage is free and unconstrained – the objective is creativity

  • Do not dismiss anything
  • Be open to other people’s ideas
  • Do not worry too much about practicality or attractiveness

 

Suggestions

Suggestions are ideas that are liked, or at least plausible – the objective is initial due diligence

  • Intelligent pushback
  • Alternative suggestions (and perhaps even completely new ideas)
  • Plausibility analysis

(Note “suggestions” is plural i.e. still at the stage of multiple possibilities.)

 

Proposal
The objective here is sufficient detail needed to make a decision.

  • Narrowed to a primary suggestion, or perhaps an examination of a small number of options.
  • Key area is to highlight major issues/red flags
  • No problem suggesting going back a stage for some more ideas and suggestions rather than moving ahead.

 

Decision

A clear moment and where the project transitions to a very different stage.

 

Implementation
Objective here is work out how to do something and actually do it

  • Most people are far more comfortable at this stage

 

To illustrate the process, here is a trading example:

(1) Ideas

Let’s just list a few basic investment ideas:

Buy S+P

Sell S+P

Buy European equities

Buy EM equities

Sell US bonds

(2) Suggestions

We like the idea of long equity exposure
We narrow down to S+P and DAX as the prime candidates

(3) Proposal

After detailed analysis, the proposal from the analysis team is
“to buy $50m of S+P as soon as practical.”

(4) Decision

After review, the proposal is refined, and we decide to buy $75m of S+P exposure

(5) Implementation

At this stage, the process of ideas, suggestion, proposal, and decision can be repeated, this time for implementation. Thus, a decision could be to use S+P mini futures and execute within the first hour of the opening of the US cash market the next trading day.

 

 

What goes wrong?

Over the years, I observe that many people in a work environment show a preference for either the pre-decision “ideas and suggestions” zone or the post decision “implementation” zone, rarely both. Each style can be very useful, but I’ve learnt it’s important to be aware of the differences, to play to people’s strength and to avoid confusion.

Those who prefer implementation:

  • Premature decision making

It’s very easy to start the process with a decision already made, skipping the supporting steps, with any subsequent analysis purely a rationalisation to present to others and ourselves, in other words confirmation bias.

  • Rush to implementation

In the framework above, it is clear an idea is not a decision and also a suggestion is not a decision. In reality, what can sometimes happen is when I suggest an idea, people around me think I have made a decision and move straight to how we would implement. This is especially confusing when it turns out that those same people never thought it was a good idea! People often explain that previous bosses have strong opinions and just expect to get it done. In this respect, I have learnt to be very explicit to avoid causing confusion.

Those who prefer the ideas and suggestions stages:

  • Lack of details

Preferring the positivity and creativity of the early stages, people often don’t value the details or due diligence required to actually make a decision. Red flags or major issues are critical to consider pre-decision, as once the decision is made, momentum makes it hard to go back again.

  • Inability to drill down to a concrete proposal

We can always find another idea or another suggestion.
However there comes a stage of pragmatism in all decision making, when some suggestions need to be discarded, and others more deeply investigated to form a proposal.
This is also the stage where implementation considerations are important; but people who prefer “ideas and suggestions” may not pay sufficient attention to these and so it’s crucial to widen the team.

 

“Plan”

Note that I did not use the word “plan” above. This is because it is commonly used to describe a proposal and also relates to implementation. In fact, these stages share common materials; the details from the proposal will often cover some of the implementation. The crucial difference is one is before decision and the other is after.

Again, people used to working on implementation, can take the details involved in the proposal as indication that a decision has been make. The temptation to move the project along, rather that focus on any issues that may indicate a major mistake.

 


Conclusion

To make good decisions, it’s clear you need both types of people!

Having a team which excels at implementation is a wonderful thing, similarly having people around you that get energised by thinking about new ideas. But even more important perhaps, is making sure that you spend sufficient time and energy on both aspects and find a way to integrate the contributions of everyone.

Thinking about where you sit in the process above, being aware what kind of preferences you have, could be helpful to your career, making you much more effective within teams at work.

The path to becoming a Portfolio Manager

Throughout my career, I have helped train and mentor a number of aspiring portfolio managers. Many find themselves prepared for various technical aspects of the job i.e. how to trade certain products, how trades settle, how to calculate risk, how to build a portfolio, how to manage stop-losses etc. In my opinion, these technical skills will not be the biggest problem faced on the journey, but rather the emotional issues that accompany it and sadly most people do not enjoy that aspect of the job.

For most becoming a portfolio manager is not a good career choice, but for a small number it is perfect. Therefore, one of the things I try and help aspiring managers to understand is the different stages they will pass through.

 

Stage 1 – Observer

This is the stage where people have shown real interest in financial markets. They follow the news, read analysis, develop their technical knowledge and skills, and enjoy forming market views and expressing them to others.

A common error for an aspiring PM is to think this stage is a long way along the road. A key element is the lack of clear feedback mechanism; or rather feedback is likely to be qualitative (perhaps social i.e. do people like what they say and write) but unlikely to be quantitative or objective.

 

Stage 2 – Paper trading

This is a helpful stage that I push aspiring PMs towards – I explain that this is what I did myself. My observation is that those who will become successful PMs will have already done this sort of activity on their own. After all who could stop them?

Paper trading is the stage where people can realise if they care enough about forming views and narrative about financial markets, or care about playing a game in which you keep score by how many dollars you gain or lose. Paper trading becomes engrossing because it is an active feedback mechanism on your decisions and thus the only way you could ever improve. All I do at this stage is help them think about trading and how to evaluate their decisions for themselves. The key is that only those that enjoy it and like keep to score in an honest way, can actively progress from here.

Most aspiring PM’s actually stop at this stage and soon revert to stage 1. Some get bored, some use their paper portfolio as a means to signal their “view” e.g. bullish the Australian dollar, much like a research strategist does. The preference to talk about trades where they were “right” often becomes dominant, rather than all the other lessons they learnt. If I point out that their overall paper portfolio has lost money they will often blame “money management” or “risk management” as though this is some technical add-on that is of secondary importance to their view formation.

 

Stage 3 – trading real money (small)

At this stage, aspiring PMs are often shocked to find out how much worse they perform than when they ran a paper portfolio. To the outside observer, it may appear identical, but for the participant I would highlight these key differences:

It is public
Actual P+L in a firm will be reported. In a paper portfolio you are free to make any decision you want and the only person who will ever know about them is yourself. Once real money is at stake, all your decisions are visible, and can be can be looked at much later by other people who will judge them. In this respect it is similar to my very first blog post “How to Write“, your thought process will change in the same way that writing in a private diary is different from an essay submitted to a teacher.

It is real money
I remember being really stressed at this stage in my career, partly because I was so bad at it! I kept losing money. It felt real to me. I would lose perhaps $500 on an FX trade and this felt like a lot of money. I could buy a TV for that. I struggled to understand why my bosses were so relaxed and tolerant of me throwing the firm’s money away. Later once I was the manager I understood that this is a cost of training and most people really struggle at this stage.

It matters for your career

This is especially tough as you are starting to take risks with your future. You need to persevere, building up evidence to convince people to give you more money to trade. It is hard to predict who will make this transition and who will fall back into the far more numerous careers in stage 1.

 

Stage 4 – trading real money (large)

By the time you get to Stage 4, the vast majority of aspiring PMs will have already fallen away. This does not mean that you are now the finished article and that it will be easy from here. Once you start managing larger amounts of money you will face different stresses.

Now your trading decisions will have a material impact on your life and career. If you do really well you will get a large bonus, buy a flat and a nice car. If you do not, you may get fired.

It is starting to be too late to simply go back to Stage 1 and find another path in finance (unlike at stage 3). Here you will be highly vulnerable to Desirability Bias (Desire – The Fatal Flaw). You will want to make good decisions really, really badly. You will really, really want the decisions you have made to be good ones. This can damage the delicate cognitive processes that are required for nuanced decision-making.

Some people struggle here and effectively behave as though they are still in Stage 3. They will take small risks and although they enjoy trading and are good at it, they cannot commit to risking their job and livelihood based upon it. For some reason, I loved this stage. I felt freed up from the restrictions of Stage 3 and had huge (over)confidence in my ability. In hindsight, I still had an awful lot to learn but my confidence and ambition kept me moving forward.

 

Stage 5 – full-time portfolio manager

Here there is nowhere to hide. Managing money is not just a part of your job – it is everything. The decisions you make will determine whether you can buy the nice house, pay for your kids to go to private schools, what lifestyle you can afford and more broadly your status in society.

My sense of this stage is that the people who really care about money, in the sense of what it can buy you, do not become portfolio managers. There are many safer and more reliable routes in finance to get those things.

The ones who do better are perhaps more like me. I did not care very much about leading a very affluent lifestyle, I had earned enough money in my career not to worry that I would end up in severe financial stress and so leaving the relative security of running a business in a bank did not feel very risky.

Conclusion

What I find striking is how hard is it to predict who will succeed at the various stages.

The people who were outstanding at Stage 1 might be complete failures at Stage 3. Those who were very good at Stage 3 would not come across anywhere near as well as the analysts and strategists in terms of their ability to talk about markets, economics and strategy.

Those who were successful at Stage 3 generally focused on the task at hand (i.e. find something, anything which they could turn into making a profit.) This might mean they became an expert in a tiny section of a market and thus needed to know nothing at all about unrelated areas of finance and broad market drivers. It is the focus on making money that is far more important than a broad interest in financial markets.

To become a portfolio manager, not only do you have to refine your technical ability, you will need add emotional strength to deal with the challenges. This can be even harder to predict.

Games 7 Is trading gambling?

My story of the racetrack (https://appliedmacro.com/2017/07/12/desire-the-fatal-flaw/) is how many people, from outside finance, see my world of traders and hedge fund managers. A bunch of gamblers who, at the mercy of their desires, love the thrill with the outcome largely down to luck.

This is invariably intended to be an insult. While I do not enjoy being insulted, I also find it interesting that it is so poorly directed. As with many insults, there is an element of truth but it says more about the speaker than the target.

Using the previous framework on games, they are suggesting that trading is:

  1. High volatility
  2. Low skill
  3. Motivated by desire for excitement

This is probably a fair representation of how a non-professional might engage in it. It is a very fair description of how I play poker with friends. This is why I think it says a lot about the speaker.

In contrast, I would describe professional trading in the game framework as:

  1. High volatility
  2. High skill
  3. Desire for consistent profits and to minimise excitement

This is also a good description of how a professional poker player would view their play.

For both trading and poker, the experience and motivations of amateurs and professionals are very different.

For a non-participant, the most common error is to assume that high volatility games are low skill ones – which we have already seen is certainly not the case. It is also easy to generalise from the few lucky cases that make a good story, and then mistakenly think that luck is all that matters.

Conclusion

Trading and poker have a lot in common. To some, they can be games with a high degree of randomness, where the motivation for playing is the fun that comes from experiencing the volatility. Or they can be games played by professionals, who want to reduce the volatility as much as possible to focus on the non-random positive earnings they can obtain from it.