Wisdom I have gained

I was answering a question from Thor at Traders Anonymous last night regarding where I learned what I know about trading/investment. I answered that I did not think I was much of an expert but had worked with a lot of great traders and hoped it had rubbed off on me. Thinking about it though, I realised that I had probably learned as much from the mistakes of poor traders than the successes of the good ones.

Please see if you can spot the connection between these people?

1. Trader at a large European IB who had the biggest corporate bond book in Europe. Not content with this he also took massive punts on US interest rates. Despite predicting the large correction in 2004 coming he did not reduce his book, instead he attempted to hedge using cds. He stopped being profitable that year and was forced out a couple of years later, the bank unwinding some positions which would have been massively profitable (he had tens of millions of 5 year cds on the US broker dealers bought at spread of 20-30 bps).
2. Trader at the same IB who, not content with running a profitable CDO origination desk, levered up massively to buy positive carry AAA CDOs (subsidised by poor funding charge allocation by the bank).
3. Trader who bought extremely cheap equity (0-2.5%) protection from unsuspecting investors in European ABS (including Allied Irish Bank if memory serves). However rather than waiting for this protection to pay out, which would have been a great trade, he tried to monetise the theoretical day 1 gain by entering into a large portfolio on which the present value of the carry was shown to massively outweigh the protection payment. The bank let him have his pnl on day1, never considering the possibility that the assets could fall more than 2.5% below par (hey they are AAA!).
4. Brazilian and Swiss hedge fund managers who made massive leveraged bets on mid caps, hedged with large caps and indices. They made hay in the bull markets of 2005-2007 before being wiped out in 2008.
5. Another Brazilian hedge fund who stopped their relatively successful strategy of buying reverse convertibles with floors when equities became “too cheap” in mid 2008. They bought the bargain stocks (C! AIG! Lehman!) and took out the floors on the RCNs on their usual names to get “more return”.
6. Big name prop desk head at big name bank who tried to apply his previously stellar performance in trading relative values in listed equities to investing in private equity based on the same kind of analysis. He wiped out three years of profits in a private equity book which was only 30% of his portfolio.

Lessons learned:
1. If in doubt, reduce risk, don’t try to hedge by adding more positions. It’s no use entering a great trade early if you are not around to see it to conclusion.
2. Short term greedy generally makes you a long term loser and if you don’t assess people’s performance relative to gross as well as risk adjusted capital, they will act in their own interests, not those of the firm.
3. See 2. And don’t fall in love with one product just because it has not hit a bad patch in the last few years. Everything has a spell on the ropes at some point.
4. Earnings multiples matter about as much as the colour of the paper in the Annual Report when liquidity disappears. Never leverage bets on illiquids, even if you “hedge” the market risk with shorts. The shorts can turn round and gobble up your capital in a flight to quality just when you need them most. The NAVs of these two fund went down in almost perfect correlation despite them operating in completely different markets – liquidity tends to be a global phenomenon in a crisis.
5. Not saying that their original strategy would have been a winner in 2008 but sticking to what you know and not getting tempted by bargains in areas you know less about is vital to riding out a storm.
6. Again stick to what you know. Private investment is all about timing and the ability to back and influence the right management. Investing blind and sitting back to await your payday only cuts it in a debt fuelled bubble. There are no shortcuts even for the best trader.

The answer to the connection is that all of them are fabulously wealthy and all (except number 6 who is about level) have cost their employer enormous sums of money. Perhaps the main lesson is that you should make your mistakes with other people’s money.