Humble Pie Prevents 99.8% Drawdowns

/Humble Pie Prevents 99.8% Drawdowns

Humble Pie Prevents 99.8% Drawdowns

By | 2017-08-18T17:03:13+00:00 January 22nd, 2015|Behavioral Finance, Uncategorized|1 Comment

It’s not every day you hear news of a 99.8% drawdown, but it looks like today is one of those days.

Owen Li of Canarsie Capital reportedly wrote a letter to investors saying he was “very sorry” that his fund, which within the last year had reported $98 million in AUM, had been reduced to $200,000. Li, a former trader for Raj Rajaratnam’s Galleon Group, had struck out on his own but apparently ran into a buzz saw last year.

One thing about traders is that under adverse market conditions, they can become volatile powder kegs of behavioral bias. What are some behavioral biases that may have affected the hapless Li?

Illusion of Control

People suffer from the illusion of control when they overweight the likelihood of potential outcomes that are consistent with their desires, and underweight the likelihood of results they don’t want, rather than recognizing the true distribution of potential outcomes.

According to reports, Li suffered some losses and thought he could make successful stock option bets that would allow him to dig himself out of his hole.

This sounds a lot like Victor Neiderhoffer. Niederhoffer had a drawdown during the Asian currency crisis, and doubled down by selling a bunch of out of the money calls. This ended up blowing up his fund.

Similarly, Li reportedly made an aggressive option-based bet on the direction of the broader market. Li thought the market was going higher, and made an aggressive bet, expressed with stock options. He bet wrong.

I’m sure he had a good story and what he thought were strong macro arguments supporting why his trade was a good idea and was going to work out. He thought that his superior market insight would allow him to save the day and earn higher returns for his fund.

Here was a man managing a $100mm hedge fund. Some would argue you only get into such a position by exhibiting some ability to control circumstances. He almost certainly had a view that he had the ability to trade out of a mistake.

Here’s a post we did on the Illusion of control.

Confirmation Bias/Backfire Effect

Confirmation bias occurs when we selective focus on confirming evidence that supports our original interpretation, and ignore evidence to the contrary. Perhaps Li was biased towards focusing on good economic news. Perhaps he ignored what the bears were saying were risks to his thesis.

When your views are contradicted by evidence, you incorporate new confirmatory information into your thinking that supports your previous position, which continues to strengthen in your mind even in the face of mounting disconfirming evidence. The addition of new disconfirming evidence thus “backfires” by actually strengthening the previous beliefs, instead of leading us to doubt them.

Here’s a post we did on confirmation bias.

Overconfidence

Regardless of your so-called “expertise,” it is a dangerous thing to make a big bet on some broad market trend. That’s called market timing. What is the statistical reality here? Markets move up and markets move down. For any given short time frame, the likelihood the market will move in a specific direction is fairly close to 50%. It takes a pretty high degree of confidence to feel that number is so different from 50% that it makes sense to make an aggressive bet on that. Yet that seems to be exactly what happened. With the benefit of hindsight, we can probably safely label Li’s actions as overconfident.

Certainly, however, it can work out. Zach Schreiber made $1 billion shorting oil last year.

Other times it doesn’t work out. Here’s a post we did on overconfidence that highlights a couple of terrible calls, one long and also an epic short call by Wes. A quick quote from the post:

In the end, the hope is that I can convince myself that I am a true idiot and that I should not be trusted to make decisions based on my “feelings.” – Wes Gray

I love humble pie – mmm, mmm good!

One wonders whether Owen Li is eating some humble pie this week. Chances are probably good. Although perhaps I’m being overconfident.


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About the Author:

David Foulke
Mr. Foulke is currently an owner/manager at Tradingfront, Inc., a white-label robo advisor platform. Previously he was a Managing Member of Alpha Architect, a quantitative asset manager. Prior to joining Alpha Architect, he was a Senior Vice President at Pardee Resources Company, a manager of natural resource assets, including investments in mineral rights, timber and renewables. He has also worked in investment banking and capital markets roles within the financial services industry, including at Houlihan Lokey, GE Capital, and Burnham Financial. He also founded two technology companies: E-lingo.com, an internet-based provider of automated translation services, and Stonelocator.com, an online wholesaler of stone and tile. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.

One Comment

  1. Michael Milburn January 22, 2015 at 11:05 pm

    I’m struggling w/ market valuations right now and the associated behavioral biases. I “want” and “expect” to see markets revert to more “reasonable” levels as forward expected 10yr returns are probably in the 3-4% range. It’s difficult to stay invested when your gut tells you risk/reward is out of whack. Like you say, I’m probably looking for confirming evidence to justify holding high cash levels currently, and am probably more dismissive than I should be of positive news.

    But what’s interesting is in no way do I “feel” that I have illusion of control, or that I’m over-confident. Maybe it’s there – that’s how biases work I suppose – but there’s also a lot of humility that I’m trying to inject. (Howard Marks points out that you have to be contrarian AND you have to be right. That’s kindof what I’m shooting for.)

    In this context, I’m looking at oil, right now. My view after looking at both a) historical price decline events, and b) OPEC/Saudi motivations – is that it’s likely patience will be required for investments in the space. It’s difficult to tell if this conclusion is overconfident, if I’m ignoring information I should be considering, or if I’m giving incorrect probabilities to various outcomes. On the whole, it’s largely a psychological observation that money is still eager to move into oil stocks, and has been eager during the entire price decline in oil. Oddly, it’s been greed the whole way down, and fear is just now starting to show up with realization that prices “could” stay relatively low for quite a while (and all that comes with that).

    I don’t know where I’m going with this other than: it seems like (given behavioral biases) any time we draw investing conclusions or investing decisions we’re probably being overconfident. Is the best approach just to a) take our conclusion, b) admit it’s probably quite a bit less likely than we expect, and c) invest accordingly?

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