Great insights stand the test of time. The value of 100-year-old trading books attests to this.
An excellent insight of more recent vintage comes from a 1999 article by Rick Bookstaber, “Risk Management in Complex Organizations.”
The Bookstaber excerpt I am thinking of, with clear application to trading, praises the virtues of the humble cockroach. (No, that is not a typo.)
Here it is:
The best measure of adaptation to unanticipated risks in the biological setting is the length of time a species has survived. A species that has survived for hundreds of millions of years can be considered, de facto, to have a better strategy for dealing with unanticipated risks than one that has survived for a short time. In contrast, a species that is prolific and successful during a short time period but then dies out after an unanticipated event may be thought of as having a good mechanism for coping with the known risks of one environment but not for dealing with unforeseeable changes.
By this measure, the lowly cockroach is a prime case through which to study risk management. Because the cockroach has survived through many unforeseeable changes — jungles turning to deserts, flatland giving way to urban habitat, predators of all types coming and going over the course of the millennia — the cockroach can provide us with a clue for how to approach unanticipated risks in our world of financial markets. What is remarkable about the cockroach is not simply that it has survived so long but that it has done so with a singularly simple and seemingly suboptimal mechanism: It moves in the opposite direction of gusts of wind that might signal an approaching predator. This “risk management structure” is extremely coarse; it ignores a wide set of information about the environment — visual and olfactory cues, for example — which one would think an optimal risk-management system would take into account.
This same pattern of behavior — using coarse decision rules that ignore valuable information — appears in other species with good track records of survivability. For example, the great tit does not forage solely on the small set of plants that maximize its nutritional intake. The salamander does not fully differentiate between small and large flies in its diet. This behavior, although not totally responsive to the current environment, allows survivability if the nature of the food source unexpectedly changes. We also see animals increase the coarseness of their response when the environment does change in unforeseeable ways. For example, animals placed for the first time in a laboratory setting often show a less fine-tuned response to stimuli and follow a less discriminating diet than they do in the wild.
The coarse response, although suboptimal for any one environment, is more than satisfactory for a wide range of unforeseeable environments. In contrast, an animal that has found a well-defined and unvarying niche may follow a specialized rule that depends critically on that animal’s perception of its world. If the world continues on as the animal perceives it — with the same predators, food sources, and landscape — the animal will survive. If the world changes in ways beyond the animal’s experience, however, the animal will die off. Precision and focus in addressing the known comes at the cost of reduced ability to address the unknown.
A prevailing set of market conditions can be thought of as a “fitness landscape.” As Bookstaber points out, fine-tuned optimization for that landscape can provide great rewards on a temporary basis. But if the landscape shifts suddenly, there is risk of disaster. (Sound familiar?)
If going extinct is comparable to financial wipeout, then “extinction events” happen in markets on a routine basis — seemingly every few years. A strategy that worked quite well for a certain environment, for a certain length of time, dies a sudden, violent death, taking its overly complacent practitioners down with it. (Though some rise again from the dead: In the 2008 crisis, T. Boone Pickens had an energy fund that was down 98%.)
For traders, the lesson of the cockroach is clear: Simple, straightforward risk management techniques are superior for ensuring survival over time. Using a reasonably tight stop loss on a position that is moving against you may not sound very sophisticated, for example. But then, the champion survivors of the animal kingdom aren’t in it for style points either.
What’s more, the benefit of survival is greater than just “not going extinct” (though that is a pretty sweet benefit). The other compelling bit of logic is this:
- Truly spectacular trades (and truly wonderful market conditions) only come along every so often.
- The longer you survive, the more of those trades you’ll get to make (and the more of those conditions you will see).
Not rocket science… but apparently not all that obvious, given the vast number of traders who burn up or fritter away their capital (via overtrading in poor conditions or excessive risk taking in hostile environments).
In further benefit, a robust trading methodology can find and exploit opportunity in all manner of environments. (Not every single one, but a wide and diverse percentage.) In reference to the chart-informed trifecta of fundamentals, technicals and market sentiment — as applied with a strong risk management overlay — Michael Marcus expressed the opinion that one could trade “any market in the world that way.” That is the biological equivalent of surviving and thriving in all kinds of habitat… from deserts to jungles to plains.
This train of thought was jogged by a Wharton discussion with Nassim Taleb on fragility and over-optimization (available via Paul Kedrosky here).
In arguing why an oil shock could actually be a good thing — a sort of wake-up call to get us off our butts — Taleb brings up the concept of “anti-fragility,” also the subject of his “Black Swan” follow-up:
There is robustness, fragility, and anti-fragility. [Anti-fragility] is not robustness, it is beyond… you give someone a little poison and they get stronger.
Economic life gets stronger not with bailouts, but with bankruptcies. Evolution works not with bailouts — there are no bailouts in nature — but with competition and natural selection.
So you need to have some stressors. And we have not been stressed enough (in regard to oil prices)… this is the fragility of depending on one source, one product.
It is optimal to use oil, but more dangerous… almost 99 cases out of 100, optimization makes you vulnerable and fragile.
Taking this back to trading, it seems clear that some strategies are “fragile” while others are “anti-fragile.” To be “anti-fragile,” a strategy must not only survive violent dislocations as a rule, but actually become even more attractive when things get rough.
Fragile strategies, in contrast, are highly dependent on rosy or otherwise optimized conditions — a backdrop of extreme complacency and cheap liquidity for example — and prone to disastrous collapse when those conditions change.
Looking back at the shifting fitness landscape of the past 20 years or so, we can see just such a mix of fragile and anti-fragile outcomes in play.
Those investors and traders who relied on one-way markets and cheap credit flows (hallmarks of optimized conditions in which fragile strategies bloom) repeatedly found themselves facing “extinction events” every few years: 1994, 1998, 2000, 2002, 2007, 2008 and so on. (At the height of the madness, the extreme abundance of fragile strategies led Michael Milken to exclaim that “leverage is not a business model.”)
The anti-fragile strategies, in contrast — typically more generalist than specialist, and more pro-volatility than anti-volatility — tended to underperform somewhat in euphoric or optimized periods, but then survived or even outperformed fantastically when the major dislocations occurred.
Better still, anti-fragile approaches tend to experience “extinction events” at a far lesser frequency, or even not at all. For true longevity in markets, it is not the mild times one needs to have covered, but the wild times. A predilection for tight risk points and a basic respect for fat tails, for instance, is enough to sidestep “the big one” entirely.