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The Alchemy of Finance by George Soros

January 14th, 2009
The Alchemy of Finance George Soros

The Alchemy of Finance George Soros

Buy From Amazon:
The Alchemy of Finance

by George Soros
Originally Published in 1987

Key Takeaways

This is not an easy book to read, but it deserves your attention.  I had heard the book should be skipped because it is long winded and difficult to follow.  But Soros is such an important figure in the world of investments that I had to read his seminal book on his Theory of Reflexivity and trading activity.

Although George Soros has a brilliant mind, he’s not necessarily a brilliant writer.  He used four hundred pages for ideas that should have been expressed in two hundred pages.  I don’t regret reading the book though.  He is a philosophical man with a lot of thought provoking ideas.  I respect his Theory of Reflexivity and enjoyed learning how Soros used it to identify investment opportunities while running his Quantum Fund in the 1980s.

The book has three core parts (officially it has five parts, but I take the liberty of viewing them as three): Part One advances Soros’s Theory of Reflexivity, Part Two is a journal account of Soros’s trading activity, and Part Three includes a potpourri of philosophical meanderings on the markets.

Part One is useful for its explanation of the Theory of Reflexivity, but it should have been condensed to 1/3 the number of pages.  Part Two is excellent for its rare view into the trading mind of the most successful hedge fund manager of all time.  Part Three was largely useless – it is composed of philosophical meanderings that he will later dismiss as irrelevant or incorrect.  What was the point?

Readers looking for concrete investing strategies, similar to those provided in James Altucher’s How to Trade Like a Hedge Fund, will be disappointed. The book gives you strategies, but they come on Soros’s terms – in an abstract form.  Largely philosophical and esoteric.

I have encountered several incorrect accounts of George Soros’s Theory of Reflexivity.  Most people oversimplify the interpretation and miss a final important concept.  Read on for a clarification of the reflexivity concept and what I believe are the key takeaways of the book.  If you like what you see, I encourage you to purchase the book here.

Page – 3 New Introduction to Reflexivity

The Concept of Reflexivity: In situations that have thinking participants, there is a two way interaction between the participants’ thinking and the situation in which they participate.  The two functions can interfere with each other by rendering what is supposed to be given, contingent.

Soros calls the interference between the two functions “reflexivity”.  He views reflexivity as a feedback loop between the participant’s understanding of a situation, and the actual situation in which the they participate. Thus, situations with thinking participants are circular.

Soros claims the concept of reflexivity is especially useful when evaluating financial markets, and that the concept of reflexivity succeeds where traditional economic concepts fail.   His writing becomes philosophical and technical, but he essentially tries to refute the belief that financial markets arrive at ‘rational’ and ‘efficient’ equilibria.  He says, “The Alchemy of Finance was meant to be a frontal assault on the prevailing paradigm.”  In the end, he holds that the Theory of Reflexivity is a superior theory to the efficient market hypothesis.

Soros starts off by saying that market participants (e.g. investors’) perceptions can influence prices.  And that this is especially obvious during times of greed or fear.  Prices get bid up or sold off irrationally because of people’s perceptions.

On the surface this sounds exceedingly obvious, and is why many people dismiss Soros’s Theory of Reflexivity as worthless.  For example:

“Reflexivity is nothing more than the notion that market participants affect a price, but that prices are dynamic and constantly influenced by perception — and here’s the GREAT insight — and perception sometimes is misled by unfounded herd momentum.”

or

“His philosophical tenet, Reflexivity, denotes a feedback loop: Individuals act on their views of a situation, thereby changing the situation. For example, if traders believe a stock is going up, they buy it, thereby bidding it up. But their belief caused the result; there may be no fundamental reason for the rise. Thus what we think determines what we do and has consequences, but typically it is not correct.”

Each of these readers miss the crucial and final point in the Theory of Reflexivity’s application in the financial markets.  They miss the point that while prices may rise initially on perceptions only, that prices can affect perceptions such that perceptions begin affecting fundamentals.

This is Soros’s crucial point.  That prices affect perceptions and that perceptions affect prices and that prices in turn affect fundamentals. So perceptions affect fundamentals.  i.e. perceptions can (temporarily) make an industry ‘fundamentally’ stronger.

In Soros’s own words:

Many reviews described reflexivity by saying that prevailing sentiments greatly influence market prices.  If that were all, I would be indeed belaboring the obvious. What makes reflexivity interesting is that the prevailing bias has ways, via the market prices, to affect the so-called fundamentals that market prices are supposed to reflect.  Only when the fundamentals are affected does reflexivity become significant enough to influence the course of events.  It does not happen all the time, but when it does, it gives rise to boom/bust sequences and other far-from-equilibrium conditions that are so typical of financial markets.

If this is still confusing, let me provide an example:

Reflexivity explains why the technology boom of the late 1990s got so out of control.  From 1997 to 2002 the Nasdaq rose from 1,200 in 1997 to 5,000 in 2000 and then fell back to 1,200 by 2002. That’s a tremendous change in value in a short period of time, and cannot be explained by an ‘efficient’ and ‘rational’ market.

How did this happen?

The Soros Theory of Reflexivity says that perceptions influenced prices and that prices influenced fundamentals. But that supporting fundamentals with perceptions is eventually unsustainable and that the entire structure eventually collapsed.

Let us consider the Theory of Reflexivity in the context of the consumer Internet sector in the late 1990s.  Yahoo! pioneered the sector and started out as a healthy and profitable company offering Internet services to users and advertising space to advertisers.  As Yahoo! continued to grow, it attracted more and more users, which in turn enabled it to sell more and more advertising space to advertisers.  This increased Yahoo!’s profitability, which in turn caused investors bid up Yahoo! shares to reflect the company’s increased value.

Now Reflexivity starts to enter the picture.  Yahoo!’s success attracted a first wave of Internet startup imitators.  The first wave of Internet startup imitators were able to point to the growth and success of Yahoo! shares to raise venture capital. After raising venture capital, the first wave of Internet startup imitators purchased advertising space from Yahoo to attract new users to their web sites.  This enhanced Yahoo!’s profitability.  It also provided the first wave of Internet startup imitators the opportunity to begin selling advertisements on their own web sites.  This caused investors to bid up the shares of Yahoo! and of the first wave of Internet startup imitators.

Increasing share prices attracted more investors and a second wave of Internet startup imitators. The second wave of Internet startup imitators purchased advertising space from Yahoo! and from the first wave of Internet startup imitators.  This increased the profitability of Yahoo! and it increased the profitability of the first wave of Internet startup imitators.  Soon, Internet startup imitators were raising more and more venture capital and were purchasing more and more advertising space from each other.  You can imagine how the system perpetuated itself.  More and more advertising revenue, meant more and more investment, meant more and more web services for users, meant more and more eyeballs, meant more and more advertising dollars, meant more and more investment.  The system was self reinforcing.  And the fundamentals looked great.  Lots of revenue and profit growth – all correlated to ‘eyeballs’.  The numbers did not lie either – revenues, and in certain cases, profits, were growing smartly.  All fueled by investor perceptions that had ‘altered’ the fundamentals.

Some observers will counter, “The web services the Internet startups were providing had value.  Once they gained ‘critical mass’, the Internet startup imitators stopped purchasing advertising and could ‘self fund’ through organic web usage.  Sure, lots of investors lost money on bad companies, but that was just a consequence of speculation, i.e. funding the bad companies, instead of the good.”

Yes, some companies could stand on their own. Yahoo! was profitable and could ‘self fund’.  About.com was profitable and could ‘self fund’.  Match.com was profitable and could ‘self fund’.  And yes, thousands of other companies were doomed regardless – they would never have provided enough ‘organic’ value to stand on their own, and were probably only the result of pure speculative excess.  But there was an undeniable slice of firms in the middle that temporarily thrived on the ‘reflexive cycle’, and who only existed in the first place because of funding fueled by investor perceptions.

Reflexive systems have a way of reinforcing themselves until savvy investors start to catch on that the system is unsustainable in the long run, and pull their money or until an outside event occurs that causes a pullback.  Once savvy investors caught on to the fragile business model of Internet companies, and their reliance on venture capital derived advertising revenue, they began to pull money and the entire system was flushed of the firms that relied unduly on the ‘reflexive cycle’ for Internet advertising.  In the end, reflexive cycles end violently because perceptions can change quickly.  And when perceptions change at the end of a reflexive cycle, changes in fundamentals quickly follow.

The Alchemy of Finance covers numerous examples of reflexive boom bust systems, such as the sovereign lending boom of the 1970s where it was not recognized that credit extension enhanced the various debt ratios by which the banks measured a borrower’s creditworthiness, or the conglomerate boom where investors put a high value on earnings growth through acquisitions that reinforced the overvaluation of conglomerates, or the technology boom where investors valued top line revenue growth which could only be sustained by selling more stock at inflated prices.

I hope I have accurately described Soros’s concept of a reflexive process.

(be sure to scroll through additional pages below)

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The Post American World by Fareed Zakaria

January 10th, 2009
The Post American World by Fareed Zakaria

The Post American World by Fareed Zakaria

Buy From Amazon:
The Post American World

by Fareed Zakaria
Published in 2008

Key Takeaways

Don’t let the title fool you.  The first sentence of the book reads, “This is a book not about the decline of America but rather about the rise of everyone else.  It is about the great transformation taking place around the world, a transformation that, though often discussed, remains poorly understood.”  This is not a book about America’s decline, but a book about the emergence of the rest of the world and how America can best fit into the new world order.

I am a fan of Dennis Gartman’s The Gartman Letter.  The Gartman Letter is a widely read daily commentary on the global capital markets.  It is subscribed to by traders and investors globally. A few weeks ago Dennis extended, for only the fourth time in his letter’s 20+ years in existence, a new ‘must read’ book recommendation to his readers.  This recommendation was The Post American World by Fareed Zakaria.  His past recommendations have been: Reminiscences Of A Stock Operator by Jesse Livermore, both Market Wizards books by Jack Schwager, and By The Numbers by W. Stansbury Carnes and Stephen Slifer – all investing classics. So when he recommended The Post American World, I went right out and bought it.

Putting the book into the same vaunted category as Reminiscences Of A Stock Operator and Market Wizards is a stretch, but I liked the book and thought it was worthwhile.  My overall take is that the first five (of seven) chapters were mediocre, but that the last two chapters were excellent.

The problem with the first five chapters is that they are yet another rehash of the Brazil, Russia, India, China (BRIC) story.  Zakaria throws out all the predictable statistics and their implications: population size, economic growth, engineering talent, economic progress, opening of markets, widgets manufactured, outsourcing trends,  cultural dispositions, etc.  As someone who has heard the BRIC story ad nauseum since 2003, the chapters were largely recycled.  If you’re not familiar with the BRIC story, or want another rehash, then the first five chapters are very good.

The last two chapters of the book are where Zakaria’s book shines.  In the following post, I have summarized what I believe are the Key Takeaways of the book.  If you like what you see, I encourage you to buy the book.

(be sure to scroll through additional pages below)

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Finance and Investing Quotations

January 7th, 2009

Buy From Amazon:
Trend Following: How Great Traders Make Millions in Up or Down Markets
by Michael W. Covel
Published in 2005

Michael Covel’s Trend Following book was atrocious.  Probably the worst investing / trading book I’ve ever read.  The one place he excelled was in the collection of finance quotations (he included them presumably to make up for lack of original material and to boost his page count).  Luckily one can’t copyright quotations, so I’ve included the best below.

Famous Finance, Business, Trading, and Investing Quotations

No good decision was ever made in a swivel chair.
General George S. Patton, Jr.

A prudent investor’s best safeguard against risk is not retreat, but diversification. True diversification is difficult to achieve by spreading an investment among different stocks, or different equity managers, or even by mixing stocks and bonds, because the two are not complementary.
David Harding

Men wanted for hazardous Journey. Small wages. Bitter cold. Long months of complete darkness. Constant danger. Safe return doubtful. Honor and recognition in case of success.
The Time, London, 1913
Recruitment ad for Shackleton’s Antarctic Expedition

When it is a question of money, everyone is the same religion.
Voltaire

Education rears disciples, imitators, and routinists, not pioneers of new ideas and creative geniuses. The schools are not nurseries of progress and improvement, but conservatories of tradition and unvarying modes of thought.
Ludvig von Mises

The important thing in science is not so much to obtain new facts as to discover new ways of thinking about them.
Sir William Bragg

Fish see the bait, but not the hook; men see the profit, but not the peril.
Chinese Proverb

If you think education is expensive, try ignorance.
Derek Bok

The perfect speculator must know when to get in; more important he must know when to stay out; and most important he must know when to get out once he’s in.
Unknown

It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change.
Charles Darwin

The trend is your friend except at the end when it bends.
Ed Seykota

The four most expensive words in the English language are “this time its different.”
Sir John Templeton

Price makes news, not the other way around. A market is going to go where a market is going to go.
Peter Borish

Be less curious about people and more curious about ideas.
Marie Curie

I began to realize that the big money must necessarily be in the big swing.
Jesse Livermore

Most of us don’t have the discipline to stay focused on a single goal for five, ten, or twenty years, giving up everything to bring it off, but that’s what’s necessary to become an Olympic champion, a world class surgeon, or a Kirov ballerina. Even then, of course, it may be all in vain. You may make a single mistake that wipes out all the work. It may ruin the sweet, lovable self you were at seventeen. That old adage is true: You can do anything in life, you just can’t do everything. That’s what Bacon meant when he said a wife and children were hostages to fortune. If you put them first, you probably won’t run the three-and-a-half-minute-mile, make your first $10 million, write the great American novel, or go around the world on a motorcycle. Such goals take complete dedication.”
Jim Rogers

Whenever you can, count.
Sir Francis Galton

The beginning is the most important part of the work.
Plato

Life is a school of probability.
Walter Bagehot

Everything flows.
Heraclitus

I always know what’s happening on the court. I see a situation occur, and I respond.
Larry Bird

The difference between a successful person and others is not a lack of strength, not a lack of knowledge, but rather a lack of will.
Vince Lombardi

Measure what is measurable and make measurable what is not so.
Galileo Galilei

I think the only cardinal evil on earth is that of placing your prime concern within other men. I’ve always demanded a certain quality in the people I liked. I’ve always recognized it at once – and its the only quality I respect in men. I chose my friends by that. Now I know what it is. A self-sufficient ego. Nothing else matters.
Ayn Rand

Losing an illusion makes you wiser than finding a truth.
Ludwig Borne

A trader’s job description is stunningly simple: don’t lose money.
Richard Donchian

Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.
Jesse Livermore

The criterion of truth is that it works even if nobody is prepared to acknowledge it.
Ludwig von Mises

Success demands singleness of purpose.
Vince Lombardi

When the mind is in a state of uncertainty the smallest impulse directs it to either side.
Publius Terentius After

Lenny (Dykstra) was so perfectly designed, emotionally, to play the game of baseball. He was able to instantly forget any failure and draw strength from every success. He had no concept of failure. I was the opposite.
Billy Beane, Moneyball

Life is too dynamic to remain static.
John W. Henry

History does not repeat itself, people just keep forgetting.
Jason Russell

Knowing others is wisdom. Knowing self is enlightenment. Mastering other requires force. Mastering self requires strength.
Lao Tsu

If there is one trait that virtually all effective leaders have, it is motiviation. They are driven to achieve beyond expectations – their own and everyone else’s. The key word here is achieve. Plenty of people are motivated by external factors such as such as a big salary or the status that comes from having an impressive title or being part of a prestigious company. By contrast, those with leadership potential are motivated by a deeply embedded desire to achieve for the sake of achievement.
Daniel Goleman

Fat, drunk, and stupid is no way to go through life, son.
Animal House

Reason is the main resource of man in his struggle for survival.
Ludwig Von Mises

What feels good is often the wrong thing to do.
William Eckhardt

Human being never think for themselves, they find it too uncomfortable. For the most part, members of our species simply repeat waht they are told – and become upset if they are exposed to any different view. The characteristic human trait is not awareness but conformity… Other animals fight for territory or food; but, uniquely in the animal kingdom, human beings fight for their ‘beliefs’… The reason is that beliefs guide behavior, which has evolutionary importance among human beings. But at a time when our behavior may well lead us to extinction, I see no reason to assume we have any awareness at all.  We are stubborn, self-destructive conformists. Any other view of our species is just a self congratulatory delusion.
Michael Crichton

Having an education is one thing, being educated is another.
Lee Kuan Yew
Former Prime Minister of Singapore

Never call your intuition. It calls you.
Jason Russell

To be uncertain is to be uncomfortable, but to be certain is to be ridiculous.
Chinese Proverb

From error to error, one discovers the entire truth.
Sigmund Freud

I have no special talents, I am only passionately curious.
Albert Einstein

We want to buy stocks to hold forever.
Warren Buffett

If you want a guarantee, buy a toaster.
Clint Eastwood

We are what we repeatedly do. Excellence, then, is not an act, but a habit.
Aristotle

No human investigation can be called real science if it cannot be demonstrated mathematically.
Leonardo da Vinci

Never let fear of striking out get in your way.
Babe Ruth

If you don’t risk anything, then your risk even more.
Erica Jong

Life shrinks or expands in proportion to one’s courage.
Anais Nin

Most battles are won before they are ever fought.
General George S. Patton

Luck is a dividend of sweat. The more you sweat, the luckier you get.
Ray Kroc
Founder of McDonalds

The search for truth is more precious than its possession.
Albert Einstein

When the facts change, I change my mind.  What do you do sir?
John Maynard Keynes

I looked at myself as an athlete or a boxer in training who had to sacrifice many other things for the sake of success.
George Soros

Managing a hedge fund requires single-minded devotion.
George Soros

A man’s reach should exceed his grasp.
Robert Browning

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Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael Covel

January 6th, 2009
Trend Following Michael Covel

Trend Following Michael Covel

Buy From Amazon:
Trend Following: How Great Traders Make Millions in Up or Down Markets
by Michael W. Covel
Published in 2005

Key Takeaways

I’ve read a lot of investing books.  And this may well be the worst.  All fluff and no substance.  Reminded me of a bad high school English paper that spams the reader with superfluous words and narrow margins to meet a page count requirement.  After 150 pages, I seriously considered abandoning the book and moving on. But its in my DNA to finish any book I start, so I tortured myself skimming the last 250 pages of uselessness.

Trend Following is an excellent trading strategy and deserves to be studied.  But Covel, in Trend Following, is not the way to learn.  Covel goes in circles gushing about how great Trend Following is and about how great the Hedge Fund managers are that employ Trend Following.  But he sounds much more like a starstruck high school girl with a teenage crush than a trading guru.  He never gets around to giving us the beef.

Definitely don’t buy this book, you can get what you’re looking for in this post where I profile the techniques he covers, or you can read my post on ‘The Slow Turtle Trade‘ from James Altucher‘s book How to Trade Like a Hedge Fund.  When I find a good Trend Following book, I will update this post.

The one thing Covel did well was collect some excellent quotes on Finance, Trading and Investing.  He included at least two quotes per page (presumably to make up for lack of original material and to boost his page count).  For this, I was grateful and have provided the best in my post on Finance Quotations.

Page 266 – Trend Following Systems

(Yes, it took Michael Covel until 266 pages into his 400 page book to write anything worth remembering.)

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average

  • Buy the index when the Fast SMA (50 day) crosses over the slow SMA (100 day)
  • Sell and then go short when the fast SMA (50 day) crosses under the slow SMA (100 day)
  • Set a stop loss of four times the Average True Range (ATR) of 10 days

Note: The stop loss risk control avoids a loss of more than 2% of equity

Note: The True Range is the absolute value of the greatest of the following:

  • The distance from today’s high to today’s close
  • The distance from yesterday’s close to today’s high
  • The distance from yesterday’s close to today’s low

The Average True Range calculates the Simple Moving Average to the True Range.

Results:
Backtesting this trade from November 2001 to March 2002 results in a an average annualized return of 19.6% with a maximum drawdown of 46%.  But less than 40% of the system’s trades are profitable.  Using sensitivity analysis for the number of days to use in the Fast and Slow SMA, combinations in the 40 – 60 fast SMA days and 100 – 120 slow SMA days provide the best results.

Fast Simple Moving Average (SMA) Crossover of the Slow Simple Moving Average with Pattern Entry

This system combines trend following and countertrend concepts.  It is called Trend with Pattern Entry (TPE) and was first introduced by Dion Kurczek and Volker Knapp in Active Trader Magazine in April 2003.  The premise is that prices above the SMA indicate a bull trend, but should only be bought on countertrend pullbacks.  Similarly, prices below the SMA indicate a bear trend, but should only be sold short into countertrend rallies. The prices wait for three consecutive countertrend (down or up) days before entering the market.

  • Buy the index if the price is above the 100 day SMA and the closing price decreased over the last three days.
  • Exit the position (sell) if the price reaches the trailing stop, which is 4 times the ATR of 10 days subtracted from the current closing price.
  • Then short the index if the price is below the 100 day SMA and the closing price increased during the last three days.
  • Exit the position (buy to cover) if the price reaches the trailing stop, which is 4 times the ATR of 10 days added to the current closing price.

Results:
Backtesting this trade from October 2000 when the market experiences a strong up-move three times in a row while still below the SMA.  The system starts short and finally ends in early 2002.  The system generates 21.8% annualized returns, but experiences several drawdowns of over 20% and one of 49%. Indeed, large drawdowns are the biggest challenge for Trend Following systems.  The large drawdowns are why investors are instructed to Trend Follow a basket of uncorrelated assets and commodities.  If an investor were to get hit by highly correlated large drawdown across all investment classes, it could wipe them out.

There are several variations to these techniques such as Pyramiding, or adding to a position shortly after the trend is validated and proved profitable.

Remember, the best part of the book are the quotes Covel collected, so be sure to visit my post on Financial Quotations.

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