Charles-Henry Monchau・31 March 2021・ Investing
The setbacks of the Archegos Capital fund remind us that some management mistakes can be fatal--especially when they are cumulative. This past Monday, we learned who was behind the gigantic orders placed on the market the previous week. In a perfect "remake" of the movie "Margin Call", the Archegos fund was forced to liquidate more than $20 billion of positions after failing to meet margin calls. This liquidation caused a stir on the world markets, with Credit Suisse and Nomura declaring "significant losses". How can a fund of such a large size and managed by seasoned professionals disappear in just a few days? Are these management errors avoidable? It is interesting to note that the majority of investors, whether seasoned or novice, often make the same mistakes. Below, we review what we consider to be the 7 deadly sins of trading and investing. A trading or investment strategy is a guideline to follow regarding the initiation of a position, the setting of a target, a time horizon, and the use of stop-losses. Without a trading plan, emotion and irrationality can take over. The use of stop-losses allows you to limit losses before they become too large - which can be very helpful when using leverage. It is also highly recommended to plan ahead of crises rather than during them. Most traders wait for the markets to crash before developing a strategy. This leaves them completely unprepared. The best solution is to develop a plan in advance. For example, by buying small amounts in the downward phase of the markets - a practice known as "dollar-cost averaging". The history of financial crises proves that this is a strategy that has very often proven to be successful. Buying options without knowing the specifics is a recipe for failure. It is essential to do a thorough analysis of the instruments and assets one wishes to buy. Investors must also look at the market players, the fundamentals, supply and demand, etc. Warren Buffett himself says that he only invests in companies whose business models he understands. Whether we are talking about investment or trading, the problem remains the same: it is preferable to position yourself on what you know. This system allows you to control your emotions during very volatile periods. It is easier not to panic when you have a strong conviction about the asset in which you are invested. As in other disciplines, the euphoria generated by a success can cloud judgment and decision making. The adrenaline of a win can lead investors to rush into another position with the newly gained capital without prior analysis. This can lead to losses and wipe out recent gains. That is why it is important to stick to your trading plan. Another way to keep your feet on the ground is to adhere to the discipline of "rebalancing" your portfolio, that is, periodically readjusting the strategic weightings of your portfolio. For example, after a strong period of rising equity markets, a portfolio may have a disproportionate allocation to equities compared to other asset classes. A portfolio rebalancing forces the investor to take profits on positions that have disproportionately outperformed and re-allocate to positions with more promising potential. Like a plane crash, the biggest losses in the stock market are not the result of a single mistake but the accumulation of several failures. Overexposing capital to a small number of positions can lead to higher profits, but it also increases the inherent risk of the portfolio--hence the importance of diversifying portfolios. One of the aggravating factors is the use of leverage, which is essentially a loan made to a trader to increase the size of their position. By betting more than his capital, the gains can be multiplied but so can the losses. Indeed, when the position turns out to be losing, the trader has to resort to margin calls or forced sales in order to cover losses. The risks incurred by traders become even greater when the instruments traded have low liquidity. In case of forced selling, the trader is forced to liquidate a large amount of securities in a tight market, creating what is called a downward spiral: the more securities the trader sells, the lower the price, the more margin calls force the trader to sell more and so on. This is exactly what happened in the case of Archegos. By concentrating their portfolio on a small number of positions with very high leverage, the Archegos fund got into a vicious cycle once the market went against them. You should cut the losers and ride the winners. A typical mistake made by many traders and investors is to hold on to losing positions in hopes of "making it back". The temptation to leave losing trades open in the hope that the market will turn around can be a serious mistake, and failure to limit losses can wipe out profits that an investor has made elsewhere. The same psychological mechanism means that winning positions are often cut too quickly, in order to make a sure gain. Successful traders operate in the opposite way. They want to limit their losses (risk management very often via stop-losses) but leave the door open for gains. When a position is in the process of being won, the momentum is often on the trader's side and it is therefore appropriate to leave a position open. It is very often in the great bullish phases that the largest profits are made in trading. On the other hand, closing all winning positions prematurely is bound to fail. Many investors tend to think that the market is wrong, without speculating that they may have misinterpreted certain developments. How many investors have bet against the bond market in recent years on the grounds that yields are too low (or even negative)? Why did so many investors pick up on the extraordinary success of companies like Apple, Google or Tesla too late because of too generous a P/E? Even modern portfolio theory teaches us that there is a rational justification for every price movement. An almost systematic mistake is not to invest in a stock or market because the valuation ratio is too high. It is more important to understand the reason behind a valuation premium or discount but also the factors that could create a change in market perception. Of course, the market can sometimes be wrong, with investors overreacting on both the upside and the downside. It is during these famous "turning points" missed by the consensus that "contrarian" positioning can be most beneficial. But investors and traders who systematically bet against the market lose in most cases. Countless investors have missed out on two unprecedented bull markets: the bond market bubble of the past 25 years and the U.S. equity market bubble since 2008. The reason given by the skeptics? Quantitative easing and over-indebtedness policies can only lead to a macro-economic catastrophe, synonymous with inflation, corporate bankruptcies and loss of credibility for governments. But it is indeed the torrents of liquidity injected by central banks that have created the famous TINA (There Is No Alternative), "forcing" investors to invest their cash in bonds and shares. Fiscal stimulus seems to be contributing to the continuation of the bull market in risky assets. At the risk of bursting the bond bubble? Once again, investors should not underestimate the creativity of the Federal Reserve and the famous "Don't fight the Fed". A basic principle: policymakers set the rules of the game - investors should allocate their capital according to those rules - not the other way around.Not having a strategy.
Not knowing what you buy.
Overconfidence.
Triple trouble: concentration; illiquidity; leverage.
Keeping losers, cutting winners.
Blaming the market.
Betting against monetary and fiscal policy.
Charles-Henry Monchau
Introduction
As an expert in trading and investing, I have a deep understanding of the concepts discussed in the article you provided. I can provide insights and information related to the 7 deadly sins of trading and investing mentioned in the article. Let's dive into each concept and explore them further.
1. Not having a strategy
Having a trading or investment strategy is crucial for success. It provides a guideline for initiating positions, setting targets, determining time horizons, and implementing stop-loss orders. Without a strategy, emotions and irrationality can take over, leading to poor decision-making. It is recommended to plan ahead and develop a strategy in advance, rather than waiting for a crisis to occur. One effective strategy is "dollar-cost averaging," which involves buying small amounts during market downturns. This strategy has proven successful in many financial crises.
2. Not knowing what you buy
Thoroughly understanding the instruments and assets you invest in is essential. Conducting a comprehensive analysis of the market players, fundamentals, supply and demand, and other relevant factors is crucial. Warren Buffett, a renowned investor, emphasizes the importance of investing in companies whose business models you understand. By investing in what you know, you can better control your emotions during volatile periods.
3. Overconfidence
Overconfidence can be detrimental to trading and investing. After experiencing success, the euphoria can cloud judgment and lead to impulsive decision-making. It is important to stick to your trading plan and avoid rushing into new positions without proper analysis. Rebalancing your portfolio periodically can help maintain discipline and adjust strategic weightings based on market conditions.
4. Triple trouble: concentration, illiquidity, and leverage
Concentrating capital in a small number of positions can lead to higher profits but also increases the inherent risk of the portfolio. Diversifying portfolios is crucial to mitigate risk. Additionally, using leverage, which involves borrowing to increase the size of positions, can amplify both gains and losses. Illiquid instruments further exacerbate the risks, as forced selling in a tight market can create a downward spiral. The Archegos fund's recent liquidation serves as an example of the consequences of concentration, illiquidity, and leverage.
5. Keeping losers, cutting winners
A common mistake made by traders and investors is holding onto losing positions in the hope of recovering losses. Conversely, winning positions are often closed too quickly to secure guaranteed gains. Successful traders follow a different approach. They aim to limit losses through risk management techniques like stop-loss orders while allowing winning positions to continue benefiting from momentum. Great profits are often made during bullish phases, so it is important not to prematurely close winning positions.
6. Blaming the market
Blaming the market for investment losses without considering personal misinterpretations is a common error. It is crucial to understand the reasons behind valuation premiums or discounts and the factors that can influence market perception. While the market can sometimes be wrong, investors who systematically bet against it tend to lose. Identifying turning points and adopting contrarian positions can be beneficial, but it requires careful analysis and understanding of market dynamics.
7. Betting against monetary and fiscal policy
Many investors have missed out on significant market opportunities by betting against monetary and fiscal policies. Quantitative easing and fiscal stimulus measures have influenced market dynamics and created favorable conditions for certain asset classes. Investors should not underestimate the impact of central bank policies and should align their capital allocation accordingly. It is important to recognize that policymakers set the rules of the game, and investors should adapt to those rules.
In conclusion, the 7 deadly sins of trading and investing discussed in the article highlight common mistakes made by both seasoned and novice investors. By understanding and avoiding these pitfalls, investors can improve their decision-making and increase their chances of success in the financial markets.
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