A Curious Dilemma
How can managers and traders reconcile conviction and uncertainty?
BY WAYN E II. WAG N E R
L-",. L- ^,,rne> ttp 1ilh
,. ^,,,1^,. ,.
these things?'' said the trader, look-
ing at another offbeat order from a
mar-erick portlblio manager. Where
indeed! Hor'v do managers ancl traders
cope lvith the extraordinarl complexi-
ties of market information vet reduce
them to simple br-ry. and sell instructions?
\ r.,-,. aPtrr\
rYrarl\ ^-,-1.. \ r^.-1. r.,\ains.lbreff a_
tion that "It difference of opinion
r'r'as a
that led to horse racing" to financial mar-
kcts. Tri ain i5 corrcct hut tlot'sn t rcally
get to the source of the phenomenon. It's
not the difference of opinion that counts,
it's the clifferent mental processes each of
us employ's. The market encompasses so
rnanl dirnensions .rl huntrtt expcricntc
ancl emotion that each ol us sees it not
asit is but only' through the filters and
biases of our perceptlon.
Information Overload
Simpi,v stated, the marl<et is too compli-
catecl for an)rone Lo fully'comprehencl.
lltcre are ju't t,ro rnitn\ m\r\ ittg part:.
more than can be simultaneousil' com-
prehended b1' the human mincl. Our
minds are tralnecl over [rany genera-
Irons lo iclrnrifr the.tcnping slr)req in
"How do managers front of us rather than take in the n'hole
vier'r' as a camera does. \Ve're not built
and traders cope r'r,ith enough mental hardrvare.
'' I hc crrr ironrncnl contains a r lri-
with the extraordinary
ct1 of go,r.ls antl torirrr. hrrhingers
complexities of market and distractors, stepping-stones and
information yet reduce pitfalls." r,r.rote philosopher of science
Daniel Dennett rn his book Kind.s o/
them to simple buy tr{inds. "These resolllces often amount
and setl instructions?" to an embarrassrlent of riches in com-
petition for the agent's attention."
Trrre in tho h".te'_-orthcrnr. errr i-
ronlnent-and certainlv lrue in the
marke t.
Economist Herbert Simon. ln X,lorl-
els of Man, iclentified this phenomenon
as "bounded rationalit)'." Bounclecl
rationalltl-, stated simplr'. means that
CFA MAGAZINE / IVI AY-jUNE 2oo7
there is too much information for anv
one human being to process. \\ie need
to simplif,v in orcler to clarifv the deci-
sion and find some handles b1'r.r,hrch
we can secure a n-rental grasp.
I look or-rt rn1'oIfice u'indor.v and
see buildings. cars, clouds. and blue
sk1'. ''See" is not the right r,r.ord; "notice "
rrr "rrrrcei\ c ir| mr)rc accuraLL. I tlitlrr't
rr'allr sec { \cr\rhinp rhat rras out thc
ri irrtluri: I .ju>t .ru tlr. thing. thlt
errrolrl
-....D... .../
rnr' ,.r r' ,.ilnt 8cl\
._ tl
l-r +rr
Irroces\cJ rhr.rugh filtrr. o[ 1q fi21 is pcr-
\olrallV irn|o|tent or intcrerting. suclr
rq 'H,rrv lnrro
'' ''b ir" il'-'.',rinob'-tn lrlic rne I,r
get home in the traffic?"
\pplictl to tlrc rnarkct. thi. prirrci-
nl,
r'' \r,ro.\lq
""bb_"'" tlrrl , a, h In1rrzo.r
- .^b_ .'lnrl_'
trader focuses on a lerv thir-rgs that he
or she personall,v consrclers important,
lhe t'c.l ,'t'ts ipnrrrr'tli lhcsc rLcisit,tt
b_'"'b'_\,__til
dlir"ers rnight be funclamentals, techni-
cai signals. srqrphy'clernar-rcl shifts, trnd
numerous financial variables. ratios,
rn(l rhort( ut\. \\ lrrtcvcr tht r arc. thcr
are a relatir.e hanclful in number. That's
all the human mind can deal rvith at
one trrne.
Which of these elemenrs art: nosr
irrrrrnrt:rnl)
....r .-...^... Sin,,. ,rrrl ir
-. ..nPT('\5tUllS
,lnlir n frnrn nrrr npr\,!nrl
'"'-"""'l'" lif, , rneri-
ences. lhe ans\\'ers differ frorn person to
person. Thus. rve r.valk backr'r,ards into
t1-re future, r,r.ith our mir-rcls anchored bv
the imprintecl lessolrs of the past.
Thi. Fltrrinr,rrrnlics
_'''" _,''___'_b "rr" to brrth nttn-
agers ancl traders. although their choic-
e' o[ Llc( i5ion tlt'ir, rr u ill .li[l'r sigrrifi-
cantly The portfolio manager \\,ants to
take a long drive; the trader neecls to
knor'',, horv to get the car started (or
stopped.)
Curiously: this''ferv-r,ariables effect"
is true of statistical moclels as rvell as
active decision making. Those rvho builcl
slrrt k-scleclir rn oI nricc-ntr)\ Cntcnt lilOd-
els knor,r' that after fir.e fhctors or so,
rdtling adrliti.rrral t'rplarratorl r ali-
ablcs Jccrca*e: r'dthr'r int rt'arr'r lhc prt -
dictive po\\,'er. A feu, variables are the
main drir er': evcr\ llring cltc it cithcr
too smali or too fleeting to play a useful
role in decision making.
The Marl<et of the Mind
I hc net re.ult is that rr c don t plrl thc
real market; rather, we hurn along n'ith
tlre song the rttarkel sirrgr 16 our indi-
vidual heads. At times, our mental
model fits r'vell enough; at other times,
\\e rc otrl oi tunc. .\nd rrc (rn l prcdiel
rvhether the next shift nill be favorable
to our thinking or not. Hoq'ever,
because each participant reflects a dif-
ferent set of liles experiences, the mar-
ket effectir.ely processes nll the infor-
mation and choices-those that are in
s)'nc as well as those that are not.
Thus the market delivers its or'vn
truth. ln The Wisdom of Crol.'ds, James
Suror,viecki puts it this wa)r' "a cror,vds
'crrllcctir e intelligcnce u ill pr,'tluce
better outcomes than a small group of
experts, er.en if members of the cron'd
don't know all the facts or choose, incli-
viduall-r,', to act irral-ionall1. . peoples
errors balance each other out; ancl
inclucling all opinions guarantees that
tht' re>ull> rre >lnarter rlran il a singlc
expert had been in charge." In other
u,orcls, the market is smarter than anv
participant in lt. Without such collec-
tive intelligence , an index fund could
nol r'r,ork.
Not only does the market a11or'r. us
to act on our o\\.n decision drivers, but
it also allor,vs the world to correct us.
"The markets objective," jokes Ken
Fisher, "is to humiliate as manv people
as pos:ihlc lor ar mu, lr monc\ ts pu>\i-
hle li'r as long as po:sihlc. L ltirnatelr.
a standard outside ourselves becomes
the judge of the correctness of our
model. Witl-rout it, r'r.e lir.e on oLlr o\vn
little imaginarv planets. spinning out of
corrtrol. lhcrt rc--_'_
ut' brokc.
The Marl<et of the Gut
Thc tllrkctr are g()()(l al \()r'lin!, (rLtt
rational thoughts ancl equa11y. good at
rcsponJing to elnotional [actorr. lrr par-
t iculrr'. tttlrkcts necd to ptrni'lr ()\ ('rt x-
uberance. Markets fincl the price that
balances supplying sellers u'ith
demanding buyers. If either group is
u,ildl,v or.errepresentecl, markets cannot
fi nd . lerri rrg pricc\ f,nrl I rxnrfl( t i ng
halts. The most clramatic example is the
panic of October 1987, r,r.hen the mar-
ket had far too man1, sellers and
norvhere near enough bu\.ers.
W'hat u.ent r'r'r'ong? Portfolio insur-
ance mechanicalll- createcl a {1oor value
so the portfolio coulcl not lose ntore
than some prespecified clollar anrount,
Sponsors quickly sar.v that as the possi-
bilit1' of loss u';rs taken out of equitv
inr.esting, the need for boncl portfolios
as stabilizers n'as strongll' chmrnished.
\\'h,v not sell the bonds and inr-est the
irroceeds in eqr.rities lvith a higher
C\lccte(l rt'tttrn J Tht'n .trtne,rnc figurc.1
out that once voll hacl made sorne
mone)'. ,vou coulcl raise the guaranteecl
lloor rrnd loe k in r out gains.
Higher returns, lor'r'er nsk. locked-in
gains-$ho c,rttld rtsist a prop.rsilitrrt
like that? Portfolio insurance had created
' rirkl,''. inrcrlnrr'nl>. cunl(rrling lll('
grcrJ-lcar balancc ftrr p1n.16n spun5tlr\.
Many plan sponsors couldn't resist, and
by 1987, an estimatecl 10 percent of pen-
sion assets r,vere "insurecl."
This crou,d lr,as destined to stam-
pede in the same direction at the same
tinrc. \\ hcn an crternal tliggcr c:rutcd
markets to fall, portlolio rnsurance
managers had to sell equities to fullill
the insurance contract. When thel'sold.
the rnirrket clropped, r'r.hen the market
droppcLl. rh.'r hatl lo \ell nlolc. A \ cr)
vicious cvcle indeecll
Thus, fear is a necessart'factor in
the operation of an,v market. Remor:e
fear, as portlblio insurance drd. ancl the
rnarkets can not restrain rampanl greed
and exuberance. The only n'av to cor-
rect the imbalance rvas fbr portlblio
''insrtlarrct" to tlc[eult on it\ gulr']ntcc.
lhLts crerttirtg tn unf()rgcllilblc p*1 ql1,'-
logical experience for manl' supposeclll,
sophisticated jnvestors. As Frecl Schrvecl
said in Whcrt Are fhc Cu.stomcr.s'
)'rrcirts?, "There are certain things that
cannot be aclecluzlte1y' explained to a vir-
CFA MAGAZINE / l\lAY-JUNE 2oo7
gin. either br- rvords or plctures. Like all
ol lifes rich ern,'lional erpcricnccs. tltt'
full flavor of losing important mone]'
cannot be convel.s{ b,v literature."
Every Day ls a New Day
A. borh 5chr,r ed ;rnJ Fi'hcr .uggc5l. lhc
stock market is among the most uncer-
tain and anxietr'-prr:ducing areas of
humarn enclear,or. Notl-ring is assured;
nothing u'orks at all times-not e\ren the
best intellect. research, and ardor. C)ur
most noti\.21ted anci intensive efforts
cannot guarantee the desired results. \Ve
need to appl,v the best of our science
arrd art. hrrt a [, ] :lroke: oI scrcndipi-
torls timing alr'r.a)'s come in handli
\\c
' - rnipht
__-_--__ -- tcrnote.l
be _-__-r_- tr' think that
mega-super computers, threading
thror-rgh chaos theory or neural net-
u.orks, might {ind signals that are too
nuancecl to be picked up br, mere
human intelllgence. Unlbrtunatelr', cap-
ital rrrirrkt'ts are lo(r c('mple\ eVctt [ot'
such sophisticaterd, nonlinear tech-
niques. What leads to ontcome A on
Monday'may leacl to Not-A on Tuesdal'.
Thinl< of the market as a flu 1,i1l1s-
once \\,'e think rve have it peggecl, it
mutates into something ncr'r''.
Tl.rus, traders. especialh', neecl to
irllLrnc to tlte crer-changing hallnte tr['
hrrr crs arrd :ellcrr. \Vhilc f,rrt lolio
managers search for the long trends and
hidden r.alues, a tracler expcriences a
brand ner,v marke t er.err, da):
A cr"irlous dilemma aflects managers
lnJ tluder': Btrth rrecd thc coulagc oI
their convictions )'et sirnultaneousll'
must listen 1or the market's messages.
Pt rhaps lltc *rrn8 trur tnetnorr i-
singing in our head is out of tune r,r'ith
r,r-hat the market reveals. Experience
means kno*'ing r.r'hen to act on the
conviction and when to la,r. |61'. 1Lturt
r.r'h). s1w)- managers ancl tr:rclers get
paid the big bucks. ^/
H. lVagncr- is senirrr- adtisor Jor
Wa,,-nt
ITG Inc. ttntl .founde r oJ OI4/Nf ConsuLt-
irtg Pctrtntrship.