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What kind of horse are you going to catch (if you can)? If you are like me, you’ll agree that the question is an important one that should take into account all contributing factors.
Let’s start by identifying the following critical constraints:
• Market conditions are both dynamic and unpredictable. Sometimes they’re good and sometimes they’re bad; and it’s very difficult to know one from the other—at least until after the fact. Conditions also change rapidly and without warning.
• Market participants have finite resources, most notably those associ- ated with time and the ability to sustain losses.
Given, then, that you are operating with limited resources in a universe where the quality of the environment is difficult to measure and constantly shifting, I believe that your goal setting must take into account a number of possible outcomes. At one end of the spectrum, there’s certainly noth- ing wrong with thinking expansively, and I’d be the last to argue against setting ambitious objectives simply because difficult obstacles may stand in the way of your attaining them. However, part of your planning should also reflect the fact that the markets themselves may limit your upside and that no set of objectives would be complete if they fail to contemplate cap- ital preservation under difficult if not disastrous circumstances.
To reinforce these points, I recommend the setting of not one but three sets of objectives:
1. Optimal Target Return. This is the amount of profit that you are shooting for if everything (i.e., external market conditions and internal account management) goes right. Your profit figure should typically be high enough that you will have to stretch your skills to reach it, but not so high as to be inherently self-defeating.
“Too low they build, who build beneath the stars,” said the English poet Edward Young in Night Thoughts. I’m not sure that this is always true for the science of portfolio management and trading; but then again, maybe I’ve been on the risk management side of the business for too long.
2. Nominal Target Return. This figure should be fixed at the amount of revenues that you feel confident you can achieve under almost all mar- ket circumstances and below which you will acknowledge that some- thing may have gone wrong with your plan, thereby allowing for sub- sequent critical analysis.
3. Stop-Out Level. Perhaps the most important parameter of all, this figure is the amount of loss at which you commit to a complete
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liquidation of your portfolio—and is a figure that you must commit not to exceed.
Because these objectives will serve as critical benchmarks, not only in judging overall performance but also in terms of evaluating the efficiency with which you are managing your resources, I discuss each in further detail.
OPTIMAL TARGET RETURN
Another righteous English poet, Robert Browning, said (in Andrea Del Sarto), “Ah, but a man’s reach should exceed his grasp, or what’s a heaven for?” Each year (or other applicable period of your own choosing), it’s almost certainly a good idea to set a performance goal that is sufficiently aggressive as to represent a major accomplishment if you are able to achieve it. While this might raise a few eyebrows among my brethren at the Temple of the Risk Averse, I am willing to accept their derision because I feel that the setting of an Optimal Target Return is an ideal start- ing point for the formation of a plan of attack for any upcoming trading cycle.
If you’re going to be at your best in this difficult project, it’s pretty important for you to challenge yourself. You really have no choice but to try to become better at this game, as you are not likely to remain at the same level of investment competency for very long. By definition, either your skill set is improving or it is eroding. If you want to succeed, you must continually push yourself.
Even if you are making more money than you ever imagined and/or have accumulated more capital than you can envision spending, if you wish to continue on in the business of trading, it will be necessary to reach for performance objectives that are beyond your grasp,if nothing else as a means of ensuring that you don’t fall into a comfort zone that may be harmful to your longevity in the markets.
How does the setting of an ambitious performance objective help ensure that your trading skills continue to improve, as opposed to erode?
Among other factors, the mere process of setting the high target will force you, if you are not given to introspection, to carefully examine every aspect of your trading in order to identify potential areas of improvement.
In particular, if you are comfortable that in a given cycle you are likely to make $X and then set your target level of return to, say, between 125 per- cent and 150 percent of $X, you will simply not have any alternative other than to take a look at every individual associated subprocess in order to find sources of potential efficiency improvement and scalability.
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Indeed, while the market superstars I have known are as diverse a group as the United Nations General Assembly, they all have in common the setting of aggressive performance goals. At least once a year (more fre- quently if necessary), they use the exercise of setting the optimal target return to undertake a full-scale evaluation of their programs and to make whatever changes they deem necessary to help them achieve their lofty objectives. Again, the underlying objective here is to continue your pro- fessional growth so as not to fall into a trap of stagnation that can lead to regressive behavior and deteriorating performance.
How does this reengineering process occur? What forms can it assume? Obviously, this will vary from situation to situation. Following is a list of four analytical steps that you might begin to take, which may pro- vide great insights into the best means of achieving goals that you may believe are currently outside your grasp.
1. Critical Self-Assessment of Performance during Previous Cycle.
The first step in the evaluation process should be a review of your performance over the recent past. Here, you should begin by looking at everything that touches your trading/investing process, from the quality of market opportunities to the physical environment in which you are operating. How were the markets last year? Were you satis- fied with your performance in light of these conditions? Which opportunities did you make the most of and which did you miss?
What component of your performance can you honestly attribute to good luck, to bad luck? Given all of this, what would you have done differently?
2. Review of Current Conditions. The next step is to take a very close look at the current characteristics of your trading environment. Here again it is important to evaluate both market-based factors and situa- tion-specific factors. Note that the purpose in doing so is to create an objective and realistic backdrop for your strategic market initiatives, not to force yourself to generate a “market call.” If your market call is good enough, you will need little in the way of trading technique in order to be successful; and you will not find very much in this book or any other trading manual that would create much of an additional impact. Most of us are weak in this area, and we know it; so it’s impor- tant to develop as careful an understanding of the prevailing condi- tions as is practical.
Focus here on qualitative factors. Are the markets trending or choppy? What types of participants are increasing their activities?
What types are reducing capital usage or bailing out altogether? How is all of this impacting the market’s liquidity and volatility? Answer these questions as objectively as possible. Now, try to assess how the
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associated answers are likely to present themselves—in the form of opportunities and obstacles to optimal performance.
It is also important to review the more immediate external factors associated with your trading. How comfortable are you in your physi- cal trading environment? How is your relationship with those immedi- ately around you and with your supervisor or capital provider? What are the best and the worst elements of this setting, in terms of associ- ated prospects for maximizing your performance?
3. Formulating an Action Plan. Once you have completed the review of recent performance and current external environment, you are in a very strong position to figure out the adjustments necessary for you to operate on the higher plateau that the optimal target return concept demands. If all is going well, the key factor here might be an increase of your trading size, intensity level, and/or support resources. If, how- ever, you have experienced a recent history of trading at levels below your optimal expectations, other more rudimentary changes may be in order. For example, you may have to commit to structural changes in your trading behavior (a concept we will discuss in further detail), to a rethinking of your day-to-day operating modes, or to other similar adjustments. Maybe you are simply not working hard enough. Maybe you’re overdoing it. Whatever the case may be, it will be up to you to identify the opportunities for improved performance, to formulate a plan, and to put it into action.
Finally, with respect to optimal target return, I should mention that in some cases this figure may justifiably be set at levels below his- torical performance. This would be particularly true in cases where recent returns have been suboptimal and/or erratic or where a trader’s market environment has changed sufficiently to warrant a downgrade of expectations. The point is to identify a performance target level that will take you out of the zone of comfort and into that of challenge and to build your trading program around this objective.
4. Masters and Their Master Plans. I’ve actually been amazed at the effort that I’ve seen superstar traders put into this goal-setting busi- ness. After awhile, it started to make more and more sense. Most of them are introspective by nature and are always tinkering with various aspects of their portfolio approach. However, these efforts are minor compared to the all-encompassing, top-to-bottom analysis that takes place in very solemn fashion for nearly all of these guys at the end of each year. While this analysis is typically very scientific, the goal- setting part of it is often not. For one thing, the figures they set tend to be positively astronomical. For another, the actual numbers at which they arrive have a ritualistic quality to them that varies in its origin from one to the next. One guy might like nice round figures, so his
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targets always have multiple zeros at the end. Another trader I’ve observed adds the amount he’d like to give to charity (increasing each year at an increasing rate) to the amount he anticipates his wife will spend (rate of acceleration even higher still) to determine the amount he needs to make. Sometimes, if he meets or exceeds his revenue pace, he has been known to prod his wife to spend even more so the bar can be set even higher.
Once the superstars have the appropriate number in mind, they have to figure out how to get there, and this involves focusing on ques- tions like: How good are markets likely to be next year, opportunity- wise? Where are these opportunities likely to be? How do I need to change my trading style to capture them? What adjustments do I need in terms of my support resources? What trading sizes will work best in these markets? How can I adjust my work habits to help achieve my goals?
I’ve seen this analysis process yield amazing results, even when the trader in question, as often happens, failed to reach his or her target returns at the end of the period. It’s taken me awhile, but I’m now con- vinced that the exercise is a worthwhile one.
It all kind of reminds me of what I believe artists must do to sustain their relevance. Whether it be Bowie and Iggy Pop migrating to Berlin in the mid-1970s to record astonishing albums behind the Iron Curtain, or John Lennon breaking up the Beatles at their creative peak, or Vincent van Gogh abandoning the comfort of his artist’s community in Paris only to burn his brains out with badly made absinthe in the bleeding hot sun of Arles, intellectual excellence can only be achieved through continuous evolution. Guard against getting too comfortable in the markets; like the wilderness itself, the creed of “adapt or die” prevails.
NOMINAL TARGET RETURN
As important as it is to set an optimal target return, it is equally important to set a minimum performance target that represents the lower bound of acceptability. In this case, instead of targeting a performance objective that is geared toward challenge and development, you want to set a figure that is at a level entirely within your comfort zone. The main reason for this is that I want you to think of the nominal target return as a benchmark, which, if you fail to reach it, will cause you to acknowledge that some ele- ment of your portfolio strategy is not working. In turn, this will force you to review your entire portfolio management environment, this time with an
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eye toward either fixing what’s broke or scaling back your expectations, or some combination of the two.
For certain professional traders (particularly those operating in formal financial institutions), this figure might be tied to your budget revenues, though I am hesitant to be too formulaic in this regard as the relationship between budget revenues and nominal targets will vary from situation to situation. In some cases, trading managers will take the incredibly scien- tific approach of setting their budget revenues at an arbitrary but signifi- cant percentage above last year’s performance, oftentimes without giving due consideration (or, for that matter, consideration of any kind) to any obstacles that may render such an objective unrealistic or even irrespon- sible. In other cases, management may set the budget bar too low, prefer- ring the somewhat illusory comfort of knowing that they will meet or exceed this target under all but the worst foreseeable market conditions.
In any event, while you certainly will want to be mindful of the budgetary process in establishing your nominal targets, you should not allow the (potentially irrational) budgetary process of your firm to interfere with the process of carefully and objectively determining your nominal profit/loss (P/L) target.
If you are operating outside the framework of a professional trading organization, you will have more freedom to establish a rational lower- bound return target. However, I encourage all free agents to go through the process in a fairly rigorous fashion nevertheless. While it will be tempting to tie this figure to such nonmarket factors as meeting minimum spendable income levels, I suggest that you instead orient the goal entirely toward issues that pertain directly to your trading. Make a realis- tic assessment of all aspects of your portfolio management environment, including the markets, your modes of execution, and financial con- straints. Then ask yourself the following question: “Operating within the conditions/constraints that I currently face, what is the minimum per- formance that I would consider satisfactory?” Understand that if you don’t reach this threshold, certain adjustments are in order. It’s halftime, you’re down by 10, and your matchup zone just ain’t working. Number 43 is lighting you up. If you’re going to win the game, you better try a box- and-one.
By doing this, you stand to accomplish a number of objectives. First, the review process will force you toward the types of sound trading habits that we will continue to stress as the difference between success and fail- ure in many circumstances. In addition, by committing to realistic minimal return objectives, you will impose a level of objectivity on your trading that I believe separates the highly successful traders from the rest of the crowd.
Absent this kind of thought process, it will be easy for you to evaluate any suboptimal interval of performance, identify some related external factors
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as the source of your trouble, and happily forgive yourself any transgres- sions that you may have contributed to the breakdown. However, if you rise above this kind of wishful thinking, you will place yourself in a posi- tion of control that, as I have seen time and time again, articulates itself in the form of a fatter bottom line.
Finally, this type of analysis will be invaluable to the health and well- being of anyone whose best trading strategy is to get out of the markets altogether (and, sadly, there are many of us out there). If you are consis- tently failing to meet what you have objectively set as minimally accept- able return goals, it becomes relatively easy to start to quantify the cost of continuing on, as measured in terms of mental/physical health, lost oppor- tunity to devote your energies more effectively elsewhere, actual financial expense, and so on, and to walk away when these costs become prohibi- tive. Conversely, I find that those without a formal program of this type run the risk of falling into a pattern of perpetuated failure until the cold, hard realities of the financial marketplace take the timing of the exit decision out of their hands.
STOP-OUT LEVEL
In addition to casting our sights to the heavens, Browning also warns us about “hearts, how shall I say, too soon made glad” stating (in My Last Duchess),“I gave commands; Then all smiles stopped together.”1Recall- ing this, our task of establishing performance parameters simply cannot be considered complete until we address the issue of maximum tolera- ble loss. The hard fact is that this is the most important performance parameter of them all, and one that all portfolio managers ignore at their peril.
Think of it in this way: The business of trading is rooted in the trade- offs between risk and reward. From this perspective, it is perhaps not an exaggeration to characterize riskas “the currency of trading.” And what is risk other than the propensity for a given situation to generate negative outcomes? Each trading account has (explicitly or implicitly) a finite amount of this currency, and it is vital to manage portfolio affairs in such a way that respects this resource constraint. Moreover, while the amount of risk that a given trader can responsibly assume has absolute boundaries (expressed, typically, in financial terms), within these boundaries, it is usu- ally within the control of the individual to set his or her individual risk tolerance at levels that are likely to reach these boundaries or to exceed
1Browning, in addition to being righteous, was quite prolific.
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