Leverage and Volatility

Suppose a trader predicts a given stock to rise by 25% over the next 10 days. Of course, if he is unleveraged, if the stock does indeed rise by 25% in 10 days, his 10-day return will be 25% irrespective of how volatile the stock price was in the interim. This, however, is far from true were he leveraged (i.e.trading on margin, as opposed to trading unleveraged while taking outside loan for providing capital). If he was 300% leveraged, then his return at the end of 10 days, is far from 100% (4 times 25%) as one would naively imagine, but a devastating -47%, in the volatile scenario 1. It is only in the non-volatile scenario 2 that leverage actually multiplied his returns.

Notes to myself on Investing

The biggest enemy of an otherwise prudent investor is an inability to sit tight. If he only acts upon his strongest convictions, in terms of putting on trades, and lets the low conviction trades pass by without feeling compelled to "see what happens once I put it on", he will over the long term be profitable. I have learned this from experience, but it is echoed by such great investors as Warren Buffett, that I do not have to worry as much about depending solely on my experience. Another note: don't depend solely on anything, irrespective of what thing it is. Well, depend on it at times, but don't bet the bank on it.

Of course, all this assumes that he is otherwise prudent, that is, understands the mechanics of the global markets well. This again, is not a 'talent'. It is a skill developed through self-effort. Self-effort, again, does not translate to merely working hard, although working hard is an indispensable part of it. In the context of investing, working hard entails reading a lot: books, academic research, market research. If hard-work was all, you could just maximize your profits by maximizing the numbers of pages read. However, this indiscriminate focus on quantity falls short on three things:

(1) Separating wheat from chaff: Deciding what to absorb and what to ignore is important, because much of what is out there has greater potential to harm than to benefit. Partly, this discrimination comes from experience, but I hope that not all of it must come through experience, because experience in this case often means trading losses. There is some respite. Discrimination also comes from a general attitude of thinking for oneself, even when reading. Too much reading is no better than gluttony: you become so busy eating you forget you have to clean and eat. Arthur Schopenhauer expresses it very will in his essay "On Thinking For Oneself":

The visible world of a man’s surroundings does not, as reading does, impress a single definite thought upon his mind, but merely gives the matter and occasion which lead him to think what is appropriate to his nature and present temper. So it is, that much reading deprives the mind of all elasticity; it is like keeping a spring continually under pressure. The safest way of having no thoughts of one’s own is to take up a book every moment one has nothing else to do. 

(2) Reading is not understanding: You have got to leave enough time to mull over things you have read, but perhaps this belongs to the previous bullet point. What definitely belongs here is to emphasize that it is very easy to misunderstand content when your fundamentals are not strong. Therefore, as important as it is to read, it is of greater primacy to study. Study entails not reading the latest book of economic wisdom acclaimed by one and all, but reading and solving problems from your boring, old textbooks. It is important that you have studied back in college (other than being rejected by a hot (to you, at any rate) girl) if you are to take away the important lessons from all the reading you will do as an investor. If you didn't, do that first. Depending on the kind of investor you are, it may include macroeconomics, accounting, statistics, financial mathematics, or all of them.

(3) Being wary of confirmation bias: Irrespective of what or how much you read, it is easy to come out of it with just your prior opinions solidified, as the mind has a tendency to read every little reaffirmation of your prior beliefs in bold, life-sized print, and read everything that's not so agreeable in Arial Narrow. So be careful. It is also important to emphasize breadth, than to read five books about the same thing, your favorite topic. Investing is a complex subject, it lacks the hard rules governing the physical sciences like Physics, and it is often tempting to ignore this aspect of investing, especially the more mathematical your training is. Don't. Because of this nature of investing, breadth has a depth all its own. Read widely. Read about things not immediately applicable to your next trade. CLR James and Harsha Bhogle rightly re-ignite Rudyard Kipling's famous sentence on England by applying it to Cricket: "What do they know of Cricket who only Cricket know?" The essence of this wisdom has a central place in investing. "What do they know of Equities who only Equities know?" Replace 'Equities' with any specific part of financial economics, and you will see what I mean.

In essence, make the goal of your reading be "to improve your perspective", and the three points above will largely be taken care of.

Reading list for the near future

Philosophy of Mind
Arthur Schopenhauer "On Thinking for Oneself"
Henry Hazlitt "Thinking as a Science"
Francis Bacon "On Studies"
Herbert Spencer "What knowledge is of most worth?"
E.H. Griggs "The Use of the Margin"
Adi Shankara "Vivekachoodamani"
Anonymous "Kenopnishad"
Anonymous "Taittriya Upanishad"
Swami Chinmayananda "Self-Unfoldment"
Iain McGilchrist "The Master and His Emissary"
Richard Thaler "Misbehaving"
Daniel Kahneman "Thinking Fast and Slow"

Finance and Economics
Andrew Ang "Asset Management"
Antti Ilmanen "Expected Returns"
John Cochrane "Asset Pricing"
Lasse Heje Pedersen "Efficiently Inefficient"
Steven Drobny "Inside the House of Money"
Will Durant "The Lessons of History"
Ray Dalio "Economic Principles"
George Soros "The Alchemy of Finance"
Robert Shiller "Irrational Exuberance"
Raghuram Rajan "Fault Lines"

Biographies
Robert Kanigel "The Man Who Knew Infinity"
Richard Ravitch "So Much To Do"

Fiction
William Trevor "The Story of Lucy Gault"
John Banville "The Untouchable"
P G Wodehouse "The Most of P G Wodehouse"
Kingsley Amis "Lucky Jim"
_________

Will write a review on this blog for each (more likely 'lessons from them' than 'reviews of them') once I read them.

Why waste words ..

.. when everything that you have to say is best said without any.