Improving Trading Skill: Part 1
Foundation Series
Thank you for reading our Substack! This has been a lot of fun so far, and I'm excited about our Twitter Spaces tomorrow. We will share some news on what our team has been working on. Make sure you check it out below:
Friday Funday: Public Research Project
Trading is similar to an athletic pursuit. It takes deliberate practice to improve. Athletes improve by creating a training program and being disciplined enough to execute the prescription daily. Our goal should be to pursue peak performance, which can only be done when we deliberately practice and improve.
Most of the time, trading and finance is treated like a field that can't be learned or practiced. Trading is a Blackbox, it can feel like a big secret that everyone, but you is succeeding. Trust me, it is just mental masturbation to look good in the community. You mainly see this where individuals create a thesis based on elaborate macro musings to sound smart or try to be a "contrarian." I hate those two types of people in finance because they’re trying to display they have an edge, but they don't even know their edge. This is why they must write long papers explaining the trade, use elaborate option structures to express a view, or be "contrarian" because "the crowd is always wrong." It is all to be part of the high finance society! It is just a trap, and remove those people from your Twitter feed.
My goal here is to remove all excuses from improving your edge and provide an action plan with steps so that you can improve. These steps are from a book, Managing Equity Portfolios, by Michael A. Ervolini.
Managing Equity Portfolios Summary:
Managing Equity Portfolio discusses the importance of managing equity portfolios effectively by improving trading skills. It emphasizes the role of behavior, deliberate practice, mental models, and decision-making processes in enhancing investment performance. The text also highlights the risks associated with an optimistic bias, the importance of objective decision-making, and the need to love the investment process, not just the stocks held.
Your Action Plan Overview:
Develop a deliberate practice plan to improve decision-making skills and build mental models of market conditions and asset types.
Implement a checklist to strengthen decision-making processes and ensure investment decisions reflect the desired rigor.
Be aware of optimistic bias and avoid focusing on uniqueness when developing investment theses.
Approach investment decisions objectively, considering both the potential for gain and loss.
Develop a process-oriented mindset and focus on loving the investment process rather than specific stocks.
Focus on identifying the combination of attributes that describe successful investment choices and sort through overwhelming choices to identify maximizing options.
Improving the Right Way:
"Be a King. Dare to be different; dare to manifest your greatness."
-- Jaachynma N . E . Agu, The Prince and the Pauper
Project 1: Embracing the Scientific Method
Improving intuition requires training your automatic responses to propel you toward intended outcomes, not unintended ones. The scientific method can be adapted for portfolio management to improve intuition.
Action Plan:
Delineate choices: Understand when intuition is used, which is when an idea or choice is required.
Capture data: Collect data in a simple way that can be sustained. Use accounting, trading, and performance measurement systems for some information, but collect more specific data to connect intuition to skills or choices.
Analyze: Evaluate choices using the framework described in Chapter 3, starting with constructing visualizations that depict choices and outcomes together.
Draw up an improvement plan: The plan should be simple, fact-based, and emotion-based, including reminders and feedback.
Implement the plan: Successful implementation requires process and internal fortitude. Refine processes using checklists for critical decision points.
Project 2: Maintaining a Diary
Summary: Conventional portfolio management tools like accounting, performance measurement, and risk management provide feedback about outcomes but say nothing about the decisions that produced the outcomes. To improve, managers should maintain an investment diary.
Action Plan:
Start maintaining an investment diary.
Write down the decision-making process for each trade or investment.
Record the reasons for buying, selling, or holding a security, including research and analysis.
Include thoughts and emotions during the decision-making process.
Review the diary regularly to identify patterns and areas for improvement.
Project 3: Accounting for Skill
Summary: The three basic skills managers use to generate excess returns are buying, selling, and position sizing. To improve performance, managers should measure their skills and identify areas for improvement.
Action Plan:
Identify names: Identify all positions in the portfolio that had an active portfolio weight as of the first day of the current quarter.
Identify new buys: New buys consist of all positions in the portfolio with an active portfolio weight on the first day of the current quarter but not on the first day of the previous quarter.
Establish the buy portfolio: The buy portfolio includes all stocks whose names appear in any new buys in the current quarter or any prior seven quarters.
Compute various skill measures for the identified names and buy a portfolio.
Use the rolling one-year name return to compute sizing and selling skills.
Project 4: Dealing with Uncertainty
Summary: Uncertainty is inherent in investing and can cause anxiety and stress. Managers should prepare for various scenarios and have a contingency plan to deal with uncertainty.
Action Plan:
Prepare for various scenarios: Identify potential market events and the likely impact on investments.
Develop a contingency plan for each scenario: Decide on a course of action for each scenario and establish triggers for executing the plan.
Revisit and update the plan regularly: Market conditions change, and the contingency plan should be adjusted accordingly.
Project 5: Managing Risk
Summary: Risk management is an essential part of portfolio management. To manage risk effectively, managers should have a risk management framework.
Action Plan:
Identify and measure risk: Identify the types of risk present in the portfolio and measure their impact on the portfolio.
Establish risk limits: Determine the acceptable risk level and limits for each type of risk.
Monitor risk: Monitor the portfolio regularly to ensure risk limits are not breached.
Take corrective action: If risk limits are breached, take corrective action to bring the portfolio back within acceptable levels of risk.
Project 6: Calibrating Sizing
Summary: This project aims to evaluate a portfolio manager's sizing skills for high- and low-conviction positions by comparing the actual returns of actively weighted positions to the returns of a passive portfolio with equal position weights. The project also analyzes the manager's high- and low-conviction sizing skills by creating two alternate name portfolios and comparing the returns to the actively weighted positions.
Action Plan:
Calculate the basic or overall sizing skill by subtracting the rolling one-year name returns from the rolling one-year actual returns.
Create a second name portfolio comprising only high-conviction names and calculate high-conviction sizing skills by comparing its returns to the actively weighted positions.
Create a third name portfolio comprising only low-conviction names and calculate low-conviction sizing skills by comparing its returns to the actively weighted positions.
Compute the difference between the returns of the name portfolio and the low-conviction name portfolio to determine whether the manager is skilled at picking the correct positions to underweight.
Project 7: Checklists
Summary: This project emphasizes using checklists to improve processes and avoid avoidable mistakes. It suggests building in speed bumps to slow down and draw into consciousness information appropriate to the immediate challenge.
Action Plan:
Develop a checklist that includes all the critical steps for each task.
Implement the checklist in the workflow to ensure that all steps are completed in the proper order.
Continuously update the checklist as new steps are added or existing steps change.
Encourage team members to provide feedback on the checklist and suggest improvements.