Traders often implicitly assume recent conditions will persist - without checking whether that's likely to be true.

You need to understand the assumptions you are making, and whether they are reasonable.

Here are some examples and a simple analytical approach 👇👇👇

"I want to find an asset with characteristics X

"So I'm going to look for stuff which showed these characteristics in the recent past - and I'll hope it carries on having them for a while."

Sometimes this is reasonable. Sometimes it is wishful thinking.

How do we tell?

Here's an example of something we know is persistent - volatility.

"I want to find a low volatility stock - so I'm going to look for stocks which have been low vol this year"

Is this reasonable, or wishful thinking? Let's see...

3/n Image
We look at Russell 1000 constituents since 1999.

We estimate vol as the sd of close-to-close log returns * sqrt(252) for each stock, each year.

We create a scatterplot. A point for each stock for each year.

Vol on the y-axis and its vol the previous year on x-axis.

4/n Image
There's a clear relationship. The assumption WAS reasonable

Stocks with higher vol last year are more likely to have higher vol this year.

Stocks with lower vol last year are more likely to have lower vol this year.

I put a green arrow on the chart. #quant

5/n Image
"I want to find a stock that goes up next year - so I'm going to look for stocks which went up this year?"

Is that reasonable, or wishful thinking?

Are returns persistent over that horizon?

6/n Image
Same procedure... We calculate annual returns for each stock. Then we scatterplot.

Each point is an annual observation for one stock.

Annual returns on the y-axis. Annual returns the previous year on the x-axis.

7/n Image
It's not such a reasonable assumption to be making.

Most assets lack clear and obvious persistence of returns. (Also referred to as "trend").

To make trend-following work will require some skill. You can't assume the stuff that went up will carry on going up.

Next one...

8/n Image
"I want to trade mean-reversion on some stocks (explicitly in the underlying or implicitly via options)

"Hurst exponent quantifies mean-reversion/memory (kinda)

"So I'm going to look for stocks with low Hurst exponent"

Reasonable assumption or wishful thinking?

9/n Image
Same procedure...

First "Hurst Exponent Go Brrrr" over daily log returns for each stock each year.

(Probably some sample size bias in that simple function - but all my samples are the same size everywhere, so it'll be similar everwhere)

10/n Image
Now scatterplot.

Each point an observation for a stock for a year. (No overlaps)

Hurst exponent on the y-axis. Hurst exponent last year on the x-axis.

11/n Image
There's no real evidence of any kind of persistence here.

A stock with a low Hurst exponent last year isn't more likely to have a low Hurst exponent next year.

The assumption of persistence - at least generally and at this timescale - would be unreasonable.

Screening for mean-reversion candidates on the basis of past estimations of Hurst exponent alone probably isn't a good idea.

You knew that already, of course...

Market prices are highly efficient and returns are dominated by noise.

Does this mean that "data-mining/screening for past time series characteristics" is worthless?

No - we do some of it (not often tho)

It means you need to *carefully identify the assumptions you are making* and do your best to ensure they are reasonable.

Remember our most useful tools as a trader are:
- Economic Intuition
- Simple Data Analysis

Never forget the first...

An understanding of the structural constraints / pressures that would *cause* the price behavior you are interested in is more valuable than trying to observe it directly in the past time-series.

See @SqueezeMetrics work for pointers here.

Of course, being able to do both is ideal... but we can't always get what we want.

The most important lesson:

*Identify all the assumptions you're making and test whether they are reasonable.*

Don't bullshit yourself.


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More from @therobotjames

2 Dec
In this brilliant article, Kris talks about the importance of trying to "shorten the feedback loop"?

How does a fundamental manager "shorten the feedback loop"?

I don't do anything that looks like "fundamental investing" but I couldn't stop thinking about the problem...

I think of the returns from "fundamental investing" coming from two sources...

1. Risk Premium - The tendency of risky assets to be relatively cheap vs their expected cashflows. This leads them to "carry" more than they would if their real cashflows were riskless

2. Mispricing - For behavioural/structural reasons, some assets are under/over-priced vs a reasonable estimate of their ex-ante "fair value".

On average, we expect them to converge towards fair value over some long time horizon.

This is "alpha" in fundamental investing

Read 10 tweets
27 Nov
You think you've identified a new, useful predictive factor for trading...

But is it really new? Or just another way of looking at something you already know about?

How might you tell? Here are some simple ways...

A research thread 👇👇👇
First, put aside any expectation that you can isolate and quantify effects with great precision.

The market is a highly efficient beast - why means that any non-random effects we observe tend to be extremely noisy.

But just cos something is hard, doesn't mean we shouldn't try.
In fact, it's essential that we try to understand and isolate effects as best we can.

The best tools for the job (at least to start) are:
- economic intuition
- very simple data analysis (the kind of thing you could do in an excel pivot table)
Read 21 tweets
12 Nov
Shall we do some analysis on a *really dumb* factor which might predict relative returns in stocks?

"Are cheap stocks expensive?"

A research thread 👇👇👇
Options on stocks with a low share price tend to be overpriced.

Equity options (at 100 shares a pop) are quite big for a small retail trader. So we might say there is excess retail demand for options on cheap stocks - which would result in them being overpriced.
But are low priced stocks also expensive?

The AMZN share price is $3k+. There are Robinhooders who can't afford a single stock.

Do we see the same effect in Stocks as we do in the options?
Read 25 tweets

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