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.

Games 6 Why do people gamble?

In my previous post, I discussed how the common use of the word “gambling” mixes up volatility with randomness, and frequently leads to incorrect assumptions about skill.

Another perspective on gambling is examine people’s motivation.

Why do they do it?

There are four main motivations I can think of why people gamble

  1. For the excitement, the drama of winning and losing
  2. To add some interest to an activity
  3. To deliberately add volatility to an outcome
  4. To make money consistently


Volatility and expected value

Here is a framework with two dimensions “Expected Value” and “Volatility”.

Positive expected value is when you expect on average to make a profit
Negative expected value might be called “against the odds”.

High volatility means that the short-term outcome is highly uncertain
Low volatility means the outcomes are far more tightly distributed.

a. Excitement e.g. playing in a casino

This is the activity that most often comes to mind when we think of gambling: playing roulette in the casino, betting on horse racing. The desire to induce a feeling of vertigo is the primary purpose. https://www.youtube.com/watch?v=TAaSJcIIruI

A key element to this form of gambling is that it has a negative expected value i.e. you lose on average. It is well known that casinos design their games to produce exactly this i.e. the house advantage. The player gets the excitement coming from high volatility; they will lose on average but they might win big tonight!

These games tend to be low skill. There may be a skill in minimising losses but this tends to reduce the volatility or “fun” element. For example, playing Blackjack with Basic Strategy, not difficult to learn, but extremely boring to play as every decision is pre-determined.

This motivation is very common but although I understand it, I do not really enjoy it myself. A low skill game, in which I expect to lose on average, sounds dreadful.

b. Adding interest e.g. betting on a football match you are watching

This is the form of gambling that I think of when I am engaged in an activity, and people say to me they want to “make it interesting”. We might be watching a football match, or playing golf together. There is an underlying activity but it can make it more fun if a monetary aspect is added.

Some people really like this and I think it’s because they really enjoy the gambling aspect i.e. they get to combine an activity they enjoy with gambling which they also enjoy (much like a. above). It could also be that they find the underlying activity a bit dull and want to add something to it to make it worthwhile. They want to experience the feeling of vertigo and having some “skin in the game” will induce or magnify that feeling.

But perhaps the important idea is that it means spectators have a reason to personally care. They are not just watching other people play a game, they have something that means that the outcome directly affects them.

c. Add volatility

This is an interesting category to me. This is where it is important to add volatility to a result and the impact on the immediate expected value is not so important.
Some example may help to clarify what I mean:

i) You owe a loan shark £10k and if you do not pay up in full tomorrow you will be killed. You only have £5k. A good plan is to walk into a casino and put £5k on black (or red). The fact that the bet itself is slightly negative expected value is irrelevant in the broader context.

ii) You are playing chess and are doing badly, perhaps simply down a pawn or two. If you carry on as you are playing sensible moves you will very likely lose. A good strategy here may be to embrace complexity; adding complexity to the board increases the chance of a mistake from either side and may outweigh the initial advantage. Conversely if you are winning, then the simplest route to victory is best i.e. a clear technical win rather than a beautiful attack.

iii) It is the end of a movie and to defeat the monster/get the guy (or girl) /win the game etc the hero acts in a way which is highly likely to fail, but if it succeeds will end in triumph.

What is interesting about this form of “gambling” is that it is highly rational, but only applies in specific situations. If these situations were to repeat, then the expected value and volatility would be highly damaging. Unless of course you are in a Fast and Furious sequel.

d. Make consistent profits

Professional poker players or expert traders/investors fall into this category. They expect to win on average, but accept in the short term they might not. They would prefer to minimise volatility, as they are not engaging in the activity for the excitement and drama, but to make a profit. The volatility is just a price to pay for the longer-term profits.

An aspect of this that is really interesting to appreciate is the extent to which a person who is primarily motivated by winning is usually trying to minimise the feelings of excitement and vertigo. Top sports people train themselves with exercises such as breathing techniques and mental training to disengage their emotional brain as it generally leads to worse performance. Just think about golfers under stress missing short putts or footballers missing penalties in a shootout. It is the same for poker players. The amateur loves the drama but the professional is doing a job.

It is debatable whether this category of wanting to make consistent profits should be even classified as gambling.
Different people have given me clear and differing views. My view is that calling it gambling is very misleading.

This category is exactly the OPPOSITE to the first one in the grid.

  • A pure gambler plays games with NEGATIVE expected value because he WANTS volatility and wants to MAXIMISE the feeling of vertigo
  • A professional plays games with POSITIVE expected value, DISLIKES volatility and wants to MINIMISE the feeling of vertigo.

Matching motivation to the activity

All four motivations make sense. But the motivation should true up to the activity. If you are not being honest about this, it will end badly for you.

a. Excitement
You should look for a game in which you minimise your negative expected value. Then you will be able to play for longer. The dangers of gambling addiction are a massive negative impact on your life.

b. Adding interest

If you like doing it, it seems easy to self-manage. The mistake would be to pretend this is your motivation but, if you are honest, it’s more the excitement of a. This could be a gambling problem in disguise and you need to ensure you do not gamble more than you can afford.

c. Adding volatility

It is a useful skill to recognise how and when you should add volatility to what you are doing. Sometimes in a limited sense it looks risky but when you see the bigger picture it is a very logical approach.

d. Making a profit
People who enjoy playing games of skill and are emotionally able to handle short-term volatility, will enjoy and may excel at.

It is possible that with this motivation you could be seen playing high stakes poker against better players. Your motivation however must be to learn, improve and develop your skill level so that your long-term expected value becomes positive. Other motivations such as you think you are going to win, are likely to be become expensive losses to you.

I described earlier how people commonly think that excitement a. motivates the people in my profession. I also meet plenty of students who love gambling and so want to become a trader. But people like this do not succeed as this is the wrong objective.

For trading and investing, the objective is positive expected value and you want to minimise excitement (volatility). In addition, your desires will likely overwhelm your ability to make profitable decisions.

Conclusion

People engage in activities with uncertain outcomes for very different reasons. If you assume that other people are doing them for the same reasons you are you may be making a big mistake. You need to make sure that your motivations match well with the games you are playing.

Games 5 What is gambling?

I have been writing about games recently: what they are, why we play them and common confusions from not understanding the importance of volatility. A category of game that is worth further investigation are those that falling under gambling.

Definition

Gambling:

  1. Playing games of chance for money / Betting on an uncertain outcome
    “gambling on a toss of the dice”
  2. Take risky action in the hope of a desired result / taking a chance (often) recklessly
    “If you don’t back up your data, that’s gambling”
    “I’m gambling that the new store will be a success.”

I find these two main dictionary definitions to be confusing enough by themselves, but the fact they both have very different meanings can lead to even more confusion.

Is money intrinsic to the game?

If money is not intrinsic to the game, then I would say you are gambling on the game rather than the game itself being gambling e.g. betting on the result of a football match or the number of goals. Football itself is not gambling. If you play golf for money, you are gambling on the game, but golf is not gambling.

In contrast for poker, betting is intrinsic to the game. Attempt to play poker without chips and the game is reduced in skill, becoming like snakes and ladders. Chips are to poker, what goals are to football. Poker tends to be called gambling while golf does not, mainly because the monetary aspect is intrinsic to the game. Here lies an obvious confusion in the definition of the word.

Game of chance

If we go back to the games categorisation, we can observe an important issue.

Volatility?

The first thing to note is that gambling is associated with high volatility. Few people would call playing chess gambling and no-one engages in low skill low volatility games.

Does high volatility imply gambling? It is not that simple. We saw above that it is the addition of money that is critical.

Skill?

Neither definition specifies whether the game or “risky” action involves skill. I think this looseness of definition illuminating. I would say that gambling commonly implies a game of low skill and random outcome. We have seen before how high volatility often leads to the incorrect conclusion that the game is random and low skill (Game 3) We now see a similar issue with games described as “gambling”.

Let’s compare two games:

Both games are referred to as “gambling” but bear crucial differences. Poker has high volatility, but I would not call it a “game of chance” so does not even fit the original definition. However, poker is commonly described as gambling or a gambling game.

Risky vs reckless

In the above definition, both risk and reckless appear and, in common usage, can be used similarly.
However, they are very different concepts.

Let’s take a golfing example. You were the last to play on the last day of the Masters, now standing on the 15th fairway, 192 yards from the flag. Your playing partner is 2 shots ahead of you. You go for the pin.[1]

Risky? Sure
He had not managed an eagle in his previous 450 holes at Augusta

Reckless? Not at all
He needed that eagle to make the payoff which he subsequently won for his first major.

Conclusion

The problem in the definition of gambling is that it does not differentiate between an act of random chance and something which involves a great deal of skill i.e. a non-deterministic outcome with a monetary consequence.

Again we see that this uncertainly in the outcome is misinterpreted is random (logic error) and therefore there is limited skill involved (logic error) and that risk is in fact often reckless (logic error). These confusions are similar to what we have seen in games generally, but still makes them hard to spot.

 


[1] http://www.golf.com/tour-news/2017/04/09/watch-sergio-garcias-eagle-15th-masters

Games 4 Fooled by Volatility

In the last post (Games 3), we looked at how people may be confused by volatility.
You might think that people who look at financial markets would not be so easily confused.

A great example of such a confusion comes from Nassim Taleb’s bestselling book “Fooled by Randomness”. I would possibly suggest the author has been “Fooled by Volatility”!

Here is my summary of the argument of the book, with my comments on it below:

1. Events have some randomness associated to them

TRUE
Hardly rocket science, but an underappreciated point.

2. Humans are poor at understanding randomness, overemphasizing the importance of small amounts of evidence (often outliers)

TRUE
You can find similar argument in many other books (Gladwell), but useful to highlight and he provides decent examples from finance.

3. People trading the market often assign their success to skill whereas they are just lucky

Partly TRUE
This is certainly at least partially true – some rich people are just lucky and are not smarter.
I think there is a legitimate debate on the degree to which the overall statement is true

4. All trading success is down to luck
Therefore success is evidence of luck


FALSE
This is a logic error. By appealing to the emotions and prejudices of the reader, some may not spot it. The book leaves the impression that all successful traders are just lucky.

Confused by volatility

The source of the error seems to be a conceptual confusion between volatility and randomness. The author observes that outcomes have volatility but names it randomness, since it is “random” this implies there must be no skill. This is exactly the mistake I described in the last post.

It is a shame because some of the underlying arguments (see above) are interesting and true. The fact that outcomes are only partially determined by merit and that people incorrectly over-attribute success to ability is often overlooked.

For a rather extreme example, apparently even Trump’s son-in-law Kushner believes he owes his position purely to merit despite inheriting a huge fortune, reportedly having his place at Harvard bought for him[1] and then marrying the daughter of a billionaire who becomes President.

The rest of the book

For completeness, some notes on the rest of the book:

5. Traders make money by selling tail risks. They all blow up in the end


FALSE
The assumption that this is the only form of trading that exists is ludicrous.
Again, appealing to the prejudices of a certain kind of reader, it implies successful traders aren’t just lucky, they are dangerous.

6. Traders who consistently buying tail risks are the only ones that understand probability, but may appear that they have low skill given their average performance.

 

FALSE
Here the suggestion is that consistently poor investment results are an indication of integrity and intelligence, which is again ridiculous. Another emotional argument to make people feel better about not being able to replicate the success of others.
See my thoughts on the link between desire and belief here (Desire – The Fatal Flaw).

7. Everyone else who makes money is just lucky, but Taleb can make money by being skillful

!!!!
Here the suggestion is Taleb is a unique genius

Summary:

It is a real pity that the arguments in this book are taken to an illogical extreme, but perhaps this is key to explain the popularity of the book. The points made in the first half of the book are significant and well explained (although not unique to Taleb).

I would have preferred if he had gone on to discuss how to spot the difference between skill and luck; or possibly how to avoid incentivising tail sell behaviour in financial markets.

Instead I read it as some kind of personal therapy about his career angst.
It reminds of a lovely quote – “all autobiography is a form of revenge”.[2]

 


[1] https://www.propublica.org/article/the-story-behind-jared-kushners-curious-acceptance-into-harvard

[2] As an aside Nocturnal Animals is a great movie on this theme.

Sport and Volatility

There will not be any posts next week. I am going on holiday and taking a break from writing.

I leave you with one thought on volatility in sport…

I spent a very enjoyable time watching the golf at the Open at Royal Birkdale last weekend Spieth on the final day played an amazingly exciting round and ended up going on to win.

At hole 13:

He didn’t just miss the fairway
He hit the ball over 100 yards right of the fairway
So far away he eventually declared the shot unplayable and took a penalty, walked another 50 yards away from the hole and eventually hit the ball between some TV trailers on the practice ground.
He managed to finish that hole only 1 over, a bogey, a remarkable achievement

The next four shots were even more remarkable:

14th Hole                            1 under, birdie

15th Hole                              2 under, eagle

16th Hole                              1 under, birdie

17th Hole                              1 under, birdie

And by hitting par at the 18th, he took the championship.

Rory McIlroy was 5 over after 6 holes on the first day but went on a charge on the last day and despite losing a ball on the 15th, made eagle on 17 while Speith was in serious trouble on 13 and his odds of winning were tumbling fast from 100-1 to 20-1.

I like golf. But the volatility is what made the event so much fun to watch.