P&L Driven P&L
by Stephen Duneier
While in NY on my most recent trip, I gave a talk to hedge fund clients of Morgan Stanley. Among other things, I once again argued against the use of speed bumps. To review, the way a speed bump works is, if a portfolio manager or fund is down a certain percentage from their high water mark, they must cut their risk by a specific proportion. The thinking is that occasionally a risk taker isn’t seeing things clearly, but they are somehow blind to that fact. Rather than letting the wheels come off completely, the speed bump serves as a formal process for avoiding the downward spiral. Think of it like a “time out” for a troubled child. It forces them to take a step back and think about their actions. Truth of the matter is, the time out doesn’t help the troubled child avoid further problems, it simply gets them out of the parent or teacher’s hair for a while. Same goes for the speed bump. Like nearly all other risk management tools this industry has come to depend upon, the speed bump is a reactive one. Worst of all, it accomplishes just one of two things. Either it reduces the returns of a good portfolio manager or it extends the life of one that should be fired.
Interestingly, this was one of the rare times I didn’t run into fervent opposition to my argument from the audience. Instead, I was asked a simple, but very telling question. “How can you be opposed to speed bumps, while arguing that stop-losses are an essential component of an intelligent investment process?” I began to salivate, because the question itself highlighted an equally problematic issue. Stop-losses are often seen as a way to limit losses, to avoid the downward spiral, and in a way they are. There is however, a seemingly subtle, yet very important distinction between my approach to stops and that of most others. It begins with position sizing.
Very often, a portfolio manager will determine the size of a position by how much he hopes to make, or even just by picking a nice round number. The stop-loss level is then chosen by how much he is willing to lose given the resulting notional amount. In other words, the level is determined by p&l. That is the mistake, and it’s the same one made by those who use speed bumps, which is why the question was posed. The person posing the question saw my support for stop-losses and opposition to speed bumps as inconsistent, because he saw them both as being driven by p&l. He’s right, but only if you implement stop-losses as I’ve described above. I do not.
In my investment process, determining the position size is the very last step. Before the notional amount is set, I first identify the correct level at which the position should be unwound if my expectations are not met. I set my stop-loss level. It is the nearest market price that should not trade so long as my underlying thesis holds true. In other words, the last thing I want is to be taken out of a position while I still believe in the underlying view. The reason is, I know that if I stop out of a position meant to express a view that I still hold, eventually I will be compelled to express that same view again. If that is the case, what was the point in stopping out of the position? The reason is that it creates the illusion of discipline. An illusion designed to fool others, and ourselves.
Interestingly, this was one of the rare times I didn’t run into fervent opposition to my argument from the audience. Instead, I was asked a simple, but very telling question. “How can you be opposed to speed bumps, while arguing that stop-losses are an essential component of an intelligent investment process?” I began to salivate, because the question itself highlighted an equally problematic issue. Stop-losses are often seen as a way to limit losses, to avoid the downward spiral, and in a way they are. There is however, a seemingly subtle, yet very important distinction between my approach to stops and that of most others. It begins with position sizing.
Very often, a portfolio manager will determine the size of a position by how much he hopes to make, or even just by picking a nice round number. The stop-loss level is then chosen by how much he is willing to lose given the resulting notional amount. In other words, the level is determined by p&l. That is the mistake, and it’s the same one made by those who use speed bumps, which is why the question was posed. The person posing the question saw my support for stop-losses and opposition to speed bumps as inconsistent, because he saw them both as being driven by p&l. He’s right, but only if you implement stop-losses as I’ve described above. I do not.
In my investment process, determining the position size is the very last step. Before the notional amount is set, I first identify the correct level at which the position should be unwound if my expectations are not met. I set my stop-loss level. It is the nearest market price that should not trade so long as my underlying thesis holds true. In other words, the last thing I want is to be taken out of a position while I still believe in the underlying view. The reason is, I know that if I stop out of a position meant to express a view that I still hold, eventually I will be compelled to express that same view again. If that is the case, what was the point in stopping out of the position? The reason is that it creates the illusion of discipline. An illusion designed to fool others, and ourselves.
Here’s an example of how it plays out in practice. You identify an assortment of evidence arguing for company XYZ’s stock to go up. The stock is trading right in the middle of a well defined, yet fairly wide trading range. You go long. You set a “tight stop”, well within the trading range, in order to “cap the downside”. If the stop is triggered, you will lose 20 bps of your AuM. In other words, you have decided that given your level of conviction for the underlying view, you are willing to risk a maximum of 20 bps on the idea. A few days later, the stop is hit and you realize the 20 bps loss. Two weeks later, the stock rallies back to the original entry level. All of the reasons you initially believed in the trade remain in place, so you enter the trade again, with the same “tight stop”. Now you have risked 40 bps on the idea that you initially deemed worthy of just 20 bps, but it doesn’t end there. This is often repeated over and over and over again.
Eventually, your view is proven correct. The stock rallies and you make 60 bps having “risked just 20 bps.” We see this happen all the time. Remember the short EUR, the long JPY and short S&P trades that cost funds for years before finally “paying off?” If a PM is being honest with themselves, and investors, all of those trades should be combined in order to properly assess the return on investment (risk), and time.
Tight stops are a good idea, but only when it is due to the entry level being very close to a price that is significant to many market participants. A simple way to say this is, “so long as my view holds true, the stop-loss level should not trade. If it does, something has significantly changed and I no longer want to have that position.” This is a dramatically different approach to the stop-loss from the one described earlier. The decision involved is driven by the view, the PM’s expectations and the market, not indiscriminately, based purely on p&l. That is how you want decisions to be made.
Going back to the question posed by the audience member. If you approach stop-losses like most in the markets do, then he is right. It is inconsistent to argue against speed bumps and in favor of stop-losses. The reason is, in both cases decisions are being made driven purely by your own p&l, without consideration for markets, views or expectations. They are a last line of defense against an investment process that is impulsive and poorly planned. However, if the stop-loss is an integral part of a proactive investment process, derived as a result of a thorough analysis, fact-based research and a firm view, it no longer has anything in common with the speed bump. Leaving the speed bump as the only decision being made indiscriminately.
See also Risk Management Placebo
Eventually, your view is proven correct. The stock rallies and you make 60 bps having “risked just 20 bps.” We see this happen all the time. Remember the short EUR, the long JPY and short S&P trades that cost funds for years before finally “paying off?” If a PM is being honest with themselves, and investors, all of those trades should be combined in order to properly assess the return on investment (risk), and time.
Tight stops are a good idea, but only when it is due to the entry level being very close to a price that is significant to many market participants. A simple way to say this is, “so long as my view holds true, the stop-loss level should not trade. If it does, something has significantly changed and I no longer want to have that position.” This is a dramatically different approach to the stop-loss from the one described earlier. The decision involved is driven by the view, the PM’s expectations and the market, not indiscriminately, based purely on p&l. That is how you want decisions to be made.
Going back to the question posed by the audience member. If you approach stop-losses like most in the markets do, then he is right. It is inconsistent to argue against speed bumps and in favor of stop-losses. The reason is, in both cases decisions are being made driven purely by your own p&l, without consideration for markets, views or expectations. They are a last line of defense against an investment process that is impulsive and poorly planned. However, if the stop-loss is an integral part of a proactive investment process, derived as a result of a thorough analysis, fact-based research and a firm view, it no longer has anything in common with the speed bump. Leaving the speed bump as the only decision being made indiscriminately.
See also Risk Management Placebo
About the Author
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC
In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC
In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.