“When the facts change, I change my mind. What do you do, sir?”-John Maynard Keynes
“Every day I assume every position I have is wrong.”-Paul Tudor Jones
Are you living in the past, the present, or the future? Most trader/investors live in the past, claim to look at the future, and totally forget about the present. This is probably the wrong way to do it.
Instead you might want to look at living in the present, look to the future, and study the past. Rocket science right?
We have all read interviews with legendary traders where they basically say “everyday when I come in I am looking at a clean slate. If there is a position that I have from yesterday that I don’t like today it is gone.” I think that most people kind of get what they mean, but from countless conversations with people I think that they miss a big part of it.
This does not mean that you need to day trade everything, but instead that you are supposed to be revising your probabilities and risk/reward measurements as the fact change. The more you have worked through your process, the less of a mess it will be when things do change fast. You can have less stress, think clearly, make better decisions, and consequently make more money.
Day to day the probabilities and risk/reward of your individual positions, exposure levels, and overall portfolio change, some days the changes are small and other days the changes are massive. If you are not proactively going through your risk framework to constantly reevaluate your holdings then you are doing it wrong and really skewing your risk/reward in the wrong direction. This applies to you regardless of if you are a global macro trader, long/short equity, vol trader, arbitrage, etc….even a supposed “dyed in the wool Warren Buffett clone.”
Let’s take the case of a long only equity manager. Two months ago you were loaded up with names that for the most part had been working over the past year. Then all of a sudden the virus hit and everything was down -30%. Do you just stick with the names you have? Did you get stopped out of a lot of them on the way down? What is your plan? For too many managers they default to the past and they assume that “if these were good companies a few weeks ago they are good companies now.” But of course we know that in many cases this is NOT true. Now is not 2 months ago. Now things have changed. Now we are looking at a significantly different future 6-24 months out.
So now you want to look at your holdings and figure out if you should be upgrading to better names for the new future, adding to your current names, etc. Things have changed enough that in many cases you should be changing as well. Of course sometimes the best idea is to not change as well…but you should not default to that but instead make it a very conscious decision. I mean I hope no one reading this site is one of those people who says “well all my peers are down X% so I am going to stick with what I have.” That is atrocious reasoning.
If you are a long/short manager you had your best chance to add a lot of alpha since the end of year dump in 2018. When the market crashed -35% you should have been covering a lot of your shorts and looking for stocks to buy. At the very least you could have just started buying the indices for long exposure. The market was statistically oversold…by a lot, valuations got very close to the 2008 lows, and sentiment was at statistically significant levels. You should probably be using all of these tools, but relying on valuations alone should have had you buying hand over fist.
Here is the Value Line Median PE ratio. As you can see a couple of weeks ago it was just a point off from the 2008 and 1990 lows. It was basically screaming at you to drastically adjust your exposure.
Here is our RTM-reversion to the mean indicator. It is simply the deviation from the 200-day moving average. We then plot the mean and the one and two standard deviation lines. We have found it to be a great medium to long term overbought/oversold indicator and is an excellent long/short exposure tool. As you can see in the chart below a few weeks ago it was at the third lowest reading in 70 years, having only been surpassed in 2008 and 1974.
Finally, at least for now, is the Investors Intelligence Sentiment Spread. Here we take the bulls minus the bears. When it drops below zero it is a good time to be buying, and anything below -10 is great 3-12 months out.
You might use different tools to evaluate the opportunity set at any given moment, these are definitely not the only things we use. But what I am trying to get at is that you should have a tool set to evaluate where we are right now and where we are likely to go in the future. You should then have the mindset to be constantly evaluating the current situation, and by situation the risk reward of your positions and portfolio, and adjusting as needed. Never get in the mindset that “what I have should work.” Be proactive and constantly reevaluate your holdings, your views, and the risk/reward of it all…and don’t live in the past.
By the way there is one more thing that is really important to do with all of this. You want to make sure that whatever investing style and process that you use actually matches your personality and temperament. If they are not aligned then you are just running in place…but that is a topic for a future post.
Happy Trading,
P.S. If you liked this then take a free two week trial of our service. If you have any questions send me an email or find me over at Twitter @DavidTaggart
P.P.S. I hope none of this came off as preachy. But far too often we fall victim to biases like anchoring and the sunk cost effect as well as just getting scared frozen like a deer in headlights. By proactive and putting in processes to fight these issues we think that most investors can drastically improve their results.