The Invisible Hands | Steven Drobny

Summary of: The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money
By: Steven Drobny


In ‘The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money’, Steven Drobny introduces readers to different approaches to managing funds. Through the experiences of multiple hedge fund managers, the book unfolds the importance of sound risk management, unconventional methods, and psychology in navigating various market scenarios. Drobny’s comprehensive exploration delves into the significance of liquidity management, the art of trading, and the consequences of chasing momentum. This summary offers an exciting glimpse into the practical takeaways offered by the book.

The Cost of Ignoring Volatility

In 2008, Yale and Harvard faced significant asset declines during the financial crisis, resulting in job cuts and project delays. In contrast, big pension funds like CalPERS suffered from low returns due to less robust growth. The experience highlighted the importance of considering the dangers of potential volatility and crashes, even in tranquil conditions, and recognizing the value of liquidity. As old methodologies fail, rethinking real money management is necessary. Portfolio managers must have volatility in mind to manage risks efficiently.

The Benefits of Holding Cash

Investing everything during a market surge might seem like the right move, but it can increase volatility. The endowment model of investing, favored by pensions and endowments, avoids keeping cash balances, but this may not be the best approach. The absolute return investors’ philosophy is different – hold cash to enjoy opportunities when they arise. Family office fund manager, Jim Leitner, highlights this. He reserves an average of 25% of his portfolio to cash and moves nearly 90% of his portfolio to cash at times. During the 2008 crisis, Leitner used his cash reserve to invest in undervalued securities like the Ghanaian Eurobonds. It is difficult to predict the market, but it is easy to predict that stocks will trade higher in a decade than they do at present.

Success and Mistakes in Investment

A Swedish fixed income manager emphasizes on the importance of differentiating between mistakes and losses in investment. Despite doing everything right, investors can still lose money, and they may misinterpret the market and succeed. Even seasoned professionals can make fundamental errors such as underestimating potential losses by being too attached to a trade or refusing to re-evaluate investments when the fundamental premises change. Knowing financial theory and understanding its limitations can help avoid flawed thinking. The manager warns that careless mistakes can occur, such as assuming previous returns as an indicator of future success.

The Alchemy of Finance

George Soros’s book, The Alchemy of Finance, discusses how he forms market hypotheses to seek out investment opportunities, paralleled by an unnamed investor known as “the Philosopher.” The Philosopher applies hypotheses centered around themes like monetary policy and tests them regularly to see if it still holds. He believes that hypothesis testing is not always about being correct, rather about cutting losses when a theory proves incorrect. The Philosopher’s approach is different from institutional investors who rely heavily on benchmarks and hesitate to cut losses out of fear of losing their job. The Philosopher compares trading to golf, in which you can execute almost the perfect shot, but if the ball takes a bad bounce, the result will be poor- a well-executed trade can also go south for reasons beyond the trader’s control.

The Commodity Trader’s Measured Approach

The Commodity Trader earns double-digit annual gains by quickly selling losing trades and holding onto winners. Unlike other traders, he doesn’t jump into investments with oversized positions. He understands that investment themes take time to play out. The Commodity Trader also learned an expensive lesson in risk management during the late 1990s dot-com bubble when he shorted the NASDAQ. Shorting a market with a lot of momentum is almost always a mistake, even if it seems irrational.

The Importance of Psychological Capital in Commodity Trading

The “Commodity Investor” emphasizes the role of experience in building psychological capital for traders to survive volatile markets. He prioritizes on-the-ground research and believes official data is not always reliable. He employs an agronomist to travel and assess crops and speak to farmers. The assimilation of information into the price structure is a challenging aspect of commodity trading. The Commodity Investor’s projection of a bumper crop of corn differed from the USDA’s forecast in 2007, causing prices to plummet. Six weeks later, the USDA’s revised forecast aligned with the Commodity Investor’s projection, and corn prices rebounded.

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