While preparing a questionnaire for our pod-cast with Jack Schwager, I came up with a Question.
No 02 styles of trading/investing are same. At one end we have people like Ed Seykota who say, ‘if you don’t want drawdowns, don’t trade’. And people like Charlie Munger who claim manhood in their ability to withstand severe drawdowns and then there are people like Ed Thorp who do specific, risk defined statistical arbitrage so well that they have not had any negative quarter in 20 years while generating 26% CAGR
Who is better? What YARDSTICK do you use to pass a judgment?
While thinking about the answer myself I came up with 02 line of thoughts.
If a record is too good to be true, it usually is. Historically, strategies which work beautifully generating amazing alpha without any corresponding drawdown are doing something terribly wrong.
It is like a cancer growing within without giving any symptom for the victim to realize it. A frog in the pan syndrome kicks in where the Luke warm water sucks the frog into comfort and it doesn’t notice the increase in temperature.
Draw-downs act as a feedback loop, and keep you in touch with reality and the markets, if you have over optimized your system too much, you are far away from any feedback, far away from the reality of the market.
ONE way you can generate awesome alpha without its corresponding draw-down is by using an average system with alpha of say 2% and amplify it with a leverage of 15. The problem with systems which generate 2% return 99% of the time is that the 01% of the time when they don’t perform, they are not just neutral, they collapse. And I don’t have to tell you what happens when your strategy collapses spectacularly while u were 15:1 Levered.
The Chart of such a system look something like that of a THANKSGIVING TURKEY’s life . It shows an amazing CAGR returns without any draw downs for an entire life of the fund until that day (01 day before thanksgiving) when its head is chopped off.
There are examples abound, Victor Niederhoffer to LWCM to AIG. The underlying theme running in all these disasters is OVER LEVERAGE done on sure shot returns.
Stars of today like Warren Buffet and Rakesh Jhunjhunwala who now talk about Risk management and probability and position sizing were apparently not practicing what they are preaching now.
Charlie Munger is known to have bet 100% of his and his partnership’s portfolio on sure shot things, Warren Buffet did the same, he bet 40% of his partnership fund into American Express. Earlier while he was building his fortune in those private partnerships, he did the same, even bigger, bolder moves.
Who is to say that the sure shot bets could not have failed. And if you have seen the movie Moneyball, success & confidence go hand in hand. Billy Beane was a sensational player and was destined for glory, due to his initial failures when he started, he could never get the ‘confidence’ to make a mark, to be successful.
In parallel history, All these trades have backfired and WB, Munger and Jhunjhunwala have joined a list of million other over confident losers who bet too big.
Besides, returns need to be measured on risk taken. The other day somebody on twitter said DSP fund has beaten you in last 05 year CAGR basis by full 2%. My point is, this is there 02nd birth, they died in 2008 crash (Apparently, they did a lot better than their peers) just like any other mutual fund. I don’t compete with the dead.
In light of above 02 stream of thoughts, my conclusion is that Ed Thorp, hands down is a better INVESTOR than all other combined.
Never once did he take a trade in his life that would have rendered him bankrupt. Never once in his trading history, was there a situation that could have led to a risk of ruin. Never once was he over leveraged. In fact his strategy was so robust that he came out winner in 1987 crash. His Shorts even ensured a OK 2008!!
That is called ROBUST MONEY MANAGEMENT with almost zero role of luck in your result.
Sure he did not become as rich as WB, but then that’s the idea, in my book he exactly knew how much is ENOUGH, As Warren’s wife rightly said, for warren it is a competitive game up in his head and he doesn’t have a stop button.
Having said that, there ain’t many Ed Thorps in the world and therefore draw-downs are here to stay and a lot lesser evil than blowing up on sure shot naked strategies.
This is the reason I emphasize on SKIN IN THE GAME. Your fund manager need to have considerable portion of his net-worth in the fund he is managing (WB and CM score a 100 here) otherwise draw-down is just a number for him and his fund house will take second, third and nth amount of birth’s with hospital bill paid by retail investors.
Now of-course this is my conclusion and it is as limited as my small brain, and it might change as I evolve, but it is always good to pen down what you think at a given point. Comments are welcome…