Wednesday, October 22, 2014

Two perspectives on failure: How Google Works and Fail Better

Failure has become one of the hottest themes for graduation speeches, blog posts, and self-help books. It is often worn as a badge of honor. But, let’s face it, failing is painful, sometimes even fatal. So how, and under what circumstances, can there be value in falling short?

Let me start with a section from How Google Works by Eric Schmidt and Jonathan Rosenberg (Grand Central Publishing, 2014) entitled “Fail well.” They recall Google Wave, “a technological marvel but a major flop.” It failed well because it created some valuable technology that migrated to Google+ and Gmail. “As Larry says, if you are thinking big enough it is very hard to fail completely. There is usually something very valuable left over.”

We have all heard and have come to believe that a good failure is a fast one, “but one of the hallmarks of an innovative company is that it gives good ideas plenty of time to gestate.” How can we reconcile short-term successes or failures with long-term goals? “The key is to iterate very quickly and to establish metrics that help you judge if, with each iteration, you are getting closer to success. Small failures should be expected and allowed, since they often can shed light on the right way to proceed. But when the failures mount and there is no apparent path to success (or, as Regina Dugan and Kaigham Gabriel put it, when achieving success requires ‘multiple miracles in a row’), it is probably time to call it a day.” (p. 188)

In Fail Better: Design Smart Mistakes and Succeed Sooner (Harvard Business Review Press, 2014) Anjali Sastry and Kara Penn offer techniques for managing projects from their launch through their iteration to build and refine, and finally to embedding the learning.

(For those like me who thrive on the tangential, the book’s title comes from Samuel Beckett’s Worstward Ho—“Try again. Fail again. Fail better.” As the authors note, “Cast as a mantra that turns failure into success, the phrase caught on with tennis players, tech entrepreneurs, and many more, infusing it with an optimism that no literary critic would credit to ‘the twentieth century’s most depressing writer.’” [p. 15])

Fail Better is of course a business book that assumes a team trying to implement a project, so not all of its recommendations are applicable to lone traders and investors. For today’s post I decided to continue with the theme of managing time frames since I think everyone struggles with this issue.

The authors suggest that “we need a systematic method for managing our innovation projects because what looks like a failure at one time scale could actually be a success at another, if you manage things well. Or, it could go the other way: you may scrape together some quick apparent wins and declare an early victory, yet later discover that things are actually worse, when negative side effects subsequently emerge.” (pp. 215-16)

Why, the authors ask, do we get timing wrong so often? Perhaps the major reason is that “people tend to underestimate the effects of nonlinear rates of change. Consequently, they are blindsided by effects that appear to come out of nowhere but are actually the result of compounding processes playing out within the system. A similar tendency is at work when people assume that the future will be similar to the recent past: the normal human tendency is to guess that the future will continue current trends. … For anything that’s cyclical or exponentially growing or declining, this heuristic ensures that you will at some point be wrong—and that you will be dead wrong at those crux moments when rates of change are greatest (peaks and troughs in cyclical markets, for example).” (p. 228)

Both of these books are good reads, and I’ve shortchanged them by zeroing in on a single topic. But I hope that the passages I’ve quoted will inspire you to find ways to fail well in your trading and investing.

Monday, October 20, 2014

Elder, The New Trading for a Living

Alexander Elder’s Trading for a Living appeared in 1993. Now, 21 years later, Elder is out with a revised edition of the book. But unlike most revised editions, The New Trading for a Living is so thoroughly revamped that it is for all intents and purposes a brand new, and to my mind much better, book. I have no idea whether The New Trading for a Living will be an international best seller like its predecessor, but I can say that it is, in Elder’s words, “two decades smarter.”

The book explores the three pillars of success—psychology, trading tactics, and money management—as well as the factor that ties them together—record-keeping. And it does so in incisive, sometimes amusing detail. For instance, Elder writes: “Commissions and slippage are to traders what death and taxes are to all of us. They take some fun out of life and ultimately bring it to an end.” (p. 6) Or, “When a monkey hurts its foot on a tree stump, he flies into a rage and kicks the piece of wood. You laugh at a monkey, but do you laugh at yourself when you act like him? If the market drops while you are long, you may double up on your losing trade or else flip and go short, trying to get even. … What’s the difference between a trader trying to get back at the market and a monkey kicking a tree stump?” (p. 29)

Elder, a trained psychiatrist, analyzes both individual trader behavior and mass psychology—that is, the behavior of trading masses. In connection with the latter, he suggests that “technical analysis is for-profit social psychology.” (p. 43)

Six chapters are devoted to trading tactics—classical chart analysis, computerized technical analysis, volume and time, general market indicators, trading systems, and trading vehicles. Those traders who have not yet developed their own successful strategies will profit from this balanced, suggestive overview.

But armed with even the best tactics the trader will fail if he does not exercise proper risk management. As Elder writes, “Markets can snuff out an account with a single horrible loss that effectively takes a person out of the game, like a shark bite. Markets can also kill with a series of bites, none of them lethal but combined they strip an account to the bone, like a pack of piranhas. The two pillars of money management are the 2% and 6% Rules. The 2% Rule will save your account from shark bites and the 6% Rule from piranhas.” (p. 202) The first rule prohibits the trader from risking more than 2% of his account equity on any single trade. The second prohibits the trader from opening any new trades for the rest of the month when the sum of his losses for the current month and the risks in open trades reach 6% of his account equity. (p. 208)

Elder sums up the rationale for these two rules: “Putting on a trade is like diving for treasure. There is gold on the ocean floor, but as you scoop it up, remember to glance at your air gauge. The ocean floor is littered with the remains of divers who saw great opportunities but ran out of air. A professional diver always thinks about his air supply. If he doesn’t get any gold today, he’ll go for it tomorrow. He needs to survive and dive again.” (p. 212)

In the final chapter Elder describes what is involved in good record-keeping and illustrates his points with a daily homework spreadsheet, an “Am I ready to trade?” self-test, Trade Apgars to score potential trades, a tradebill to focus on the key aspects of a chosen trade, and suggestions for keeping a trade journal.

“Technically,” Elder writes, “trading isn’t very hard. Psychologically, it’s the hardest game on the planet.” (p. 250) The New Trading for a Living offers sound advice as well as the occasional crutch to make it a bit easier.

Wednesday, October 15, 2014

Cunningham, Berkshire Beyond Buffett

Warren Buffett is now 84 years old. Although he is still tap dancing to work practically every day—at least when he’s not galavanting around the country, people can’t help wondering how the company will fare once he is no longer at the helm. Lawrence A. Cunningham addresses this question and, as the subtitle suggests, gives a fairly upbeat answer in Berkshire Beyond Buffett: The Enduring Value of Values (Columbia Business School Publishing, 2014).

Berkshire Hathaway is a sprawling conglomerate comprising nearly 600 business units. (GE has 300.) Its subsidiaries include insurance operations, most notably GEICO, GenRe, and National Indemnity, and a range of other businesses big and small—for instance, BNSF, Fruit of the Loom, H. J. Heinz (50% owned), HomeServices of America, Dairy Queen, Johns Manville, Lubrizol, Berkshire Hathaway Energy Co. (formerly MidAmerican Energy), McLane, NetJets, Shaw Industries, The Pampered Chef, and the Omaha World Herald.

Warren Buffett once famously said that “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” And, along the same lines, “I can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing—you end up with a zoo that way. I like to put meaningful amounts of money in a few things.”

Buffett may believe in concentrating his stock portfolio holdings, but the Berkshire family of companies is not only large but is also quite diverse. Granted, it’s short on high tech and health care companies so it’s not quite a Noah’s Ark, but it still spans numerous sectors of the economy.

Buffett makes a point of not being involved in the management of these companies. As Cunningham explains, “Berkshire’s hands-off management approach was made by choice but became necessary by default…. The choice to operate in a decentralized manner from the beginning reflected a belief in the value of autonomy and a conviction that people properly entrusted with authority will generally exercise it faithfully.” (p. 105)

The Berkshire companies exhibit a diversity of management styles and structures, but they are loosely bound by the Berkshire culture. Cunningham devotes the largest part of his book to illustrating how individual companies exemplify particular traits that create the Berkshire culture. (He strains to make these traits spell BERKSHIRE, mixing nouns and adjectives and not always choosing the most apt word.) He traces out the origins of these companies, how they came to join the Berkshire family, and how their managers are generating long-term economic value by simultaneously pursuing economic profits and intangible values—values such as thrift and reputation. There have been hiccups along the way, but by and large Berkshire companies are ones Buffett can truly be proud of.

What challenges face a post-Buffett Berkshire? Cunningham suggests that “problems will arise from the acquisition model, hands-off management, and a sprawling decentralized structure that eludes tight control and consolidated non-financial reporting.” (p. 220) Areas where Berkshire now gets a pass because of Buffett’s reassuring presence may come under closer scrutiny.

Overall, however, Cunningham is optimistic about the future of the company. “As a new guard leads the evolution of Berkshire beyond Buffett, they will set its course and the company will never be the same. Yet the core values that define it have proven to offer unique sustaining value. It is hard to imagine Berkshire without Buffett. But it seems wiser to believe in Berkshire beyond Buffett, an institution that transcends the man and will be his legacy.” (p. 232)

Monday, October 13, 2014

Cordier and Gross, The Complete Guide to Option Selling

In this, the third edition of The Complete Guide to Option Selling: How Selling Options Can Lead to Stellar Returns in Bull and Bear Markets (McGraw-Hill, 2015), James Cordier and Michael Gross explain how to use options to make money in the commodities futures markets. Most of their recommended strategies involve naked positions; only one, the vertical credit spread, is a defined risk trade.

The authors list seven reasons for preferring commodity futures options over equity options. Heading the list are substantially lower margins and high premiums for deep out of the money strikes. “With the SPAN margin system used in the futures industry, options can be sold for margin requirements as little as 1 to 1 1/2 times premium collected. For instance, you might sell a corn option for $600 and post an out-of-pocket margin requirement of only $700.” And “unlike equities, where to collect any worthwhile premium, options must be sold 1 to 3 strike prices out of the money, futures options can often be sold at strikes deep out of the money.” (p. 63)

Traders who want to delve into this world of high leverage and theoretically undefined risk had best know something about commodities. As the authors say, “’Know your market’ is every bit as important, if not more so, as ‘Know your option.’” (p. 343) The authors thus devote one part of the book to commodities fundamentals and seasonals.

Although they suggest that selling puts or calls can be a powerful strategy, due in part to “its sheer simplicity,” (p. 333) the “best option-selling strategy ever,” in their opinion, is the ratio credit spread. In fact, they call it the Maserati of option credit spreads. In a ratio credit spread you sell a certain number of options at a particular strike and buy fewer options at the “one closer to the money strike” in the same contract month. A three to one ratio “offers the best balance between potential for profit and risk protection.” (p. 160) The authors give examples of this strategy and offer a few tips for adjusting positions to reduce risk or increase profit.

As should be clear by now, the title of this book is misleading. It’s not the complete guide to option selling in general but a pretty complete guide to selling options on commodities futures. And since, as the authors readily admit, it’s difficult at best and in many cases impossible to extrapolate from commodities to equities, potential readers of this book should be looking to expand their options trading or diversify their portfolios by including short options on commodities futures. Otherwise, they should turn elsewhere.

Monday, October 6, 2014

Book sale

Once again, I’m offering readers of this blog an opportunity to get books I’ve reviewed at cut-rate prices. Orders that total more than $100 (not including shipping charges) will receive an additional 10% discount. Domestic media mail shipping is between $3.50 and $4.00 for a single title, less per book for multiple titles. I’m willing to sell to non-U.S. buyers, but shipping charges can be prohibitive.

These books are officially used because, yes, I read them. But I have one of the tiniest “book footprints” on the planet; my used books look better than most new books at the local bookstore. No dog ears, no coffee—or, in my case, tea—stains, no visible fingerprints, no broken spines.

If you would like to buy any of these books, please email me at and I’ll give you a total price (including shipping) as well as my PayPal ID. Yes, my preferred method of payment is PayPal. I’ll fill “orders” on a first come, first served basis and will update the list as I receive payment.

Au, A Modern Approach to Graham & Dodd Investing $22
Ayache, The Blank Swan $25
Baker & Filbeck, Alternative Investments $41
Baker & Kiymaz, Market Microstructure in Emerging and Developing
  Markets $43
Baker & Nofsinger, Socially Responsible Finance and Investing $33
Bernstein, The Power of Gold (paperback) $7
Bhuyan, Reverse Mortgages and Linked Securities $19
Brown & Macke, Clash of the Financial Pundits $9
Byers, Blind Spot (stamped “review copy not for resale” on bottom
  edge) $7
Caliskan, Market Threads (stamped “review copy not for resale” on
  bottom edge) $20
Durenard, Professional Automated Trading $39
Edwards, Risk Management in Trading $32
Fabozzi, The Basics of Financial Econometrics $41
Fischer, Investing in Municipal Bonds $9
Fisher, Wall Street Women (paperback) $10
Fox, The Myth of the Rational Market $10
Fraser, Wall Street (2009 paperback) $5
Frush, The Strategic ETF Investor $6
Fung et al., Dim Sum Bonds $28
Hagstrom, Investing: The Last Liberal Art $10
Isbitts, The Flexible Investing Playbook $8
Katsman, Retirement GPS (paperback) $3
Klein et al., Regulating Competition in Stock Markets $22
Kolb, Financial Contagion $30
Kroszner & Shiller, Reforming U.S. Financial Markets (paperback) $4
Malloch & Mamorsky, The End of Ethics and a Way Back $14
Markowitz, Risk-Return Analysis $10
McCann, Tactical Portfolios $31
Phillipson, Adam Smith $10
Piros & Pinto, Economics for Investment Decision Makers $32
Rahemtulla, Where in the World Should I Invest? $4
Richards, Investing Psychology $20
Sanderson & Forsythe, China’s Superbank $20
Sandford, Goals to Gold (paperback) $11
Schneeweis et al., The New Science of Asset Allocation $25
Sklarew, Techniques of a Professional Commodity Chart Analyst $12
Stoken, Survival of the Fittest for Investors $10
Sorkin, Too Big to Fail $5
Syrett & Devine, Managing Uncertainty $7
Toma, The Risk of Trading $24
Triana, The Number That Killed Us $15
Ugeux, International Finance Regulation $33
Warshawsky, Retirement Income (paperback) $8
Weiss, The Big Win $11
Wilcox & Fabozzi, Financial Advice and Investment Decisions $52

Saturday, October 4, 2014

Book sale coming soon

A heads up. To keep my work space from completely closing in on me, I regularly cull my library of books on investing and trading. And so on Monday morning I’m going to put about fifty books up for sale at roughly half their Amazon price. I hope you’ll find something that you need or want on the list.

Wednesday, October 1, 2014

Stein, How to Really Ruin Your Financial Life and Portfolio

Ben Stein has some very charitable friends. Both Warren Buffett and Jim Rogers wrote praiseworthy comments that appear on the back cover of this paperback. (Mind you, he also wrote some nice things about them in the book.) I am not so benevolent.

I don’t normally write about books on personal finance, but I made an exception in this case because I thought it would provide comic relief from my usual fare. After all, the author gave the famous “anyone, anyone” lecture on economics in Ferris Bueller’s Day Off. Of course, even there, without the priceless shots of student reactions to this deadly teacher the scene would simply have been boring.

And so it is with How to Really Ruin Your Financial Life and Portfolio (Wiley, 2014, with new preface). Stein tries to inject some humor into his discussion of finance, but to my mind the book falls flat.

Most of the advice Stein gives the retail investor is decent. But it’s mainstream advice that’s readily available elsewhere at no cost.

If reverse psychology is a powerful motivator, then perhaps this slim book has merit. Otherwise, it’s just one more attempt to explain the merits of buy-and-hold index investing and to expose the problems inherent in picking individual stocks, investing in hedge funds, emulating endowment funds, timing the market, using margin, and not reinvesting dividends. Yawn.