Economic Rockstar

Connecting Brilliant Minds in Economics and Finance

125: Eugene Fama on the Efficient Market Hypothesis, the Feds Fund Rate, Bitcoin and Daily Routines

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125: Eugene Fama on the Efficient Market Hypothesis, the Feds Fund Rate, Bitcoin and Daily Routines

Eugene Fama Economic Rockstar

“I went into academics because I didn’t want to go into anything that would affect my sports life.” – Professor Eugene Fama

Eugene F. Fama is Professor of Finance at the University of Chicago Booth School of Business. Professor Fama was awarded the 2013 Nobel laureate in economic sciences and is widely recognized as the “father of modern finance.”

Professor Fama’s research is well known in both the academic and investment communities. He is strongly identified with research on markets, particularly the efficient markets hypothesis. He focuses much of his research on the relation between risk and expected return and its implications for portfolio management. His work has transformed the way finance is viewed and conducted.

Eugene is a prolific author, having written two books and published more than 100 articles in academic journals. He is among the most cited researchers in economics.

In addition to the Nobel Prize in Economic Sciences, Professor Fama was the first elected fellow of the American Finance Association in 2001. He is also a fellow of the Econometric Society and the American Academy of Arts and Sciences. He was the first recipient of three major prizes in finance: the Deutsche Bank Prize in Financial Economics (2005), the Morgan Stanley American Finance Association Award for Excellence in Finance (2007), and the Onassis Prize in finance (2009).

Professor Fama was awarded doctor of law degrees by the University of Rochester and DePaul University, a doctor honoris causa by the Catholic University of Leuven, Belgium, and a doctor of science honoris causa by Tufts University.

Eugene is chairman of the Center for Research in Security Prices at Chicago Booth, which was founded 40 years ago to create the finest tools for tracking, measuring, and analyzing securities data. He is also an advisory editor of the Journal of Financial Economics.

Professor Fama earned a bachelor’s degree from Tufts University in 1960, followed by an MBA and PhD from the University of Chicago Graduate School of Business (now the Booth School) in 1964. He joined the GSB faculty in 1963.

Economists:

In this episode, Professor Fama mentions: Gary Becker, Vernon Smith, John Cochrane,Robert Shiller, Campbell Harvey,  John Campbell, Narasimhan Jagadeesh, Sheridan Titman, Cliff Asness, Louis Bachlier, Paul Samuelson, Benoit Mandlebrot, Robert C. Merton, Fischer Black, Myron Scholes, Merton Miller, Harry Roberts and Kenneth French.

Economics:

In this episode, Professor Fama mentions: EMH, anomalies, Momentum Effect, January Effect, Options Pricing Model, Price Earnings Ratio, Federal Reserve, Fed Funds Rate, reserves, reserve requirements, lending mechanism, quantitative easing, economic activity, bitcoin, speculation, medium of exchange, Ripple and blockchain.

Professor Fama’s Mentors:

  • Merton Miller, Harry Roberts and Benoit Mandelbrot.

Individuals were very important to me especially Merton Miller and Harry Roberts. And Benoit too. – Professor Fama

Find out:

  • How studying economics in the 1960s differs to present day.
  • What is EMH and how it relates to the random walk and the submartingale process.
  • The beginning of mathematics in economics in the 1960s.
  • Independent, identically distributed  – a more restrictive view of EMH.
  • How prices and returns are so noisy that it is difficult to identify stock-picking skills.
  • About stock market anomalies.
  • What is the problem in academics?
  • About the Federal Funds Rate.
  • Does the Federal Reserve Bank or the market control the Fed Funds Rate?
  • If there is a lending channel.
  • Do we need a Federal Reserve bank?
  • About Professor Fama’s views on Quantitative Easing (QE).
  • About Professor Fama’s hobbies and how he uses them to regain balance in his life as an economist.
  • Why Eugene Fama went into academics.
  • Find out about Eugene’s daily routines.
  • About Bitcoin.

On the Problem in Academics:

“There is a problem in academics. Everybody wants to publish papers. That’s the way they advance and get tenure and get higher salaries. They also get noticed on Wall Street for doing it. So there’s an incentive to dredge the data and come with things that will be attention-grabbing but won’t necessarily be there in new data and aren’t the basis for new strategies.” – Professor Fama

Eugene Fama Economic Rockstar

On Theoretical Models

“Robustness is the name of the game. All scientific theories have anomalies otherwise they’re not theories, they’re reality.”

“All science is you propose models, you test them and you come up with some stuff that says that says this works pretty well and then you come with other stuff that says well it doesn’t work very well on this particular so called anomaly. And so you either tweak the model to incorporate that or you just accept it as one of the shortcomings of the model. That’s why you called them models.”

“You have to be careful. It has to be systematic empirical work. You can’t just go work with anecdotes. Anecdotes are not empirical work.”

On the Fed:

“What goes on when you go to work for the Fed or you get onto the Board or whatever, it’s the invasion of the Body Snatchers. Whatever you thought before becomes irrelevant and you buy the party line or you buy the line that says they have a lot of power.”

“I don’t there ever was a lending channel but there certainly isn’t one now.”

“The main job of the Fed is to control inflation. Unfortunately, in the current regime they can’t do that.”

On Bitcoin:

  • I’m suspicious about it as a unit of account because it has such an uncertain value. Monetary theory basically says that you want a unit of account that has a certain value.
  • It’s just like paper currency. If no body is willing to use it, it becomes valueless.

Thanks to Conor Murray for the question on Bitcoin!

On Writing:

  1. There’s no easy way to do it. I do a lot of writing with Kenneth French. We always re-write these papers that we put out at least twenty or thirty times front to back. And you struggle over every word and you try to say stuff as simply as possible because by saying it simply you reach more people than saying it in a more complex way.
  2. Work on it. Really read it. Get other people to read it and get their reactions.
  3. Organize how you present stuff. You want a brief introduction. Most papers tend to have long introductions. Get right into the guts and keep it as simple as possible for as long as possible so that you lose the fewest number of people.

Movies:

 

Patreon

If you’re a fan of the podcast and would like to show your support in anyway, please check out my Patreon page at patreon.com/economicrockstar where you can sign up for any of the awards for as little as $1 a month or you can simply follow me on the Economic Rockstar Facebook page or on Twitter or simply recommend the show to a friend, especially if they have never had the opportunity to study economics.

 

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098: Kirk Du Plessis on Options Trading and Creating on Online Teaching and Trading Platform

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098: Kirk Du Plessis on Options Trading and Creating on Online Teaching and Trading Platform

Kirk Du Plessis is a full-time options trader, real estate investor, stay-at-home Dad and personal trading coach.Kirk Du Plessis Economic Rockstar

His background and experience includes time on Wall Street as an investment banker, a senior stock analyst and a senior loan officer.

Kirk is the Founder and Fund Manager at Option Alpha, an online education and training platform for options traders with students from 42 different countries around the world.

You can grab his completely FREE 12-Part Video Training Course which will help you discover how to trade options for consistent monthly income over at optionalpha.com.

Kirk was recently featured in Barron’s Magazine as a contributor to their Annual Broker’s Review.

Kirk’s podcast, The Option Alpha Podcast, features great tips, advice and explanations on all things options trading.

In this Episode, Kirk mentions and discusses:

options, options trading,derivatives, calls, puts, bull call spreads, straddles, stock market, efficient market hypothesis, technical analysis, wasting asset, time decay, turtle traders, delta, survivorship bias, discipline, arbitrage, black swan and leverage.

Podcasts:

Links:

 

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056: Campbell Harvey on Improving Significance Tests, the Importance of Positive Skew and the Future of Blockchain

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056: Campbell Harvey on Improving Significance Tests, the Importance of Positive Skew and the Future of Blockchain

Campbell R. Harvey is Professor of Finance at the Fuqua School of Business at Duke University and a Research Campbell HarveyAssociate of the National Bureau of Economic Research in Cambridge, Massachusetts. He served as Editor of The Journal of Finance from 2006-2012 and is President-elect of the American Finance Association.

Professor Harvey obtained his doctorate at the University of Chicago in business finance. He has served on the faculties of the Stockholm School of Economics, the Helsinki School of Economics, and the Booth School of Business at the University of Chicago. He has also been a visiting scholar at the Board of Governors of the Federal Reserve System.

Campbell received the 2014 Reader’s Choice Award for the best paper published in the Financial Analysts Journal and the 2015 prize for the best paper published in the Journal of Portfolio Management. His recent work on evaluating trading strategies has won best paper awards.

Campbell’s research interests include statistical methods, risk management, asset allocation, real assets and cryptocurrencies. He is the Investment Strategy Advisor to the Man Group plc, the world’s largest, publicly listed, global hedge fund.

Economics:

In this interview, Campbell mentions: t-statistics, significance tests, trading strategies, investment premium, beta, correlation, standard deviation, confidence interval, P-value, Bonferroni multiple testing method, Type I error, Type II error, probability, normal distribution, optimal portfolio, volatility, expected returns, portfolio, pay-off, skew, over-fitting, regularisation, Efficient Market Hypothesis, Fractal Markets, stock market anomalies, Straw Man Model, momentum effect, mis-pricing and outliers.

Economists:

In this interview, Campbell mentions: Nassim Taleb, Benoit Mandlebrot, Peter Edgar, Yan Liu and Eugene Fama.

In this episode you will learn:

  • why it’s important to use t-statistics and significance tests and how it can be improved.
  • about the very simple idea Professor Campbell Harvey applies to his statistical modelling to improve the robustness of his tests.
  • why it’s wrong to use 2 standard deviations to have 95% confidence when running many tests.
  • about ‘Significant’, the XKCD cartoon that illustrates the vulnerability of statistical significance testing.
  • do green jelly beans really cause acne? How significance tests can mislead with a fluke.
  • how a trading strategy based upon picking a portfolio of shares based upon the first letter of a ticker symbol showed that those tickers that began with the letter A outperformed other stocks.
  • how testing multiple times is effectively data mining and what should be done about it.
  • about the meaning of 95% confidence and 5% level of significance.
  • what a p-value is and why we ant it to be as small as possible.
  • if it’s important for the finance and economics profession to look at how other sciences are applying testing methods?
  • whether we need a tougher standard to lower the possibility of false discoveries?
  • if there is a chance of a fluke finding and why we should apply the Bonferroni multiple testing method solve this?
  • about the decay signature of the Higgs Boson and whether it is just background noise.
  • whether the findings of many published academic peer-reviewed papers are wrong.
  • about Type I and Type II errors and their trade-off.
  • about All Trials’ mission to make all randomised control trials made public.
  • the problems when measuring and using volatility in asset returns.
  • why the level of skew in a distribution must play more of an important role in risk management and portfolio selection.
  • why Taleb’s Black Swan only looks at one side of the distribution – the negative side, and why we must also look at the positive side.
  • how applying ‘regularization’ to portfolio selection avoids ‘over-fitting’ the data so that unexpected future outcomes can be considered.
  • about the efficient market hypothesis and the 316 anomalies that have been published to refute this hypothesis.
  • why the best traders are in Asia and how insider activity makes them so.
  • about the rise of crypto currencies and Bitcoin and why schools across US universities are introducing modules on it.
  • what is blockchain and why its is safe.
  • about the bank’s idea of creating a permission blockchain.

The Problem with Significance Testing and How to Solve It

If you’re trying to see if a variable Y is associated with a variable in a significant way, we usually think of looking at that correlation and determining whether you’re 95% confident that you’ve got it right. Usually what that means is that you’re 2 standard deviations away from zero. So, zero would be there’s no relation.

It turns out that that is perfectly acceptable if we’re looking at one correlation between Y and X. However, if it’s not X, it’s X1 you try. You try X2. You try X3, you try … X100. You try 100 different things. Then the criteria of using 2 standard deviations to have 95% confidence is just plain wrong.

The reason why this is wrong, is that when you’re running 100 tests, there is going to be a high probability that something will turn up that’s 2 standard deviations from zero just by chance.

The ‘Jelly Bean’ cartoon by XKCD called ‘Significant’ illustrates how testing a hypothesis can become misleading when conducting a significance test. The hypothesis being tested here is whether jelly beans causes acne.

A randomised control trial is ‘conducted’ by scientists. This is done where, say we have 50 people with jelly beans and 50 people with no jelly beans and we count the acne. And what basically happens is that there is no significance. So the scientists don’t achieve the 95% and conclude that there is no relation between jelly beans and acne.

However, the cartoon further illustrates what happens when the color of each jelly bean is tested to see if a particular color causes acne. 20 additional randomised control trials are conducted. The cartoon shows that the link between the Red Jelly Bean and acne is insignificant. Blue Jelly Bean – insignificant. Until you get to the last jelly bean, the 20th, which is the Green Jelly Bean. They find that there is a significant relation between Green Jelly Beans and acne. The final frame in the cartoon is a headline saying ‘Green Jelly Beans Linked to Acne’.

So, if you do 20 trials, one of those is likely to show up as significant using the standard criteria and it’s a fluke.

“The idea of my research is that we need to raise the bar that 2 standard deviations is no longer – that 2 sigma is no longer – something that should be considered. We need to go much higher.” – Professor Campbell Harvey

http://imgs.xkcd.com/comics/significant.png

The Bonferroni Multiple Testing Method

When we say that there is 95% confidence, we are saying that there is a 5% chance that the finding is a fluke. The 5% is called the p-value. What you would like is for that p-value to be as small as possible. You want as small as possible probability that the finding is a fluke. So the usual p-value for a single test with just X and Y for 5%, would imply 2 standard deviations. When you do multiple tests, you need more than 2 standard deviations from zero. If there is a chance of a fluke finding, then we should apply the Bonferroni multiple testing method solve this.

What the Bonferroni does is a simple correction. What it says is ‘you discover a p-value which is, say, 0.004 and you multiply by the number of things or X’s you’ve tried, which is, say, X1 to X100. All of a sudden, your p-value transforms to 0.4 or 40%. That means there is a 40% chance that in repeated trials that this thing you’ve identified, say X57, is a fluke. So when you use this adjustment, you discard that variable.

Quotes by Professor Campbell Harvey in Episode 56 of the Economic Rockstar Podcast:

In the practice of finance, some investment manager goes to a client and shows a great strategy and looks amazing. But they don’t tell the client or potential client that they tried 499 other possibilities and this is the only one out of 500 that worked – Professor Campbell Harvey. 

“Over half of what’s published in empirical asset pricing is probably incorrect” – Professor Campbell Harvey

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“The problem with volatility is that it is a symmetric measure, that if you’re way above the average that contributes to the same volatility as if you’re way below the average” – Professor Campbell Harvey

“I’ve being pushing for the last 15 years to reform the way that we do our portfolio analysis, our standard models, to have the skew play a role.” – Professor Campbell Harvey

“It’s also a fact that it’s really hard to find any asset return that adheres to a normal distribution. If it does, it is very unusual.” – Professor Campbell Harvey

“What we want in economics and finance is repeatability.” – Professor Campbell Harvey

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“I believe, just as Gene Fama believes, that markets are inefficient.” – Professor Campbell Harvey

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“Blockchain provides a way to give unprecedented security. You’re immune effectively from this hacking.”

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Books:

Papers:

Other Resources:

Websites:

Where to Find Campbell: 

Website: Duke University

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029: John Cochrane on the Future of Finance, MOOC Education, Regulation and the Case for Free Markets

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029: John Cochrane on the Future of Finance, MOOC Education, Regulation and the Case for Free Markets

John Cochrane is the AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business and is currently Senior Fellow at the Hoover Institution.

Professor Cochrane is a Research Associate of the National Bureau of Economic Research and past director of its asset pricing program, and an Adjunct Scholar of the CATO institute.

John is past President and Fellow of the American Finance Association, and a Fellow of the Econometric Society. He has been an Editor of the Journal of Political Economy, and associate editor of several journals including the Journal of Monetary Economics.

John’s is the author of 3 books including the book Asset Pricing. Other  finance publications include articles on stock and bond markets, exchange rates, interest rates, liquidity premiums and option pricing.

John’s monetary economics publications include articles on the relationship between deficits and inflation, the effects of monetary policy, and on the fiscal theory of the price level.

John currently teaches the MBA class Advanced Investments and a variety of PhD classes in Asset Pricing and Monetary Economics.

John earned a Bachelor’s degree in Physics at MIT, and earned his Ph.D. in Economics at the University of California at Berkeley.

In addition to research and teaching, John is a competitive sailplane pilot and windsurfs.

John blogs as ‘The Grumpy Economist’.

Find Out:

  • why Professor Cochrane is known as the Grumpy Economist.
  • about John’s Proposed New Structure for US Debt.
  • how to create financial stability with a currency fit for the 21st century.
  • about the advantages of government debt.
  • what happened when Ireland guaranteed the bondholders and entered into a bailout.
  • the limitations to a eurozone country when faced with a bailout.
  • why countries should be allowed to act like companies and default.
  • why Greece should have defaulted and why Ireland should not have bailed out the bondholders.
  • about Professor Cochrane competing in the World Gliding Championship for the USA.
  • why Professor Cochrane delivered his Asset Pricing PhD course as a MOOC.
  • the costs and benefits of delivering a MOOC.
  • how MOOCs will become the textbook of the future.
  • how to monetize a MOOC and which type of course would have mass market appeal.
  • Ireland’s aim to become the capital of MOOCs.
  • how to create a social environment for students using MOOCs.
  • why Professor Cochrane went from a degree in physics to a PhD in Economics.
  • why people are stuck in the welfare system.
  • about the over-regulated US economy that restricts the development of competitive markets.
  • how Uber gave supply-side competition in the US taxi market.
  • what should be done to the US healthcare industry which is protected from competition.
  • if the US Federal Reserve should end its monopoly on the dollar and allow other currencies, such as Bitcoin, compete.
  • about the unique feature of US government debt – it cannot default!
  • who are Professor Cochrane’s heroes due to their no bullshit approach to research.
  • why the the 2008 financial crisis was proof that the efficient market hypothesis works.
  • what annoys Professor Cochrane.

Influencers:

  • University of California: George Akerlof, Roger Crane, Jim Pearce and Tom Roffenburg.
  • University of Chicago: Robert Lucas, Lars Hansen, Gene Fama, Ed Prescott and Tom Sargeant.

Defining Moment

A professor was showing an economics class that John attended in which he explained, using the Budget Constraint, why people are stuck in welfare. Up to that point, John had read that it was due to people being lazy or that it was due to moral, sociology or cultural. However, the analysis showed that any normal person who was stuck below an income threshold and receiving benefits would not welcome a moderate pay rise as they would lose entitlements.

Here was a value-free, and ethics-free, a morality-free discussion of a social problem that showed exactly where it came from, exactly how to fix it, exactly how the perverse design of the well-intentioned welfare was causing people to get stuck. That was my conversion moment.

Economics:

In this interview, John mentions and discusses: Asset Pricing, unintended consequences, free markets, incentives, budget constraints, welfare, competition, supply-side competition, regulation, monopoly, natural monopoly, bitcoin, debt, default, Gold Standard, fractals and efficient market hypothesis.

Economists:

In this interview, John mentions and discusses: George Akerlof, Roger Crane, Jim Pearce, Tom Roffenburg, Robert Lucas, Lars Hansen, Eugene Fama, Ed Prescott, Tom Sargeant, Benoit Mandlebrot

“What makes free markets work is the discipline of competition, of the ability of new entrants to come in and disrupt things” – Professor Cochrane.

“Regulation is stifling the ability of  new people with great ideas, with cost control ideas to come in and make healthcare both better and a lot cheaper” – Professor Cochrane.

The Future of Finance:

Professor Cochrane likens the financial crisis as a ‘good old-fashioned’ run on the banks. Twenty years ago, the world economy developed ‘electronic interest-paying money’. Most of the financial system uses overnight repurchase agreements, money market funds and short-term government bonds. These became very liquid and have been prone to runs just like bank notes. For financial stability, the crucial thing is to get away from this run-prone system.

John proposed that governments should provide interest-paying electronic money that will not experience a run in the 21st Century. This would look something like a money-market fund. It will always be worth $1, pays interest and will always be electronically transferable. Financial stability would be achieved and we would have more efficient payments.

On Ireland Bailing Out All Depositors

Irish banks took a lot of German deposits and invested them in US sub-prime mortgages. The money passed through Ireland and it’s not quiet clear why the taxpayers of Ireland who footed the bill for that. Why couldn’t the depositors from Germany lost a little bit of their money along the way. That would have seemed to make sense. Cyprus and Iceland made their depositors take haircuts.

When you’re a small country with an open banking system, the model of the government who bails out all depositors including foreign depositors is not one that can go on. That’s a troublesome system. Ireland maybe regretting bailing out all of the depositors in the process.

Since Ireland is part of the EU and the eurozone, it cannot print money to bailout people. Government debt in that situation becomes private debt. Ireland would not be in as much trouble if it didn’t bailout the depositors in its bank.

Greece certainly should have just defaulted the way a company defaults. If a company defaults on its debt it doesn’t have to leave the eurozone, so why shouldn’t countries become like companies.

MOOCs: The Future but Not a Substitute for Formal Education

Professor Cochrane delivered his PhD class ‘Asset Pricing’ as a MOOC. He felt that such ‘cut and dry’ material would be easier to get started with, particularly when he also had a book of the same name, rather than a more discussion-based empirical class. There were numerous challenges along the way. “It turned out being a lot more work than I thought it was going to be but it also turned out very rewarding”. It allows Professor Cochrane to leverage his delivery going from teaching 20 students to upward of thousands of students.

MOOC

Like any new technology, there are lots of unanticipated ways in which it can be used, unanticipated markets that are going to find it that nobody thought about it how that was going to work out. MOOCs were originally intended to deliver ‘introductory-type’ classes which would have mass appeal. However, John believes that the way forward for MOOCs is in the delivery of ‘distinctive-type’ classes where the class is more specialised and in greater variety.

Creating a MOOC can be costly in terms of time, resources and the infrastructure that needs to be built to deliver the course. “Like all technology, if you’ve ever made a webpage, it has a high fixed cost but low marginal cost.” The secret to putting a MOOC together is it has a high fixed cost to put it together. Creating the video content for lectures is easy. It’s putting together the significant typo-free problem sets and other materials like that that’s hard. But once the MOOC is done, it is scalable in terms of multiple years and to a lot of people.

Professor Cochrane views MOOCs as a way of creating a ‘flipped classroom’. They will not be a substitute for formal education but one of the ways that MOOCs will develop into is that they will become the modern textbook. “The MOOC is a self-contained class outside the university but it’s a textbook for my classroom”. Professor Cochrane’s Asset Pricing class at Stanford is a much less formal experience due to the flipped nature of his classroom.

MOOCs have allowed his students to review the material and answer the questions in his series of videos before they arrive to class. Subsequently, Professor Cochrane can deliver more advanced material, as well as have an in-dept discussion on the material the student reviewed on his MOOC. The class becomes a much more rewarding, personal, interactive experience.

MOOCs will be beneficial to the university in so far as creating a brand so as to attract more students to attend. Being online with a MOOC will be useful for the university to connect with their alumni who may be interested in doing an executive education. The MOOC will be paid for indirectly by attracting people into the executive programmes since the flipped classroom model would work very well for this cohort of people.

The social environment of the class turns out to be very important to getting people to stick with the course on MOOC. MOOCs need to move from its current form to a version “2.0 Social Internet and to re-create that social structure that gets people going. The next round of MOOC will need to integrate social media so that the learning experience becomes part of a community of students just like it is on campus”.

How to Create a Social Environment for Students on MOOCs

  • Scheduled classes so that students attend together.
  • Discussion forums where students are encouraged to participate after the class.
  • Weekly Google Hangouts

http://youtu.be/U5CfYQw4X7k

How Similar the Study of Physics is to Economics

Physics teaches you quantitative analysis as well as modelling.

There is some truth in the physics joke: “Physics is the study of massless elephants going down a frictionless sandpaper”. You have to find the elements of a problem, simplify it down to what’s solvable and intuit how it works, not only mathematical. It’s about the intuition of seeing something work and describing it mathematically.

Economics is similar to undergraduate physics – everything before Quantum Theory. If you’re good at mechanics and electricity of magnetism, then that structure is what’s behind economics and you should be equally good at economics. You will also be good at the modelling part of economics which is all about throwing out all the real-world details that don’t really matter to a particular problem. If the mass of the elephant wasn’t particularly important to that problem, then just assume the mass of sumables. That’s the key to economics.

Economics is full of quantitative parables and you have to make them vivid by making them simple and clear. And then understanding intuitively how to put the pieces together.

On discovering economics, Professor Cochrane believed that he could use the tools of Physics to understand all the hard social problems that everybody is fighting and getting so excited about in a value-free way.

On Bitcoin:

“The design of Bitcoin is fundamentally flawed. We have lost anonymity. That worries me for political reasons as well as economic reasons”. Anything that is done electronically, then the National Security Administration knows what you bought if you use your credit card. Cash allows you to do things anonymously. “Bitcoin promised anonymity but didn’t really deliver it in the first place.”

Bitcoin is based on the Gold Standard model where we need a fixed supply of something rather than a steady price of something.

Where to Find John Cochrane:

The Grumpy Economist

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015: Niels Kaastrup-Larsen on Trend Following Strategies and Stock Market Turmoil Ahead

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015: Niels Kaastrup-Larsen on Trend Following Strategies and Stock Market Turmoil Ahead

TopTraderPodcast NielsNiels Kaastrup-Larsen is Managing Director of Dunn Capital (Europe). Niels is a trend follower with more than 20 years experience in the hedge fund industry, working for some of the largest CTAs or Commodity Trading Advisors in the world, including Chesapeake Capital. Niels co-founded, built and managed three businesses within the alternative investment space, including Rho Asset Management.

Niels trades futures markets in a systematic and highly-automated way. He is the founder and host of the popular podcast ‘Top Traders Unplugged’, where he uses his experience and contacts in the industry to deliver insightful, engaging and passionate interviews with the most successful hedge fund managers and traders.

Economic and Finance Themes:

In this interview, Niels mentions and discusses: Trend following, futures markets, gold, anomalies, confirmation bias, efficient market hypothesis, fixed-income securities, treasuries, bonds, the Great Depression, stock market portfolio, diversification, equities, systematic trading, stop-losses, technical analysis.

Niels’ Influencers:

Jerry Parker of Chesapeake Capital, Michael Lewis and Jack Schwager

‘There’s no doubt that Jack Schwager’s book ‘Market Wizards’ was an inspiration’ – Niels Kaastrup-Larsson

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Niels’ Affirmations:

  • ‘The trend is your friend’.
  • ‘KISS – Keep it Simple’.
  • ‘Cut your losses, let your profits run’.
  • ‘Diversification is so important because markets are very different animals and you’re going to have periods of time where types of markets are trending and easy to trade.’
  • Strict Risk Control.

Niels’ Personal Habits:

Niels loves playing football on a Friday evening with a group of friends who all come from diverse backgrounds. It allows him to clear his mind and to think about things other than trading.

In todays world we really need to focus on WHY we do what we do and not just what we do and how we do it – Niels citing Simon Sinek (see recommended books below).

Find out:

  • about trend following and how to spot a trend.
  • what is a trend following strategy.
  • two ways in which we can take on market risk – one good and the other not so good.
  • how emotions can lead to losses.
  • why trend followers use computers with built-in trend following rules to make trades.
  • why we are more likely to buy a bar of soap that is reduced by 50% in a retail store than buy a stock that has fallen 50%.
  • how you should diversify a portfolio.
  • how global markets are beginning to diverge which is key for a trend following strategy.
  • why Niels believes that global markets will be in turmoil within the next 5 years.
  • why Niels believes the economic cycle will turn by October 2015.
  • why events will unfold just like 1929.
  • if the Swiss and Germans should take back their gold reserves from the United States.

  • about whether there are job opportunities in the trading industry today.

  • why the industry has become more scientific.

  • how to navigate through the noise when markets undergo a process of price discovery.

  • why Niels created the Top Traders Unplugged podcast rather than write a book.
  • Niels recommendation for a great market data resource.

Niels didn’t know what he wanted to do after High-School, but one thing he did know was that he didn’t want to go to university and try to learn from books. He was much more interested in doing things and being practical is his approach to learning.

A job in a bank seemed a good compromise – Niels would learn by doing and get paid for it!

Niels’ Defining Moment:

Niels took a job in a large bank in Denmark straight out of High-School and, during his induction week, he passed by a room full of young people waving their arms and shouting. He found out that they were trading currencies, stocks and bonds. Immediately, Niels knew that after his 2 years of training, that’s what he was going to do. At the age of 19 or 20, Niels began trading Danish government bonds.

Niels began reading international magazines about traders and came across tables of rankings based upon trader performance. These traders were systematic trend followers or Commodity Trading Advisors.

Trend-Following:

It was intriguing to me to see that these people [trend-followers] could continue to produce extraordinary returns.

Niels searched for and read books on interviews with traders in general and some were rule-based or systematic traders.

Niels got a chance to work with Jerry Parker of Chesapeake Capital who was once part of the well-publicized Turtle Trader experiment, which was run by Richard Dennis and Bill Eckhardt.

“It is the most consistent way of investing your money when you look at it in the very long-run”  – Niels Kaastrop-Larsen.

I see people like Jerry Parker and Bill Dunn with thirty or forty years track record still making all-time highs and they’re still going strong, There are not that many discretionary traders doing that. I think that there is something to this methodology.

Trend following comes down to the way we as human beings take on risk. There are two ways that we can do that:

1) a convergent risk-taking style.

2) a divergent risk-taking style.

A convergent risk-taking world is one where you believe that you know where all the risks are and you see the environment as being stable. Therefore, you are willing to bet a large proportion of your assets on a single or few investment themes because you really fell sure that you have it right. When assets go up based on on your expectations, you take your profits quickly as the movement confirms your theory.

On the other hand, when equities fall you still believe that you will be right at the end of the day. So what happens is that you are going to increase your risk and double-up – ‘you double in trouble’. Unfortunately, many investors make their decisions when prices are going against them.

In a convergent world, the profile of a trader is one who makes very small gains because you take your profit quickly. But once in a while you have a devastating loss with huge amounts because you won’t accept you’re wrong.

The equity curve or the returns profile for this trader is quite flat and then spikes downwards where you will lose most, if not all, of your money.

In a divergent risk-taking world, people confess that they don’t know what is going to happen tomorrow. So, the way they play these situations is that they are always unsure what they are going to do and, therefore, their risk-taking is generally small. But since their risks are small, it allows them to take risks in many different opportunities at the same time.

If people here are wrong and, because they feel unsure about their investment from the beginning, they cut there losses quickly just to get out. They didn’t feel good from the beginning and if they continue to lose money then it will feel worse.

When these people are right and their trades are working out for them, then they believe that something is right and they take on a little bit more risk because the movement is going in their favor. They increase their position size.

The equity curve of this trader can be flat or slightly down for some time but then spikes upward where they get a good run and increase their risk at the right time. They make a lot of money with these few investment opportunities.

‘The universe that I came from, the trend-followers or rule-based strategies, use a divergent strategy. We’re not trying to forecast what is going to happen tomorrow, we let the financial media try to that. Instead, we analyse historic price data and when data goes in a certain direction, then we essentially react to that price action’ – Niels Kaastrop-Larsen.

Trend Following Strategies:

Trend following is about ‘buying highs and selling lows’, which is the opposite to what most people would think. They buy the lows because they think it’s cheap and sell the highs as it’s more expensive.

Trend followers think completely opposite to the traditional investor.

Trend following strategies are also known as using price breakout methodologies.

If a stock, like Microsoft, was reaching a high, a trend-follower would buy or go long this stock with the belief that it could go higher. If the stock was at the lower end of a price range or band, then you would want to go short the stock.

Moving averages could also be used with the same effect, but their are small differences.

Once you’ve got your entry signal, then you need an exit because if you are wrong, you need to cut your losses. You want to have small losses and big winners.

Many traders lose money because they don’t know when to get out and even if they do, they usually don’t have the discipline to get out. This is why trend followers use computers to do it for them because, emotionally, it is not very easy to take a loss. It’s not very easy to take a profit either, so using rules and putting them into a computer.

‘The rules do not have to be complicated. But it’s the discipline of doing this day-in-day-out, even with 10 losing days in a row, you still keep doing it as you believe in the rules you created’ – Niels Kaastrop-Larsen.

Based on cognitive reasoning, our brains actually work quite opposite to our day-to-day decisions that we make.

A lot of people don’t make money in the stock market despite all the news and advice that they get.

Trading a Diversified Portfolio:

If you want others to trade for you then you need:

1) Different managers: Each manager trades different markets,

2) Speed: both short-term, medium-term and long-term periods.

3) Strategies: Then you can go into detail about the strategies.

‘You should certainly allocate to smaller managers who are more nimble, who maybe more innovative because they have more flexibility in their strategy, which the bigger firms don’t have. They can trade markets that the bigger firms can’t do.‘

If you want to trade for yourself you need to:

1) Consider whether you want to trade all markets – commodities and financials or just a few.

2) Know how you’re going to make your investments, not when.

‘You must have a prudent approach to risk and that really boils down to diversification.’

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Market Turmoil Expected Soon:

‘The problem is going to start in the fixed-income market. It’s the bond market that I worry the most. The whole system has been pumped with liquidity and a lot of bad debt is sitting in places in the system that we probably don’t know about’ –Niels Kaastrop-Larsen.

‘The whole idea of creating a strong and more stable financial structure has back-fired because the banks have not become smaller, they’ve become bigger. So the systemic risk that the authorities wanted to combat back in 2009 has in fact increased’ – Niels Kaastrop-Larsen.

The economic cycle will turn by October 2015 and once they turn, that will have a major effect on the financial markets. Once this happens, the fixed-income markets around the world will burst, so the bubble in sovereign debt will burst.

This means the whole financial sector will get into much more serious problems than before because there is not any central bank in the world that can take interest rates from 5% to zero. The weapons in their armoury is much less. This will spill over to the equity markets, but you could see a steep increase in equity markets before this happens. This is what happened in 1929 before the Great Depression.

We could be in the first depressionary environment since 1929 when we get into 2016, 2017 and 2018. That’s a scary thought but it can create opportunity.

The losers in this will be retail investors who, by their bank and financial advisor, will be advised to buy more bonds or more stocks because that’s where we’ve seen the gains in the last 5 years.

If you don’t understand history, you’re likely to repeat your errors.

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Gold Reserves and The Swiss Referendum:

The people of Switzerland made the wrong choice by not demanding that the Swiss National Bank should hold at least 20% of their reserves in gold and by not demanding that gold be returned to Switzerland.

Gold will get its shine back. It will fall a little before going back up.

There are a number of theories about the amount of gold in Fort Knox, with one of them being that there is no longer the amount of gold in the vaults there that we may once believed.

‘Many believe that gold is a hedge against inflation. To me gold is a hedge against government’ – Niels Kaastrup-Larsen

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If you had an asset at a time of crisis, wouldn’t you want it at home? Countries should have their gold at home. The Americans told the Germans it would take them 8 years to deliver the gold. So maybe there is some truth about whether the gold is still there or not.

Are There Job Opportunities in Trading Today?

The approach to trading is more scientific now more than ever. Trading firms look for scientists who can work with large volumes of data in order to identify patterns.

‘There are less need for traders because machines have taken over’ – Niels Kaastrup-Larsen

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You are more likely to get a job in the trading industry if you come from a more academic or scientific approach.

If you trade your own account and have found a system, then it could be a good idea to approach a large firm and tell them of your system and trading history. You should be honest that you do not know of all the answers. That way you could get a position with a firm.

‘90% of assets are managed by 10% of managers, and 10% of assets have to be divided by 90% of managers’

How to Navigate Through the Noise When Markets Undergo a Process of Price Discovery:

If you are using moving averages, you have the element of time involved meaning that the moving averages have to turn and cross before you get a signal to either enter or exit a trade.

When it comes to exiting a trade, using moving averages can be dangerous in some ways because if you have a very steep and fast change in trend you could give back a lot of your profit.

A price breakout strategy would allow you to use stop-loss rules that can allow you to move up underneath the trend.

The only thing you should look at is the price. Price is objective. It is probably the only thing we can rely on that in this very second the price of a financial futures market is what it is. Anything you start doing after price is a derivative of price whether it is volatility or something else. I would caution against using too many fancy indicators – KISS – Keep It Simple’

Favorite Books:

Favorite Internet Resource:

  • Commodity Systems Inc. – Market Data and Trading Software “Provides great data in a timely manners and it’s quite inexpensive compared to other providers

Where To Find Niels Kaastrup-Larsson:

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