Episode #244: Tom Basso, “Investing Is A Mental Game More Than It Is Having The Perfect Indicator Or…Even The Perfect Position Sizing”
Guest: Tom Basso is a long-time trader, trend-follower, author, and founder of Trendstat Capital Management.
Date Recorded: 8/19/2020 | Run-Time: 1:00:35
Summary: In today’s episode, we’re talking trend following and trading. We start with some of Tom’s early trades, cutting his teeth on corn futures, and, as a disciplined trend follower, going through hell before a silver futures trade was in the books for a nice gain. We discuss power laws and outliers, and his finding that it sometimes came down to a handful of trades that made the difference between profit and breaking even, or even losing money for the year.
We cover the critical concept of position sizing, and why it has been a cornerstone of Tom’s trading systems over the years. We get into the mental side of investing, and as we wind down, Tom lets us in on the virtues of trading multiple, symbiotic strategies.
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Links from the Episode:
- 0:40 – Intro
- 1:51 – Welcome to our guest, Tom Basso
- 6:23 – Tom’s early trades
- 6:40 – The New Market Wizards: Conversations with America’s Top Traders (Schwager)
- 13:30 – The importance of position sizing
- 14:03 – Successful Traders Size Their Positions – Why and How? (Basso)
- 19:29 – Importance of long-term trading in Tom’s trading style
- 26:18 – The Capitalism Distribution (Longboard)
- 30:20 – Option Selling Funds (Faber)
- 33:05 – Importance of being patient
- 35:52 – Panic-Proof Investing: Lessons in Profitable Investing from a Market Wizard (Basso)
- 37:08 – Investing during drawdowns
- 41:50 – Rebalancing
- 41:56 – The Meb Faber Show Podcast – Episode #18: Rob Arnott, “People Need to Ratchet Down Their Return Expectations”
- 41:49 – The Meb Faber Show Podcast – Episode #124: Howard Marks, “It’s Not What You Buy, It’s What You Pay for It That Determines Whether Something Is a Good Investment”
- 43:45 – Changes to Tom’s approach over time
- 44:07 – Automated Stock Trading Systems: A Systematic Approach for Traders to Make Money in Bull, Bear and Sideways Markets (Bensdorp)
- 48:07 – Thinking you’re diversified when you’re really not
- 50:15 – Tom’s website – Enjoy The Ride
- 57:16 – Most memorable investment
Transcript of Episode 244:
Welcome Message: Welcome to “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-Founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Hey, podcast listeners, we have an unbelievable show for you today. You will find yourself in the presence of a true investing Zen master. And by the end of the podcast, you will learn lessons not only about winning the investing game but also the game of life. Many of you will know our guest from his interview with Jack Swagger and the “New Market Wizards” book. He’s a longtime trader, trend follower, author, and founder of Trendstat.
In today’s episode, we’re talking trend following and trading. We start with some of our guest’s early trades cutting his teeth on corn futures, and as a disciplined trend follower, going through hell before silver’s futures trade was in the books for a nice gain. We discuss power laws, and outliers, and his finding that it sometimes came down to a handful of trades that made the difference between profit and breaking even or even losing money for the year. We cover the critical concept of position sizing and why it has been a cornerstone of our guest’s trading systems over the years. We get into the middle side of investing. And as we wind down, our guest let’s us into the virtues of trading multiple, symbiotic strategies. Please enjoy this episode with Tom Basso. Tom, welcome to the show.
Tom: Hey, good to be here.
Meb: Tell our listeners where in quarantine are you in the world?
Tom: I’m in a little town of about 15,000 people called Payson, Arizona up at about 5,000 feet in the mountains of Arizona.
Meb: We dipped into Arizona on our trip. So we’re on an eight-state tour with my wife and child in a Subaru. We’re on the last leg about to go home to Los Angeles. And as I mentioned to you stopped in San Francisco and a lot of NorCal. There was a fire tornado, by the way, we passed through Tahoe and they said there’s a huge warning you may come across a fire tornado. And I said let’s just go back to Colorado it seems so much safer. California feels like it’s gonna fall into the ocean but you’re getting ready to go to Colorado, right?
Tom: Yeah, I am, we’re gonna do some fly fishing, some golfing at the Broadmoor. Fly fishing at the Broadmoor as well in their new camp that they built a few years ago. And then we’re…for the first time my wife and I are gonna go glamping which is sort of a high-end tense experience where they bring gourmet food to you and you go hiking and it sounds really rough.
Meb: I’m actually a big glamping proponent. And my wife and I, one of our first dates was at a little glamping place outside of Santa Barbara called El Cap Canyon. I thought it was pretty romantic. But I remember this moment where we’re looking up at the stars, and I had like a star app that would like, show you where all the constellations are. Because I can only pick out the Big Dipper, and that’s about it. And I just remember her staring at me just being like, “Can you put the phone away?” I was like, “Yeah, but look, there’s Taurus, there’s Libra.” And she’s like, “Yeah, but this is an interaction.” So she was early to the, get off your device.
All right, let’s talk about fly fishing. So we’ve done a ton of this on this trip. If you’re watching this on YouTube, this picture in the back is from the Flat Tops Wilderness. So we’ve spent a lot of time. My two brothers are big fishermen. And I’ll tell you a secret spot in Colorado that has certainly the largest river trout I’ve ever caught, just an enormous fish. Is there any sort of fishing in the mountains of Arizona, you gotta go to New Mexico, you gotta go to Colorado?
Tom: We actually are 40 minutes away from the mountain lakes up here to the east, Woods Canyon and Willow Springs, and they have some holdovers. But they actually stock the lakes once a week with huge tanks of fish from the fishery that’s also up on the rim. And the temperature in the water is about 60 degrees spring fed. Just a sort of a dammed-up gorge, several of them, to preserve water and give the wild animals something.
We’ve got a huge Ponderosa forest, and we’ve got bald eagles, and we’ve got all sorts of peregrines, and osprey. So there’s…I’ve seen aerial battles overhead where an osprey would hunt for fish and go down and get the fish and it’s in his talon. And a bald eagle will come by and start doing an aerial combat with him, right over my head, I’m taking pictures. And the osprey to get away from the bald eagle drops the fish. Bald eagle goes into a dive, gets the fish in his talon before it hits the water and flies away to feed his young. Unbelievable.
Meb: We saw a few bald eagles on this trip. I also was wandering down a creek by myself listening to a podcast as I would do wild fly fishing. The problem with that is you don’t really hear much in the way of nature and sounds. Popped up upon a mama moose and baby. Thankfully, it was across the river otherwise moose can be a bit ornery. Well, I figure we’ll talk about markets at some point. I’ll send you my secret spot later.
Tom: Yeah, that lake behind you looks like a prime fly fishing on top maybe.
Meb: The funny part about this…this is turning into fishing hour with Meb and Tom. The river was great because my son who’s three, we went down the river and it’s like you could catch anything on a fly, use little small brookies. But the lake was obviously the bigger trout. My wife, who I learned has never caught a fish in her entire life, she’s like, “Look, I wanna do the fly fishing, but I don’t wanna catch the fish. Like, I don’t wanna torture them.” I was like, “Well, we can just cut off the hooks and they’ll just like bite the flies, bite the yarn and you can have fun doing it.” We at least let her catch one to say she caught a fish and let it go. But now she’ll just probably be [inaudible 00:06:22.459].
Okay, anyway, let’s rewind a few decades, you’ve been at this investing world for a long time. And there’s a topic I wanna jump on to, but I think it would be instructive first because it’s a good lead-in to talk about a few of your first trades. I read about some of these in “Market Wizards” as well as some other podcasts. But when you were particularly young, some of the trades involving corn and silver. And I’d love to kind of walk through those because it leads into something I really wanna get into. Can you rewind, as painful or [crosstalk 00:06:55.709]?
Tom: Yeah, when I first started I had no clue what I was doing. And back in those days, there wasn’t Globex and electronic trading, you had to call your broker. There weren’t any really “machines that you could look at live over the internet.” So I decided I’m gonna do some futures trading. I had already sort of not mastered but felt very comfortable trading stocks, and I’d made some money and I could split off some assets to trade futures. And I decided corn was a small enough contract and moved slowly enough that that would be a good place to start. And I only had like, I think $2,000 in my account.
So I tried to understand it and I got my indicators all ready. I was using point and figure charts by manual on pieces of paper. I bought the breakout, promptly lost $600 and had no clue how I lost $600. And I had to go in and understand the math and what the value or the face value of the contract is, and what the big number value in front of the decimal point is with corn. And then I finally figured out okay, I really don’t need to be trading three or four contracts of corn, I need to be trading one and I need more capital. So that was a big lesson there and I had to take a hiatus for a while and figure out what was going on. I finally figured it out and started trading a number of different things.
The silver trade, I guess the famous silver trade, everybody knows from “New Market Wizards” was one where now I’m putting money into my futures account, I’m trading it. I’m now actually profitable. I’ve gone through four years of losing the first year, losing less the second year, losing less the third year. Finally breaking even in the fourth year. In the fifth year making money. And somewhere along the way into the future from there, I end up with a signal for a silver contract. I’m up to 130,000 roughly in my portfolio in just futures. And boy, I’m gonna be a disciplined trend follower, I’m gonna buy that thing and I’m gonna hold on for dear life no matter what happens.
And it turns out that the hunts were trying to corner silver at that point. So everybody was buying silver futures, they were buying bullion silver, they were trying to just suck up all the supply in the world. And what happened is the exchange caught on and had an emergency meeting and meanwhile I’m there cornering the silver and it’s going up, and it’s going up, and it’s going up. And it’s more than doubled in the face value and I have made so much money. And now my account is worth about a half a million dollars at that point. So I’ve gone from 130 to half a million and I’m having a hard time sleeping, I’m having a hard time doing anything except trying to call my broker every hour and bug him about where is silver now.
And can’t do anything about it because I’m gonna just…I keep moving my stops up. And son of a gun it finally hits the top, changes the margins. No longer can the hunts corner the silver market using futures, they have to pay full margin for it. They don’t have that money, they have to sell their contracts. Now we’re going gap down every day, boom, can’t get out. But I’m nowhere near my stop so I kind of don’t care but I’m losing thousands and tens of thousands of dollars a day. I finally ended up, stopped out at $250,000 value in my account.
So outside looking in, if you didn’t know the details of what I went through over that month or two, you might say, “Well, gee, son, that was a good trade, you went from 130 to 250.” And I would say, “Yeah, but I went through hell to get there.” It was really, really…the mental anguish that I was suffering. And I thought I gotta deal with this a little better and how could I do that? And that’s where I really came up with my volatility control as a percent of equity. And what I realised is, if I started with three or four or five contracts of silver, there’s no need to hold that number of contracts for the rest of the trade. All you have to do is change your position size slightly throughout the trade and you can keep your mental side a whole lot more even-keeled.
And that fed to all my Trendstat days with clients keeping my performance more stable. We had a nice business last a 28-year run. Didn’t have to declare bankruptcy or anything like a lot of other market wizards did. And didn’t have to shut down my firm for such poor performance that it ended up causing people to just have to close their accounts because there was no more money left.
So when we closed it down, we had a market math partnership that was doing awesomely. We had six or seven different strategies being traded inside one fund. I was the largest client of the fund personally. It was great. But it just got to the point where government regulations and accounting and everything it just seemed like I wasn’t having a whole lot of fun anymore, and I’m having a lot of fun in retirement.
Meb: Yeah, that’s very clear. We talk to a lot of young aspiring investors and universally, I say to them, I say, “Look, managing money and the business of money management, are not the same thing.” I say “I spend half my day signing forms, talking to lawyers, reading legal, the SEC.” SEC I love you. All these sorts of things, dealing with hiring and firing, and payroll, and insurance. Everyone thinks it’s like the sexy part of watching the show “Billions” but there’s a lot of just old school business.
One of the rarity Tom where you have so many people…it’s like the “Seinfeld” episode, stay too long. It’s like all my friends in investment banking when they start out as analysts, say, “I’m just gonna do a couple of years.” “I’m gonna work 100 hour weeks.” And fast forward like 10, 20 years and they’re just like, “I’m just gonna do it till I make partner,” “I’m just gonna do it until…” there’s this carrot. There’s always this carrot. But you seem to be happy trading your own account and fly fishing.
Tom: I absolutely love trading my own account. I don’t have any SEC looking over my shoulder with rules. I don’t have to publish any track records. I don’t have to even create a track record. I don’t have to audit anything. I don’t have to have people show up without being announced to go through my files and hopefully not…
Meb: You don’t have to get your tweets approved.
Tom: Oh, no, I just say what I want.
Meb: By the end of this podcast, you’re gonna convince me to sell my company and to move on. So let’s go back before I go down that route. So what’s interesting about the first couple of these trades, which I wanna hear you talk about. Because 99% perhaps of individuals and professionals and maybe 99.9%, when you talk about investing, when we do this podcast, when you go on CNBC, when you listen to “Bloomberg,” all that anyone wants to talk about is the sexy part, what do I buy and what do I sell?
You had a great book which I recently read on position sizing, “Successful Traders Size Their Positions.” And you talk as one of the only inputs being the buy and sell might not even be the most impactful input. Let’s hear you expand on that. I wanna hear you talk about that because to me, that’s sort of like mastery level of investing. Everyone thinks it’s what should I buy? Is it gold right now? Should I short Tesla? But in reality, the other things are probably even more important.
Tom: I call it cocktail party investing. I like Tesla because I made a bunch of money last year, whatever. If broken down at the simplest chunks I would say in investing in my mind you’ve gotta have a buy-sell engine, some indicator. Some way of what are you gonna buy, and when are you gonna buy it, and all that. You gotta be able to put your order in, that’s one part of trading. That’s the part that everybody loves to talk about and is always on the television, radios, podcasts, whatever.
The second part of trading is a lot less glamorous. It’s how much will you buy or sell. And that’s the whole position sizing concept. And I think that that, when I’ve done studies, and the famous study that I did once was the random number generator. I used to get into approximately I think it was like an eight or a nine futures portfolio, two directions. It would trigger a signal up or down so you’d either buy or sell. And then you would stop-loss and trail your stop behind it by just a logical moving stop-loss. So as the market moved your way, you just went ahead and tried to capture as much of that as reasonable, giving room to do a little bit of noise.
I found that when I ran every 1,000 cases because every case because of the random number generator would come out different, you’d either buy or sell each day. As soon as you got out of a position, you rolled the dice again or flip the coin, that afternoon and the next morning you went in on open. That was how the study was done. Every single 1,000 run sample that I did showed a slight propensity. Slight meaning you wouldn’t wanna trade this way. But a slight propensity to make money, you don’t even have a buy-sell indicator, it’s a flip of the coin. So that kind of led me to believe.
But I did have great position sizing in that study. And I tried to prove to me that if you don’t have position sizing, your drawdowns are gonna be bigger, your runs up will also be bigger, but your return to risk goes down. In every study I’ve ever done, your return to risk goes down. I think people focus so much on when the good times are rolling and just knocking it dead, that they forget about the drawdown. Like in COVID just recently in March, you know, you have one of the most severe and volatile periods in the entire history of trading and you have to be able to deal with all markets. Up markets, down markets, sideways markets, you gotta have a plan, you gotta have a strategy.
And I think position sizing gets more into that area where you’re dealing with the fact that the market does not stay stable, it doesn’t stay just going up or just going down. When your conditions are constantly shifting, why can’t your position sizes be shifting? If all of a sudden the risk is low, you can take on a bigger position. If the risk is high, take on a smaller position. That way you maintain the third area and the more important of all of them of trading is the mental side. If you do not have…you as the trader can override your position sizing, override your buy-sell engine. I’ve heard all sorts of people do that.
I’ve heard of professional CTAs, not gonna name names, that have overridden their trading strategy during the COVID crash. Just because it was so insane, so volatile, they didn’t trust even what they were doing. And that, to me is a sad state of affairs as a trader, because now you’re out there not knowing when you’re gonna get back in, and how are you gonna get back in, and what markets are you gonna get back in and what conditions have to exist so that now you can override your override and go back to trading? You get lost in a twilight zone of trading and I hate to ever put myself into that position.
So I traded during the whole crash of COVID. I’ve traded all the way up again. I’ve had the best single month of my life in March of 2020 with the downswing. There was so much movement, so much volatility that if you just jumped on the trend, and rode it you just made a ton of money. And then it turned around, went the other way and we’re up 50% now.
Meb: You touched on a couple of really important points. I think it was not only CTAs you even saw some of these massive indexes, just say, “Hey, we’re not gonna rebalance.” Who is it? Invesco got fined like $100 million in one fund because they just forgot to rebalance. So I always laugh when people talk about indexes where you mentioned there’s a very real human element.
And some of the biggest hedge funds in the world, again, I’m not gonna name names, during the global financial crisis, said, “Hey, we have this approach.” And then “Oh, wait, wait, hold on just kidding, we’re doing something else.” And you kind of scratch your head and say that’s the whole point. Literally, you’re supposed to be preparing for these outliers otherwise, it doesn’t even matter in normal times.
Anyway. Okay, so, trend following. I think one of the really important properties you touched on when you’re talking about this sort of random generator, that trend following. And oddly enough trend following and market-cap indexing, sort of have as the Venn diagram. I mean, market-cap indexing, you could very easily argue is a trend following strategy. Is this not guarantee but almost a guarantee for owning something that…is it a really long term trend, the really big compounders where this trend lasts for not just weeks and months, but potentially even years. Maybe talk to me a little bit about the importance of that property, and kind of gets into power laws of these massive, massive winners.
Tom: The best story I have on that was back on…I don’t know what got into me. But we were up at Trendstat one year in futures, I wanna say it was like 8%. It wasn’t a phenomenal year, we made money, it wasn’t a bad year. And I decided to do an analysis of all of the trades we had done that year and just see, from top to bottom, the best trade of the year, the worst trade of the year. Just take a look from a distance and say, “Do I learn anything from this? Is there anything that pops out at me that I can improve my trading on?”
And much to my amazement, when we added everything up, it turns out the two trades that year made the difference between Trendstat being at 8% and Trendstat being at zero. There was two trades, one of them was Japanese Yen, I can’t even remember the other one. But they were so huge that they were the profit. The rest of the stuff, essentially, literally hundreds and thousands in some cases of trades depending on what program you’re talking about, literally, were break-even, there was all that work for nothing. Two trades paid the way.
The very next year I decided that was so interesting the year before I’m gonna do it again. And this year, we had a little bit better year, there was something like three or four trades that paid all the way. Year after that was sort of a not-too-great year, a single digit again. One trade was the difference between making a profit and breaking even. And I haven’t done that analysis in quite some time but what it told me is that outlier that you talk about, the one that is the black swan, the big move, if you capture that that makes you so much money that it pays for literally hundreds of other trades that are small profits, small losses.
There are a lot of activity that you’re doing in trading and you’re buying and selling and that’s what traders think they do. But they all wash, it’s just a lot of work to get nowhere. You wanna get on board that one big one. Well, the lesson to be learned there is if you flip a coin, eventually you’re gonna be on that trend the right way. And if you just let it run and keep your stops, reasonable distance away and not get lucky enough to not get stopped out, you’re just gonna trail that stop. And you might be in a position…I remember a Japanese yen position I was in a year and a half. And people think commodity trading is all this buying and selling, it’s aggressive, and it’s speculative, and it’s dangerous.
I’m one of the most boring investors you’ve ever seen. I don’t view futures as anything other than just a vehicle and how you dial in the leverage and the diversification, and your strategies and your position sizing make a world of difference in how you make it exciting, or you make it boring. And I’m probably someplace in between. I don’t think I’m completely boring, but we had a good March and we’ve had a very good month this month too. But I think you have to think through all that stuff and I don’t think a lot of traders do, it’s all the buy and sell.
They go on the broker platform, and they got their little Donchian channel, or the Keltner band, or the Bollinger bands, or you pick up any one of the hundred-plus indicators on investopedia.com. Throw it up on your screen, and then when it crosses the line you buy it and when it crosses the line you sell it, and you forget about everything else. And I think that’s a very shallow way to look at trading.
Meb: I’ll tell you a funny story. We had joked for many years about doing the old “Wall Street Journal” dart throwing contest, right, which often used to beat the pros. And I said once our firm gets big enough, we’ll actually file for this as an ETF, really, as a way to just poke most of the money management industries saying, “Can you not even beat this dart-throwing ETF?” Because if you can’t, what are you doing?
I actually thought about I said, “We’ll do the dart throwing, but then we should overlay some sort of trend following exit on these stocks.” And then it adds even a better element of performance, and then it’s gonna be really hard for them to beat. And we were actually gonna file for it in Q1 and then corona happened and I just felt the timing probably wasn’t right to really incite people and say, maybe we’ll do it later.
Tom: Add not only your stop-loss stuff but add your position sizing to it so that you balance all the positions and I almost guarantee you’ll end up beating the pros.
Meb: We have some good tickers, monkey, and random for that so one day it may come out.
Tom: I can’t wait.
Meb: Here’s the funny thing is that if you think about…I feel like trend followers is this subset of the world that actually labels ourselves trend followers. But again, market-cap-weighting is trend following, you’re just based on price. The bigger…it’s naive, but almost no market-cap-weighted Vanguard indexers the Bogleheads are gonna identify as trend followers. In fact, if you talk about trend following, they pull their hair out and go crazy. But also, VC and angel investors, there’s a good paper that just came out recently to show the distribution of venture capital private equity and stock returns. And the same thing applies to all of them. Where is this long tail of massive winners that determine essentially all of the returns.
Now the VCs and angel investors understand this. They say, “Hey, I’m gonna invest in 50 companies, my one Uber, my one Zoom, the 100x, the 1000x is the outlier winner.” Now they have a naive sell methodology, which is the company just goes to zero or they don’t even care about the doubles or the evens.
Tom: They’ve bought a call on the 50 companies and one call pays off and the others go to zero.
Meb: But it’s interesting how little Venn diagram overlap there is in the thinking behind…like all three of those groups that’s the driving force, the massive winner outliers. And your friends Eric Crittenden wrote a paper on this on the stock return distributions later co-opted by a bunch of banks. Why do you think that the sort of narrative behind it doesn’t jive across boundaries? I don’t know any venture capitalists, angel investors, Vanguard Bogleheads that also philosophically “believe in trend following.” What do you think the break is there? Is there any sort of thoughts?
Tom: In this world of instant everything, I remember competing against some advisors back in the day that were doing, for instance, selling…or were they doing. They were holding high-yielding currencies and selling low-yielding currencies and picking up the differential. And they would make money month after month, after month, after month, after month, after month. And they were even a little leveraged because that way they could have a nice return and besides, they were profitable every month, why not?
But of course, what happens in that type of strategy and you can see it just as sure as we’re sitting here talking to each other is, sooner or later that high-yielding currency like an Irish punt or something, in the days before the Euro, just devalues. And that’s a leveraged part of your portfolio and you are long, you just got yourself bankrupt.
And I’d be plugging along and I’d practically be saying to the guys at Trendstat “Who are those guys?” Like Butch Cassidy and the Sundance Kid, the guys that are trying to catch up with Butch and Sundance and never let go. They just kept coming and coming and I’m thinking, who are those guys? They make money every month. I’m a good trader, I’m doing everything I can and I can’t keep up with these guys. And of course, then I’m still in business for 28 years and they’re out selling software or something.
I think that that happens a lot with the index funds and even a lot of the mutual funds and all the TV shows. And everybody is worried about how you did this last month or this last week, or I got this stock, which went crazy, isn’t that great? And they don’t think through, like I do, for instance, my next 1,000 trades, my next 2,000 trades.
That’s what trading is all about to me. I’ve gotta do another 1,000 trades to make sense of anything that I’m doing today. That’ll give me a sample size that makes sense. And when you start doing that, and you realise that markets are going to have their up and down moves and I think that accounts for in my mind, by my definition around 25% to 30% of all of time is either up or down. And it’s heavily weighted in the stock market to up. Out of the 25, 30, it’s probably pushing…well, it’s probably pushing more like 25% of the time up, perhaps 9%, 10%, 12% down, 7%, something like that.
And then the other two-thirds of the time I rate as a sideways market. You spend two-thirds of your time as a trader in a sideways market. And so things like trading ranges, little pivot points, and swing trading and all that, day trading lately, it gets a lot of flash because people are making tons of money doing it. I mean, Tesla, Amazon, some of these moves inside of a day, if you could day trade it, you can make a lot of money. But they don’t think through the fact that that’s not the way the world always works there’s gonna be down moves, there’s gonna be sideways. And I think when you take your next 1,000 trades, you take a little bit more strategic perspective and then trend following makes a lot of sense.
Meb: A lot of it probably goes back to the fact that people, I think, with markets really gravitate towards having a high batting average. Short volatility strategies eventually blow up every three years. They’re up every month a percent or two, they have a Sharpe ratio of three, and then they get nuked. I’m sure there’s zero that made it through 2020. We did an article that was pre-financial crisis, warning about the option selling funds and I think all of them are gone with the exception of maybe one after the fact.
But the same thing I think applies to kind of the carry trade you’re referencing, people put a premium on certainty and consistency, but it’s trend following which has a lower batting average, but a lot more grand slams, was a lot more robust over time.
Tom: Right, it is robust over time. And over my lifetime, I would just…it would be a guess, but I think I might have run 33% reliable over all the trades I’ve ever done trend following in my life. Somewhere in that ballpark, it might be 30, it might be 35. I haven’t kept every trade and figured it out. But my estimate is every time I go into a trade, I tell myself, I’ve got a two-thirds chance of losing on this trade. And part of the mental side is then hey if I’ve got a two-thirds chance of losing, I better watch my stop-loss make sure I set it properly, make sure my position sizing is right because I got a two-thirds chance of losing. And that kind of positions my mind in the right place.
Meb: How many trades do you think you’ve placed over your lifetime, broad guess, over-under?
Tom: Oh my gosh, well, it’ll certainly be tens of thousands. Have I hit 100? I don’t know.
Meb: You better step up your game.
Tom: Twenty-eight years in the business probably would be pretty far from 100,000. I’m probably up in the, I’d guess 50,000 range maybe or something. I often tell new traders that when you get to your 50,000th trade believe me it’s as easy as breathing, that’s about right. I mean, it’s just another trade in a very large sample size. So it just goes with the territory, gray hairs and thinning hair.
Meb: It’s a challenge, I think for people to detach the emotions from any one trade. And I think with practice perhaps, you mentioned doing tens of thousands, it becomes more of a Zen detachment. But that’s hard. I think for some people, certainly automating it, going back to the certainty one of the exits. If you want a trading system that has like…it’s like a 99% win rate is put on a trade, it could be even random, exit on the first profitable close. So most of the time is the next day, then it’s not as the next day, but then you just hold it forever and you’re never exiting. But it’s a terrible distribution, you have all these tiny, tiny and then all these massive losers. It’s like the inverse of a true trend following system. But most people would probably be attracted to that.
Tom: Novices will trade that way or something similar to that.
Meb: I talked about this on the podcast on one of the benefits. And I’ve changed my mind over this over the years on the private investing side, kind of with the angel investing. Is that it’s almost a force function, it makes you become a trend follower because you cannot sell the investment. It’s like the old Coffee Can portfolio except there is no sell criteria. So the only way that you end up exiting is if this stock or investment goes 10, 100x because otherwise, there’s no liquidity.
And so it’s like a way of forcing people to become trend followers that’s almost like a modern hack that I don’t know that most people I think in their head if they saw an investment that doubles. My entire 20s and 30s I probably would have sold that you know. Oh my god, that’s the best thing ever, this investment just doubled. But in many cases, you’re selling that before a triple, quadruple potential 10xer.
Tom: Yeah, exactly. And then the other thing you got going is the drawdowns and things like more of the commodity side of the industry or even the equity side of the industry. You go through a bear market in whatever your equity drops, people say they can tolerate 10% or 20% drawdowns, but they really can’t. I did a study once it’s on the website that says that even professional allocators that would hire me as a commodity trading advisor and the rest of the top 30 trading advisors when I was in my heyday back in the 90s and 2000s when you looked at money flowing in and out of the industry, it always flew in at the top of the equity curves when people had made a bunch of money and it always flowed out right at the bottom of the equity curves after a drawdown.
And investors enjoyed a worse track record than the commodity trading advisors had created with their NFA, National Futures Association approved and audited track records. The actual client monies actually enjoyed a lower return. Why? Because of when they put the money in and when they took it back out again, not because the CTAs were doing anything bad.
And I think that back in the day, I actually considered and talked to my buddies at Trendstat, my fellow people at Trendstat, do we wanna do some kind of fund with a lock-up of some sort where we get people, we force people to stay for three, four years? The consensus was you’d never be able to sell it because people like the liquidity. But liquidity is sort of like handing dynamite to a nine-year-old kid or something. It’s dangerous because of the client’s inability to actually be a good client.
One of the first books I wrote was “Panic-Proof Investing.” The story behind that is I was so frustrated at my own clients, pulling money out at the bottom of a drawdown giving me money at the top of a surge. I wrote “Panic-Proof Investing,” and I forced everybody to get a copy of that when they signed up with me. Did they read it? Probably not. Whatever, I tried. I tried to make my clients better clients because what they do affects what I do. I have to operate within the extreme fighting cage that they put me in. If they let me have the universe and I can do anything I want, I can go anywhere I want, I can do any trick I want.
In some case, government regulation limits what you can do as a money manager and certainly, you know that. It limits what you say, it limits what you can do, certain instruments you can’t touch unless you’ve somehow figured out a way to get that past a certain Investment Company Act laws and other things. You get it down to this, okay, here’s the rules I gotta operate. I’ve got my right arm behind my back and I can’t use my left two fingers and now I’ve gotta try to make these people money. It gets a little bit more difficult. And you know, one of the reasons why I’m having so much fun in retirement is I’m my client, I’m not gonna sue me.
Meb: You wrote an influential paper, at least to me early on, about investing during drawdowns. And over the last 10, 20 years, I’ve consistently seen… And this isn’t just individuals, institutions too. There’s a study I love to cite that said something like, it was 95% of institutions. And this is real money institutions like hundreds of billions, trillions of dollars in AUM. How long they would tolerate a manager underperforming before they fired them. And it was 95% said three years or less. And it’s the exact opposite of what it should be, which is you establish a manage or a strategy that you would actually want to be allocating more. And it’s the same thing with stocks as far as valuations.
Going back to the old quote I attributed to Mark Yusko that says, “Investing is the only business that when things go on sale, everyone runs out of the store.” So having a strategy, theoretically that you like, you should like it a lot more when it’s going through the hard times. But people they think the opposite, they chase performance and it’s a consistent detriment to what they’re trying to do. And it’s hard to try to make it systematic and educate people against it because I think it just goes against their normal human nature.
Tom: It goes against human nature. And that’s why a lot of investors fail. It’s why guys like me have an Eric Crittenden at standpoint and others out there have figured it out investing is a mental game more than it is having the perfect indicator, or having even the perfect position sizing. It’s a mental game to come up with a robust strategy that makes money in various conditions, loses money in other conditions and for you to understand when those conditions exist. And I always tell traders if you’re in the middle of a drawdown, you’ve done your simulations and let’s say you’re down 10%. And your simulation so that this strategy during these types of conditions would be down 20% then it sure isn’t broke, don’t start fixing it. I mean, this is normal.
Ed Seykota who’s a famous trader from way back. One of the first automated traders actually. He often said trading is like breathing in and breathing out. Breathing in is like profitable and breathing out is like losing money. You can’t live without breathing in and out. And that’s the way trading is you can’t trade without having profits and some losses. And the job is to try to make the profits be more than the losses are and over time you do fine. But people have a hard time with that. I think a lot of people say a good day for a trader is when he makes money. I say a good day for a trader is when he follows his trading plan. It has nothing to do whether he made money or not, the markets are gonna do what the markets are gonna do. I am way too small to dominate the market.
Even George Soros and those types of guys are too small to dominate the market. The market is gonna do what the market is gonna do. And that’s another famous saying I say over. And my wife quotes it now, “The market will do what the market will do.” If it goes up and you’re long, you’re gonna have a profitable day. If it goes down that day, you’re gonna have a negative day. But you did what you were supposed to do, that’s the important thing about trading, you gotta come up with a plan and execute the plan.
Meb: We tried to illustrate some of what you’re talking about with losing money in drawdowns to the buy and hold crowd where I said, “Look if you look at any historical asset, stocks, bonds, gold, there’s only two states, it’s all-time high or drawdown and that’s it. So there’s nothing else, you’re either in some form of drawdown or an all-time high. And the fact is, most markets spend most of their time being in a drawdown just kind of by definition. And then I walk through a simple example where I said, “Most people are…” I think Jerry Parker says this, “Are fearful with gains and hopeful with losses.” And I said, ‘Well, think of the dumbest investing strategist only investing in markets when they hit all-time highs otherwise, you’re sitting in cash.”
And as naive as that is, it turns out to be an incredible trend following strategy. You only trade…like the average trade it’s like the longest possible one. And it’s not the optimal, you do like a 12-month look-back, probably better. But just to be an illustration, because most people they hate investing at all-time highs. Anyway, the thing we always say is about having an investing plan and trying to write in all the possibilities. So where you talk about a lot of that can be accomplished with rebalancing. Say look, I’m gonna do 30% trend following, 30% stocks, 30% bonds, and rebalancing that has a natural sort of reallocation, meaner version.
And we had on two of the all-time great investors, Rob Arnott and Howard Marks both talked about it using different words. Rob called it over-rebalancing. So when something gets totally nuked, instead of rebalancing directly to target, maybe allocate more. And Howard called it calibrating. All the masters seem to arrive at this same sort of concept which takes advantage of the people that don’t use it.
Tom: The study I did on rebalancing was clear. If there’s a cost of almost nothing, I mean, Schwab and others have gone to zero commissions now. So you got the bid-ask spread is your cost may be very, very small. And if you were to take, say, if you were a novice investor and you just took 10 sector funds, ETFs let’s say. Let’s say you have $100,000 and put 10,000 in each, and you just bought and held them over time. And then what you did is at the end of every month, you take your total amount of equity, divide it by 10, and put that much in each of the 10. Just keep rebalancing it, your return, the risk will go up over time.
I’ve done the study over and over again with lots of different strategies, lots of different markets. It’s all dependent on the cost of rebalancing. If you’re in load funds, for instance, and you had to pay like a 5% or 10% fee to rebalance, then that wouldn’t be a good idea because the cost of the rebalancing would not equal the benefit that you take on. But if you have zero costs, rebalance every day. In Trendstat, we had eight different strategies, and those computers would go in and take magic equity that we knew we had the total fund equity that we had to deal with, and we had the allocation to each. All we did for all the new trades that day, was to rebalance that new equity across all the strategies and we did it every day. There was no cost to that so why not do it? And it improved the return to risk ratio?
Meb: How has your approach changed over the past 30 years, either philosophically or practically? What have been some of the differences?
Tom: Well, one of the profound things that I think in the last decade, I’d say that I’ve really come to appreciate and it’s due to a friend of mine Laurens Bensdorp, who wrote a book called…that just came out, I think this year, maybe January. “Automating Stock Trading Strategies,” I think it is. It sells on Kindle at Amazon and you can get hard copies if you want and stuff. But he’s a guy that heard me speak back in the Tharp conference days back in the 80s when I would help out Dr. Tharp was an investment psychologist, really good trading coach.
He actually listened to me talk, he listened about position sizes, and really took a lot of what I said to heart and really worked on his own mental side heavily. And he’s become a spectacularly successful investor for himself. And one of the things that that book just nails so perfectly in my mind, and matches what my last decade or so of work has been in retirement. Is to instead of trying to come up with one single way that’s perfect to trade that captures always every move that you want and eliminates every move that you don’t want, why not look at different types of conditions?
Perhaps a simple example, up markets, well, you wanna be long in stocks in an upmarket. So let’s say you do that with part of your portfolio. And then you develop a second strategy that is a short only strategy that only gets put on when you wanna hedge the long stock portfolio. So maybe the short strategy trades SPY ETFs, or maybe it trades ES futures, which is the E-mini, the Standard & Poor’s 500, or NASDAQ’s and NQ’s.
And what you’ve got then is two strategies that are very symbiotic. They are going to help each other at times. When the market is going crazy upward, we’ll call it with my hand facing upward making money this way, losing money that way. When you’re doing that and there’s no hedge involved because the trend-following short strategy, if it’s an upmarket is not gonna have a position. So now it’s sitting in cash and you’re just making money over here. When the thing goes the other way, at some point, you’re gonna get a sell signal. Now, this hand the hedge comes on, that’s gonna be fighting the other one.
They are gonna be symbiotically fighting each other and essentially, now your risk is much lower. If you have a COVID 35% down, you’re gonna lose a little bit maybe but you’re gonna be hedged for a lot of it. I made, I think 20 something percent on my hedges, my stock portfolios in March and that offset a whole lot of potential loss that I might have had over in the ETF portfolio or equities or whatever.
And I think that you can take that to an even greater extreme by, let’s say taking equities and overlaying futures like Standpoint has done for instance. And like I do with my personal portfolio. You can do a lot of other things add in shorter-term timeframes, longer-term timeframes, intermediate-term timeframes, different markets, different countries. When you start doing that all these different multiple strategies are exploiting a certain part of trading that you wanna exploit. And when you start adding them all together, they become the pistons of an engine. If you ever see a cutaway of a car engine and how one piston is going up and the other pistons going down, but they’re all moving the car, right? They’re doing their thing going up and down, but they’re propelling the car in the right direction.
That’s what happens when you do that with your portfolio. And with automated platforms becoming a little bit more available than they used to be, are certainly…I wasn’t born with a knowledge of programming. So it’s a learnable skill. You can go out and do some things to help yourself, leverage your time, exploit different types of markets, and not kill yourself doing it. And I think that gives you multiple strategies as a way to go that helps I think traders be able to exploit situations without trying to design this perfect thing, this one thing that’s gonna always be right all the time. I think that’s chasing a holy grail that doesn’t exist.
Meb: It’s interesting because so many portfolios we see not just individual, but institutions too, they look like they might be diversified. But when you kind of get down to the core, they almost universally are just so overweight, some particular risk. Now, it may be a risk of inflation, it may be risk…the one we see the most is just, it’s all stocks, right? And traditionally, in the U.S, it’s all stocks in the U.S. And those sorts of exposures often get exposed during periods like this year or other years…
Tom: 2000, 2008.
Meb: And so diversifying across assets, but also strategies. And it’s always strange to me on the trend following side, that if you were just to put the strategies on a piece of paper and blind them and try to put them together in a way where people had to be honest but didn’t know what they were, they almost universally ended up with A, a chunk at all, which most don’t have. But B, a very large chunk in trend following type of strategies. But it ends up…when this gets to implementation, the brain starts to short circuit or something.
And if you take this a step further, it even applies to I think human capital sort of ideas when people have risks. So many times throughout history, we see people investing in their 401(k)’s in their own company’s stock and just quintupling down on one very specific risk. Enron and others as well. But the beauty of what you’re talking about, I think, is a much more thoughtful way of maybe not optimising the exact return but optimising survivability, which is the most important thing.
Tom: Especially in retirement like me.
Meb: Yeah, you don’t see that retired to me, you seem pretty active.
Tom: Well, yeah. My friend, Sam, the busiest retired guy they’ve ever met, but I’m having a lot of fun. I mean, it’s fun talking to you, it’s fun…When I’m done talking to you, my wife and I are gonna go hit some balls at the golf course. Gonna finish up my packing this afternoon, that’s all having fun. I’ll cook dinner tonight or we’ll go out to dinner, life is good.
Meb: Let’s touch on a few of those. It reminded me as you were talking about Butch Cassidy is we had stopped at a place the Hole in the Wall Gang used to hide out in Wyoming as a famous fishing spot near Kaycee, Wyoming, beautiful country. You write a website where you talk about a lot of your adventures and ideas enjoying the ride, I believe at that world. Tell me about some of the focus. What are some of the main topics you’ve touched on a few?
Tom: Mostly trading, and it all came about… My wife and I were having a glass of Rosato at the pool in Malaga, Spain on a vacation going over and visiting a friend. And I was relaying to her this problem that because I’ve been retired a lot of years I’m fair game for people that know me from “New Market Wizards” or interviews that I’ve done over the years to ask me trading questions. So I’m a new trader, and there’s an email and I’ve got this problem and how do I solve it? And I’ve always been…I’ve answered thousands of these emails.
And I said, “It seems like I do this more and more, as more and more people realise they can ask me these questions.” I don’t mind answering the question, but I kind of get a little bored answering the same question over and over again, with the same exact words. And I was at that point trying to figure out a way I could automate this a little more. So I could, okay, that’s a question on buy-sell engines. So what I’m gonna do is have this standard thing that I’m gonna attach to the email, send it back, save myself a lot of time. And we kicked it around. And then she said, “Well, you’re retired, maybe you could do Zoom calls or some kind of group calls and help people that way.”
And I said, “Yeah, but then I gotta schedule that then I’m working again. I don’t wanna work again, I’m enjoying retirement.” So we came upon the concept of synchronous versus non-synchronous. You and I have to be on this call at the same time so that we can talk to each other. But the emails that set it up were all asynchronous. Somebody in your operations sent me an email and when I could get around to it I send a response. That’s the kind of thing that you could do in retirement and then not have to be tied down. So I said, “Well, how about a website?” And she said, “Well yeah, and you always end all your tweets with “enjoy the ride.” Why don’t we get enjoytheride.com?”
Well, it turns out enjoytheride.com was taken, but enjoytheride.world was not taken. And I thought I’ve got people sending me emails from all around the world, that’s perfect. So I grabbed that URL, and it took a year to design the website but with various people helping. And it cost me probably 5,000, 6,000, 7,000 something like that. But what I tried to do there is make it a retirement website for me. Takes all my knowledge of trading, all my recommended reading. People ask me what books should I read? Well, you got a whole list, just hit the reading tab. If you wanna get a video about what I think you have to do to create your own personalised trading strategy. I did a 16-video series on that, that’s in the store.
There’s the book you mentioned on the position sizing, you can get an electronic copy there. There’s research, all the research papers I’ve ever produced in my life are all in one place. My entire hedging strategy explained in gory detail is another tab. So all these questions that I get from people on various things, I’ve just tried to stick them on the website. And it has actually cut down slightly on the amount of emails I get. I do get a few. And they’re usually a little bit more interesting emails. They’re asking me a question that’s really difficult to answer and it challenges my brain. I love those. I’ve also been able to help a lot of people, just thousands. I mean, I’ve got thousands of users. I’ve got 4,000, or 5,000, 6,000 traders show up in the website every month.
The website pays for itself by way of the stupid little things we sell at the store. It’s a way of just giving back to the industry without me having to be sitting answering emails all day long, over and over again saying the same things. So it’s been fun.
Meb: We’ll post a link in the show notes. You talk about cooking on there, what’s your go-to? Do you have a favourite recipe?
Tom: I got an O on the end of my name it’s Basso B-A-S-S-O which is a bass voice in the choir by the way. Basso voice. My wife has this charming thing she says to people. “When Tom gets in the kitchen and tries to cook something, it starts out as maybe Asian or French or whatever, and by the time he’s done, it’s sort of Mediterranean.” That’s probably true. That’s probably my sweet spot is the flavours of sage, and rosemary, and basil, and tomatoes, and cheeses, and those types of things. Veggies I like al dente veggies. I love seafood. I love chicken steak, all the meats.
I actually like more of the exotic stuff too the bisons, the elk. I love rabbit. I’ve done a lot of great rabbit dishes, those are fun. So that’s kind of where I go. And, I try to do different things. And I cook something that she likes. She says “This is a company dish.” And I say, “Well, I’ll never make it again exactly that same way because I just sort of taste things and make it up.”
Meb: If you haven’t heard this, stop me if you have, listeners have many times, they’re probably sick of me talking about this. But I had gone through an experiment, being a quant, a rules guy, I said theoretically, most recipes are essentially rules. If you and I had a recipe, broadly speaking, we could follow it, come out to near the same result. Now, I’m not talking about the art side if you’re doing foams and gels are like pure masterpieces, but just the big fat part of the distribution. And I said there’s all these recipe websites half of them don’t have ratings. The ones that do you can’t sort them, you can’t manipulate them.
So I found a guy in Poland on one of these websites where you can hire developers. I said I want you to scrape the top 10 recipe websites and pull it into a database for me. They said, “Sure, like, what’s your budget?” I said, “God, that would take me like a week.” I was like, “I don’t know $500 bucks.” And within like an hour, he had done it. I said, “Oh man, I should have said like $50 bucks.” Anyway, I got a database “New York Times,” food.com all these. And then was able to sort them with a theory that the 5-star rated recipes with 10,000 plus reviews would be universally better than the ones with 2 stars and did a fun experiment.
We were gonna call it the quant cookbook where I was gonna go through and cook all these. And we did about the first 5 or 10. Interesting takeaway was there was a lot of like crowd-pleasers is like the world’s best lasagna, you know, or gooey chocolate chip cookies. Which I love but I think I would be 50 pounds heavier in quarantine for most of these. But I’ll send you the link, it’s for a fellow quant and may appreciate some of the outcomes.
Tom: Yeah, recipes are nothing more than a guideline to me and I create my own.
Meb: Yeah, I love it. Tom, if you look back over the career, you mentioned a few, but we always ask people what’s been their most memorable investment. One of the ones you mentioned, something else come to mind, good bad in between?
Tom: Memorable investment, there’s been only tens of thousands but of those…
Meb: Yeah, of the 50,000 you gotta pick one.
Tom: I guess getting involved in a small company in Phoenix here, which ended up becoming the largest supplier or distributor of bulk cream. If you ever go into a Kwik store or like a 7-Eleven those types of things, you go get a coffee and you see this gray looking cream dispenser that you can put half and half, or cream, or flavoured creams and things into your coffee. That was produced by a company called Creamiser, I was the largest shareholder of it.
Meb: How did you find that, just local due diligence, was it private?
Tom: It was local, somebody needed private equity, I ended up investing in it. I invested in it again when it was about to go bankrupt. And then I kept it from bankruptcy a third time. Served on the board for a lot of years. And was there at the end when I think it was Dean Foods came in and bought us out. That ended up being a pretty good role.
Meb: There’s a natural hedge to your trend following. There’s a value investor in there somewhere, Tom.
Tom: Well, I knew…yeah, I knew the bulk cream was so much cheaper to produce and to get out to the public. So if you’re a 7-Eleven, and you do those little tiny…what do you call those little cream things and you grab two or three of them. And they actually did studies at Creamiser which were humorous where we had one-way mirrors and we’d watch people sticking a whole handful in their purse, and guys would put them in their pockets. And people were only pouring half of it and then they’d leave a mess all over the counter and clerk has to go over and do something with the mess.
We just show a video to people about what really happens with the way that they’re doing their cream, and all of a sudden everybody wanted our bulk cream dispensing. So we ended up with over a 90% market share at bulk cream dispensing. It was a fun little project, we had a lot of brushes with bankruptcy as we were trying to muddle through what every business goes through. Getting off the ground and finding injection molding people to do those refrigerated cases. And backup suppliers from Brazil to get the refrigeration units and all sorts of other stuff that was not related to trading at all, but it taught me a lot about business.
Meb: Agony and ecstasy of being an entrepreneur. It’s too much work. I wouldn’t wish it upon anyone but it’s so much fun. Tom, we’ll post a link to the show notes, your website, and everywhere else. It’s been so much fun. We’d love to keep you all day but you got some golf balls to go slap around. Thanks for joining us today.
Tom: Hey, thanks, Meb.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it shoot us firstname.lastname@example.org we love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. My current favourite is Breaker. Thanks for listening, friends, and good investing.