MAGGIE LAKE: Hello, and welcome to part one of this exciting journey across financial markets. I'm Maggie Lake, and I'll be your guide over the coming days and weeks. Throughout this course, we'll take you through the entire process of building an investment portfolio and managing risk. I'm sure some of want to roll up your sleeves and dive straight into generating ideas, analyzing charts, and putting on investments.
Before we do that, though, it's very important to get a better understanding of the game we're playing, its rules, the other players, and our own approach to it. To some, markets seems simple. After all, many new platforms try to boil down your decision to a simple buy or sell. But there's a lot more to it.
People often refer to the market as this single entity, Mr. Market. But that isn't the case, even if it sometimes seems to act like that. Markets are a confluence of ideas and an accumulation of positions across different time horizons. On the surface, you see the price go up or down. But under the hood, there's an entire world.
In order to be successful in the outer game of buying and selling and hopefully making a profit, first we all need to get an idea of what we call the inner game of investing. That's where a lot of the answers and foundation lies. Let's turn on the projector and I'll show you what I mean.
DENISE SHULL: Poker and portfolio managers generally go hand in hand. Not all portfolio managers play poker, but a lot of them, and a lot of traders play poker too. There's a certain appeal to it, I think, because it's like the markets. And it is in many ways a good analogy.
The markets are a global poker game really. You have all these participants, who are looking at these numbers making bets on their relative value, just like the poker table making bets on the relative value.
And in poker, you win not with the cards, but by betting against other people's bets. It's really about figuring out who's bluffing and who's not. So that's also true in markets, not that anyone's bluffing. But that you win in markets-- the neuroscience shows that those who are best at predicting price action are predicting the people.
Our brains are very social. The market is effectively social. The value of any given thing at any given moment is just a collective social perception. There's not some be all end all truth over here that says, this is worth that. Because tomorrow it's worth something different.
So you're always betting against what other people are thinking, which is really the way you win in poker. So that's why there's a good parallel. The thing about the markets though, is the cards change. At least in poker, the cards do mean what they mean. They don't in the markets.
The relationship between bonds and the dollar, or gold and oil, or whatever, it's going to change. And the relationship between the aces and the kings isn't changing. So the markets are actually harder than poker. But the process of practicing thinking about what cards do these people have and how are they betting, that process is good practice for market decision-making.
The main difference also, the poker game ends. The market doesn't end, which also makes the market harder. But at least you know when the hand is over and who's got what money, which makes it a little more satisfying than the market. The whole never-ending thing, and you can't make anything happen is part of what makes markets so hard.
You got to know what game you're playing. And the game of markets is unlike any other game. It's not exactly like poker. Poker is the closest, but it's not a sport. The game never ends. If the ball goes backwards, you don't if it's a good or bad thing. There's a clock-- there is no clock in the market.
So realizing that you are in this never-ending game that's going to give you constant information that's in conflict with the previous information, that the current information only means something in context of the previous information. It's way too easy to use sports analogies. The worst is, in sports you can make something happen. The point is to make something happen. There are very few people or institutions in the world who can make anything happen.
But yet, we tend to invoke these make it happen sports power analogies, which tend to just lose you money. So by recognizing how fluid and uncertain the game is, and how the fact that it never ends keeps you playing, keeps you hoping. Get a good grip on the parameters of the market as a game and how it's different than anything else.
MAGGIE LAKE: This is where it all starts. And Denise described it beautifully. The game you're playing or are about to start playing is incredibly nuanced and complex. Something that sets investing apart from other fields is that it's one of the only competitive domains where complete novices and professionals are playing on the same field. That doesn't mean it's impossible to compete. But you should be cognizant of this fact when considering your approach to the game.
So in this first part of the journey, we'll focus on the broader game, some of its core rules, and some principles to help you navigate the playing field, the players, their styles, their objectives, and the mistakes they make.
Defining your game-- analyzing the continuous flow of information that comes your way. So let's start from the top and look at the broader game first. There were four core parts of that excerpt with Denise that we'll look into.
One, there is no be all end all truth in markets. There's no formula saying, this is how things should be. This is important for your overall portfolio management process, because while many things can be quantified, investing is more art, perception, and judgment than any hard rules or formulas.
Two, markets keep changing because the investors, economies, and businesses that markets are made up of keep changing. This will be critical for the second part of this course where we talk about market drivers and their ever-changing nature.
Three, markets are a continuous process without a specified ending. Without any clear ending, it's up to you to exit a position. This will be critical when we talk about risk management and losses.
And lastly, you shouldn't take the game personally. The market is not out to get you. Understanding how little you can do to affect the market will help increase your ability to select high quality investment opportunities and quickly exit losing ones. Let's dive right in.
RAOUL PAL: If you remember, Kyle Bass's first question in the masterclass with John Burbank is, John, how do you size a trade? There are no answers that anybody knows. Everybody gets it wrong. Everybody gets their time horizon wrong. Everybody gets the stop losses wrong. Everybody underestimates or overestimates the size of the move. Everybody takes too much risk at the wrong point. Everybody misses a trade. Everybody beats themselves up when they want to get a trade they didn't get.
It's all normal. Nobody knows what they're doing because there is no perfect answer. What there is, it's a process of honing your skills to just get better. But never believe there is a Holy Grail. Because it doesn't exist.
SUBJECT: Yeah. The market would be pretty boring if there was a formula. It would be flat. All asset prices would be flat. And there would be these gaps up as the information inputs change. You'd have binary events, the market would gap, and it would flat, and then you'd have another binary event, and it would be flat. And it would be a very boring game.
JARED DILLIAN: Well, sentiment is how people feel about the stock market or the bond market. It's literally their emotions. And it's something that's impossible to quantify. There's been a lot of efforts to quantify it. There are some technical sentiment indicators.
I prefer to do it the anecdotal way, which is listening to what people say and talking to them, picking up the phone and talking to people and asking them how they feel about the markets. Because this business, you have the CFA, you have lots of math, people try to quantify finance.
Finance resists all attempts to quantify. There was actually one point during the pandemic during March of 2020 when stocks were crashing. And I tweeted out. I said, if you have a CFA, is it helping? And the reality is, is that none of that stuff helps. Because sometimes the market just turns into raw emotion. And by the way, those are actually the most profitable times, is when the market turns into raw emotion. You're just trading on sentiment.
MAGGIE LAKE: As we said earlier, there are no silver bullets. There is no one formula that gives you the answers. Finance is often considered a scientific subject. But in reality, while there are some formulas and guiding math principles, in general, the field, especially when it comes to investing, is guided by the raw human emotion of the crowd.
That is both the exciting and frustrating part of investing. It's a puzzle that can never be solved. And the only thing we as investors can hope for is to continuously improve at the craft and compound our wealth over time while doing it.
The good thing is that you don't need all the answers to make money. You only need a decent framework that's suited to your needs. We'll get to that. Let's continue on that path of understanding the game we're playing.
JARED DILLIAN: So the markets have this property called non-stationary, which means that the markets are a game where the rules are constantly changing. So imagine you're playing chess and a knight goes two steps forward, one step to the left. And you're in the middle of the game and they change the rules, and knights start going diagonally. That's what the markets are like.
And you don't know how the rules are going to change. The rules are changing constantly. So what happens in the markets is that you'll have regimes in the market, whether it's a low volatility regime, or a momentum regime, or something like that, where the markets are behaving a certain way, stocks and bonds are negatively correlated, and then something changes and those correlations break down. And you're in a new regime and you have to adapt to the new regime. Or else if you keep doing what you were doing before, you're going to get carried out.
MAGGIE LAKE: This is really, really important. And it is a foundational concept to everything that follows. Markets are a complex adaptive system where change is the only constant. Both Denise and Jared used different analogies with poker and chess respectively to describe the same thing. The consequence of markets always changing is that the relationship between certain variables like specific asset classes changes. And unless you adapt to the changing market, your portfolio might be relying on the wrong assumptions.
For instance, you might have a strong view on the US dollar and because of it look to short commodities, which tend to be inversely correlated to the dollar. However, as we learned throughout the pandemic, there are market environments where both the dollar and commodities can go up at the same time.
We'll talk a lot more about these market regimes in the next part of this course. But it's very important that you remember that concept. Before we close out this chapter, there's one important and often overlooked aspect we need to talk about. None of this is personal. Most traditional games you play in life, there's an opponent that you need to beat. Whether it's one person or an entire team, there is competition and the desire to win, to prove a point, to be right.
Well, that's not really what investing is about. There are other ways to prove a point. Investing is about being positioned with the market and making money from that. Plus, as Denise said at the start, unless you are a really big player you really can't affect how the markets move. It would be like a surfer getting mad at the sea and trying to change the direction of the waves. Focus on catching the waves, not proving the sea is wrong.
PETER BRANDT: And so losses-- losses are losses. Losses come with the territory. Hey, the markets-- I'm speaking to your audience. The markets don't know you people. They don't know where you live. They don't know the color of your hair. They don't know your personality. They don't take you personal. They don't know you exist.
So why do you take a loss personally? It's not a personality defect. It's not a character fault. It's a loss, people. Losses happen. A lot of losses happen. Because you got to work your way through a lot of losses to find the trades that really are going to matter.
JARED DILLIAN: And the other thing that I did was is I bought BAX futures. And BAX futures are short-term interest rates in Canada. It's-- bankers acceptances are like LIBOR in Canada. So basically, I was betting that interest rates would go down. And in 2017, I went on vacation. I came back from vacation. I got off a plane. I looked at my phone. And the BAX futures were down about 16 ticks.
I knew instantly that I had lost a great deal of money. And I looked through the news. And I saw that Carolyn Wilkins, who was a deputy governor of the BOC, she said that-- she basically hinted that the Bank of Canada was going to hike rates.
And I said, Canada is on the verge of recession. This is impossible. And what I did was is I picked a fight with the Bank of Canada. And they hiked rates. And they hiked rates again. They hiked rates five times. I refused to sell the position.
And at one point, I was down about $700,000. My broker-- there was a risk manager that called from my broker. And she said, Mr. Dillian, are you OK? Is everything all right? And I said, yeah, everything's under control.
And I held onto that position for three years. I rolled the futures contracts over the course of three years. And then in 2020, the pandemic hit. The Bank of Canada cut rates to zero. I made back all my money, and then I doubled it. Now I ended up-- the story has a happy ending. But that is my worst trade because I was so undisciplined. And I vowed never to do that again.
This is a common flaw for a lot of people. I've been working on it over time. I still suffer from this a little bit. But it's the desire to be right is a flaw. Because the goal isn't to be right. The goal is to make money. And a lot of people confuse the two.
And sometimes being right means making money. But getting stubborn and picking a fight with the position and because you have to be right is one of the worst possible things that you can do. So it's all about conserving your capital.
BRENT JOHNSON: I think one of the biggest mistakes that I used to make, and it's one of the biggest mistakes that I try to point out to people now, and it's probably because it was such an eye-opening thing for me once I realized that I was making this mistake that I want to share it with everybody else, is that if you're trying to change the world, it's OK to make investments for the way you want the world to be.
But if your goal is to make money, you should play the world as it is. In other words, you shouldn't invest based on what you would like to see happen. You should do the analysis and then place your money based on what's actually going to happen, whether you want it to or not. And it took me a long time to figure that out.
And I think there's a lot of people now who would like to see certain things happen, whether they think it's justified or it's justice will be done, and especially in the age of QE, and central bankers, and monetary policy, hijinks, and the influence from politicians, that shouldn't happen, we should do it this way. Well, just because you think you should do it this way doesn't mean that those politicians are going to start acting the way you would like them to.
And again, my clients have not hired me to be a financial justice warrior or to change the world, so to speak. They've hired me to protect their portfolio and make their money. And so I think one of the big things is separating what you would like to see versus what you actually think is going to happen.
MAGGIE LAKE: All of this is well summarized by what Dan McMurtry said in his Investor Masterclass. I will not go down on my own sword. I don't do holy wars, none of that stuff anymore. Emotional detachment from your positions and worldviews is essential. Investing is about predicting and capitalizing on outcomes in the markets, not about your opinion of politics or how the world should be.
If there's a new secular promising trend in technology, by all means, start a business or invest in businesses that will benefit. But make sure there is tailwind. Just because something's not right or unjust doesn't mean it will be a good investment. And again, it's not about you and your idea being wrong. The market doesn't care about you. And the sea doesn't care about the surfer.
Now, there is a very important caveat to what I just said. Taking losses personally and trying to pick fights with the market are things that you definitely shouldn't do. But you shouldn't go to the other side of the extreme either and become a robot trying to eliminate all emotions. Emotions are not the enemy. In fact, they're a valuable source of information about ourselves.
Emotionalism, on the other hand, meaning emotional choices and behavior is what we definitely want to prevent. As the saying goes, the hero and the coward feel the same. They just act differently. Let's hear from Denise again.
DENISE SHULL: Your emotions are information. But the only thing you have to control is your behavior. The only thing you have to control is your choice-- push the button, call the broker, whatever. Your emotions, on the other hand, give you information.
And you need to learn to create a dictionary on yourself as to what those physical experiences mean and not try to not have them. Because if you literally didn't have them, you couldn't even decide anyway. You have to have the confidence or the conviction to do the thing.
I spend a lot of time trying to plan the trade, trade the plan, be disciplined. I was really good about taking my stops, because I was a good girl who did the right thing.
But it's not the way the human brain really assesses markets. It's not the way the human brain does anything. But it particularly doesn't assess the hardest game on the planet, this massive social game that is just a perception game. Your senses, feelings and emotions give you information. And man, do I wish I knew that-- I had known that.
MAGGIE LAKE: So those are the four concepts you need to remember about the markets right off the bat. There is no neat formula or holy grail to tell you what to do in markets. Even if there was one, as we said, the markets keep changing all the time. So that one formula would be as accurate as the broken clock that's right twice a day.
You also have to remember that unlike many other activities that have an end, markets are a continuous process without an end. It's up to you to make a proactive decision, or create systems, or minimize decisions. Some investors dollar cost average into a specific investment at the end of each month regardless of the price. That's not investment advice, but just an example of a simple process that reduces the need for decision-making. Many pension plans that take from your salary at the end of the month work the same way.
And lastly, amidst all that complexity, it's easy to believe that all of this is personal and the market wants to take your money. This game is not about you or me. It's about assessing inputs of information to generate money-making investments. Use your emotions as a valuable input but make sure they're not in the driver's seat of your behavior. Remember that.
But even though we said there are no formulas or holy grails to markets, there are some principles and mental models to help you navigate this financial jungle. Let's look at those next.