A Curious Dilemma

A Curious Dilemma How can managers and traders reconcile conviction and uncertainty? BY WAYN E

II. WAG N E R

L-",. L- ^,,rne> ttp 1ilh these things?'' said the trader, look,. ^,,,1^,. ,.

ing at another offbeat order from a mar-erick portlblio manager. Where indeed! Hor'v do managers ancl traders cope lvith the extraordinarl complexities of market information vet reduce them to simple br-ry. and sell instructions? \ r.,-,. aPtrr\ ^-,-1.. \ r^.-1. r.,\ains.lbreff a_ rYrarl\

tion that "It

difference of opinion that led to horse racing" to financial markcts. Tri ain i5 corrcct hut tlot'sn t rcally get to the source of the phenomenon. It's not the difference of opinion that counts, it's the clifferent mental processes each of us employ's. The market encompasses so rnanl dirnensions .rl huntrtt expcricntc r'r'as a

ancl emotion that each ol us sees it not it is but only' through the filters and

ri irrtluri: I .ju>t

errrolrl rnr' -....D... .../

,.r

.ru tlr. thing. thlt

r'

l-r +rr ._ tl ,.ilnt 8cl\

Irroces\cJ rhr.rugh filtrr. o[ 1q fi21 is pcr\olrallV irn|o|tent or intcrerting. suclr rq 'H,rrv lnrro '' ''b ir" il'-'.',rinob'-tn lrlic

rne I,r

in the traffic?" \pplictl to tlrc rnarkct. thi. prirrci-

get home

nl, ""bb_"'" r'' \r,ro.\lq

tlrrl

, a, h In1rrzo.r - .^b_ .'lnrl_'

trader focuses on a lerv thir-rgs that he or she personall,v consrclers important,

as

lhe t'c.l ,'t'ts ipnrrrr'tli lhcsc rLcisit,tt

biases of our perceptlon.

dlir"ers rnight be funclamentals, technicai signals. srqrphy'clernar-rcl shifts, trnd numerous financial variables. ratios, rn(l rhort( ut\. \\ lrrtcvcr tht r arc. thcr are a relatir.e hanclful in number. That's all the human mind can deal rvith at one trrne. Which of these elemenrs art: nosr irrrrrnrt:rnl) ir ....r .-...^... Sin,,. ,rrrl -. ..nPT('\5tUllS ,lnlir n frnrn nrrr npr\,!nrl '"'-"""'l'" lif, , rneri-

Information Overload Simpi,v stated, the marl<et is too complicatecl for an)rone Lo fully'comprehencl.

"How do managers and traders cope with the extraordinary complexities of market information yet reduce them to simple buy and setl instructions?"

there is too much information for anv one human being to process. \\ie need to simplif,v in orcler to clarifv the decision and find some handles b1'r.r,hrch we can secure a n-rental grasp. I look or-rt rn1'oIfice u'indor.v and see buildings. cars, clouds. and blue sk1'. ''See" is not the right r,r.ord; "notice " rrr "rrrrcei\ c ir| mr)rc accuraLL. I tlitlrr't rr'allr sec { \cr\rhinp rhat rras out thc

lltcre are ju't t,ro rnitn\ m\r\ ittg part:. more than can be simultaneousil' comprehended b1' the human mincl. Our minds are tralnecl over [rany generaIrons lo iclrnrifr the.tcnping slr)req in front of us rather than take in the n'hole vier'r' as a camera does. \Ve're not

built

r'r,ith enough mental hardrvare. '' I hc crrr ironrncnl contains a r lri-

ct1 of go,r.ls antl torirrr. hrrhingers and distractors, stepping-stones and

pitfalls."

r,r.rote philosopher of science Daniel Dennett rn his book Kind.s o/ tr{inds. "These resolllces often amount to an embarrassrlent of riches in competition for the agent's attention." Trrre in tho h".te'_-orthcrnr.

ronlnent-and certainlv lrue in

errr i-

the

marke t.

Economist Herbert Simon. ln X,lorlof Man, iclentified this phenomenon as "bounded rationalit)'." Bounclecl rationalltl-, stated simplr'. means that els

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AY-jUNE 2oo7

b_'"'b'_\,__til

ences. lhe ans\\'ers differ frorn person to person. Thus. rve r.valk backr'r,ards into t1-re future, r,r.ith our mir-rcls anchored bv the imprintecl lessolrs of the past. Thi. Fltrrinr,rrrnlics _'''" _,''___'_b to brrth nttn"rr" agers ancl traders. although their choice' o[ Llc( i5ion tlt'ir, rr u ill .li[l'r sigrrificantly The portfolio manager \\,ants to take a long drive; the trader neecls to knor'',, horv to get the car started (or stopped.) Curiously: this''ferv-r,ariables effect" is true of statistical moclels as rvell as active decision making. Those rvho builcl slrrt k-scleclir rn oI nricc-ntr)\ Cntcnt lilOdels knor,r' that after fir.e fhctors or so,

rdtling adrliti.rrral t'rplarratorl r aliablcs Jccrca*e: r'dthr'r int rt'arr'r lhc prt -

dictive po\\,'er. A feu, variables are the main drir er': evcr\ llring cltc it cithcr too smali or too fleeting to play a useful role in decision making. The Marl<et of the Mind I hc net re.ult is that rr c don t plrl thc real market; rather, we hurn along n'ith tlre song the rttarkel sirrgr 16 our individual heads. At times, our mental model fits r'vell enough; at other times, \\e rc otrl oi tunc. .\nd rrc (rn l prcdiel rvhether the next shift nill be favorable to our thinking or not. Hoq'ever, because each participant reflects a different set of liles experiences, the market effectir.ely processes nll the information and choices-those that are in s)'nc as well as those that are not. Thus the market delivers its or'vn truth. ln The Wisdom of Crol.'ds, James Suror,viecki puts it this wa)r' "a cror,vds 'crrllcctir e intelligcnce u ill pr,'tluce

better outcomes than a small group of experts, er.en if members of the cron'd don't know all the facts or choose, inclividuall-r,', to act irral-ionall1. . peoples errors balance each other out; ancl inclucling all opinions guarantees that tht' re>ull> rre >lnarter rlran il a singlc expert had been in charge." In other u,orcls, the market is smarter than anv participant in lt. Without such collective intelligence , an index fund could

nol

r'r,ork.

Not only does the market a11or'r. us to act on our o\\.n decision drivers, but it also allor,vs the world to correct us. "The markets objective," jokes Ken Fisher, "is to humiliate as manv people as pos:ihlc lor ar mu, lr monc\ ts pu>\ihle li'r as long as po:sihlc. L ltirnatelr. a standard outside ourselves becomes the judge of the correctness of our model. Witl-rout it, r'r.e lir.e on oLlr o\vn

little imaginarv planets. spinning out of corrtrol. lhcrt

rc--_'_ ut' brokc.

The Marl<et of the Gut

Thc tllrkctr are g()()(l al \()r'lin!, (rLtt rational thoughts ancl equa11y. good at rcsponJing to elnotional [actorr. lrr part iculrr'. tttlrkcts necd to ptrni'lr ()\ ('rt x-

uberance. Markets fincl the price that balances supplying sellers u'ith

demanding buyers. If either group is u,ildl,v or.errepresentecl, markets cannot fi nd . lerri rrg pricc\ f,nrl I rxnrfl( t i ng halts. The most clramatic example is the panic of October 1987, r,r.hen the market had far too man1, sellers and norvhere near enough bu\.ers. W'hat u.ent r'r'r'ong? Portfolio insurance mechanicalll- createcl a {1oor value so the portfolio coulcl not lose ntore than some prespecified clollar anrount, Sponsors quickly sar.v that as the possibilit1' of loss u';rs taken out of equitv inr.esting, the need for boncl portfolios as stabilizers n'as strongll' chmrnished. \\'h,v not sell the bonds and inr-est the irroceeds

in

eqr.rities

lvith a higher

C\lccte(l rt'tttrn J Tht'n .trtne,rnc figurc.1 out that once voll hacl made sorne mone)'. ,vou coulcl raise the guaranteecl lloor rrnd loe k in r out gains.

Higher returns, lor'r'er nsk. locked-in gains-$ho c,rttld rtsist a prop.rsilitrrt like that? Portfolio insurance had created ' rirkl,''. inrcrlnrr'nl>. cunl(rrling lll(' grcrJ-lcar balancc ftrr p1n.16n spun5tlr\.

Many plan sponsors couldn't resist, and 10 percent of pension assets r,vere "insurecl."

by 1987, an estimatecl

This crou,d lr,as destined to stamin the same direction at the same tinrc. \\ hcn an crternal tliggcr c:rutcd markets to fall, portlolio rnsurance managers had to sell equities to fullill the insurance contract. When thel'sold. the rnirrket clropped, r'r.hen the market droppcLl. rh.'r hatl lo \ell nlolc. A \ cr) vicious cvcle indeecll pede

Thus, fear is a necessart'factor in the operation of an,v market. Remor:e fear, as portlblio insurance drd. ancl the rnarkets can not restrain rampanl greed and exuberance. The only n'av to correct the imbalance rvas fbr portlblio

''insrtlarrct" to tlc[eult on it\ gulr']ntcc. lhLts crerttirtg tn unf()rgcllilblc p*1 ql1,'logical experience for manl' supposeclll,

sophisticated jnvestors. As Frecl Schrvecl said in Whcrt Are fhc Cu.stomcr.s' )'rrcirts?, "There are certain things that cannot be aclecluzlte1y' explained to a vir-

CFA MAGAZINE / l\lAY-JUNE 2oo7

gin. either br- rvords or plctures. Like all ol lifes rich ern,'lional erpcricnccs. tltt' full flavor of losing important mone]' cannot be convel.s{ b,v literature." Every Day ls a New Day

A. borh 5chr,r ed ;rnJ Fi'hcr .uggc5l. lhc stock market is among the most uncertain and anxietr'-prr:ducing areas of humarn enclear,or. Notl-ring is assured; nothing u'orks at all times-not e\ren the best intellect. research, and ardor. C)ur

most noti\.21ted anci intensive efforts cannot guarantee the desired results. \Ve need to appl,v the best of our science arrd art. hrrt a [, ] :lroke: oI scrcndipitorls timing alr'r.a)'s come in handli

\\c __-_--__ ' - rnipht

be _-__-r_tr' think that -- tcrnote.l

mega-super computers, threading thror-rgh chaos theory or neural netu.orks, might {ind signals that are too nuancecl to be picked up br, mere

human intelllgence. Unlbrtunatelr', cap-

ital rrrirrkt'ts are lo(r c('mple\ eVctt [ot' such sophisticaterd, nonlinear techniques. What leads to ontcome A on Monday'may leacl to Not-A on Tuesdal'. Thinl< of the market as a flu 1,i1l1sonce \\,'e think rve have

it

peggecl,

it

mutates into something ncr'r''. Tl.rus, traders. especialh', neecl to irllLrnc to tlte crer-changing hallnte tr[' hrrr crs arrd :ellcrr. \Vhilc f,rrt lolio managers search for the long trends and hidden r.alues, a tracler expcriences a

brand ner,v marke t er.err, da): A cr"irlous dilemma aflects managers lnJ tluder': Btrth rrecd thc coulagc oI their convictions )'et sirnultaneousll' must listen 1or the market's messages. Pt rhaps lltc *rrn8 trur tnetnorr isinging in our head is out of tune r,r'ith r,r-hat the market reveals. Experience

means kno*'ing r.r'hen to act on the conviction and when to la,r. |61'. 1Lturt r.r'h). s1w)- managers ancl tr:rclers get paid the big bucks. ^/

H. lVagncr- is senirrr- adtisor Jor ITG Inc. ttntl .founde r oJ OI4/Nf ConsuLtWa,,-nt

irtg Pctrtntrship.