Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

Michael Covel said it well in Trend Following: 

There are only a limited number of Fed meetings a year; however, this is supposed to help us infer the direction of interest rates and help us manage risk on a daily basis. How do you manage risk in markets that move 24 hours a day, when the fundamental inputs do not come frequently? In the grain markets, crop reports are fairly limited, and demand information comes with significant lags, if at all. How can this information be best incorporated in the daily price action? Under these types of conditions, simple approaches, such as following prices, may be better.

Source: Covel, Michael W. (2009). Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets, (Kindle Locations 1489-1493). FT Press. Kindle Edition.

This is an outstanding presentation by Dan Gilbert about expected value and  potential errors in calculating it. Gilbert first explains the expected value equation:

Expected Value = (Odds of a Gain) x (Value of a Gain)

If we can estimate and multiply these two things we will always know what decision to make - how to make the "good bet". Of course, these things are probabilistic, never certain.Many people don't think their decisions are a bet or gamble at all - they assume they can be right, so they don't consider what may happen if they are wrong. They are the people who have unexpected bad outcomes and they're unprepared for them.

There are errors in estimating the odds of an outcome and errors of estimating the value of the outcome. Gilbert goes on to explain the behavioral errors in these estimations.

Expected value is the little-known foundation of tactical decision-making in portfolio management. To be a great portfolio manager (among the few with a real edge) one must have a system of decision making that uses the probabilistic nature of outcomes to create a positive expectancy portfolio management process. That is, a method for entry, exit, and bet size that results in greater average profits than average losses. It isn't about stock picking or perfectly timng the market - it's about generating larger average profits than average losses that leads to a positive asymmetric imbalance between the two. The pursuit is one of magnitude (size of the profit) not frequency (probability). Those two make up the expected value equation.Once a person grasps what this means to portfolio management, then you have to figure out all the ways you'll play games with youself in creating the expectation. If you get beyond those errors and illustions then you may find an edge: average profits > average osses that looks like the graphs on the top of this page.

A hat tip to John Kopp for sending me this video.

http://www.ted.com/talks/dan_gilbert_researches_happiness.html

So says David Wilson at Bloomberg in his recent article: Extreme Pessimism Sets Stage for U.S. Stock Rally: Chart of the Day

He offers a nice chart showing two sentiment polls and explains:

The CHART OF THE DAY displays the results of weekly surveys by the National Association of Active Investment Managers and the American Association of Individual Investors since the beginning of 2009. Each appears in a separate panel.

This week’s reading for the manager index was 13.47, the lowest since March 2009, when the latest bear market in stocks ended. Survey responses can range between 200, indicating that managers are borrowing to profit from stock-market gains, and minus 200, showing the use of leverage to bet against shares.

The top panel tracks the active-manager readings, and the bottom panel shows the percentage of bulls among respondents to the survey of individual investors. The latter dropped this week to 20.9 percent, also the lowest level in 16 months.

Source: Extreme Pessimism Sets Stage for U.S. Stock Rally: Chart of the Day, Bloomberg.

Of course, investor sentiment is a topic I've mentioned a lot the past few months since it has swung from one extreme to another. Back on April 27th, before the -17% decline in market indexes, I posted Crowd Sentiment is Optimistic: No Surprise to See at Least a Short Term Price Decline. Investor optimism had hit an extreme optimistic level, and sure enough it preceded declining stock prices. As evidenced by sentiment polls like those in the chart, since stocks have now fallen the optimism changed to pessimism. We've also seen a lot of magazine covers with bearish tones, for example, the one I mentioned in Magazine Cover is a Bullish Signal for Crowd Sentiment.

As I've mentioned before, in order for prices to reverse back up to a new rising trend, buying demand simply needs to overcome selling pressure. These sentiment polls continue to show that investors, both professional and individuals, feel negative about the direction of the market. As their sentiment gets to an extreme they tend to over-react, eventually driving prices low enough to attract buying demand from those of us who raised cash when the crowd was extremely bullish.

However, there is no better measure of investor sentiment than the current direction of prices. As I've stated previously, sentiment alone isn't the best signal. The crowd can be right for some time. Sentiment can always get more extreme. Sentiment is confirming evidence of price action - don't fight the tape. The actual price direction is the judge and the jury, so that's our main guide. It appears in the days ahead we'll likely see if sentiment is negative enough to set the stage for a continuation to the upside, or if prices need to go lower to attract sustained buying interest.

On May 28th I posted the cover of The Economist magazine that pictured a shark swimming in the water with the headline "Fear Returns: How to avoid a double dip recession". I called that post Magazine Cover is a Bullish Signal for Crowd Sentiment suggesting the negatively toned magazine cover may be a positive. You see, by the time information hits the cover of the magazine and the public hears it, it isn't "new" anymore. Their sentiment is a countertrend indicator. We give a hat tip to Lee Edgcomb for pointing out another bearish magazine cover just released. Below we show the cover of Bloomberg Businessweek. Of course, for our purposes we are only making reference to the cover, not the content. The article was written by Jessica Silver-Greenberg and can be read in the link below the cover.

Source: http://www.businessweek.com/magazine/content/10_25/b4183048417437.htm

I have empirical evidence that bearish magazine covers like these often mark the lows of a stock market correction and bullish covers are seen at peaks. I say this because I've witnessed it enough times in the past 15 years that it's become a contrary sentiment indicator for me. It's simply an indication of sentiment as the editors of these magazines are no more on the right side of the trend than the average person. We give another hat tip to Nicholas Manley, who is a student at the University of Richmond, who reminded me of a study completed by some professors at his school. Tom Arnold, CFA, John H. Earl, Jr., CFA, and David S. North found: “Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance.” To learn more about this study, read: Are Cover Stories Effective Contrarian Indicators?

As you will hear me say often: "If we are to have an advantage in the market, we necessarily need to do things others aren't. About 80% of the time, I'm going to do the complete opposite of the thing you think I should be doing". For me, that means I'll be going with the flow in the direction of the trend until its end when the sentiment gets to an extreme when I'll perk up in preparation for the trend to reverse. When it does, so do I...

Speaking of trend, I guess with the recent sentiment showing a lot of fear it is no surprise to see today's 2%+ rise in the popular stock indexes. You see, a reversal of the downtrend since April will occur once those who want to sell have sold and buying demand overcomes the selling pressure. It's a good time to offer an update from what I wrote on May 25th: A Follow Up on the Stock Market… and a Word on Loss Traps and Risk Management and Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend (when you see the words are a different color, that means you can click on them to revisit the prior post).

You should probably revisit the prior comments to understand what the chart below says about "now". As you can see, today's action was a breakout to the upside, so we now at least have a higher high in the short run. It appears more likely this price may continue to advance for a while. The relatively high level of fear among investors recently seems to support that hypothesis. We'll see...

As a follow up with yesterday's comment "Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend "... so far, so good. As you can see in the chart below, the February lows held today. The stock indexes were down 2-3% most of the day. But by the day's end, the selling pressure dried up. The index closed very close to yesterdays closing price. For those who are looking for a reversal up, you "may" be in luck soon. I say this because of today's price action.

If you look at the blue arrows, those are called a "Hammer" on a candlestick chart. The Hammer is a common bullish reversal pattern that forms after a decline. It's common enough that a Hammer marked the February low. In addition to a potential trend reversal, hammers can mark bottoms as it did in February. The height of the candle shows the wide high to low price range that traded today as sellers drove prices lower during the session but buyers stepped in at the end of the day and took over. Hammers are similar to selling climaxes. We'll want to see confirmation, which could be a gap up in the days ahead. For prices to reverse back up, the selling pressure that drove it down simply needs to be overwhelmed by buying demand. For that to occur, prices have got to get to a low enough level to attract buying interest.

 Chart courtesy of eSignal Pro

Times like these can be very difficult for the passive investors who remain fully invested all the time. They are caught in a loss trap and don't know for sure how long it may last or how deep the losses may get. If the current price range does not hold support (the red highlighted area on the chart) and reverse up, the pressure will get stronger and stronger as their losses mount. There is also a possibility that stocks could reverse up for a few days or weeks and then reverse down to eventually break the February lows. From that point, it could keep going to the March 2009. Anything is possible. This is why, at Shell Capital Management we actively manage our risk by increasing and decreasing exposure to the possibility of loss... When prices are peaking out or start reversing down and volatility is rising, we exit weak positions systematically to reduce our exposure to loss. The market isn't the risk. The risk is the exposure. If we have no exposure, we have no risk. Our risk control system is a huge advantage for us. It allows us to control our risk to a maximum amount we're willing to take as we aim for capital gains. You see, we can't fully hedge or eliminate our risk all the time and expect to earn a profit. We aren't unwilling to take any risk at all. We must employ "some" risk in order to have profit potential. In order to earn a profit, we need exposure to some degree at some point. What we do differently is control the "degree of exposure" and the "point". We only want exposure when the odds are overwhelmingly in our favor. We do it by buying and selling things...

As it turns out, we have something in common with many of the most famous investors in the world. The following statement was written by Warren Buffett in a 2003 "Letter to the Shareholders of Berkshire Hathaway".

 

When we can’t find anything exciting in which to invest, our “default” position is U.S. Treasuries, ... Charlie and I detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton.*

It appears that Mr. Buffett, like us, has an objective of absolute returns ...

We like avoiding large losses on our portfolio (as defined by -15% or more). We like not having to "worry" if this Hammer is indeed a setup for a reversal, or not. We reduce our exposure to loss to an acceptable level and then go with the flow...

 *Source: http://www.berkshirehathaway.com/letters/2003ltr.pdf