Full Transcript: Brent Donnelly on Thinking Differently to Invest and Trade Better
Edge Decay, Rationality Over Intelligence, and Not Blowing Up
Matt: You’re watching Excess Returns, the channel that makes complex investing ideas simple enough to actually use, where better questions lead to better decisions. Who’s with me? Spectra Markets, the must-read and still very free Friday Speedrun author, and he’s got this new book, Trade Outside the Box: Advanced Thinking for Professional Traders. I love this. There are so many little dog ears and footnotes in this, it’s not even funny. You might know him as Beeper. You probably don’t. In which case, let’s welcome Brent Donnelly back to Excess Returns.
Brent: Wow, that’s a deep cut. Hi, Matt. Thanks for having me.
Matt: Man, I love this book, and I think I love this book so much because I realized the hard way I wasn’t cut out for stuff like this, and I think this was part of me discovering your work and reading it, ‘cause I would read stuff and I’d go, “Obviously that’s not me. There’s a person who does this.” And if you could, can we just start... I wanna start with this idea, these four quadrants. Can we talk about that again? What are these four quadrants? Launch me right in.
Brent: So everyone that trades or reads books about trading generally learns about fundamentals, technicals, behavioral bias, and quantitative finance or systematic trading kind of stuff. And those are kind of the four foundational sort of parts of finance and more about trading that you need to know in order to understand trading. And I wrote another book called Alpha Trader, which essentially covers those four. And my purpose there was to kind of cover the more important things like risk management and psychology that I feel like aren’t always covered very well in books.
I think just generally, the fun part of trading is coming up with trade ideas. So if you read a lot of blogs and, you know, even FX strategy and stuff like that, it boils down a lot to trade ideas. And people don’t spend enough time thinking about risk management, trade structuring, and things like that, which actually are very often the determinants of whether you make money or not. Like, many times I’ve been right and lost money, and so digging into why would that happen? How can you make that not happen?
But then, so that was Alpha Trader, and then the new book is essentially saying, “Okay, now that you’ve got those four pillars, what else can you do to develop an edge and to make money trading?” Because sort of the tagline for the book is, “If you do what everyone else does, you’ll perform the way everyone else does,” which is a highly pejorative comment because most people underperform a simple index or a simple benchmark or, you know, whatever statistics you look at, like day traders lose money, 80 to 90% of day traders lose money, et cetera.
So if you’re doing what everyone else is doing, then you’re gonna lose money. So once you have the basics mastered, then you need to figure out, “Okay, how am I gonna actually make money?” And my belief is that you mostly do that by thinking differently and doing different things than what everyone else is doing. So you do need to know the basics, and I’m not shitting on fundamental or technical analysis or behavioral bias and things like that. I feel like those are absolute must-haves, but they’re necessary but not sufficient to actually make money.
Matt: And I think what’s fascinating about it, and again, emphasis on Trade Outside the Box. This is basically what you’re talking about. Here’s all these things. The four quadrants are there, not in the image, but the four quadrants are there, and you have to master those in order to go outside of them. And whether you’re doing due diligence on a bunch of asset managers or trying to understand a hedge fund and where they might have edge or whatever, this is where it emerges from. Here’s something they understand.
Brent: Yeah, and part of the inspiration, I think, was... So I was a participant in many analyst programs at banks over the years. And what you get in those analyst programs is very intelligent, book-smart people who are quantitatively very strong but aren’t necessarily creative and don’t necessarily have a long history of thinking for themselves. Because what you’re trying to do in order to get to an analyst program at a bank, you know, you need very high grades at a five-star university, like a strong university. And the way that you do that is by correctly answering all the questions on the test.
And that doesn’t really work in markets because what you will see if you canvas 20 of those analysts and say, “Okay, we need you to present a trade idea at the end of your three-month internship,” those trade ideas—and again, these are smart people, but this is just the way it works—those trade ideas will be incredible contra indicators because what they’ll do is amalgamate all the known information and essentially extrapolate from the current environment to a trade idea that is probably fully priced in and all the information that they’re looking at is probably well known.
So how do you get away from that? And the sort of primary idea, like, if you just read the book and took my ideas, that’s one thing, but that’s not really what I encourage or what I advocate. What I would encourage is you read the book and then you see, okay, this guy does it a certain way. He takes things from areas that he’s familiar with—clinical psychology, gambling addiction, poker, all those kind of things, or even like multiverse theory and random shit that I’m interested in—and then applies it to trading.
And I think that’s what people should really be trying to do, is take something that you’re really good at or that you know a lot about and see, is my specialization in how viruses propagate through biology, is that relevant to how narratives propagate through markets, because markets are kind of this quasi-biological system, and things like that.
So specifically, like I said, there’s areas that I feel like I know a lot about. And, you know, if you’re a trader and you’ve been trading for a long time, you just start to see trading stuff everywhere. Like, a friend of mine who read the book, his son participates in F4 racing, which is kind of like F1 racing, but this kid’s 15. And so my friend has a good knowledge of F4 racing and the psychology of it and all that, and he was like, “Yeah, there’s so many different ways that auto racing is applicable to trading. Like, you’re trying to go as fast as possible without hitting the wall,” and things like that, which is essentially maximizing leverage without blowing up.
And so I think when you start to think about areas outside of trading, you start to have inspiration for ideas in trading that are different. And then also, sometimes you can use poker as a laboratory for trading. So one issue with trading is you don’t get a ton of reps. Like, my time horizon’s pretty short, so I get a decent amount of reps and that definitely helps. But in poker, especially online, but even live poker, you just get a lot more reps.
So if your approach in trading is tight aggressive, which is like the textbook way to play poker, which is be super tight and fold bad hands, but then when you have a good hand, play super aggressive and maximize what you’re gonna extract from that hand. And really, that’s what trading is too, right? For me, if I’m trading well, I’m sitting there doing nothing, or I have like one or two line items. And when there’s something that really stands out to me, you know, I’ll have my spreadsheet that tells me my maximum allowable risk, and then I’ll get to that maximum quickly when there’s a really strong opportunity.
But if I’m trading poorly, it’s the equivalent of getting like jack six off-suit in poker and you’re bored, so you just play it for no reason, and then you find yourself three betting, and then you find yourself all in with jack six off-suit and the other guy had a pair of eights or whatever. And that happens a lot in trading. You know, it’s 2:00 in the afternoon, you’re up a lot of money and then you are bored and you see some thing flicker 8% lower for no reason and you buy it for no reason, and then it’s 16% lower by the end of the day and you’re like, “Why did I do that?”
So the discipline of folding bad hands in poker over and over and over, even if you get 15 bad hands in a row, if you can do that, and then you sit down the next day to trade, you’re gonna be in a stronger position to be disciplined.
Matt: So what I did is I took the book. You got a number of these principles running through it, which is fantastic. I divided them up into some clusters, and I was wondering if you’re game, let’s go through some of these clustered ideas, and we can unpack how they apply. And I’m gonna say this again, this applies to trading, it involves investing, it applies to longer term trains of thought, too. It’s just all about process.
Brent: Yeah. That’s my favorite part about this. Actually, it’s interesting you say that, ‘cause I think the biggest compliment that I’ve ever got on Alpha Trader and this book is people saying, like, “I’m gonna give this to my 21-year-old son even though he doesn’t trade, because it’ll help him understand the game of life,” you know, through expected value and risk appetite and how risk is a spectrum and all that kind of stuff. So ideally, although I wasn’t writing it this way, I do think that a ton of this stuff applies to real world stuff outside of trading, even like chess, poker, whatever, the games, but then also the bigger game of life.
Matt: Yeah, I mean—
Brent: Okay, let’s do it. Cluster me up.
Matt: I’m gonna cluster you up. And you know, in a way, you writing advice like this, you’re like degen Howard Marks almost. I mean that as a compliment.
Brent: That’s a great compliment. You know, one time I actually wrote a critique of one of his letters, and I sent him an email asking if he wouldn’t mind giving me feedback on his critique, ‘cause I respect him, and he said, “Yeah, sure, give me a call.” And I talked to him for like an hour and a half, and I’d never talked to him before. So kudos to him for giving some random Canadian dude his time.
Matt: That is the most Howard Marks thing ever. I’m so not surprised at that. All right, cluster one. I call these the adapt or die principles. I want one person out there to hear the Skate or Die 2 theme song in their head before playing the half-pipe level.
All right, so this was, I wrote down principles number one, number nine, number 18. The way you make money today is not how you will make money tomorrow. There’s nothing new under the sun. Match your analysis to your trading timeframe. Do these relate to each other? Do you see them together?
Brent: Yeah. So these are all lessons that I learned a little bit later on. So, you know, you can learn certain things early on from books or from trading, but some things you just have to feel the pain of like years of trading in before they really hit home. And the whole thing about whatever you’re making money on now will not be how you make money in the future, you know, that cost me a lot of money in the past.
I think the essential idea is that markets are efficient on a longer time horizon. So if you find some strategy that’s a four Sharpe, by definition other people are gonna slowly find it and the Sharpe of that strategy is gonna decay. So I think you can assume that the Sharpe of all strategies decays to zero over time, except for a few exceptions. Obviously, if it’s small enough, nobody will go to it ‘cause you can’t make enough money, et cetera.
So the sort of main example of this is before the global financial crisis, people didn’t really understand correlation trading that well. It wasn’t really a thing. There were hedge funds doing it and some people did understand it, but to give you a sense of how poorly understood it was, I had live feeds for gold and S&Ps and things like that, and most people on the desk—and I worked at Lehman Brothers, which was a strong firm with a lot of smart people—most people didn’t even have live feeds for futures and equities and oil and things like that.
So when, say, there was a strong correlation between carry and S&Ps, which there was. You know, if S&Ps ripped 15 handles for some reason, you could just buy Aussie/Yen and it would go up 20 pips and you could sell it, and you could do that. You could basically just sit there all day and trade lead lag correlation stuff.
And then during the global financial crisis, all the correlations went to one, and financial blogging kind of started at that time. So by like 2010, 2011, if Aussie had dislocated from copper, there was 15 blogs writing about it, and everyone had a live copper feed at that point. But I had so much muscle memory from doing this for years, ‘cause I had started doing it in like 2003, that it was very hard to stop doing it even though it stopped working.
So I had plenty of evidence by like 2011, 2012 that this strategy just doesn’t work anymore. But it’s like an old friend who you grew up with, but who is really actually a bad person, and you just can’t get away from being their friend ‘cause you’ve been friends with them for so long. It’s kind of like that. You made so much money trading lead lag correlation for, whatever, eight, nine years, that it was very hard for me to stop doing it. So I just had the muscle memory of if S&Ps rallied 10 handles, I was buying cross Yen, and that absolutely didn’t work. And I had plenty of evidence to see it didn’t work. But it took me a few years to realize.
And I think part of the reason I didn’t stop was that was just such a big part of my trading strategy that I didn’t have a fallback. I didn’t have like six other things that I could be doing ‘cause I knew this thing didn’t work. And so now whatever I’m doing, whatever the strategy is, I’m always thinking of, “Okay, this is probably temporary. It might work for six or 12 or 18 months, but I gotta have like five, six, seven other ideas and five, six, seven other strategies that I’m working on learning about or doing.”
So, say, a more recent example for people that aren’t as old as me: during COVID, there were times when you could just buy calls around earnings and make money because the calls were just too cheap and the moves were absolutely insane because there was so much retail money coming in. Or, more recently, there’s been some weird convergence trades of things trading way above NAV converging back towards NAV. And so there’s all these different things that work in different periods, but they never really work forever. So the idea is whatever you’re doing, you need a bunch of other strategies that will potentially work in the future or start working now and not rely on one thing.
And part of that is just not being a one-trick pony as well. Like, you can also apply that to trading styles. People that came of age that I know that are senior traders at banks and stuff who came of age during the global financial crisis just grew up being breakout traders. ‘Cause when vol’s high, breakout trading works. And then all of a sudden, you get into a VIX 15, 18 regime for three years, and the person doesn’t make money for three years ‘cause all they know how to do is breakout trading. So those are two kind of similar things, of not being a one-trick pony, but then also just understanding that whatever you do now is just probably not gonna make money in the future.
The time horizon thing is really something that it’s more something that I don’t really do that much but I see it a lot, is people talking about like Tesla stock being overvalued relative to other automakers and always wanting to be short Tesla, for example. And that’s just not a strategy that’s gonna work unless you have an unlimited time horizon and no stop loss. And still it might not work ‘cause Tesla’s probably gonna merge with xAI and, you know, go out at 420 bucks, so.
Matt: Space cars, man. Space cars.
Brent: Yeah, space cars and moon bots or whatever. So in general—and I mean in the past I’ve got called out on it too—like I’ll write something about Canadian fiscal policy and real estate crisis in Canada, this and that. And then like, so I’m short CAD with a 2% stop. And someone will email me like, “Dude, you’re talking about a three-year structural story with a two-day range stop loss.” So I think that’s a mistake that people make a lot as well, is mismatching time horizon with the actual trade that they’re doing. Like the analysis that they’re doing versus the trade that they’re doing. So those are kind of two separate things.
And then there’s nothing new under the sun, which kind of sounds like the opposite of how you make money today will not be how you make money tomorrow. But that really more applies to the big picture waves of human idiocy, you know, that will always keep on happening. And so whatever you see in AI today or railroads in 1900. And the trick with that is not to just go point at every bull market and say it’s a bubble, but to recognize that there’s different phases of narrative in every bull market and if you can recognize those phases now, they’re very similar to the phases in ‘08 or in 1907 or whatever.
And so understanding that... I think that the biggest edge in markets is being able to predict what humans are gonna do, not what economies are gonna do or what central banks are gonna do. And that’s because humans just keep on doing the same thing over and over. And part of the reason I know that is from studying history and all that, but also from seeing myself do it. You know? It’s just so hard not to get sucked into, “Oh, this is a new paradigm for memory stocks. This time they’re signing three to five-year contracts,” this and that. It won’t be boom bust. And it’s just very easy to get sucked into the idea that today is special. Every election is the most important election of all time, et cetera. This is the biggest technology of all time. It’s different from all the other technologies, et cetera. And it’s really hard to fight that, so I kinda always have to be fighting that.
Matt: You kinda always have to be fighting it. And it’s that humility which I feel very deeply here. It’s the humility of like, “I’m a little different today, and so is the rest of the world.” Judge accordingly.
Brent: Yeah. Yeah, I think that’s fair. I think it’s funny because... Okay, I’m trying to remember when it was, but I would say probably around 2010 or so. I’d been writing and publishing my thoughts for about six, seven years at that point. And one time I wrote this thing about like New Zealand Central Bank, and it was just like the wrongest thing you could have written. Like, everything I said was wrong. They did the exact opposite of what I predicted, and I was stopped out of the trade like nine hours after I put it on or whatever.
So I wrote this whole thing of like, “Here’s why I was wrong. You know, I’m embarrassed to say that every way possible that I read this, this, and that was wrong,” sort of like a postmortem, but then there were some takeaways and, you know, for the next time I look at a central bank, here’s what I’ll do differently. And I was blown away by how much positive feedback I got because I guess there’s a world of financial prognosticators and human beings, right? Like not just finance, but just people who will never say that they were wrong. They’ll just always move on to the next thing and pretend that other thing didn’t happen or bullshit their way of why the central bank is an idiot and they shouldn’t have done what they did, and that’s why I lost money, et cetera, et cetera.
And part of the beauty of being a short-term trader and having traded for a long time is I’ve just been wrong so many times now that it just doesn’t hurt. And a corollary to that is if you collect data on your trading, which I started in like ‘06, you start to see the sort of texture of how your trading works in a statistical way. And what I learned from collecting data on my daily P&L is that my win rate is always around 50 to 53% every year. Like, it’s crazy how it never changes. And whether I did well that year is predicated on the ratio of my winning trades to my losing trades. Like, did I make 200 grand on the winners versus losing 100 grand on the losers? You know, that’s the only thing that changes.
So if you look at eight years of trading data, say in 2014, I would look at it, and you see, okay, I was wrong 50% of the time, and I trade 250 days a year. You’re just wrong so many times that at some point, it just has no emotional resonance or valence or whatever, right? It’s just like, okay, I was wrong.
And then if you’re good, you can then split it into two things. One is variance, which is like, okay, I know twice a year I’m gonna lose money six days in a row ‘cause that’s just statistics, that’s just variance. Or I lost money three days in a row, but, you know, I’m having a huge fight with my wife and I’m worried about my son ‘cause he’s at a new school and I’m having trouble getting out of bed in the morning. Losing three days in a row in that condition is a completely different thing than six days in a row where you’re like, “I followed my process and I was wrong.” You know? Then, literally I just don’t care about that. And I think over time, you can separate the two, and then what you do about it is huge, right?
Because I think one of the biggest turns in my trading career was when I really had a manager that really believed in me, or I believed in myself enough ‘cause I’d been around long enough, but also had a manager that believed in me, where I could lose money five days in a row, and on day six, if there was a super high-quality opportunity, I could go full risk according to the parameters I had set. Whereas for a long time, if I lost money five days in a row, I’d be like, “Ah, I better take it easy today, go to 30%.”
And then what ends up happening is you’re kind of reducing risk after a drawdown and increasing risk when you’re overearning, but your P&L has a certain slope baked into it. So essentially what you’re doing is increasing risk when you’re doing well, reducing it when you’re doing poorly, and really all that ends up doing is flattening your P&L curve. So if you have a good process, and you have a good manager, or you don’t have a manager and you believe in yourself, and you know the difference between variance and actual bad trading where you’re not following your process, then you can maintain a way steeper slope of your P&L. Did that all make sense?
Matt: I mean, total sense to me.
Brent: Okay.
Matt: And especially the self-actualization of it, which there’s a meta theme emerging on Excess Returns in the last week, which is just the conversation of variance and when variance is useful versus when variance is dangerous to use as a definition, and how you apply it to different things. You fired all sorts of stuff off in my brain that I hope shows up in a later episode.
Brent: And then another, just a small offshoot of that which I’ll share, is my thing. So when I’m trading poorly, I’m able to stick to my process quite well, but when I’m making a lot of money, then I do start to experience the house money effect of, like, when you’re at a casino and you have eight black chips in your pocket, and you started with 100 bucks, now you got 800, and you’re like, “Ah, let’s go to the bigger table, and let’s bet on some stupid shit.”
And so I have conditional formatting in my P&L spreadsheet when I’m overearning, and then I actually reduce my risk, because it’s very hard to do it because I don’t wanna listen to the spreadsheet. But it’s just an actual empirical fact for me, that when I’m overearning, I trade worse, and any blowups that I’ve had... Say I worked at a bank, I would never go from zero to minus 6 million, but I could easily go from plus 12 to 6 really quick because I’m like, “Oh, it’s fine. I’m still up 10. I’m still up eight. Oh, shit, now I’m only up six.”
So knowing yourself is one thing. But you just lie to yourself so much, like as a human being, it’s much better to have data and then conditional formatting and things that pop out and say, “Hey, you made X today.” And the other reason that that happens is that normally if you’re trading a fairly fixed position size as percentage of capital, there is kind of a limit. Like if you’re in FX, things don’t generally move more than 1% a day. So if you’re trading $100 million positions, your P&L, you’re gonna notice, is gonna top out around one million a lot, just ‘cause that’s the way that FX trades. And that was actually a thing for me at banks, was so many days I’d be up like one, 1.1 and end the day up 520,000. And simply because I was probably doubling down after a thing had moved 1% because I was so excited about my P&L. But that was like the worst possible time to be doubling down.
Matt: It’s just fascinating because for all the talk on the behavioral side of prospect theory and the... Like, nobody wants to touch the stove. And you remember the stove twice as bad. Most people aren’t repeat stove touchers, but they are, “I wonder what this button does.”
Brent: Yeah. Yeah.
Matt: It’s the starting conditions. It’s the starting conditions.
Brent: We’re both of those things. Yeah. Euphoria is just a crazy thing. And I know this is specifically for me, like euphoria is my kryptonite, and some people, being down is their kryptonite ‘cause they can’t take risk, and then they stop believing in their process and all that.
But normally the sort of thing that I actually explain in the book is that risk appetite is a spectrum, right? So you have from risk-averse to extremely risk-seeking, and you wanna be like 7 or 8 out of 10. You wanna be risk-seeking but not insane kind of thing. But then the thing that I explain in the book is that that number that you are, whatever you say you are today, you’re not always that number every single day. Your number changes based on external conditions and your year to date and a lot of different things like that.
So you might be an eight, but if your manager’s a three and she sends an email every time you lose money even though you made twice as much money the day before, then your eight then becomes a six, and then you lose money three days in a row, then you become a three. So what I previously explained was essentially how my own risk appetite changes based on my P&L. But there’s a lot of other factors that can change it. And having the self-awareness of like, okay, this is a thing that makes me risk-averse, or this is a thing that makes me go crazy, can be super useful.
Matt: Let’s go to the second cluster, rationality over intelligence. I love this because we have a couple of them I’ll rattle off here. Ten, thirteen, fifteen, and nineteen. The most rational trader, not the smartest trader, wins. Professional traders maximize expected value, not leverage. Elite traders don’t gamble, what we were just talking about, and elite traders are pragmatic, probabilistic, and agnostic. Let’s just talk about the most rational trader wins, not the smartest. Can we start there? Who are you talking about? You calling somebody out on this?
Brent: No, not really. I think I’m just sort of saying in general, and even from my own experience, that intelligence is like the minimum, just table stakes to get into trading. Like, you obviously have to have some basic kind of sense of mathematics and expected value and, you know, a lot of things that move markets are somewhat based on things that require an understanding of economics or macroeconomics or company-specific finances and things like that.
But having a CFA or a degree in economics or an MBA isn’t really that much of an advantage. Like, if you took two smart people and taught them how to trade, the one with the MBA isn’t necessarily gonna have an advantage over the one who’s much more rational. And so there’s so many different ways you can be rational and irrational in trading. So risk spectrum is one of them.
But I think a lot of people have so many different biases as well in markets. Like there were people that I worked with at banks who traded a currency who couldn’t be short that currency. Like, especially like yen as an example, for a long time. I’ve worked with a couple of different yen traders who just basically could never be short yen. And, you know, you imagine as a market maker, you’re a pretty short-term trader. That’s like an absolutely massive disadvantage to only be able to trade one side of a market. You know, especially obviously now ‘cause dollar-yen’s been going straight up for 10 years or whatever. But even when it’s not, it doesn’t matter.
Or people that are always bearish equities is a massive one. That’s probably like the biggest leak in finance, is people are just too negative and too bearish all the time. And sometimes for reasons that are literally bullish equities, like inflation and deficits and things like that. People are worried about the world blowing up because, much as I believe it doesn’t make sense that we can continue to spend forever, however, empirically, deficit spending and inflation below three and a half percent are bullish equities generally.
So one thing I used to do when I was in my 30s was we would go to visit clients all the time, like the famous people, whoever. Like the ones that own baseball teams and football teams and all those kind of CIO type of people. But I was not senior enough to meet with the head of, you know, Tudor or whatever. I’d be meeting with the senior PMs at that place. And so I always asked them, “Why do you think that guy”—it was always a guy—”is so successful, like such a good trader? What do you see about him that’s different from, you know, a run-of-the-mill PM?” And every single time they’d say something to the effect of, “We have our morning meeting, and he goes through all the reasons he’s bearish. And then at the end of the day, I look at the position report, and he is like max long.”
And it’s just that level of flexibility to literally not care. Like, there’s a sort of cliché of like, “Do you wanna be smart or make money?” And it’s true. Sometimes I can feel myself trying to do this smart thing. Like find the bottom in semis or pick the top in semis or whatever, you know, at different times of the cycle. Instead of just like, “Okay, everyone hates semis, probably gonna sell off straight from the open.” And you know, that’s what happened today.
And so sometimes you can overthink things, and also be stuck in a mode and things like that. So like max agnostic, max flexible. But then, like all these things, there’s a spectrum, so if you’re so flexible that you never take a real view, then you’re buying something, and then you’re like, “Oh, actually, maybe I’ll flip short. Oh, now I’ll flip long.” So it’s like the concept of strong opinions weakly held, where you have a strong opinion, but then really what you’re waiting for is not price action or some nonsensical reason, but you’re waiting for new information to come in.
And this is the whole... Another thing which I think I only learned this when I was like 35, was just Bayesian thinking. Like, I have my view, but then I’m gonna adjust my probabilities as new information comes in, and I’m gonna look for places where my probabilities are different from the market’s. But I could be wrong, you know? And every single trade that I put on, I’m always just open to the fact that it’s probably 50/50 I could be wrong. But if I’m right, I’m gonna make 1.7. If I’m wrong, I’m gonna lose one. Like, that’s kind of how I go into thinking about these things. And if you go into every trade thinking that, it just doesn’t really hurt when you’re wrong, so you don’t feel that urge of not wanting to stop out or doubling down because, like, I liked it at 800, now it’s at 700, so now I like it even more and things like that. Like, in trading, if you buy it at 800 and now it’s at 700, it’s strong information that your idea was wrong, not that your idea’s getting better, you know?
So all that stuff kind of comes together. And then, you know, you were saying, am I calling anyone out? I guess what I’m calling out is the sort of book-smart world of looking at things and saying, “Oh, the market’s wrong. This should be this,” that’s one thing I would be calling out. And then the other thing is just simple extrapolation as a forecasting method where people say, “Okay, this thing is gonna be huge, so I’m gonna buy the stock,” but with no understanding of where we are in the cycle of, like, has literally every other human being in the world already bought the stock for the reason that you’re buying it, and now you’re the greatest fool that’s selling to the person who was hoping for a greater fool, kind of thing.
So, yeah, I think that kinda covers it, but being smart is great, but it’s not really how you make money trading.
Matt: What happened at 35? What’s the Bayesian flip?
Brent: Well, that was just like somebody just told me about Bayesian thinking, and I was like, “Wow, that’s just so...” Like, I guess maybe I was kinda doing it, maybe subconsciously, but I didn’t come from a stats background or anything. You know, I took economics and I went to business school. But I never really got deep into statistics and stuff. Not that that’s that deep into it, but I guess that shows how shallow my statistical knowledge was.
And I think it’s just a really good way of thinking about the world because first of all, it always acknowledges that this is my view today, but I could be wrong tomorrow. And I think it’s essentially, I guess, the strongest antidote against confirmation bias, is when you look at new information, really being open to, okay, does this push my probability up or down? And being wildly open to the idea that any new piece of information should be useful. It shouldn’t just reinforce whatever you were thinking before. It should just be taken at face value and assimilated.
And then, you know, how do you do that in a world where negativity sells? I mean, this is a whole separate topic, but I’ll just briefly touch on it. You really have to curate your diet of information to get enough bulls and bears because that’s the other thing I found probably around the same time. It’s so easy to read bearish stuff all the time on Twitter, even on Bloomberg and Reuters and all that. It’s just like everyone knows, even I know, as a person who’s trying to be unbiased, if I tweet something that’s bearish, I’ll get 900 likes, and if I tweet something bullish, I’ll get 200 likes. So my motivation, if I have some really clever thing to say and it’s bearish, I’ll probably post it ‘cause I know it’ll get me some dopamine or whatever. But if it’s bullish, I might go, “Ah, you know what? No one’s gonna pay attention to that anyways. I’ll just go back to reading whatever I was reading.”
So the whole world is built to reward negative... You know, there’s not that many utopian novels. There’s a lot of dystopian novels. It’s just the way everybody works. So I’ve gone out of my way to find Substacks that lean more bullish, or more agnostic is really what I want, is people that are just Bayesian and agnostic. But if I can’t find that, I’d rather at least read a bunch of bullish people because I’m never gonna run out of bearish stuff to read, you know? I can always find retweets of Hussman’s work and all that kind of stuff. Whereas, you know, even though we’ve been essentially in a bull market since 2010 with a few quick V-shaped craziness, people just love to be bearish about the economy, about markets, about everything. Humanity, especially.
Matt: Humanity especially. And let’s never forget, there’s no dystopia without a solid shot at creating a utopia first.
Brent: Right. That’s true. That’s true.
Matt: You gotta overshoot. Okay, cluster number three. I called this thinking like nobody else, and we were just touching on a bunch of this. And part of thinking like nobody else is figuring out how to get a lot of those ideas into your brain. I like to think about this too. I do the YouTube scroll on a channel just to see what’s the flavor of their little thumbnail tiles. And it’s like if they’re all fires and stuff blowing up on the finance channel, you’re not predicating hell. You’re literally already there. You’re already in hell. You’re surrounded by flames. You’ve curated nothing but the flames. This actually tells me all the signal I need to know. But at the same time, like you, I need a tiny sample of that, ‘cause that’s my disposition.
Brent: Right. But you know you’re doing it when you’re doing it. And I mean, that’s part of it too, right? Is just being aware of what you’re reading and knowing the person and knowing their track record and knowing their background. I feel like a lot of times I used to be surprised when I got to know someone who had written something and maybe they weren’t really even an expert in the thing that they were writing about, and I had taken it at face value ‘cause I was 28 and I just didn’t know the person. So now if I’m reading something, I try to dig into like, okay, who is this person and what do they write about? And not necessarily how smart they are or anything, just more what are their biases so I know, okay, if this person’s been bearish since 2010, it might be fun to read, but it’s definitely not gonna be useful.
But what you alluded to in terms of thinking differently is sort of like I said at the top of the show, is bringing in things that have nothing to do with markets. And so I like to read the most random stuff that I can and then try to sort of, without... You can obviously go a little too far with this stuff, but without trying to go crazy, think about like, okay, is there a way that this might apply to markets? Or if you read something about narrative contagion, and you think about like, okay, that’s kind of what markets are most of the time. You know, there’s a real thing happening, but stories a lot of the time are dominating versus whatever the real thing is. Then going and just reading research papers or a couple of books about narrative contagion and things like that can be super useful, I think.
Because essentially, like I said at the top, if you just are doing what everyone else is doing, and you got your CFA, and you read Daniel Kahneman and whatever, all the books that you have to read, you’re gonna be literally thinking all the same stuff as everyone else. And so the idea of disparate concepts making connections in your brain and then spitting out cool ideas, I feel like that applies a lot in finance. Even though finance isn’t generally the place where you think all the creative people are, I do feel like creative people are more likely to succeed on Wall Street than non-creative people.
And when I say succeed, if you’re a very inside-the-box thinker who can get like a perfect SAT, you will definitely have a job on Wall Street, and you’ll have a high base salary and probably do okay, and your clients will blow up when everyone else blows up, and that’ll be okay because, you know, what could you do? No one saw it coming. But if you wanna have actual alpha, you need to bring in things that not everyone else is bringing in.
And I feel like a lot of that action happens in the sort of unconscious brain. You read a thing about biology, or avalanche physics or whatever. Like, “Oh, that’s how stock market crashes happen,” you know? Like the sand gets wobbly or the snow gets wobbly underneath and then, whatever. Maybe I can build a model that can detect weakening in the microstructure of the market that leads to crashes or whatever. I feel like that’s where the good different ideas come from.
Even like video game methodology, you know, creating the right hotkeys. Like when I was day trading, having better hotkeys than the other people was a massive advantage ‘cause when a headline came out, if you only had to hit F11, and they had to hit F11 and click on a box or whatever, you’re always making more money than them. So that’s an extremely stupid example, but it’s a real example, right? If you’re good at video games and you knew how to set up hotkeys and macros in 1999, you had an edge in markets, you know?
And so I feel like that kind of stuff is definitely useful. And again, it’s kind of like real outside of trading stuff that you’re good at can apply. Like a good poker player, ceteris paribus—a good poker player who’s never traded and a super smart person who’s never traded—the poker player’s gonna be a better trader just because you have all these sort of instincts and probabilistic ways of thinking and ability to work with incomplete information, which is not what you do in academia generally.
And so yeah, I think that’s kind of the way to get to the promised land, is to think differently. Now, one thing is that the wrong way to think about that, which is what I did for like 10 years when I started, was I’m gonna do the opposite of what everyone else is doing ‘cause I’m way smarter, you know?
Matt: Blind contrarianism.
Brent: Yeah.
Matt: That always works.
Brent: And that’s even worse than trend following. So trend following empirically does make some money. It has big drawdowns, and it has long regimes where it doesn’t work, but trend following does work. Reflexive contrarianism does not work. So what you don’t wanna do is do the opposite of what everyone’s doing.
What you ideally wanna have is a nuanced view of everyone else is doing this, and everyone else is gonna keep doing this for like two more years ‘cause this is the biggest thing since sliced bread. So I’m gonna jump on board, and I’m not even gonna think about shorting this thing. But then also be able to at some point say, “You know what? Like my mom’s asking me about vaccine stocks now in 2021 or whatever. Maybe the vaccine story’s fully priced in at this point,” you know? As opposed to just September 2020, you could’ve been shorting the vaccine story because, okay, this is known. The vaccines are gonna come out, but then it just kept on going for another year or so.
So it’s very nuanced. You can’t just do the opposite of what everyone else does. What you really wanna be doing is having your own independent thinking that’s cognizant of what everyone else is doing, but not anti and not pro, just, you know, both of them or either of them.
Matt: So I think this leans nicely into cluster four. I titled this one Don’t Blow Up First, which is 14, 12, and 20. And really out of 14, avoid risk of ruin first, maximize returns second. It sounds obvious, but why does it need to be said?
Brent: So I think the number one reason it needs to be said is because of Reminiscences of a Stock Operator.
Matt: That Jesse Livermore. He really mucked up a whole generation of people.
Brent: Edwin Lefèvre screwed us all. Yeah.
Matt: They didn’t follow through to the suicide.
Brent: Well, yeah.
Matt: Real damper.
Brent: Yeah. Real damper. A key point was left out of that book.
Matt: That’s dark.
Brent: But one thing that I found super interesting is that the things that got me into trading were Wall Street the movie, Liar’s Poker, and Reminiscences of a Stock Operator. Those were kind of like three things I consumed when I was 15 years old, and I was like, “Trading’s awesome. I wanna do this.” And looking back, as a rational person who is an adult now, which I wasn’t when I was 20 or whatever, those are all cautionary tales, right? They’re all telling you, “Do not do this. Do not do this.” But what I saw when I was reading and watching those things was like, “I wanna do that. I wanna do that.”
And so, you know, to this day, I would say Reminiscences of a Stock Operator is still viewed as like a how-to for trading. But really, it’s an awesome book. And I still think it’s an awesome book.
Matt: It is an awesome book. But—
Brent: But it’s really a how not to, right? It’s saying no matter how skilled you are, even if you’re the most skilled trader in the world, which he probably was one of the most skilled of all time, your final chapter is not gonna be good if you don’t manage your risk in a way that you won’t blow up.
And there’s other examples, right? Like Victor Niederhoffer, again, one of the most genius traders, but he couldn’t stop blowing up. There’s many examples, including like hedge funds more recently on Silvergate Bank and all that. It’s just not worth it. So there’s strategies that sometimes you’ll see like, “Okay, this move on Friday at 5:00 p.m. on a headline is totally wrong. I’m gonna buy the stock because it’s gonna open higher on Monday.” But you can’t risk manage it because of the gap risk, and if you’re wrong, you’re gonna lose your account. Just say that’s the setup. But the expected value is super positive, and you know there’s like a 1% chance that you’re gonna blow up if this other 1% thing happens.
Well, by nature, if you do that and you make money, guess what? You’re probably gonna do it 99 more times in your career because you got rewarded for doing it. So the point is essentially... And it’s not to be afraid of things that are never gonna happen like, “Oh, what if an asteroid hits?” and ridiculous scenarios. Most of the things that people blow up on ex ante could have been identified, right? There’s not very many times when someone blows up and it’s like there’s no way you could have ever forecast that that would happen. Normally, they’re short an option or synthetically short an option, essentially is what people mostly are.
And that doesn’t mean you can’t be short options still. If you’re gonna short options, you need to know what you’re doing. You need to have some way of managing the risk. So people will say, “Okay, well, the nature of selling options is that you’re short convexity,” and all that. But there’s people that sell options that don’t blow up because either they buy even bigger, farther away tails, or they’re diversified enough, or however they structure their book, they’re not subject to just absolutely blowing up.
But many, many people blow up, and obviously then retail is more likely to blow up because if you have a $35,000 account and you kinda need to make 50 grand to pay your rent and your groceries and whatever in a year, then making three grand doesn’t really cut it, so you end up just taking bigger risks than you should, and you end up blowing up. But then if you do that, you never get a chance to see if you’re actually a good trader because you just keep blowing up $35,000 accounts over and over.
So anything I’m doing, I pass on a lot of trades that look really good just because I can’t measure the risk. That’s essentially what it comes down to, right? Okay, if this is gonna cost me 8% of my account and the expected value is absolutely massive, I might still do that trade. But if I don’t know how much it’s gonna cost me, then I just won’t do it. Even if the expected value looks unbelievable, I just simply won’t do it.
And I guess that’s part of why I’m still sitting here doing a podcast about trading I started 30 years ago, is because I just never blew up. When I was down or negative P&L, I would trade in a way that I wasn’t gonna lose my job or blow up my account or end up on the street. Because ultimately, if you love trading, you wanna survive long enough to learn all the stuff.
Matt: Well, from one person who can’t give it up to another, Cluster 5: The Process Principles, 2, 3, 8, 17, 21 if you’re checking off a list somewhere at home. I know one of you are. In here is the Serenity Prayer. So when we talk about your 30-year addiction to this thing, is this the Jared Dillianification of finance books where we have to put things like the Serenity Prayer in there? What is this? I did not expect to come across.
Brent: So I first heard about that in 2007 when Lehman Brothers was going down, or 2008 I guess it was, and, you know, I was worried about this and worried about that. Like, what if... You know, I wasn’t really worried about my job as much, but I had stock and then I kind of was worried like, “Okay, what if all of finance kind of disappears? Am I gonna move to Maine and go fishing or whatever?”
And my boss at Lehman sent me the Serenity Prayer, and I just never really thought that way before. Like, okay, what can I control? Well, I can make money if I can possibly make money while this thing’s still alive. It may still be alive, so what am I gonna do, hide under the desk for eight months until I find out if it’s alive or not? Like, that’s not gonna help either. What if it does survive? Or even if it doesn’t survive, probably the people making the most money are gonna be the people that get the jobs outside of Lehman Brothers anyways. So I’m just gonna trade my best. I’m gonna do my best. I’m gonna come in every single day, and I’m not gonna really pay attention to the headlines of whether the CFO resigned and all that.
And it really helped me a lot because I just stopped worrying about all this bullshit that I couldn’t control. And then as I got older and through different harder parts of my life, it keeps coming up and I just keep saying, it’s just a good way to live. Just, okay, what can I control? Okay, these are the things I can control. I accept them or I change them, and all the other things I can’t control, really just let them go blah in the background. And, you know, like US politics, gun violence, all those things—either I’m gonna become an advocate to reduce gun violence or I’m not gonna let it bother me because I can’t control what’s going on out in the world and I choose to live in the United States.
So just on so many different levels, I just feel like it keeps me sane. It allows me to just come into work every day and go, “Okay, what am I gonna do today?” Make money, write a good piece, do it again tomorrow. Make money, write a good piece, do it again tomorrow. And, you know, same thing at home. Just, you know, the thing that happened to my son, that sucks and I hate it and I wish it happened to me, but it didn’t. There’s nothing I can do about it. I’m not gonna dwell on it too much. I’ll give him what he needs and that’s about it. I’m not gonna start thinking about why I wanna beat up the kid that stole 100 bucks from my son and things like that. You know, unproductive things that I definitely shouldn’t be thinking.
And so I don’t know. I feel like it’s a good, useful thing in trading, but it’s also something that’s just useful in life. So I guess if people don’t know what it is, it’s, “God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference.” And I don’t think I always knew the difference until someone sent me that.
Matt: We evolve with that. And it’s a running list now. You could be degen Howard Marks, you could also be degen Bruce Wayne if you wanna take up that issue with that 100-year-old thief there.
All right, cluster number six, and this goes right into it. I call these the life first principles, and I’m calling these out, four, five, and six. Choose family and health over markets. You only need to get rich once. I especially love that one. Take the job, but not yourself, seriously. Again, these in a trading book—why are these so important to remind somebody with a trading interest who’s gonna get this deep into the book to be thinking about these concepts?
Brent: Well, I think because you can go to a kind of dark place even when you’re making money. Mostly when you’re losing money, but both, where you become kind of obsessed with trading and it just becomes like the thing that drives you. It’s a stimulation. You can’t wait for Sunday markets to open so you can watch the things start going up and down. I mean, I have all those things in me.
Matt: There’s a chart in the book. That’s the one that showed what institutional investors worry about versus what retail investors worry about.
Brent: Yeah.
Matt: What a wonderful chart that was.
Brent: It’s funny. And so I think over time... Also, part of some of the little quick stories that I tell in the book are times I made the wrong call and I chose work over family. And like, you know, I was staying in New York because I didn’t wanna leave to go to my grandmother’s funeral, and that was 30, 25 years ago. I still feel bad about it. So if I can get one person to not make one of those mistakes, then that’s a win.
And also because I made the wrong decisions in the past and now more in like the last 10 years, I tend to be more on making the right decisions in those examples. Like, I missed Brexit ‘cause of a fishing trip with my son, and do I care that I missed Brexit? No. But am I glad I went on the fishing trip? Yes. It’s awesome. My son still talks about it. So having made the totally wrong and dickish decision and the right decision, it takes the experience of doing both, for me, for me to learn, and then maybe I can pass that on to one person.
Unfortunately though, a lot of wisdom can’t be transferred or whatever. Like, wisdom isn’t transferable a lot of the time. I know for me, someone could’ve told me all this stuff and I still would’ve done the same thing ‘cause you have to learn it. Like, I had to learn it the hard... I have to learn everything the hard way. But also I know not everyone’s like that, so hopefully some people can read what I’ve written and go, “You know, this resonates with me, and I was almost gonna choose work over family, but I decided to do the right thing instead.”
Matt: I’m an advocate for learning stuff the hard way, just not the hardest way when possible.
Brent: Yeah.
Matt: I feel that deeply.
Brent: Yeah. I feel like other than blowing up, most of the stuff I’ve learned the hard way. Blowing up for some reason, I don’t know, I just always had this more visceral thing of like, I just wanna be a person that never blew up. I don’t know. I always from the start felt that way. I don’t know, maybe partly from reading Reminiscences and then reading his biography. And when you know the real story, you know it wasn’t really all fun and games ‘cause every time you blow up, it’s just more and more painful and it’s just hard, you know?
But also I think part of the reason—you said like, “Why am I writing about these things in a trading book?”—is just like, what’s the point of all this if all you’re gonna do is come in and grind and be angry and make a shitload of money? You know, which I’ve had periods where that’s what I was doing. I was just kind of grumpy and commuting and in a not really that light of a place, making a ton of money, and that’s not really a win, you know? So the win is obviously you still wanna, in trading, wanna make money, but you wanna kind of make money doing it the right way if possible. Because I feel like no matter how much money I ever made, doing it the wrong way just isn’t really a win, you know? I’d rather make a little bit less money and do it the right way, in my own right way. Everyone has their own values. And then you come in and you feel good about what you’re doing, or feel at least okay about it.
Matt: Okay. So you might’ve just answered it, but I’m gonna ask it anyway. If somebody reads the book, is there one overarching thing you hope somebody walks away with? And how they behave with the market, how they think about the markets, just how they think about this giant mechanism that blinks green and red and other lights in front of our eyes all day, every day. What would you hope they’ll think about differently after they hit this book?
Brent: Try to think of creative ways to look at the market, not just ways that you’ve already read in another book. I think that’s kind of the takeaway from this book.
Matt: I like it in the sense of, and it might’ve been somewhere in the book too, where it’s the first thought is, “Wait, that’s somebody else’s opinion.” And then you have to sit with somebody else’s... Was that you or was that from somebody else in the book?
Brent: No, that’s in there. Yeah. So that’s a thing that I’ve really been working on my whole life, but specifically more recently, is understanding that the first thought in my head is not really me most of the time. A lot of time it’s some reaction to something. You know, even in a conversation with someone or whatever, a lot of times my first thought is like some sarcastic thing or a thing that’s literally wrong. You know? Sometimes my first thought is just like a completely wrong thing that’s not even true.
And so being able to sit there before I speak or before I trade and let that first thought go through and then let the system two, more rational brain have a chance to look at it and go, “Yeah, no, we’re not gonna do that today,” that’s been a big advance for me just in regular life. So it’s helpful in trading, I think, and it’s also helpful in marriage and whatever other relationships.
Matt: Other things that maybe don’t have the same profit and loss tied to them that you measure and tally up at the end of every day. The book’s Trade Outside the Box: Advanced Thinking for Professional Traders, Brent Donnelly. It’s great. Where else can we send people to bug you on the internet? We gotta replace some of those Alpha Trader books on the back shelf there behind you. We gotta get some red ones in there.
Brent: Oh, yeah. What’s going on there? It’s still mostly... Oh, there’s a couple. Oh, maybe, no, maybe they’re cut out. Oh, yeah, down below there’s a couple, but—
Matt: Down below I see a few peeking out. Yeah. We’re gonna update the background. That’s the next part.
Brent: So Spectra Markets, S-P-E-C-T-R-A markets.com. Everything I do is pretty much right there.
Matt: Go there, get the Friday Speedrun if nothing else. It’s free. It’s wonderful. There’s always a great music anecdote or pop culture thing at the end. It’s worth the scroll every single time.
Brent: That’s definitely the most fun thing that I write, ‘cause it’s just my voice, not conforming to any institutional constraints.
Matt: And back again to the breadth. If you’re not looking for ideas or looking for things that take you out of the world, how are you gonna have a different perspective?
Brent: Right.
Matt: Unless you let stuff like that into your head.
Brent: Yeah.
Matt: That’s the whole game in a nutshell. Brent, thanks so much for doing this.
Brent: All right. Thanks for having me.
Matt: You’re watching Excess Returns. Check out the Substack. We’ll have a write-up, transcript, all sorts of stuff on Brent there. And wherever you’re watching or listening, thank you so much. Like, comment, subscribe, all the things below, and we are out.