Interview with the World's Most Successful Day Trader
Is eight figures a realistic goal? Yes! It has been done by private own account traders for years.
Paul Rotter from Germany, 32 years old, is one trader that has made €50-60+ million ($65-78 million) per year for 10 years trading the most liquid contracts at the biggest futures exchange in the world, Frankfurts Eurex debt futures, primarily the Bund contract. Paul is arguably the single largest and most succesful individual futures trader on planet Earth, executing trades on the German Eurex exchange primarily in the Bund, but also in the Bobl and Schatz interest rate futures. He trades between 200-300,000 roundturns daily using the X_Trader platform, and clearing through GNI Touch. Every trader can aspire to imitate Pauls success as he is proof that it IS possible for a small trader to build on his success and grow into the biggest most active speculator around. Paul Rotter has made it - he belongs to the best traders in the world and counts as a real big player. he usually does 150 000 rt/d, sometimes up to 250 000 mostly in BUND/BOBL/SCHATZ futures. In the hall of fame of celeb EUREX players he´s top notch end even leaves tom baldwin (bonds) or lewis borsellino (S&P) behind. he had to work ahard to make it. he blew up in the beginning of his career, which was painful but also educational - he learned his lesson and with lots of research, seeking improvement all the time, he became the man.
Q: was there any key event that brought you into the game?
A: no, no key event like 'buying my first stock'. took part in some trading contest while at school.
Q: how did you get to professional trading?
A: when i was apprentice in a german bank i had to work on the DTB (now EUREX) execution desk for several weeks. this attracted me a lot. during that time i was doing gamble trades on my private account, losing pretty much all of it. when it was deeply in the red, i had to leave the bank but shortly after, i was allowed to start trading in a japanese bank. i was very lucky here, since i was allowed to gain knowledge through learning by doing.
Q: did the bank give you any mentor?
A: not, i didnt have one. in the beginning i was exchanging ideas with the chieftrader ajiasaka, who was constantly profitable. he sometimes even hedged the positions of his boss, when he thought that his boss was wrong. i had many conversations about market psychology, which proved to be very helpful, especially after bad losing days.
Q: how was your trading back then? have you been constantly profitable from the very beginning?
A: i was doing 100 - 150 rts a day after a short time...i had no losing month with the first 3 years of my trading. later on with bigger position sizes i took occasional hits, especiallly after EUREX allowed terminals in the US and big players like harris brumfield / chicago were entering the field.
Q: there is a saying that every trader has to completly blow up his account at least once before he can become successful. what did you learn out of it?
A: like i earlier said, my private account saw some bad times during my apprentice in the bank, although i must admit, that back then i had absolutely no idea that there was something like 'risk-managment'.
later on i found 7-digit losses to be cumbering. on day i had a blackout and after losing 2,5 mln € i was seriously thinking about stopping. i still had enough capital left to live without having to worry about financial issues and i just wouldnt want to take those psychological hits anymore. after taking 4 weeks off, i regained my motivation and returned in the ring. i was able to make up the loss in a relatively short period of time, so that i came out stronger than before.
Q: has this changed the views of the market in a way?
A: with the expirience of bigger losing days coupled with good phases right afterwards, i´m not so sensible for losing days anymore. i know that i can make it back. this has lead to being able to switch off the screens on a day with medium/small losses more easily, instead of forcing the way back into positive territory.
Q: what are your strengths as a worldclass trader and where are the differences between you and other traders?
A: it´s the ability to get more aggressive in winning phases, taking bigger risks, and scaling back in losing times. this is against human nature. the best thing is to have somebody around who is neutral to trading, that switches the terminals off, when a certain loss level has been reached for the day.
Q: you are known as a orderbook-scalper, could you please explaining to our readers what you are doing and what your strategies look like? what is your tactic?
A: it´s some kind of market making where you place buy and sell orders simultaneously, making very shortterm trading decisions b/c of certain events in the orderbook (level2). for example, i usually have lots of orders in different markets at the same time, pretty close to the last traded price. the resulting trades are usually a zero sum game, but i get a pretty good feeling for what is going on and then ultimately can make a decision for a larger trade.
Q: how long are you usually in a positon?
A: since i do trend plays very seldom and actually scalp the market, i constantly get fills in different markets on both sides which can cause constantly changing positions for hours. sometimes i change my opinion several times within a couple of minutes, which is not pretty hard for me, since i´m only looking for the next 3-5 ticks.
Q: during your professional career, have you always been a scalper or did you try other strategies (momentum/swing) as well?
A: yes, i have always been a scalper, but i am adjusting my strategies to different market situations all the time. on volatile days i of course have less orders in the market and do more 'single trades', although i ususally hold them only for a couple of seconds.
Q: your strategies only work on electronic exchanges?
A: yes, b/c you cannot handle that much orders in a pit, looking for counterparties and so on. computer exchanges grant faste orderflow and are not as easy to manipulate.
Q: as a scalper, are you trying to run stops?
A: well, yes, but because of the increase of liquidity in the last couple of years, the fast spikes caused by stops are not happening that often anymore. apart from that, that stops often are not where you would suppose them to be, because the other market participants are not silly either or learned their lesson in the past.
Q: what role plays risk-managment in your trading?
A: i set daily goals for my p&l, whereas the most important thing is the stopping limit, the maximum loss i take, before i switch off the screens. my biggest positions are 5 digit number of contracts. i dont use any specific money-management rules.
Q: what are you doing when a position goes against you? are you using stop-loss orders?
A: i striclly close my position when they start going against me. with bigger positions this is not that easy, because i move the market against me, which could cause other traders to get in the same situation like me, which could accelerate the move. however, most of the time i am able to make some of the losses up, b/c i know what caused that move and therefore take the opposite position.
Q: why dont you have any problems with closing out the position and even taking the opposite direction? shouldnt a trader stick to his opinion?
A: no, definetly not. an analyst or some kind of gure has to stick to it, but as a trader you should have no opinion. the more opinion you have, the harder gets it to get out of a losing position.
Q: what role plays market psychology?
A: i constantly try to read the psychologiy of the market and base my decsisions on it.
Q: how do you handle distracting thoughts and emotions?
A: when it gets really bad - taking a cold shower or jumping in a cold swimming pool.
Q: how do you prepare for the trading day? do you follow any routines or do you take it as it comes?
A: before the open i check all the economic reports that are about to be released, speeches of central bankers - simply anything that could move the market. then i try to define important levels in the markets i trade. i do this through my own analysis and through reading analyst commentaries. that´s how i get a picture of the market and its important levels. i am not interested in opinions of other market participants as this would influence my own opinion.
Q: anykind of mental preparation?
A: nothing specific. actually i am motivated all the time...i see trading more as a sporting challange and try to erease the thought of the money.
Q: how many hours do you spend in front of your screens?
A: usually 5 hours, thats when i trade actively...in case of special events i can be up to 11 hours
Q: isnt it hard to spend that much time in front of your pc´s? how do you stay concentrated for such a long time?
A: that is what my japanese colleagues asked themselves as well...well i take it as some kind of game where i forget the time. therefore the real troubles are more physical (eyes) than psychological.
Q: what do you do to calm down / relax?
A: i do lots of sports and take lots of vacations.
Q: what equipment do you use?
A: MD-trader from TT, reuters, bloomberg, CQG and a USD-squawkbox.
Q: why a USD-squawkbox?
A: i use it because €/$ had some effects on the intrest rates over the last couple of months. those effects change, right now it influences oil prices and the DAX.
Q: what timeframes are you using on your charts?
A: usually 5- - 30-min charts for trendlines and indicators. i prefer p&f charts because they give me a clearer view on patterns (triple tops). for indicators i like the CCI because it also shows the volatility of the markets.
Q: do you think is it possible for a single player to manipulate the market?
A: no, in my opinion a single player cannot influence the market around the clock. there are always several big players in the market. take the BUND for example - there are one million contracts traded a day. when a trend starts out of the blue with only slight pullbacks, i could trade against it, but with no effect. i couldnt stop the market from going up, because there would be more money needed that i could bring in. apart from that, so-called 'Analytics' computerized scalpers have made it tougher for me lately. as far as i know they are analysing the behaiviour in the orderbook and create a fully automated system. since they act in several markets at the same time, i think these computer freak come from the fully automated arbitrage- and spread-trading.
Q: what has one to do if he wants to become a scalper?
A: he has to watch the orderbook for a very long time."
Q: What are your strengths as a world-class trader and what are the differences between you and other traders?
A: I have the ability to get more aggressive in winning phases, to take bigger risks, and to scale back during losing times. This is contrary to human nature. The best thing is to have somebody around who is neutral to trading, who switches the screens off when a certain level of loss has been reached for the day.
Q: What role does risk management play in your trading?
A: I set a daily goal for my profit and loss, with the most important thing being the stopping limit, the maximum loss I take, before I switch off the screens.
Q: Shouldn't a trader stick to his opinion?
A: No, definitely not. An analyst or some kind of guru has to stick to it, but a trader should have no opinion. The stronger your opinion, the harder it is to get out of a losing position.
Q: Do you do any kind of daily mental preparation?
A: Nothing specific. Actually I am motivated all the time... I see trading more as a sporting challenge and try to eliminate thoughts of money.
Q: How many hours do you spend in front of your screens?
A: Usually 5 hours, when I trade actively... in case of special events it can be up to 11 hours.
Q: Isn't it hard to spend that much time in front of your PC? How do you maintain your concentration for such a long time?
A: That is something my Japanese colleagues asked themselves as well. I think of it as a kind of game and I forget the time, so the real trouble is more physical (eye strain) than psychological.
Tuesday 8 May 2012
Volume is a measure of how much of a given financial asset has been traded in a given period of time. It is a very powerful tool, but it's often overlooked because it is such a simple indicator. Volume information can be found just about anywhere, but few traders or investors know how to use it to increase their profits and minimize risk.
TUTORIAL: Analyzing Chart Patterns
For every buyer there needs to be someone who sold them the shares they bought, just as there must be a buyer in order for a seller to get rid of his or her shares. This battle between buyers and sellers for the best price on all different timeframes creates movement while longer term technical and fundamental factors play out. Using volume to analyze stocks (or any financial asset) can bolster profits and also reduce risk.
Basic Guidelines for Using Volume When analyzing volume, there are guidelines we can use to determine the strength or weakness of a move. As traders, we are more inclined to join strong moves and take no part in moves that show weakness - or we may even watch for an entry in the opposite direction of a weak move. These guidelines do not hold true in all situations, but they are a good general aid in trading decisions.
Volume and Market Interest A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm in order to keep pushing prices higher. Increasing price and decreasing volume show lack of interest and this is a warning of a potential reversal. This can be hard to wrap your mind around, but the simple fact is that a price drop (or rise) on little volume is not a strong signal. A price drop (or rise) on large volume is a stronger signal that something in the stock has fundamentally changed.
Exhaustion Moves and Volume In a rising or falling market we can see exhaustion moves. These are generally sharp moves in price combined with a sharp increase in volume, which signal the potential end of a trend. Participants who waited and are afraid of missing more of the move pile in at market tops, exhausting the number of buyers. At a market bottom, falling prices eventually force out large numbers of traders, resulting in volatility and increased volume. We will see a decrease in volume after the spike in these situations, but how volume continues to play out over the next days, weeks and months can be analyzed by using the other volume guidelines. (For related reading, take a look at 3 Key Signs Of A Market Top.)
Bullish Signs Volume can be very useful in identifying bullish signs. For example, imagine volume increases on a price decline and then price moves higher, followed by a move back lower. If price on the move back lower stays higher than the previous low, and volume is diminished on second decline, then this is usually interpreted as a bullish sign.
Volume and Price Reversals After a long price move higher or lower, if price begins to range with little price movement and heavy volume, often it indicates a reversal. (See Retracement Or Reversal: Know The Difference for additional information)
Volume and Breakouts Vs. False Breakouts On the initial breakout from a range or other chart pattern, a rise in volume indicates strength in the move. Little change in volume or declining volume on a breakout indicates lack of interest and a higher pro****lity for a false breakout.
Volume History Volume should be looked at as relative to recent history. Comparing today to volume 50 years ago provides irrelevant data. The more recent the data sets, the more relevant they are likely to be.
Volume Indicators Volume indicators are mathematical formulas that are visually represented in most commonly used charting platforms. Each indicator uses a slightly different formula and, therefore, a trader should find the indicator that works best for their particular market approach. Indicators are not required, but they can aid in the trading decision process. There are many volume indicators; the following will provide a sampling of how several can be used.
On Balance Volume (OBV) OBV is a simple but effective indicator. Starting from an arbitrary number, volume is added when the market finishes higher, or volume is subtracted when the market finishes lower. This provides a running total and shows which stocks are being accumulated. It can also show divergences, such as when a price rises but volume is increasing at a slower rate or even beginning to fall. Figure 5 shows that OBV is increasing and confirming the price rise in Apple Inc's (AAPL) share price. (For more on the OBV, see On-Balance Volume: The Way To Smart Money.)
[b]Chaikin Money Flow[/b] Rising prices should be accompanied by rising volume, so this formula focuses on expanding volume when prices finish in their upper or lower portion of their daily range and then provides value for the corresponding strength. When closes are in the upper portion of the range and volume is expanding, the values will be high; when closes are in the lower portion of the range, values will be negative. Chaikin money flow can be used as a short term indicator because it oscillates, but it is more commonly used for seeing divergence. Figure 6 shows how volume was not confirming the continual lower lows (price) in AAPL stock. Chaikin money flow showed a divergence that resulted in a move back higher in the stock. (For related information, see Discovering Keltner Channels and the Chaikin Oscillator.)
TUTORIAL: Analyzing Chart Patterns
For every buyer there needs to be someone who sold them the shares they bought, just as there must be a buyer in order for a seller to get rid of his or her shares. This battle between buyers and sellers for the best price on all different timeframes creates movement while longer term technical and fundamental factors play out. Using volume to analyze stocks (or any financial asset) can bolster profits and also reduce risk.
Basic Guidelines for Using Volume When analyzing volume, there are guidelines we can use to determine the strength or weakness of a move. As traders, we are more inclined to join strong moves and take no part in moves that show weakness - or we may even watch for an entry in the opposite direction of a weak move. These guidelines do not hold true in all situations, but they are a good general aid in trading decisions.
Volume and Market Interest A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm in order to keep pushing prices higher. Increasing price and decreasing volume show lack of interest and this is a warning of a potential reversal. This can be hard to wrap your mind around, but the simple fact is that a price drop (or rise) on little volume is not a strong signal. A price drop (or rise) on large volume is a stronger signal that something in the stock has fundamentally changed.
Exhaustion Moves and Volume In a rising or falling market we can see exhaustion moves. These are generally sharp moves in price combined with a sharp increase in volume, which signal the potential end of a trend. Participants who waited and are afraid of missing more of the move pile in at market tops, exhausting the number of buyers. At a market bottom, falling prices eventually force out large numbers of traders, resulting in volatility and increased volume. We will see a decrease in volume after the spike in these situations, but how volume continues to play out over the next days, weeks and months can be analyzed by using the other volume guidelines. (For related reading, take a look at 3 Key Signs Of A Market Top.)
Bullish Signs Volume can be very useful in identifying bullish signs. For example, imagine volume increases on a price decline and then price moves higher, followed by a move back lower. If price on the move back lower stays higher than the previous low, and volume is diminished on second decline, then this is usually interpreted as a bullish sign.
Volume and Price Reversals After a long price move higher or lower, if price begins to range with little price movement and heavy volume, often it indicates a reversal. (See Retracement Or Reversal: Know The Difference for additional information)
Volume and Breakouts Vs. False Breakouts On the initial breakout from a range or other chart pattern, a rise in volume indicates strength in the move. Little change in volume or declining volume on a breakout indicates lack of interest and a higher pro****lity for a false breakout.
Volume History Volume should be looked at as relative to recent history. Comparing today to volume 50 years ago provides irrelevant data. The more recent the data sets, the more relevant they are likely to be.
Volume Indicators Volume indicators are mathematical formulas that are visually represented in most commonly used charting platforms. Each indicator uses a slightly different formula and, therefore, a trader should find the indicator that works best for their particular market approach. Indicators are not required, but they can aid in the trading decision process. There are many volume indicators; the following will provide a sampling of how several can be used.
On Balance Volume (OBV) OBV is a simple but effective indicator. Starting from an arbitrary number, volume is added when the market finishes higher, or volume is subtracted when the market finishes lower. This provides a running total and shows which stocks are being accumulated. It can also show divergences, such as when a price rises but volume is increasing at a slower rate or even beginning to fall. Figure 5 shows that OBV is increasing and confirming the price rise in Apple Inc's (AAPL) share price. (For more on the OBV, see On-Balance Volume: The Way To Smart Money.)
[b]Chaikin Money Flow[/b] Rising prices should be accompanied by rising volume, so this formula focuses on expanding volume when prices finish in their upper or lower portion of their daily range and then provides value for the corresponding strength. When closes are in the upper portion of the range and volume is expanding, the values will be high; when closes are in the lower portion of the range, values will be negative. Chaikin money flow can be used as a short term indicator because it oscillates, but it is more commonly used for seeing divergence. Figure 6 shows how volume was not confirming the continual lower lows (price) in AAPL stock. Chaikin money flow showed a divergence that resulted in a move back higher in the stock. (For related information, see Discovering Keltner Channels and the Chaikin Oscillator.)
The Core Principles of Scalp Trading
"Speed and fear" is the essence of scalp trading. The most important thing to remember is to protect your capital rather than capturing profits. Always remind yourself to buy and sell quickly and take profit on small price changes. Do not be greedy and do not attempt to bag the elephant. Basically the center assumptions are:
i. A brief exposure to the market lower the chances of running into an adverse event. (See, scalping has the advantage to let you fight greed and let you ride safely during these uncertain time.)
ii. Smaller moves are easier to obtain as bigger imbalance of supply and demand is needed to warrant bigger price changes.
iii. Smaller moves are more frequent than larger ones. Even during relatively quiet markets there are many small movements that a scalper can exploit.
iv. Accept the fact that scalp trader lose in a while. Do not put all your egg in one basket and do not let paper loss scare you off.
v. To benefit handsomely from smaller price moves, you need larger capital.
vi. Your wife is leverage and your best friends are buy/sell queues and volume. Your enemy is greed and your foes are fundamental indicators e.g. PE ratio, intrinsic value.
"Speed and fear" is the essence of scalp trading. The most important thing to remember is to protect your capital rather than capturing profits. Always remind yourself to buy and sell quickly and take profit on small price changes. Do not be greedy and do not attempt to bag the elephant. Basically the center assumptions are:
i. A brief exposure to the market lower the chances of running into an adverse event. (See, scalping has the advantage to let you fight greed and let you ride safely during these uncertain time.)
ii. Smaller moves are easier to obtain as bigger imbalance of supply and demand is needed to warrant bigger price changes.
iii. Smaller moves are more frequent than larger ones. Even during relatively quiet markets there are many small movements that a scalper can exploit.
iv. Accept the fact that scalp trader lose in a while. Do not put all your egg in one basket and do not let paper loss scare you off.
v. To benefit handsomely from smaller price moves, you need larger capital.
vi. Your wife is leverage and your best friends are buy/sell queues and volume. Your enemy is greed and your foes are fundamental indicators e.g. PE ratio, intrinsic value.
6 common investment mistakes.
1. Being Too Conservative
Burned by two severe bear markets within the past decade, many investors are still gun shy. However, allocating the bulk of your portfolio to cash has never been a winning strategy over the long-term. In fact, with cash currently yielding close to zero it can negatively impact your standard of living in an inflationary environment (see our article Beware The Real Cost Of Your Cash Allocation for more on this). If you hold significant amounts of cash, consider reallocating to more productive asset classes without incurring too much additional risk.
2. Stretching for Income or Yield
Perhaps the flipside of the mistake noted above, some investors have searched too hard to find income generating assets. They are often enticed by a high yield, but don’t fully understand the credit risk, interest rate risk, or illiquidity risk they are taking to achieve the projected income on the investment.
For example, many investors were attracted to Auction Rate Preferred Securities (ARPS), but these seemingly safe securities returned in many cases mere pennies on the dollar in the midst of the credit crisis. If income is a priority, consider diversifying yield through sources such as traditional bond funds, MLPs, and emerging markets debt, among others. For example, we include SteelPath Alpha MLP (MLPAX, the first open-ended MLP mutual fund) and Lazard Emerging Income (a limited partnership focused on short-term sovereign debt) as alternative yield drivers in our client portfolios.
3. Timing the Hedge to a Portfolio
During the throes of a bear market many investors substantially increase their allocation to hedge funds or other investments that provide downside protection. By then it is often too little too late and, perhaps more importantly, investors fail to effectively benefit from an eventual rebound. In our view, investors should have downside protection as a core, ever-present part of their portfolios, while also maintaining attractive upside potential. We detailed this “permanent hedge” approach in a prior column (Rethinking Long-only Equity), noting investments such as The Gateway Fund (GATEX) and our own proprietary strategy which uses a combination of ETFs and options to control risk and enhance returns.
4. Having a Portfolio that is Too U.S. Centric
Economists have coined the term “home country bias” to illustrate that investors typically have 90% of their assets in domestic (i.e. U.S.) based investments. However, principles of diversification show that international exposure should be higher than the typical 10% allocation to account for the large percentage of world GDP contribution from overseas markets. Additionally, it is clear the bulk of the growth in this century is coming from the emerging markets. Therefore, it is logical investors should increase their overseas exposure, albeit in a risk controlled fashion. A new fund we like for this is the PIMCO EqS Emerging Market Fund (PEQWX).
5. Owning Too Many Illiquid, Leveraged and Non-Transparent Investments
The endowment model, espoused by Yale and others, sailed along during the 2000-2002 bear market that followed in the Internet bubble, but revealed its inherent weaknesses during the credit crisis, when many endowment funds fell in excess of 30% in 2008. The secret that drove much of their prior success was an overreliance on illiquid and highly leveraged investments, such as private equity funds.
Furthermore, the lack of transparency with many private investments, including hedge funds, makes it difficult for their owners to understand the fundamental drivers of investment results. Hence, many investors were caught off guard as their investments imploded in 2007-2009. In rare, but devastating cases, as with Bernard Madoff, there may be outright fraud. Investors should always favor transparency, liquidity, and lack of leverage in their investment choices. This is especially important when implementing a “permanent hedge” approach as suggested above, as many hedged solutions are inadequately liquid or transparent.
6. Not Risk-Adjusting Investment Returns
The oft repeated maxim “there is no such thing as a free lunch” has proven its sagacity over many decades. High returns are almost inextricably tied to high risks, but these risks often have not yet manifested themselves. Investors should compute risk-adjusted returns for all of their investments. Furthermore, risk should not simply be tied to historical volatility. Prospective or concurrent measures of risk, such as liquidity, leverage, drawdown potential and transparency, should also be incorporated in any thorough analysis. Inflation is also a risk factor many investors neglect to consider. Funds such as the new Loomis Sayles Multi-Asset Real Return fund (MARYX) aim to mitigate the risk of inflation on purchasing power.
Burned by two severe bear markets within the past decade, many investors are still gun shy. However, allocating the bulk of your portfolio to cash has never been a winning strategy over the long-term. In fact, with cash currently yielding close to zero it can negatively impact your standard of living in an inflationary environment (see our article Beware The Real Cost Of Your Cash Allocation for more on this). If you hold significant amounts of cash, consider reallocating to more productive asset classes without incurring too much additional risk.
2. Stretching for Income or Yield
Perhaps the flipside of the mistake noted above, some investors have searched too hard to find income generating assets. They are often enticed by a high yield, but don’t fully understand the credit risk, interest rate risk, or illiquidity risk they are taking to achieve the projected income on the investment.
For example, many investors were attracted to Auction Rate Preferred Securities (ARPS), but these seemingly safe securities returned in many cases mere pennies on the dollar in the midst of the credit crisis. If income is a priority, consider diversifying yield through sources such as traditional bond funds, MLPs, and emerging markets debt, among others. For example, we include SteelPath Alpha MLP (MLPAX, the first open-ended MLP mutual fund) and Lazard Emerging Income (a limited partnership focused on short-term sovereign debt) as alternative yield drivers in our client portfolios.
3. Timing the Hedge to a Portfolio
During the throes of a bear market many investors substantially increase their allocation to hedge funds or other investments that provide downside protection. By then it is often too little too late and, perhaps more importantly, investors fail to effectively benefit from an eventual rebound. In our view, investors should have downside protection as a core, ever-present part of their portfolios, while also maintaining attractive upside potential. We detailed this “permanent hedge” approach in a prior column (Rethinking Long-only Equity), noting investments such as The Gateway Fund (GATEX) and our own proprietary strategy which uses a combination of ETFs and options to control risk and enhance returns.
4. Having a Portfolio that is Too U.S. Centric
Economists have coined the term “home country bias” to illustrate that investors typically have 90% of their assets in domestic (i.e. U.S.) based investments. However, principles of diversification show that international exposure should be higher than the typical 10% allocation to account for the large percentage of world GDP contribution from overseas markets. Additionally, it is clear the bulk of the growth in this century is coming from the emerging markets. Therefore, it is logical investors should increase their overseas exposure, albeit in a risk controlled fashion. A new fund we like for this is the PIMCO EqS Emerging Market Fund (PEQWX).
5. Owning Too Many Illiquid, Leveraged and Non-Transparent Investments
The endowment model, espoused by Yale and others, sailed along during the 2000-2002 bear market that followed in the Internet bubble, but revealed its inherent weaknesses during the credit crisis, when many endowment funds fell in excess of 30% in 2008. The secret that drove much of their prior success was an overreliance on illiquid and highly leveraged investments, such as private equity funds.
Furthermore, the lack of transparency with many private investments, including hedge funds, makes it difficult for their owners to understand the fundamental drivers of investment results. Hence, many investors were caught off guard as their investments imploded in 2007-2009. In rare, but devastating cases, as with Bernard Madoff, there may be outright fraud. Investors should always favor transparency, liquidity, and lack of leverage in their investment choices. This is especially important when implementing a “permanent hedge” approach as suggested above, as many hedged solutions are inadequately liquid or transparent.
6. Not Risk-Adjusting Investment Returns
The oft repeated maxim “there is no such thing as a free lunch” has proven its sagacity over many decades. High returns are almost inextricably tied to high risks, but these risks often have not yet manifested themselves. Investors should compute risk-adjusted returns for all of their investments. Furthermore, risk should not simply be tied to historical volatility. Prospective or concurrent measures of risk, such as liquidity, leverage, drawdown potential and transparency, should also be incorporated in any thorough analysis. Inflation is also a risk factor many investors neglect to consider. Funds such as the new Loomis Sayles Multi-Asset Real Return fund (MARYX) aim to mitigate the risk of inflation on purchasing power.
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