It was October of 2007 and the bull market in Asia was rip snorting mad. I was having a spectacular year sitting on 25%+ gains and probably letting my hubris get the best of me. I had begun to dabble in overseas trading that year as I expanded my strategies and tried to add another weapon to the arsenal. The 6 1/2 hour trading day in New York wasn’t cutting it any longer. In essence, I had become a market junky. What resulted was one of the worst months of my life.
I have always been a bit of a contrarian investor, but like Warren Buffett, I have also always waited for fat pitches – grape fruit size pitches. China’s bull market in 2007 was the contrarian fat pitch that just kept getting fatter. In the middle of October 2007 I took a cut – a pretty big cut for me. I shorted a number of Hong Kong traded equities. Primarily large cap stocks traded in Hong Kong and Shanghai. It just so happened that I had shorted the market to the very day of the peak in Shanghai. I had nailed it. Almost to the minute. But a funny thing was going on in Hong Kong. Regulators were talking about a way to reduce the price discrepancy between the Hong Kong market and the Shanghai market.
In case you don’t know, China has three large stock exchanges – Shanghai, Hong Kong and Shenzhen. Many of the same Chinese companies trade on multiple exchanges. But the exchanges have different rules. For instance, only citizens of mainland China can own the Shanghai A shares. In Hong Kong, however, foreigners can purchase stocks (as I was doing). The problem with this format is that you can have the same company trading on two exchanges at very different prices. Many experts say that the rules in Shanghai create liquidity restraints and make for a less efficient market. They say this is why the Hong Kong shares often trade at more reasonable valuations. It’s long, detailed and complex, but you get the basics. There was an arbitrage to be had and I wasn’t familiar with it.
The Shanghai market began to immediately tank after I sold the HK shares short. I had top ticked the market – I was going to make a fortune, right? No. See, traders in Hong Kong were buying shares while shorting shares in Shanghai. It was a gimme arbitrage opportunity for those who understood it. Being right had never felt so wrong. Being someone who had never traded HK stocks before – I didn’t understand what was going on. Over the course of the next 3 weeks the HK shares I was short rallied 20% on average. I spent 3 sleepless weeks staring at the computer screens trying to understand the mistake I made. I was too smart and too good at trading to make such an error, right? Wrong. Those three weeks were spent endlessly learning and stressing over the mounting losses as the stupidity of my error became evident….
I knew I was right. My analysis was not wrong by 20%. I knew the market was about to roll over hard, but I hadn’t understood the intricacies of the market before I placed the trade. In a stress induced frenzy I added to the position. Mind you it was a fairly small portion of my portfolio (less than 25%), but for me that was too much volatility in one position. I had broken one of my cardinal rules of letting 20% of my portfolio dictate 80% of my daily performance. Even worse, I had let my emotions get the best of me. I was unraveling. I experienced a 10%+ total draw-down that month. For a supreme hedger like myself, this was a huge move. I was floating in the market’s wind like a feather as opposed to hedging and controlling price as I had grown accustomed to. I felt as though all of my years of hard work were suddenly flawed. Then it all reversed.
The first 15 days of November 2007 were nothing short of spectacular. The Hang Seng folded like a lawn chair. I made another classic psychological error and cut out at break-even. The stress had been too much. This was not exactly what I had in mind when I placed the trades just a few weeks earlier. My thesis at the time was about an enormous global housing and stock bubble that was similar to the Nasdaq and on the verge of leading the global economy into a spectacular recession. You know, kind of like what happened over the following 18 months. But I made not one penny on the trade. The next two weeks were spent revamping a clearly flawed investment approach.
In retrospect it turned out to be the best learning experience of my entire career. I’ve had bigger losses. Much bigger, but none was so educational. The result is much of what you read here at TPC on a daily basis. I learned that psychology is the most important driver of price. Never let prices control your psychology and never let your psychology dictate your trading. I learned not to over trade. 6 1/2 hours is plenty of stress for one day. I learned never to trade something you don’t completely understand. I learned to follow rules systematically. And perhaps most importantly, I learned that trading is not the most important thing in life. When I was stressed to the max the people around me were the supporters I needed most. I learned that you trade to live, not live to trade. It sounds cheesy I know, but it’s true. Mistakes are valuable in life. As long as you learn from them. We all make them. Own them and learn from them….Trading is no different.
Hopefully my mistake helps someone else out there avoid one of their own.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.