The Art of Streetplay

Wednesday, July 20, 2005

Unspoken Languages

The past few entries have been quite focused on the thought process and foundational elements of trading/investing. For good or for bad, expect more of the same this time around.

I read a blog today comparing a bottoms-up approach to investing with a top-down approach. I think it's great that people are throwing out their opinions and notions like this because that's the sort of thing which spurs on knowledge and intellectual discovery. That being said, the blog troubled me. It wasn't even the content which troubled me; it was the paradigm underlying the ideas (I have written about this in prior posts). I am very much open to the notion that the bottoms-up approach is fundamentally flawed, and that filter rules or other such quantitative measures aren't "optimal" for a first pass-through analysis of the market. But it seems a little silly to me to extrapolate the performance of one mutual fund onto the whole field of bottoms-up value investors (extrapolation bias). It seems just as silly to discredit filter rules by discrediting a rolling P/E ratio on the market. Following insider trading doesn't work on average; numerous papers have pointed this out (although Professor Metrick among others falls into the other camp). Maybe it doesn't work on average, but then again, maybe it does *ahem ahem*

Taking a step back, imagine for a moment that you knew nothing of insider trading and were told to construct a trading strategy around it. What was your split second reaction? Read all news articles with the words "insider trading" in them? Go to Google Scholar or SSRN to pull up all academic studies? Find all books published on the topic?

My initial reaction was basically what I would now call exploratory data analysis followed by quantitative analysis with an overlay of academic papers. It wasn't necessarily the best approach, but it seemed to work decently well.

That sort of exercise really makes me think about what it is that makes a trading strategy successful. One element of my hypothesis is that it has to do with our ability to think, speak, and write in useful foundational languages. I would consider accounting, for example, to be as much of a language as French or SQL. If I can familiarize myself deeply with accounting mechanics and principles, it allows me to open up books that I simply wasn't able to open up before (literally). I don't really see how that is functionally different from my ability to speak a foreign language allowing me to converse with others who speak the same language. My ability to understand quantitative concepts allows me to understand quantitative trading strategies-- if I didn't speak the language, I would probably have attempted at another strategy which I had access to given the languages I did speak.

The implications of the above schema are interesting. For example, languages are not mutually exclusive, and languages can be mutually reinforcing. Perhaps this whole notion is silly and trite, but I've found it puts things in the right perspective when I attack problems. The languages we know, no matter what those languages may be, are nothing more than tools; no more and no less. How you choose to leverage those tools is up to you, but the tools are there nonetheless. There is nothing forcing you to use just one tool, and with time, there is arguably no tool you can't pick up by learning the appropriate language(s).

I would say that bottoms-up and top-down investing are as good as your ability to lever the tools you've picked up over time.

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2 Comments:

  • Hi Dan - I enjoyed reading your comment and agree that "foundational languages" can make or break a trading strategy. Options trading immediately came to mind for me when I read your post, where I think about how the "language" (i.e., implied volatility, deltas, etc.) in options trading can help "quantify" a potential position. Again, nice post, and keep up the good work.

    By Blogger Aaron Koral, at 2:35 PM  

  • Thanks for the link. You might find this post on AQR capital interesting:

    http://ddo.typepad.com/ddo/2005/07/the_new_york_ti.html

    Link

    By Blogger Ed, at 4:13 PM  

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