Submitted by Nicholas Colas of DataTrek Research
We have 3 lessons about how to manage money and emotions in volatile markets. All come from our time at SAC, watching great traders navigate treacherous volatility during the 2000 bursting of the dot com bubble. The key takeaways: communicate, stick to a hyper-disciplined process, and make your environment work for you.
Earlier in the week, as S&P futures were indicating a gap-down open, I had a flashback to the bursting of the dot com bubble in 2000. The location of that memory was the parking lot in front of SAC Capital, which was then headquartered in a modest Connecticut office park. It was about 7am and I was in a small cluster of other PMs and traders, all chatting and gathering up our courage to go upstairs and start the day.
Then we saw another trader slowly circling the lot in his car with the windows down. We could hear he was talking, but to no one in particular… “It’s going to be bad…. It’s going to be really, really bad…”
That was a shock, because this was someone who usually traded like his pad was thickly coated in Teflon. He was a consistent moneymaker, day in and day out. And he was scared. This did nothing for the mood of the group, so once he finally parked we collected him and went upstairs.
Yes, Story Time this week centers on methods I have seen over the years that help investors and traders manage the mental challenges of outsized price volatility. As is our custom, we have 3 points on the topic:
Lesson #1: Talk – and listen – and talk some more.
In the old SAC trading room Steve sat in a row surrounded by his senior PMs – a hugely talented group of traders – and he spoke to them consistently throughout the day. Yes, sometimes during specific events like Fed decisions the room got very quiet. But more commonly, and especially when things got choppy, these senior traders were constantly feeding Steve ideas, information and perspectives. Sometimes all they got was a nod in return. Other times, it could be a 5-minute conversation. But Steve wanted to hear – and often talk – about everything.
As I have mentioned in prior STTs, SAC had an in house psychologist named Ari Kiev and we all met with him weekly. Yes, he wanted to talk about our feelings, but the conversation was always centered on how we literally felt when we bought and sold stocks. Confident? Anxious? What made us feel that way?
There is a reason early psychoanalysts called their therapy “the talking cure”. Humans are social animals. Bottom line: communication gives internalized stress a more productive outlet than self-flagellating introspection.
Lesson #2: Stay Disciplined and Tread Carefully
That trader with the mini-meltdown in the parking lot was highly successful because his trading discipline would put an ancient Spartan to shame.
He ran a market-neutral book, so his long exposure was typically within a few dollars of his shorts. Every single-stock position had a parallel position on the other side. Long GM, short Ford, for example, and dollar for dollar.
When anything he was trading hit his price target, he would both start to sell it down and simultaneously reduce his exposure in the offsetting trade. It didn’t matter if the other side of the trade was working or not. Off it came.
He got some grief for this approach because he seemed to be leaving money on the table by not taking seemingly minimal intraday market risk. But he never broke from the discipline and during whippy markets it kept him mentally stable and profitable.
Lesson #3: Make Your Process An Ally Against Stress
Volatile markets make the open an especially fraught time. Seeing steep losses once markets start trading can derail otherwise competent investors/traders. Instead of sticking to process, it can be all too easy to double down on losing positions and cut loose winners to reduce exposure.
One very senior trader had a clever hack around that. At the end of every day he would override the closing price and mark his positions lower. None of this affected the books and record of the firm – those were kept separately – so it was kosher.
Why would he consciously want to go home showing less of a gain or larger loss? Because it all but guaranteed that, once the pricing system refreshed the next morning at 930am, he would see a gain.
I know this sounds strange, but just imagine seeing a $500,000 profit at 9:31am versus a similar sized loss. It makes a big difference and lowers stress levels materially. Good decisions come easier when you are up on the day.
Summing up: these observations are meant as investment parables – stories about how individuals develop mental hacks to short-circuit the damaging behavioral effects of market volatility. And despite the fact that all come from a hedge fund experience, they apply to all forms of investing. Managing volatility is not only about what sorts of assets you own. How you shape your environment and maintain discipline matters just as much.