The Van Tharp Institute

January 11, 2006 � Issue #253

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In this Issue:

Workshop Special

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Feature Article

How Academia Leads Wall Street Astray, by Van Tharp

Trading Tip

Foreign Exchange Markets Strive for Credibility, by D. R. Barton, Jr.
Listening In Is Return Always Proportional to Risk?
Special Reports Reports by Van Tharp: Self Sabotage, Changing Markets

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Feature

How Academia Leads Wall Street Astray

by Van K. Tharp Ph.D.

This week I'd like to share a sneak-peak from my next Market Mastery newsletter. The following is excerpted from my interview with Dr. Scott Brown. 

Scott became a big proponent of my work after working through a number of my home study courses and workshops. Scott was well versed in the fundamentals of "Tharp Think" before he went to graduate school to get his Ph.D. in finance. In fact, I even warned him that he�d have to forget many of the ideas that he believed in order to survive in academia. 

However, he had a strong part of him that wanted a Ph.D. and he did survive the ordeal. And, that puts him in an excellent position to comment on what�s happening in academia in the areas of finance and economics. 

His opinion on many current theories in finance and the way they feed the "Wall Street Machine" are much more charged than mine.

Note to Market Mastery Subscribers: The full 14 page interview will be published by the end of this month. For all others, back issues will be available at a later time.

VT:  Scott, tell me what the average person learns when they get a finance degree.

SB:  There are four primary ideas that all finance majors become indoctrinated in before they become brokers, portfolio managers, or financial planners: Efficient Capital Markets (ECM), the Random Walk (RW) hypothesis which is used to test and support the idea of ECM, Modern Portfolio Theory (MPT), and the Capital Asset Pricing Model (CAPM). Remember that most financial professionals are totally indoctrinated in these theories before they assist you.

VT:  So let�s go over each of these factors. Please explain them in simple language that everyone can understand. And give your opinion about how it influences Wall Street. Let�s start with ECM.

SB:  Eugene Fama�s Efficient Capital Markets Theory says that all financial prices correctly reflect all public information at all times. In simple language this means that you never under or over pay for a stock or futures contract given what is publicly known at all times. This theory says that prices may appear to be too high or too low at times, but any prices that seem to be incorrect must be an illusion according to ECM. The average investor totally fails to understand that this will only hold true at very best in the very short-term, like in the next ten minutes.

VT:  And, in simple terms, what do you think is wrong with ECM?

SB:  All of the major textbooks today, which promote a view of the markets as working rationally and efficiently, do not provide arguments as to why speculative bubbles can occur. These textbooks do a major disservice to university finance students today because they neglect to mention widely documented bubbles or Ponzi schemes. To quote one of our most highly regarded economists today, Dr. Bob Shiller of Yale University, "these textbooks convey a sense of orderly progression in financial markets, of markets that work with mathematical precision. If the phenomena [psychological factors] are not mentioned at all today, then students are not given any way to judge for themselves whether or not they are in fact influencing the markets." More importantly Shiller says that, in demanding precise mathematical precision in financial research at the academic level, financial economics forces results that are irrelevant to the investor.

VT:  Okay, how about Random Walk (RW)? What is it and how does it influence Wall Street?

SB:  The theory that financial markets are very efficient and the extensive research in financial economics investigating this theory form the leading intellectual basis for arguments against the idea that markets are vulnerable to excessive psychological optimism or price bubbles. Stock prices, by this theory, approximately describe "random walks" through time: the price changes are unpredictable since they occur only in response to genuinely new information, which by the fact that it is new is unpredictable.

VT:  And haven�t they just randomly generated prices to attempt to mimic stock market behavior?

SB:  One of the arguments that I see presented all of the time by efficient market academics are charts of price movements created by some mathematical model that simulates randomness. It irks me when they point out what appear to be trends in their random price simulations and then smugly say, "See how this proves that there are no trends in the stock market!" This to me is equivalent of standing on the edge of the ocean with a lunatic who sublimely smiles as he points to the horizon and says, "Look at the flat line out yonder and behold how I have proven that the world is flat!"

VT:  Isn�t it correct to say that markets could easily be random except for the fat tails? Markets tend to have huge price swings that cannot be explained by randomness. For example, the stock market crash of 1987 contained a 20% move in the stock market in one day. On a random basis, you might expect that once in a thousand years, not within a few years after a S&P futures contract is developed.

SB:  The literature on the evidence for this theory includes work of the highest quality and therefore, whether or not we ultimately agree with it, we must at least take the efficient markets theory seriously. In the long-term there are no financial theories that exist that either prove or disprove long-term, multi-year price trends in stocks or commodities. Gradually shifting supply and demand relationships in the futures markets or psychological herd behavior that gradually shifts aggregate perception in the stock markets could create long-term trends. I think Paul Samuelson, the father of modern mathematical economics and Professor Emeritus at the Massachusetts Institute of Technology (MIT), sums it all up nicely: "the stock market shows �micro-efficiency� but NOT �macro-efficiency.�"

VT:  And why do people think the theory is true?

SB:  The most simple and direct argument for efficient markets, which the supporters of the theory banter around, is the observation that it seems to be difficult to make a lot of money by buying low and selling high in the stock market.

VT:  That�s true, but I think it has to do more with people�s psychology and lack of understanding of position sizing than anything else.

SB:  Surprisingly to me at least, these very smart financial academics miss the point entirely that this argument that they hold in such high regard does NOT tell us that the stock market cannot go through periods of significant miss-pricing, lasting years or even decades. This limitation of the efficient markets theory is nearly universally overlooked in university finance textbooks and classroom discussion. The assumption is very falsely made that the same efficient markets theory that says it is difficult to predict "day-to-day" changes also implies that one cannot predict "any" changes. In reality, EMT tells us absolutely nothing about long run price changes in the stock market.

 

About Van Tharp: World�renowned trading coach, author and psychologist Dr. Van K Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors.

Dr. Scott Brown, a.k.a. "The Wallet Doctor" holds a Ph.D. in finance from the University of South Carolina and is part of the finance faculty at the University of Puerto Rico School of Business.  He has extensive experience as an investor in futures, options, real estate, and stocks.   You can learn more about his new home study course at http://www.bonanzabase.com/

 

Trading Tip 

Trading Tip

Foreign Exchange Markets Strive for Credibility

by D. R. Barton, Jr.

The Foreign Exchange (or Forex) market has always seemed a bit like the old �wild west� with very few rules or regulations, lots of opportunity, and a feeling of being on the cutting edge of something new.

Like most markets, Forex has evolved quickly from an institutionally dominated market to one that is welcoming retail traders.  At a time when the U.S. equities market was adding regulations to limit the ability of small traders to participate (e.g. $25,000 minimums for day trading accounts), the �wild west� allure of the Forex market was offering open arms to anybody with a  pulse and $200 bucks worth of credit line left on their Mastercard or Visa.

And the Forex �brokerages� have been proliferating wildly.  Offers of �no commission fees� are coupled with starting account minimums of $200, and 400-to-1 leverage (that is not a typo!) and are too good for retail traders to pass-up.

In the fall of 2000, I attended the Day Traders Online Expo in Las Vegas.  Forex brokers were few and far between, while stock brokers were everywhere.  I attended the same version of that Expo in New York City last year and the tables had turned � you couldn�t swing a dead cat without smacking a Forex broker.

The offers of �free commissions� are offset by brokers that were collecting the spread on both sides of a trade.  And while spreads have reduced as competition has increased, they represent huge transaction costs for traders � and huge profit margins for brokers.

Add to these big transactions costs the reality of unregulated (or at least minimally regulated) brokerages and you get some horror stories:  brokers who by the nature of their set-up always take the other side of the customer�s trade.  This led to the questionable practices of re-quoting prices, failing to fill orders or widening spreads to monstrous proportions in fast markets, and other methods that only helped the brokers and hurt the traders.

But the tides are turning.  Electronic exchange networks such as those at COESfx, hotspot FX and InteractiveBrokers FX are following the models set so successfully by the Archipelago and Island exchanges in the stock world.

Over the next couple of weeks, we�ll look at some of the new changes in Forex trading that are providing a more level playing field for traders.  In the meantime, if you have any hands-on trading experience with any of the Forex brokers using the Electronic Currency Exchange (ECN) model, I�d love to hear your thoughts.  Send your comments to me at [email protected] (please be a concise as possible!)

Until next week � great trading!

D. R. Barton, Jr.

D. R. Barton, Jr. is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching, and teaching in the markets since 1986.  D. R. has taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

His writing credits include co-authoring Safe Strategies for Fin-ancial Fre-edom and co-creator and contributing author on Fin-ancial Fre-edom Through  Electronic Day Trading.

 

Listening In...  

From Van Tharp's Mastermind Forum


Is Return Always Proportional to Risk? 
Author: Bert
Date: 01-09-06 14:09

Is return proportional to risk? When I look at my monthly performance over the last year I see variations of -5% for my worst month and 21% for my best month. My risk, however, was a fairly constant percentage of my equity from month to month. How is my return proportional to my risk? 

Bert


Reply To This Message 


Re: Is Return Always Proportional to Risk? 
Author: Pumpernickel
Date: 01-09-06 14:34

Suppose your twin brother had taken the exact same trades as you, at the exact same time as you, except he traded half the "size" (# of shares, lots, contracts, units) that you traded.

His returns would be half as large as your returns. And his risk would be half as large as yours.

Therefore, comparing him versus you, return is proportional to risk. Half the risk produces half the return. This is what people mean when they say "return is proportional to risk".

Future return on investments that involve risk, is BY DEFINITION unknown. (That's what "risk" means). You could lose money. You could make money. However it is certain that the more you risk, the greater will be your wins (or losses).


Reply To This Message 


Re: Is Return Always Proportional to Risk?
Author: PMK
Date: 01-09-06 14:54

Bert,

Think of each trade as a x% chance of a y% gain and a (100-x%) chance of a z% loss. You can increase your edge (by increasing your win% and reducing the number of trading opportunities) or you can increase your position-size (with a corresponding increase in both gain% and loss%).

Therefore you can never increase potential return without some increase in potential loss. The trick is to try to find ways that increase potential gain without a larger corresponding increase in potential loss.

Hope this helps

Paul

Editors Note: As Always...read the complete and unedited thread  at the link below. Look for the title Is Return Always Proportional to Risk, to read many more posts on this topic.
Participate on Van's Trading Forum, a place for traders and investors to share ideas and learn from each other.

Special Reports By Van Tharp

Click below to read page one of each report, or to order. 

Self  Sabotage - Two Reports of Self Sabotage

Does Your System Still Work in Changing Markets?

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