This is a Guest Post by Alex @MacroOps which was originally posted here: Beware The Top Performers
“And, at any point in time, the richest traders are often the worst traders. This, I will call the cross-sectional problem: At a given time in the market, the most successful traders are likely to be those that are best fit to the last cycle. This does not happen too often with dentists or pianists—because these professions are more immune to randomness.” ~ N.N. Taleb
Trading is a funny game. You can do everything right: research your assumptions thoroughly, wait for the perfect technical entry, size the position correctly, and even successfully exit before price starts to turn. But unfortunately, this still doesn’t guarantee you’ll have a good year. Successful process execution only ensures profits in the long-run. Anything can happen in the short-run.
The opposite is true as well in the case of undeserved windfall profits. You can pick a stock based purely on “gut feel”, plow your entire account into it, and make an absolute killing because price rallied big time on surprise news. This methodology may work for some time, but it always ends the same way — in a spectacular and devastating blowout.
As Taleb so brilliantly explains in his book Fooled By Randomness, the market has a real knack for fooling us with noise. The effect is a whole host of market participants tricked into thinking they’re the next Market Wizard, usually in a bull market, only to blow up during the first innings of the next bear trend.
Taleb explains how the most successful traders in the here and now are really just the ones best fit to the last cycle. They aren’t the tried and true risk managers that survive for the long haul. He calls this the cross-sectional problem.
Have you ever participated in one of those stock market contests? They are a perfect example of why the cross-sectional problem exists.
Take the standard stock market game in any finance class for example. The professor tells each of his students to build a stock portfolio in a paper account. They can go long/short, use leverage, or any other tactic they want. The game is “no holds barred”. The winner is the student with the best returns by the end of semester.
What makes this game different than real life is that the game only lasts half a year. In real life “the game” lasts in perpetuity.
And this is where the problem lies. You won’t win the semester-long contest if you use a robust long-term method. A student that properly controls risk throughout the semester can’t possibly beat the class maniacs who leverage themselves and go all in on one or a few stocks. Most of these guys will blow out before the end of the semester, but the one guy that gets lucky and survives will destroy the performance of the student properly controlling risk.
In the short-term, top performance is always achieved by the trader who takes blowout level risks and hasn’t hit an unlucky streak or “reset” point yet.
Think back to the epic tech rally during the late 90’s. During that time the market “gods” were those buying breakout stocks on huge size. Because of the nature of that cycle, their strategy worked extremely well. As long as you bought strength and held you were rewarded again and again. Betting small and exercising proper risk control actually impaired returns in the short-run because everything went higher everyday. Smaller positions meant less money.
The guys plowing into internet stocks were achieving incredible returns while the world’s true top hedge fund managers were caught shorting the rally or not participating. This created a situation where the richest traders in the short-run had a high probability of blowing up and were therefore the worst traders in the long-run.
Sure enough, once the bubble popped almost all the tech-star traders went bust. The professionals who respected risk didn’t make 1000% returns during the run up, but they’re the ones still here playing the game today. The overfit day traders and swing traders on the other hand exited the game, many of them permanently.
It’s not easy to avoid this toxic focus on the short-term. Humans aren’t good at playing for the long haul. It’s goes against the monkey brain that wants everything right this second. This is especially true considering how hard it is to watch your friend or another trader in your peer group absolutely knock it out of the park with multi-hundred percent returns while your account is clocking in a measly 10% for the year.
At Macro Ops we always ask ourselves, who are the richest traders right now, and how are they best fit to the current cycle?
Which strategy do you think is overfit to the current cycle?