CIO: Thank you Mr. Schwager for taking out time and talking to us. Over your long career in the markets you have interacted with some of the greatest traders. Could you share with us what you perceive are the qualities of great traders?
Jack Schwager: There are really very many. I will give you a few key ones. First on the list would be discipline. I can\'t think of anybody I have interviewed or met as a trader who has been very successful but has not been disciplined. I think that\'s probably an absolute essential.
Secondly, money management and risk control is certainly critical in one form or another. Most of the traders that I have interviewed will be the first to acknowledge that they consider money management actually more important than the methodology.
The other thing that is definitely worth mentioning is that successful traders find an approach that fits their personality. Time and time again, I see that the method that a trader is using very much reflects that person\'s characteristics or natural tendency. For example, when I interviewed Paul Tudor Jones, he set a time that was during market hours. At the same time I was interviewing him, phones were ringing, people were coming in with messages, and he was watching multiple monitors around his office and yelling out orders on open phone lines to a number of different floors. It was almost complete bedlam, but he actually thrived in that type of atmosphere. That\'s the way he traded.
On the other hand, there are people I have interviewed who use a very analytical and quiet type of an approach. The most extreme example I can think of is Gil Blake who came up with a method of fund timing. He would actually spend weeks at a time in the library going through microfiche looking for price patterns in mutual funds. He didn’t even use a computer. He would be then trade his system from a home office in his bedroom, without any contact with other people. That\'s the other extreme, and this methodology really worked well for who he was. Most people have heard about the importance of discipline and money management, but the criticality of having a method that fits your personality is certainly something that most people don\'t realize.
Another trait certainly worth mentioning is confidence. It\'s a bit of a chicken-and-egg question. Are great traders confident because they succeeded or do they succeed because they are confident? I don\'t know whether this question is clearly answerable, but I can say that when I am looking for people I think are going to be successful as traders, especially now that I am working as a fund of funds manager, confidence is certainly one of the characteristics I consider. Of course, one person\'s confidence could be another person’s cockiness, and it can be a thin line between the two. I can think of traders that I have interviewed who some people would consider conceited or egocentric, but whom I saw as extremely confident in what they were doing.
Love of what they are doing tends to be another important element. This trait is even reflected in the language great traders use. For example, some of the analogies the people I interviewed used to describe trading included: “trading is like a three-dimensional chess game,” and “trading is like a 10,000 piece puzzle where someone is always taking out some pieces and putting in new pieces.” One trader patted his chart book and said, “it is like a treasure hunt; somewhere in here there is a treasure and my job is to find it”. These are all game-like analogies. What does this tell you? It tells you that for these people trading is more like a game than work.
Trading is also hard work. People are often attracted to markets because they think it\'s an easy way to make a lot of money. But in reality, the people who are successful work very long hours. Sometimes they work every day, rarely taking vacations, and even if they take vacations, they are still involved. These people are not attracted to trading as a way to make easy money. The traders who really succeed are the ones who work very long hours, very intensively, often to the point of obsession.
Another important concept is flexibility. Really good traders do not get married to their positions. They don\'t hope that the markets will go in their direction. They act immediately. If they believe they have made a mistake, they get out and may even reverse their positions if they feel that\'s the appropriate action.
The best example is probably Stanley Druckenmiller who made the incredible blunder of switching from short to long in the U.S. equity market on October 16, 1987. (For people who have trouble placing the date, it was a Friday.) Over the weekend he realized he had made a mistake. He came in on Monday morning with the market opening way down and not only covered his new long position but also reversed back to the short side. That\'s the classic example of a trader’s ability to be totally flexible.
Those are some of the key attributes that successful traders share, but there are certainly many others
CIO: Can you name some of the traders that you admire the most and why you admire them?
Schwager: With three books of trader interviews, and having met and interviewed many other traders in my job as a fund of funds manager, it’s hard to isolate only a few. But I will give you a couple of examples.
The first one I would mention would be John Bender. Bender is an options trader. His approach is based on his belief that standard models for pricing options are incorrect. They assume a normal distribution, where in reality, normal distributions are inappropriate in many cases. He would look for situations that did not fit the normal distribution assumption of option prices. Essentially, he made his trading profits by betting against the conventional models. Thus his methodology represents a really independent and creative way of approaching the markets. The reason why I mention Bender is: (1) his approach is unique, and (2) he is extremely good at applying his methodology. But, perhaps the most important reason why I mention Bender as someone I admire is that he didn\'t just make a lot of money—end of story. He actually used his market profits to do something worthwhile and fulfill a personal goal: buying up large sections of the Costa Rican rain forest in order to preserve it. Basically, that\'s his motivation for trading—to generate more money so he can buy up more land and protect more of the rain forest.
Another example is someone who is not a trader in the conventional sense, and that\'s David Shaw. David Shaw is much more the scientist and quant. In any case, he has developed an elaborate arbitrage operation, which employs scores of Ph.D.s in mathematics and computer science and other sciences to run what is an extraordinarily complex methodology. It involves the simultaneous trading in 10 or more of the world\'s key financial markets, in various securities and derivatives, seeking out inefficiencies based on probably 20 or more different types of strategies, all running simultaneously. His fund has put in a solid performance year in and year out for the last 14 years. In fact, in recent years, his fund’s performance has actually improved, notwithstanding the fact that his firm is managing billions of dollars.
I also admire Shaw as a bit of a Renaissance man. Besides being the architect of one of the world’s most successful hedge funds, he was one of the first developers of the supercomputer. He has founded and spun off a number of companies, perhaps the best know being Juno. He is heavily involved in the use of computers to design drugs, having taken an active role in a couple of companies that specialize in that field. He was also an adviser to President Clinton on science and education.
CIO: So in your opinion are traders born or made and how much of trading is an art and how much is a science?
Schwager: I’ll use a running analogy to answer that question. Running a marathon is a very difficult thing to do, but people who are determined to do it, even if they are handicapped, can train and complete a marathon. Someone fit but not trained could never do it without that type of work.
Running a marathon at a world class speed, say 2:12 for men, is a feat that most people are going to find is impossible because their bodies are just not biomechanically designed to be able to achieve that result. No matter how hard they train, no matter how determined, no matter what their emotional strength is, they are not going to be able to achieve that type of a standard, because it is just physically impossible. They may run a marathon, and they may even run it in reasonably good time, but they won’t run in it in a world-class time. A few people will be able do it because physically they have the right type of body. It has to be a combination of both the physical capability and the determination and hard work.
Now the analogy applies to the trading side in the following way. Most people if they work hard enough, are disciplined enough, and follow all the basic rules that I tried to outline as being common denominator traits of great traders will make profits in the markets and certainly do better than the average person. But will they be market wizards? Well no. I mean most of them won\'t be any more successful than most people would be as world-class runners if they went into running, or more than most people would be as world-class solo musicians if they decided to take up music. To reach exceptional success in trading or anything else requires a combination of both innate and hard work to exploit that talent.
CIO: So, is it an art or is it a science?
Schwager: It depends on the person. If you watch somebody like Steve Cohen who takes in all sorts of different inputs, reacting to them instantaneously and actively trading, it seems to be more art than science.
If, on the other hand, you look at someone like David Shaw, who employs an extraordinarily complex model that simultaneously trades thousands of securities and derivatives on all the major global exchanges, using a score of mathematical methodologies, that’s clearly science.
Finally, you have some people, such as John Bender, for whom trading is both an art and a science. Bender looks for situations where he believes the mathematically implied option prices are out of line with market realities and probabilities as he sees them. His approach is a science insofar as it relates to the quantitative analysis of options, but is also an art in that it depends on his evaluation of which markets have probability distributions different from those assumed by the standard option pricing models. The art comes in being able to decide how the current scenario in a market is likely to play out. For example, judgments such as saying that the chance of a sharp break in a particular market is much greater than would be implied by a normal distribution.
So you really have examples of people who operate more on the art side, people who are operate more on the science side, and people who blend the two.
CIO: So then getting into the mechanics of successful trading, how do successful traders allocate positions?
Schwager There is a lot of variability on the allocations side. There are some traders that I know who are extremely diversified, and that is one end of the spectrum. But there are other traders who are extremely concentrated. In fact, one of the best performing funds we have in our portfolio takes very concentrated positions. By their definition, they trade 22 different sectors. In virtually every quarter there will be one sector that accounts for 25 to 50 percent of their entire long position. Of course, the specific sector with the concentrated long position varies. It depends on their prevailing scenarios for each sector. If they have an hypothesis that a major fundamental shift will occur in a given sector, then they will bet heavily on it, and they have done enormously well using that approach with surprisingly low drawdowns relative to their gains.
The only commonality I would cite in terms of allocations is that that just about all successful equity traders I have spoken to will have some sort of maximum individual position size on the short side. They won\'t allow a short position to get above a certain percentage of the portfolio. Or there will be some other sort of constraint on shorts because of the open-ended risk in these positions. This is the one allocation commonality that I can cite. But other than that, allocation approaches vary very widely.
CIO: Are stop loss limits an effective way of controlling risk, whether you are diversified in your number of positions or whether you are concentrated.
Schwager: That depends entirely on the strategy. for example, in futures trading, which is intrinsically heavily leveraged because margins are such a small percentage of contract value, stop controls are probably critical to survival both in terms of the long and short positions.
Equities, however, are different. Although stop-loss limits (either explicit or implicit through limits on values of positions as a percent of assets) are probably essential on short trades, long trades could be a different story. For example, consider a trader whose approach is buying extremely undervalued stocks, perhaps even stocks trading for less money than the amount of cash the company has in the bank. Assuming the fundamentals are unchanged and the stock goes down further, it almost fights this strategy to use a loss because the position is actually an even better value after a further decline. So it may be irrational for some traders to have s on the long side if the positions they are buying are really chosen in such a way that the downside is fundamentally limited.
The same is also true of many arbitrage strategies. If a linked trade is established because one instrument is believed to be out of line with another, it make little sense to get out of the trade on a loss, which implies an even wider aberration, as long as fundamental premise for the trade is still intact. In other words, as long as a link between the two securities still implies convergence, it doesn\'t make sense to dump the position. So there are rational reasons for not using -loss limits.
CIO: We talked about position sizes and we talked about loss limits. What are some of the other methods that traders use to control market risk?
Schwager: Some people try to make risk control very complex. I don’t think risk control has to be rocket science. Even the very simplest rules can get you most of the way towards risk control. For example, even a very simple rule such as never risking more than say 2 percent on any individual trade would get you 90 percent of the way towards an effective risk control methodology. Methods of risk control could include limiting losses on individual trades or limiting portfolio risk by reducing overall exposure levels. Risk control does not necessarily imply the use of explicit s, but may instead be achieved by hedging positions wherein every long is matched by a short that is linked in some way. None of those approaches are by themselves in any way complicated.
The key point I\'m trying to make here is that it\'s not the complexity of risk management that is important, but rather the discipline to apply it. I would argue that the simplest money management strategy applied with absolute discipline is superior to the most sophisticated approach applied with anything less than that.
CIO: And so in your opinion what is it that causes traders to lose most?
Schwager: That\'s easy. The answer ties in exactly to what we were just talking about, namely insufficient risk control. It is one of the most common reasons why traders get into trouble. One way or the other, the cause for large losses and traders blowing up is insufficient risk control.
CIO: Any other errors that traders often make that end up in losses?
Schwager: All the errors I can think of really come back to inadequate risk control. If someone overtrades a position, it\'s an example of insufficient risk control. If a person gets married to a position and just stays with it, giving it more and more time, it is insufficient risk control. A lot of the trading mistakes that people make when you go down one level deeper are due to insufficient risk control. Of course, people can make analytical mistakes, they can call the market wrong, and so on, but then again for that to do real damage, it\'s going to have to come down again to some inadequacy in risk control.
CIO: So it basically boils down to one word -- discipline.
Schwager: Yes. It’s not sufficient tp have an effective risk control strategy, you also need the discipline to apply it. Discipline also comes into play in other ways. If you have a strategy that signals a trade that looks very scary but fulfills all the requirements of your methodology, you need the discipline to take the trade. In other words, discipline applies not only trade to getting out of a trade but also getting in. Another aspect of discipline is avoiding trades that aren’t part of your methodology. To summarize, discipline applies to many aspects of trading, risk control being just done.
CIO: And now discipline is one trait, patience is another. One attributes patience to long-term investing. How important do you think it is in trading?
Schwager: I’ll answer that by quoting one of the traders that I interviewed, Jim Rogers. Although Rogers is probably closer to an investor that a trader, his comments about patience are quite relevant to traders. Rogers says, “I won’t do any trade until there is money lying in the corner of the room and all I have to do is walk over and pick it up.” Until a situation comes along that\'s that obvious, he just doesn\'t trade. I don\'t care whether your trading horizon is two years, two months two weeks, or even two days, the idea of not putting on a trade until the return/risk is compelling is good advice. The attitude of letting the pitches pass you by until you get one that looks really good applies no matter what your time frame of trading is or whether you are an investor or a trader.
The other element of patience applies to the exit side. Again, it doesn\'t make a difference on what time horizon you are trading. Regardless of the length of your trades, you need to have the patience to stay with the position as long as there is no reason other than wanting to grab a quick profit to get out of it. There is a quote from Reminiscences of a Stock Operator, which is a book about Jesse Livermore. The author was actually Edwin Lefevre a journalist who did such a good job describing the trader’s mindset that many people mistakenly believe the author’s name was a pseudonym for Jesse Livermore. In any case, in the book the protagonist says, "It was not my thinking that made me the money, it was my sitting.” What he is saying is that his success in the markets was not a matter of his being smarter than other people or being able to see things others did not, but rather his patience to stay with trades that were working. No matter what your approach is, no matter what your time horizon is, the idea of being able to resist taking profits when the right thing to do is staying with a good position is an important element to trading success. That\'s where patience comes in.
CIO: You are not compelled to trade every moment or to get in or out of the market.
Schwager: You are not compelled to constantly be trading, which goes back to the first idea on trade entry. You wait for the right type of opportunities and let everything else pass by—that\'s one-half of the equation. The other half is that once you are in a position, you need to have the patience to stay with it and give it time to be fully realized. Whatever your approach is, it takes time to realize the potential of a trade, and it is important not to be tempted to take a quick gain when there is still a lot of potential left.
CIO: You have expressed strong objections on the efficient market hypothesis. Could you elaborate a little bit?
Schwager: I am amazed that people can still believe in efficient markets. The reason I say that is not a theoretical argument, but rather an empirical one. I will give you a couple of examples. When I interviewed Gil Blake, he had had a 12-year track record with an average annual return of about 45 percent and returns that ranged fairly narrowly between about 35 and 55 percent annually. His worst peak-to-trough drawdown in the entire 12 years was 5 percent. He had only 5 losing months in those 12 years. I am sure that the odds of getting those types of returns in a truly efficient market would be infinitesimally small. As another example, Steve Cohen has compiled a nine-year track record with gross returns near 100% and only a handful of losing months, all very small. What are the odds of getting those type of results by pure chance? As a final example, D.E. Shaw has achieved 14 years of returns averaging close to 30 percent, in a time span encompassing both major bull and bear markets.
Some people will argue that these results still don’t disprove the efficient market hypothesis because if you have enough traders, some are going to do extremely well just by chance. Well, I can buy that argument up to a point. Yes, if you get enough traders, after a year or two you will have some with exceptional returns. But we are not talking about a year or two, we are talking about near 10 years or more. And we are not talking about just well above average results, we are talking about tremendous returns, with very low volatility, and a very high percentage of winning months.
Now, if the markets were truly efficient, how many traders would you need to get the types of results achieved by traders like Blake, Cohen, and Shaw, not to mention others I have interviewed. I would argue that you would probably need more traders than there are people on the face of the earth to statistically get some of these results as normal events. I am reminded about the old cliché that if you had enough monkeys banging at typewriters, one monkey would eventually type Hamlet. My response to that contention is: yes, but how many monkeys do you need? I suspect that the answer would imply more monkeys then could fill the volume of the perceivable universe.
Although probability can explain almost any event if you have a large enough sample, I would say that we have seen too many performance records that are too far off the charts to be the result of chance. In other words, you would need a much larger population of traders to generate those types of results. To be clear, I am not implying that there is not a lot of market randomness. All I am saying is that even though markets may be close to efficient, there are pockets of inefficiencies that skillful traders can effectively exploit. It is almost inconceivable to me that you could look at results such as those of Blake, Cohen Shaw, and others and still believe that the markets are purely efficient to the point where they are completely unpredictable and there are no patterns that can be exploited.
CIO: Talking about randomness, I believe in your book, The New Market Wizards, you write “the markets are not random because they are based on human behavior. And human behavior especially mass-market is not random. It never has been and it probably never will be”. Could you elaborate a bit on some of the common observations about human behavior that you have found revealing and applied to markets?
Schwager: We don’t have to look back very far back to get a perfect illustration. The U.S. stock market of the late 1990s, especially in technology stocks, and more particularly the Internet stocks, provides a classic example of market irrationality. In one of the interviews I conducted (not one published), a trader mentioned that Priceline, a website, was trading at a market capitalization of more than the top three airlines. This is just one isolated example of how absurd the pricing got. There were countless examples of stocks without the slimmest prospect of earning a profit in the foreseeable future trading at huge market capitalizations. This type of price action is very much reflective of distortions due to human emotions rather than market randomness.
Research has been done in decision-making theory that is very applicable to understanding human psychology when it comes to trading. Some of the best known research was done by Kahneman and Tversky who conducted experiments that illustrated the irrationality of human decision-making. Some of those experiments were particularly relevant to the influence of human psychology in making trading decisions.
For example, in one experiment, subjects were given a hypothetical choice between a sure $3,000 gain versus an 80 percent chance of a $4,000 gain and a 20 percent chance of not getting anything. The vast majority of people preferred the sure $3000 gain, even though the other alternative had a higher expected gain (0.80 X $4,000 = $3,200). Then they flipped the question around and gave people a choice between a certain loss of $3,000 versus an 80 percent chance of losing $4,000 and a 20 percent chance of not losing anything. In this case, the vast majority chose to gamble and take the 80 percent chance of a $4,000 loss, even though the expected loss would be $3,200. In both cases, people made irrational choices because they selected the alternative with the worse expected gain or greater expected loss. Why? Because the experiment reflects a quirk in human behavior in regards to risk and gain: people are risk averse when it comes to gains, but risk takers when it comes to avoiding a loss. And this relates very much to trading. It is exactly the quirk in human psychology that causes people to let their losses run and cut their profits short. So the old cliché of let your profits run and cut your losses short is actually the exact opposite of what human nature tends to do.
You can see another example of this aspect of human psychology when you look at companies that are bankrupt and in a totally hopeless situation, yet the stocks continue to trade at some level meaningfully above zero for quite some time before finally fading into oblivion. Why? Because people argue the stock once traded at $50, maybe it will come back. So if people bought a stock at $20 and it is down to $1, even if it is all but certain that the stock is going to 0, they will stay with it because they have already lost $19, and the worst case is only a $20 loss. And there is the thought that “maybe it will come back.” In short, people are risk takers when it comes to trying to avoid a total loss and that explains a lot of market behavior.
CIO: You also stated in one of your books that there is no Holy Grail or grand secret to the markets. But there are many patterns that can lead to profits. Could you elaborate on some of the patterns that you have discovered?
Schwager: It is simply a statement of the fact that all successful traders are using patterns. Whether they are purely fundamental traders or purely technical traders or some combination of the two. The specific patterns depend on the market and the personal approach of the trader. For example, a technical trader might use trend following signals or chart patterns or something like that. A fundamental trader, on the other hand, might look for some combination of valuation metrics and a catalyst. An arbitrage trader would be looking for value deviations between related instruments. One way or the other, every successful trader is really using an approach that depends on some sort of pattern.
I would argue that that even traders who think they trade intuitively are still using patterns. For so-called intuitive traders, after watching the markets for many years, a current trading situation may trigger their subconscious memories of similar situations in the past. Thus their decisions, which seems instinctive, are really pattern based, even though they may not be aware of it.
CIO: You are associated with the hedge fund industry as a fund manager. How important do you feel is the hedge fund industry as an institutional force?
Schwager: I think people are finally beginning to understand that hedge funds represent a true alternative investment. The value of hedge funds is that because of their heterogeneity, they provide the potential for creating portfolios that have much sounder return/risk characteristics than are available in any type of traditional investment portfolios.
CIO: I would like to thank you once again for talking to us and giving us your views on a lot of different areas. Thank you very much.
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