Investoid

I was approached by Timothy Sykes, a trader who met with success while he was still in high school, to read a pre-release copy of his book, an An American Hedge Fund. I agreed to read it, not sure of what to expect.

After reading through it, I found that the book is an interesting look at Sykes’ life to date. He made the bulk of his money riding penny stocks during the dot com boom, and subsequently continued to increase his wealth during the bust by shorting the same type of companies he rode on the way up. Eventually Sykes decided to leverage his personal funds into creating a hedge fund. While Sykes goes into detail about how he made his millions, this book is not about the method. It is more of a biography that has some interesting thoughts and lessons for active investors/traders.

For me, the most insightful aspect of his book is how he keeps hammering home the mistakes he made and the psychological traits that were behind his trading decisions. I think this is a crucial aspect for anyone to understand in order to achieve long term success in active investing/trading. Sykes’ no holds barred confessionals made me feel like I’ve learned through his mistakes.

Sykes devotes the last part of the book to his trials and tribulations as a hedge fund manager. He becomes disenchanted with the hurdles that hedge funds face when trying to raise capital, and uses this as motivation to write the book. While I enjoyed reading the ending sequence regarding hedge fund regulations, I thought some more detail would be beneficial (although maybe just an egghead like me wants to know the specifics).

Overall, Sykes has written an engaging book that provides some solid lessons about trading psychology. He has a readable style that makes you want to finish the book as soon as possible.

For more info on Sykes’ new pursuit of investor education on the hedge fund industry, check out his website.

Disclosure: I will be receiving a complimentary copy of the book for my review of his work.

After reading a book review on Capital Ideas over at Canadian Financial DIY’s site, I decided it would be good to write about one of the books I read last year that had a lasting impact on me.

The (Mis)Behavior of Markets is written by Benoit Mandelbrot, a mathematician who is the inventor of fractal theory. Mandelbrot has been applying fractals to many different areas of application, including finance, for over 40 years. While modern financial theory was being written, Mandelbrot was finding issues with the mathematical models used for the derivations and suggested alternatives. While his work was largely ignored during the explosion of mathematical finance, his views have been gaining momentum over the past 10 years or so.

In this book, Mandelbrot provided a non-technical account of what’s wrong with the basic tenets of modern financial theory, namely:

• Asset returns can be modeled with the normal or log-normal distributions, meaning that:
  • returns from separate time periods are independent (ie. no correlation)
  • the mean return is an important number because it can be used as an expected value for future returns
  • it is very unlikely to have extreme returns (ie. 99% of returns should be within 3 standard deviations of the mean)
• Investors have identical knowledge and goals
• Price changes are nearly continuous (as opposed to sporadic changes that cause the price to ‘jump’)

Mandelbrot uses evidence from various financial situations, not the least of which the 1998-2001 bubble/bust era, to demonstrate how these assumptions rarely hold (if ever). By refuting the models that form the basis of modern financial theory (including the Black-Scholes option pricing formula), Mandelbrot sets the stage to offer his own mathematical models that he believes more accurately depict how financial markets work.

I won’t go into any technical detail about fractals (neither does he in the book), but from his modeling he draws some interesting conclusions:

• Markets are way more risky than financial theory suggests (which most people can appreciate - just look at the huge 8.3% decline in China today).
• Bubbles are apt to happen: due to the long term correlation in pricing with his models as well as empirical evidence that trends occur in stocks, bubbles are not only possible but likely from time to time.
• Value metrics are useless: the only appropriate way of determining stock prices is based on estimating what someone will pay for it later, regardless of what is underlying the asset. Thus all value metrics (P/E, etc.) have no ability to assist with investment decisions.
• Market timing is of high importance. Because of the correlation of returns, you need to be able to follow the trends in order to capitalize on them.

Mandelbrot’s views are a fresh take on financial markets from a mathematical perspective, one that has little vested interest in actual investment outcomes. His theories are self-admittedly early in their development, and many young researchers have begun to expand on his basics to more accurately refine the models and re-develop financial theories regarding risk and portfolio construction using them.

It is important to note that fractals are not the only advanced mathematical theory out there that’s looking to supplant the incumbent theories. Chaos theory and nonlinear filtering are two other types of mathematics that look to explain price movements and take advantage of the current use of traditional pricing methods in the markets.

I don’t agree with all his conclusions, because I don’t think his models completely encapsulate investor behaviour, but they are definitely better than the current status quo. I highly recommend that you pick up his book and read it. It provides great insight into what may very well be the future of portfolio management theory and application.