Home Commercial trading Conviction is the enemy of performance

Conviction is the enemy of performance

0

In the initial phase of my career, I worked as a sell-side corporate bond trader. Trading ultimately turned out not to be my true calling, but I generated consistent profits with a simple method: buy on the bid side, sell on the bid side. Under the guidance of experienced traders, I learned to spot imperfections in the market which sometimes allowed me to improve the basic formula by buying below the bid side or selling above the bid side.

There were other voices, however, lecturing me on the vital necessity of “having convictions.” Translation: You are morally obligated to decide which direction the market is heading in the short term and load your inventory accordingly, i.e. with long or short positions.

The individuals most insistent on this point are a few interprofessional brokers. These intermediaries, most of whom ranged from harmless to genuinely helpful, earned one-eighth of a point commissions by facilitating – or if they were more skilled, inducing – trade between dealer companies. The more deals they negotiated, the higher their earnings.

Pressing me to have conviction, the most problematic interdeal brokers hoped to generate trades that otherwise would not occur. They sought to persuade me to buy bonds on the bid side, if I was bullish, in hopes of selling them at higher prices when the market rallied. It was a surefire way to lose money, I quickly realized. As far as I know, no one was able to consistently correctly guess the direction of the short-term market. Nothing in the next 45 years changed my mind about it.

The best I can say about the interprofessional brokers who urged me to have conviction is that they were less dangerous than a senior executive of a firm in which I worked. He imagined that his background in investment banking would equip him to be a timekeeper of the market. One day he reproached me: “The market is recovering, but your inventory is exhausted.” This was true, as highly motivated buyers allowed me to close my long positions with strong profits. In the current environment of all buyers/non-sellers, I couldn’t replenish my inventory at attractive prices, so I was biding my time. Predictably, the buys on the bid side that the so-called market magician forced me to do all turned into substantial losses when the rally subsided.

Why take the risk?

Many luminaries in the financial media live by the credo of “having convictions”. This is demonstrated by the absolute certainty with which they present their forecasts, instead of making potentially defensible statements such as “I think the odds are currently in favor of further pullback.” The most adamant in their positions are permabulls and permabears who pick the latest economic indicators to create the illusion that only a dunce could disagree with them.

A conundrum, however, confronts those who believe that market timing can produce sustained outperformance. We periodically see traders being charged with market manipulation, that is, forcing prices to move in a certain direction. Why would these high-paying market participants risk criminal charges if convincing themselves of the direction prices would take of their own volition was really a reliable way to generate profits?

But can you do it again?

As my career moved into credit analysis, investment strategy, and financial management, I discovered that a long-term perspective served investors better. Chasing rallies and selling out during liquidations was a recipe for underperformance. Some pundits have turned a single “great call” – likely the product of luck rather than real skill – into celebrity status or substantial assets under management, but sooner or later their supposed powers of prognosis have failed.

An analyst became famous for making a high-conviction bearish call just before the October 19, 1987 stock market crash. Her media profile grew to such a height that she was even hired to star in a pantyhose commercial. Unfortunately, her purported market timing skills didn’t translate to superior results when she moved into mutual fund management. In 1988, its growth equity fund was the worst performer in its class.

Conclusion

It does not follow from any of the above that passive management is the only valid investment choice. A variety of active approaches can be successful in generating superior risk-adjusted returns, such as sector rotation, stock selection and dynamic hedging. My experience tells me, however, that having belief in the direction of the market is not a likely path to long-term success.