Trading has taught me not to take the conventional wisdom for granted. What money I made in trading is testimony to the fact that the majority is wrong a lot of the time. The vast majority is wrong even more of the time. I’ve learned that markets, which are often just mad crowds, are often irrational; when emotionally overwrought, they’re almost always wrong.
~ Richard Dennis

In the early 1980s Richard Dennis was well-known in trading circles - the Prince of the Pits - for having turned $5,000 into over $100m trading commodities through the 1970s and early 1980s. In 1983 Richard Dennis set out to answer the question - "Can trading be taught?" - fueled by a bet with his commodity-trading partner William Eckhardt. In a two-week session Dennis taught the 21 Turtles (Turtle Traders) - who were hand-selected from over a thousand candidates who responded to a newspaper advertisement. Dennis taught them a trend-following trading system with fairly simple and systematic principles such as defined entry and exit criteria, pyramiding of bet size, limited drawdowns, technical entry and exit rules, etc .... The strategy rule-based, and it required discipline in its execution - not unlike systematic CTA strategies of today.

The Turtle trading rules were hoped to be permanently profitable, but like many hopes at the mercy of the markets, the rules didn't pan out. (Note: There is significant disagreement among the sources I found that described the Turtles' trading results, and I'm not sure on which are correct, so I'll try to present the various perspectives in this newsletter).

The search for consistently profitable rules is a Holy Grail of the markets, but according to an analysis by UCLA professor Avandir Subramanyam and colleagues the profitability (alpha potential) of published market anomalies (alpha-generating strategies) rises and falls in 3 to 5 year cycles based on liquidity. And that liquidity is driven by the whims of investors as they deploy capital into such strategies. This liquidity-driven alpha cycle is characterized by 3-5 years of low liquidity and high performance followed by 3-5 years of high liquidity and under-performance.

After a good run up to 2010, most modern systematic CTA strategies - similar in spirit to the Turtles' rules - have had negative performance over the past three years. And as described below, after a long period of outstanding performance, Dennis' trading rules stopped working consistently. We'll explain the Turtles' results in more detail below, but what is clear is that for investors to survive and thrive in constantly shifting financial markets, they've got to remain flexible and adaptable - able to find the alpha opportunities before others, and be ready to move on when their advantage dries up. But like so much in life, balance is the key - investors need to balance such flexibility against the need to stay disciplined and consistent during a temporary setback. How investors deal with these competing pressures - when to look for new strategies versus stick with an older one - is a theme of this newsletter.

This month's newsletter is the second in a 3-part series examining the traits of top-performing investors. Last month's newsletter explored a trait called intuitive expected value calculation. This month we look at adaptability. Adaptability is characterized by mental flexibility, open-mindedness to new ideas, and the ability to reverse one's outlook abruptly when contrary information is available. The greatest investors in history have this trait in common. Later in the newsletter we look at how a failure of investors to adapt in equity and commodity markets - in response to new information - leads to trends that persist over time, creating an advantage for those who can adapt quickly.

Nature or Nurture?

The world as we have created it is a process of our thinking. It cannot be changed without changing our thinking.
~ Albert Einstein

Richard Dennis' Turtles were seeded with $250k to $2m each, and they performed spectacularly at first. According to former turtle Russell Sands, as a group, the two classes of Turtles personally trained by Dennis earned more than $175 million in five years. As a result of the Turtles' out-performance, Dennis won his bet with Eckhardt that excellence in investing could be selected and trained - that Nurture is more important than Nature in driving trading success.

At the time of Dennis and Eckhardt's bet, scientists themselves had inadequate tools to address the question of nature vs nurture among traders. Fortunately, they now have tools such as rapid and inexpensive genetic assays, brain imaging, reliable personality tests and hormonal assays, and they've made fascinating progress in exploring this issue, as we frequently describe in this newsletter.

In our own research, over 28,000 people have taken our free online financial tests since 2004. Our Investment Personality Test has been our most popular test. It measures the Big 5 personality traits: Extraversion vs Introversion, Agreeableness vs Self-interest, Neuroticism vs Emotional Stability, Openness to New Experiences vs Traditionalism, and Conscientiousness vs Spontanaeity. The Big 5 personality traits are not strongly correlated with investing success (several sub-traits are more interesting), but given our large sample size, we are able see a statistically significant correlation between investing success and Openness to New Experiences (Openness). Openness is strongly correlated with mental flexibility and adaptability.

Openness has genetic components. Identical twins show similar scores on openness to experience, even when they have been adopted into different families and raised in different environments. Higher levels of openness have been linked to activity in the ascending dopaminergic system, and openness is the only personality trait that correlates with neuropsychological tests of dorsolateral prefrontal cortical function. Thus, openness (and adaptability) appears to have a solid biological - even genetic - foundation. While we can learn techniques to become more adaptable, we may not have as much choice as we would like in the matter. As a result, we need to enforce an external discipline on ourselves to learn and explore new perspectives, even when it feels uncomfortable or unecessary.

Openness Among Investing Legends

To others, being wrong is a source of shame. To me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there’s no shame in being wrong, only in failing to correct our mistakes.
~ George Soros, Soros on Soros

As George Soros describes above, being open is not just about trying new things, it's also about examining oneself - warts and all - and non-judgmentally working to improve oneself.

Openness and adaptability are hallmarks of investing legends like Soros - himself founder of the Open Society Institute. Sir John Templeton was also remarkably open, being an early emerging markets value investor when others shunned the idea. Soros' former partner at the Quantum Fund, Jim Rogers, authored the books "Investment Biker" and "Adventure Capitalist" and holds world records for the longest motorcycle and automobile trips around the globe. Soros, Templeton, and Rogers are great investors not because they follow fixed rules, but because they adapt to events in the markets, policy, and economics.

But adaptability has many flavors. Ray Dalio - founder of Bridgewater Associates, the world's largest hedge fund doesn't appear adaptable at first blush. He asks employees to digest a list of 210 Principles. (The list of Principles grows and changes somewhat over the years). Bridgewater's investing style is predicated on the discovery of simple but fundamental rules that underlie economic activity (and over the long term, govern market pricing). These core rules are evolving over time as new policy and monetary mechanisms come into being. And Dalio himself practices transcendental meditation - a technique that itself increases self-awareness and adaptability.

Life is a series of natural and spontaneous changes. Don't resist them; that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like.
~ Lao Tzu

Traits of Super-Forecasters

Adaptability is correlated with the ability to see over the horizon. Psychology professor Philip Tetlock performed ground-breaking research on the ability of experts to forecast the future, finding that experts' forecasting ability is near random, but a small group of what he calls "super-forecasters" appear to consistently make better predictions.

Per a BBC news report describing super-forecasters:

As you might expect, these elite forecasters tended to score better on measures of intelligence than the other participants. But they all shared one other trait too: open-mindedness. In everyday life, open-mindedness may be mistaken for having liberal political views, but in psychology it is thought to reflect how well you deal with uncertainty. Crucially, open-minded people tend to be able to see problems from all sides, which seems to help forecasters overcome their preconceptions in the light of new evidence. “You need to change your mind fast, and often,” says Tetlock."

These excellent forecasters are able to keep their ego - personal investment - out of their forecasting. As a result, they can change their minds rapidly without remorse.

When endorsing flexibility, I'm not arguing that we should change our minds frequently for no reason, but rather change strategically. Strive to understand the fundamental assumptions underlying your investing, and when those principles no longer hold, engage Plan B.

Evolving Rules

The snake which cannot cast its skin has to die. As well the minds which are prevented from changing their opinions; they cease to be mind.
~ Friedrich Nietzsche

Over two weeks Richard Dennis taught the Turtles a trading system with defined rules, and as a group they performed exceptionally well for several years. But markets changed. By 1986 his system was much less profitable, and from 1996-2009, the system generated no profits at all according to this analysis. Another report indicates good results for the surviving Turtles, who apparently adapted the rules and changed their styles over time in order to achieve this.

Dennis himself no longer manages money, having closed his two funds after large losses in 1987-1988 and again after reopening in 1997 and then hitting a 40% drawdown limit in 2001.

The Turtles demonstrate that while principles can be taught, they often stop working. But how can we know when to abandon our no longer functioning investing system, or if we ever should? Recent academic research shows that the best performing investors do change their styles to take advantage of opportunities that appear outside of their usual domain. "Style drift" among mutual fund managers - e.g., switching from value investing to growth investing during a bull market - leads to long term outperformance (note that this result is still debated).

So when to abandon our investing strategy and seek a new one? The answer lies in whether our assumptions are still met. For example, if we believe that we can predict currency prices based on macroeconomic events, but currencies are only now responding to unpredictable monetary policy shifts, then without a good read on the direction of policy, we no longer have an advantage.

What is needed is an awareness of our underlying assumptions and a periodic check in on whether those assumptions are still valid. If not, then we need to move on to implementing new styles or strategies whose assumptions are in place. And if you have difficulty staying in engaged in new developments and examining assumptions, then enforce a schedule (n your calendar) of periodically checking new sources of information and market events that are out of your zone of expertise.

Trends and Under-reaction in Prices

Richard Dennis and the Turtles were trend-followers. Trends occur because the markets - and the investors that comprise them - do not rapidly and completely price in new information. Instead they gradually wake up to its significance and slowly price it in - generating a price trend.

In our research with the Thomson Reuters MarketPsych Indices (TRMI), we find that some types of positive and negative news stimulate price trends. For example, the best forward predictor of commodity prices is ProductionVolume. News about high ProductionVolume of a commodity in one year correlates with an average price decline the following year. The reverse is true (price rise the following year) when low ProductionVolume is reported. News about changes in ProductionVolume take time to filter into prices.

See the below equity curve derived from a study of the top 6 commodities in the news during the prior 12-month period. Each commodity was ranked on its reported ProductionVolume, and a short position was taken in the top two and a long position in the bottom two (of six), with monthly updating of 1/12 of the portfolio. An absolute return equity curve of this arbitrage is visible below.

In equities - the Russell 1000 - the top 100 stocks with the highest PriceForecast reported outperform the decile with the lowest PriceForecast over the following year. We see a similar pattern with Innovation. The absolute return equity curve of these two decile arbitrages are below.

These findings imply that investors KNOW which stocks are the most innovative or the most likely to outperform, but they don't act on it their foresight quickly enough.

As we study bubbles, we see that fundamental triggers are often an initial cause of the positive price trend. The trend becomes a bubble when the focus of investors and the media turns to the price appreciation itself, even after the underlying fundamental trigger has dissipated. The below images of bubbles in Coffee and Cotton represent this effect. We see similar patterns in other bubbles.

We also saw this effect in Crude Oil as the consensus PriceForecast turned lower after Islamic State took over Mosul. (For commodities PriceForecast is one of the best pure sentiment variables).

The relationships I describe above are based on trends, but we see even more power in the prediction of reversals. Trading reversals requires both mental adaptability and emotional stability, and will be discussed in next month's newsletter.

Investing Corner

Recently we see that sentiment is high and faltering. What would drive an end to the U.S. equities rally? Where are global economies showing surprising strength (using our nowcasting model)? To see our investment perspective please check out the Basic Plan or the Professional plan. Please contact us directly if you represent an institution.

Closing

Everyone thinks of changing the world, but no one thinks of changing himself.
~ Leo Tolstoy

Depending on how you invest, you'll be wrong about half the time. During a drawdown, most investors feel self-conscious that others know they are in trouble, they become concerned about tarnishing their reputation, and as a result of this stress, mental adaptability declines. In the next newsletter we will address how to manage stress in order to retain mental flexibility (and other benefits).

We'll be speaking in Hong Kong, Istanbul, and Chicago in the near future. Please contact Derek Sweeney to book us for a talk or training at one of your events: Derek@thesweeneyagency.com, +1-866-727-7555.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 8,000 global equities extracted in real-time from millions of social and news media articles daily.

We love to chat with our readers about their experience with psychology in the markets and with behavioral investing! Please send us feedback on what you'd like to hear more about in this area.

Happy Investing!
Richard L. Peterson, M.D. and the MarketPsych Team

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