Sunday, April 08, 2007

Four Insightful Studies From Dr. Andrew Lo

Dr. Lo, a distinguished Professor at the Massachusetts Institute of Technology and Director of the MIT Laboratory for Financial Engineering, has contributed mightily to both quantitative and behavioral finance. He has been generous in sharing his articles online. Here are four that strike me as particularly relevant for readers.

Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation - In this study, Andrew Lo and colleagues show that it is, indeed, possible to create objective definitions of technical trading patterns and test their efficacy. Their study, conducted with data from the 1990s, found that some patterns do offer unique information to traders. David Aronson's more recent work casts doubt upon the validity of most technical patterns. This is a fascinating area of research and one that I hope to address, albeit in a more modest way, in the near future.

The Psychophysiology of Real-Time Financial Risk Processing - Dr. Lo and his team hooked traders up to biofeedback equipment to actually measure the degree to which emotional arousal impacts trading. It's a great look at how experienced traders differ from novices, and the study concludes with a thoughtful discussion of the role of emotion in trading.

Fear and Greed in Financial Markets: A Clinical Study of Day-Traders - Dr. Lo and colleagues (of which I was one) examined the role of personality in trading results. The results extend the findings of the earlier study regarding the role of emotion in trading, but raise questions as to the importance of personality traits in trading success.

Reconciling Efficient Markets With Behavioral Finance: The Adaptive Markets Hypothesis - Here Dr. Lo offers his alternative to the Efficient Markets Hypothesis by drawing upon evolutionary theory to show how markets adapt to a variety of conditions over time. This is an unusually insightful paper, and it makes a strong case that the market's risk premium varies according to the recent path of the stock market. Lo draws upon cognitive neuroscience to explain behavioral biases in financial decision-making. Ultimately, he argues, evolution determines market dynamics.

16 comments:

Kathy said...

Hi Dr. Brett:
It was interesting to read your book and this blog. I have this question:
Have you seen people make a living by trading from home? For example make $50k (on a capital of 200 to 300k for example implying 25% to 17% annual return) year after year. Does such profession exist?
What I try to get at is that if one can not become a professional trader in a trading firm can he/she just trade for a simple living?
If 1 in 10 millions can become Trader Marc, how many can become Trader at Home? 1 in 10,000 or 1 in 100,000? How many have?
Thanks.
Bruce

Brett Steenbarger, Ph.D. said...

Hi Bruce,

I don't have any statistics on the proportion of independent traders who make their livings from their trading. My experience, FWIW, is that trading for a living is much talked about, but not so often achieved. Making a living from a capital base of 200-300K means making that good return on that money every year after all costs of trading are factored in. I've seen in done, but it's not easily achieved. Many times, traders needing such returns take undue risks that, over time, catch up to them.

Brett

AnaTrader said...

Brett

If I may add, I believe if a trader can have consistent profits with good money management, and learn to increase the capital base with consistent profits, then it is not impossible for a trader to trade for oneself with a good ROI over time.

However, the trader needs a good tested system suitable to oneself in order go forward and trade for a living.

Speaking for myself, I am starting to trade better with more practice, better money management and hope to increase my capital base over time to trade with good ROI of 10 % pa consistently to start with.

Continuous education is also vital.

BarroMetrics said...

Hi Brett

If I may add to this.

31% of my graduates are private traders full-time traders.

My advice to them when they first started was not to turn to full-time trading until they had:

a) 2 years outgoings saved, and
b) had enough capital so that a 15% return would cover their cost of living.

Till then they ought to have an external source of income.

Over 90% of the 31% have kept their external sources even though most have met the two conditions.

I believe that having to make money to pay the bills generates too much pressure for most to allow them to trade well

thanks

Ray

Kathy said...

Thank you all for your replay.
Ray:
How many (in terms of numbers) of your graduates are doing this for a living?
Do you have a trader training class?
Thanks.
Bruce

BarroM said...

Hi Kathy/Bruce

Thanks for your questions; my answers:

a) There are 12 private graduates.
b) Yes I do. I have max of 5 at any given moment and right now, the quota is full.

I am not comfortable discussing what I do on Brett's blog.

I'd be happy for Brett to pass on my e-mail details to you if you'd like to discuss this farther and he is happy to assist.

Thanks

ray

Brett Steenbarger, Ph.D. said...

Thanks, Ray; I have been impressed by your trading ideas, your mentoring, and your dedication to assisting developing traders.

Brett

brywend said...

Hi Brett,
It's always good to watch you dealing with tricky questions! Cathy's question about account size is one of the great unanswered questions of the trading business. Another one is the issue of addiction and trading that you dealt with a few months back. Few, if any, of the people involved in trader education that I have come across have been prepared to speak honestly about these issues. A man with your level of integrity is clearly an oddball in this industry. Thanks for being an oddball, though.

Bryan Wendon

Kathy said...

Hi Ray and Dr. Brett:
I am interested in learning more about Ray’s class. How can I get Ray’s email from Dr. Brett?
Thanks.
Bruce

Brett Steenbarger, Ph.D. said...

Hi Bryan,

Thanks for that praise! I think it's the first time someone has complimented me on being an oddball!

But yes, I think it's crucial to speak objectively and honestly whenever possible. It is *not* realistic for traders to hope to make a consistent, sustained living trading small portfolios. It is also not realistic to assume that seeing a coach or psychologist will, in itself, give you an objective trading edge or developed trading skills.

Brett

Brett Steenbarger, Ph.D. said...

Hi Bruce,

My email address is at the bottom of the "About Me" section on the TraderFeed home page. I'll be happy to respond to questions via email. Thanks--

Brett

greytrader said...

Capital of 200 to 300k is actually 800k to 1.2 million buying power in a day trading account. 400 to 600k in a swing trading account. Making 50k return on such capital requires less than a 10% return.

Kathy said...

"Capital of 200 to 300k is actually 800k to 1.2 million buying power in a day trading account. 400 to 600k in a swing trading account. "

Hi Greytrader:

I can not figure out this statement.
Can you explain?
Thanks.

greytrader said...

Hi Kathy,

This info is for day trading stocks.
When you open a day trading margin account with a broker, they will give you 4X the buying power on average. You have to buy and sell stocks daily for a while and have a minimum of $25000 (NASDAQ rule 24520)

Margin interest varies and it is tax deductible.

For longer term trades they will give you 2X you capital as buying power.

Some prop firm will even give you 10X you capital but obviously it is more risky. Most profitable traders make full use of the leverage of their margin.

With 200 to 300k in capital you do not need to make 17 to 25% year after year. You can do very well making 10% average return. It is not easy and one should not use margin until they are consistently profitable but it is certainly possible.

D TradeIdeas said...

Dr. Lo's body of work in quantitative finance forms one of the principal foundation blocks of the algorithms and statistical analysis we perform at Trade-Ideas. We continue to offer our public and private gratitude to the distinguished Professor whose insights on empirical implementation remain invaluable.

Dharmendra said...

I completely agree with all your comments. Do you have any tool by which we can practice to avoide the imbalances of the mind? Or we can stick with our winning trade?