Sunday, April 12, 2015

The Three Paths to Success in Financial Markets

I propose that there are, at root, three basic paths to success in financial markets that correspond to three kinds of market participants.  These are very different approaches to markets and require quite different skills, knowledge, and talents.

The first path to success in markets is the path of the statistician.  The statistician is one who identifies the probabilities of outcomes as a function of current and past conditions.  A statistician, for example, might notice that two currencies are trading out of line with each other because of temporary flows attributable to mergers and acquisitions and place a bet that these will return to their historical relationship.  The idea for the statistician is to construct a portfolio that consists of many distributed bets, each of which has a favorable probability of paying off.  

The second path to market success is the path of the theorist.  The theorist is a big picture thinker who identifies an antecedent set of conditions that, over time, should drive the price movements of financial assets.  Macro money managers, those who look at geopolitical events and macroeconomic developments such as central bank policy shifts, are classic examples of theorists.  Their approach to markets is top down:  understand the big picture and then define a diversified set of bets from that understanding.  For instance, the theorist will notice that central bank policies are notably more dovish--providing more liquidity--in some countries than others and will buy stocks in those countries and sell stocks in the more hawkish regions.

The third path to success in financial markets is the path of the trader.  The trader is a pattern recognizer who exploits quick-developing shifts in sentiment, supply/demand, and relative movement.  A trader, for example, might notice that episodes of selling pressure in a a few, visible large capitalization stocks are not accompanied by significant selling pressure across the broad market.  When the selling slows down in the large caps and the broad market begins to catch a bid, the trader quickly joins that reversal for a move higher in the broad index.  Diversification is achieved, not necessarily by making many independent, simultaneous bets, but by making many independent short-term bets over time.

These three paths are extremely different.  Whereas the theorist is deductive in thinking, moving from big picture understanding to individual trades, the trader is inductive, noticing relatively minute patterns in order flow or price movement and generating trade ideas from those.  The statistician is highly analytical in a quantitative way, emphasizing prediction.  The theorist is more interested in a synthesis of information to achieve understanding.  The trader is more likely to be adept at intuitive pattern recognition--in Kahneman's terms relying on fast, rather than slow thinking.

These differences call on very different skill sets, knowledge bases, and personality strengths.  The action orientation of the trader is quite different from the analytical, cerebral orientation of the statistician.  The theorist needs confidence in his or her big picture understanding of the world.  The statistician relies on objective odds to take subjective appraisal entirely out of the trading process.  Statisticians gain expertise from intensive quantitative research; theorists gain expertise from the qualitative assembly of many different facts and trends; traders gain expertise from immersion in market patterns.

While it is popular to speak of "hybrid" traders that combine elements of these different paths, my experience is that a successful combination of approaches is much less common than is typically recognized.  Indeed, it is much more common for trading problems to emerge:  a) when market participants don't clearly identify their path to success and hence meander among different approaches; and b) when they attempt to blend paths and ultimately don't play to their strengths.

A classic example of this is when big picture macro traders become overly concerned with limiting their risk and end up behaving like short-term traders.  Similarly, statistical, quantitative traders can allow their priors to bias their research processes, skewing their results over time.  Traders with a good feel for markets can suddenly trade in tone deaf ways when they become locked into big picture views.  What generates success for one path can undermine success in the others.

Many market participants fail over time because they lack a consistent path to success and because they lack the self-understanding to chart the path that is right for them.  In markets as in relationships, success often requires a commitment to one path and a willingness to leave other ones behind.

Further Reading:  Three Winning Trading Practices