Tuesday, July 01, 2008

Coaching Hedge Fund Portfolio Managers: Bursting the Myths of Trading Psychology

In my recent post, I passed along four things that I have learned from serving as a trading coach for hedge fund portfolio managers. This post takes a different perspective, identifying several trading psychology "truths" that I have had to unlearn as a result of working with experienced professionals. Here are a few myths I've had to dump along the way:

1) Success is Largely a Function of Psychology - Simply not true. The portfolio manager generally has a core strategy that is implemented in different markets and/or across different instruments. This means juggling large amounts of information over time and viewing markets multidimensionally for opportunity, extracting themes from the relative movements of national markets and asset classes. Success is a function of information, creative thinking with that information, a deep understanding of what moves markets, and experience with different market conditions. Only when those are present does psychology matter.

2) A Good Trader Is One Who Makes Large Returns - Those who make large returns with large risks are tomorrow's casualties. In the hedge fund world, you lose investors if you cannot rein in risk. It's the ability to generate consistent, significant risk-adjusted returns--not just large absolute returns--that matters in the long run. Successful portfolio managers don't just look at daily profitability. They actively evaluate the correlations among their positions, their levels of risk, and their shifting horizons of risk/reward.

3) Execution Is a Huge Part of Success - When you have hundreds of millions of dollars or more to invest, you don't just click a mouse and enter a full-sized position. You scale into positions over time so as to not disrupt markets and so as to obtain good prices. Similarly, you can't just exit many positions all at once when you have large portfolios, particularly when some of your positions are in markets that have limited liquidity. This is where the management part of portfolio management becomes crucial.

4) Opportunity is Limited - There are plenty of markets to invest in if you have 15 million dollars. It is more challenging to find opportunities for 15 billion dollars. Firms are in a constant race to find new markets, new spheres of opportunity. This lies behind the development of the latest quantitative trading models and the development of frontier investment opportunities. For a daytrader, markets are always moving and there's always a trade around the corner. Not so in the larger world of money management. Much of the long-term success of large hedge funds hinges on their ability to push the opportunity envelope and cultivate new sources of edge.

I sometimes receive mail from traders asking me how they can break into the hedge fund world. Success at portfolio management is not simply a larger version of success at trading individual markets directionally. It's a different game, with a different thought process. Not many traders get that and, sadly, neither do many would-be coaches.


Three Myths of Trading Psychology

Resilience and Success


Krish Rathi said...

Doc, long time follower. This was one of the more beautiful posts you have written and i was blown away by the lucidity and precision of some of the points you have made. I agree it makes sense to scale into and scale back from big positions when it comes to money management. However the part where I get confused is - isn't this all really investing as opposed to trading? Even if that is classified somehow as trading, in general, when you have a portfolio of the size of billions of dollars, wouldn't longer term investing fetch you more returns than short term to intermediate term trading?
Krish Rathi

Tony said...

Krish, The difference is between "day", "swing" and "position" traders and the psychology as well as adrenaline levels are a bit different for the various time frames.

I think it's possible to be successful at all three types of trading to a certain degree.

I agree that this post and the related ones referenced at the bottom are especially useful.

Mark Wolfinger said...

Excellent post.

The most surprising part to me is that professional hedge fund managers are willing to accept coaching. I would have guessed that large egos would have prevented them from seeking guidance.

Brett Steenbarger, Ph.D. said...

Hi Krish,

I find that the investing vs. trading distinction can be a bit fuzzy at hedge funds. There are active portfolio managers who are trading every day and there are ones with much longer horizons. But, yes, as a rule, it's tough to daytrade billions of dollars in a discretionary manner.


Brett Steenbarger, Ph.D. said...

Hi Mark,

Interestingly, I find very few ego maniacs in the hedge funds I work with. They never make the cut. It's a little more common, in my experience, to find some of those folks in bank settings. Even there, though, the level of professionalism is quite high overall.