DAVE: Hi, Ken. Thank you for joining me today. Let’s jump right into your philosophy on risk control. One of the first things you stress is the importance of having a plan before entering the market. This is very basic, but I know you mention it for a reason. Can you elaborate on having a plan?

KEN: Sure, having a plan seems to be the most intuitive part of portfolio management; however, I do find it is the exception, rather than the rule. This applies to both professionals and non-professionals who are managing portfolios. Most traders and money managers have not gone through the exercise of figuring out how they are going to be successful. Planning how to make efficient use of your resources is the number one planning task for anyone managing money. The fact that most people simply do not do this is causing all kinds of slippage in the markets. It is important to keep in mind that there is not just one plan, which makes the planning function a little less intuitive. When formulating a plan, I recommend a top down approach, which begins with ridiculously simplistic questions, like what am I trying to accomplish? What are my constraints? What are my resources? Then you need to drill down deeper, planning your environment. What markets do you want to trade? What are the inefficiencies of these markets? How am I in a good position to take advantage of the inefficiencies? How can I maximize profits from the market? What are the specific modes of operation I am going to use? This all sounds very simple but I don’t think it’s being done in the universe of risk taking at all. These questions will lead to better use of resources, whether the original plan was correct or not. Hopefully this makes sense.

DAVE: Yes, I understand exactly what you mean except for one thing, you mentioned the importance of “planning your environment.” What do you mean ?

KEN: Creating a clinical environment is a critical aspect of risk management. I am not talking about the physical environment. Approaching the markets in a clinical fashion is key to successfully managing your risk. Now, you must keep in mind, that even in the most clinical environments, things happen—like planes smashing into buildings. Now, these things don’t happen very often and the rest of the time there is a wealth of tools and information available to answer the earlier questions in a clinical way.

DAVE: What other questions should a trader / investor ask themselves before committing to a trade, beyond the basics you mentioned?

KEN: What is the full range of the market I am trading would be the first question after the basic ones are answered. Stemming from this question are the following—Is there a subset of the market you choose that you have a particular advantage in? How much capital can you distribute effectively within the subset? How many positions are you going to trade? What’s your hold period? I could go on forever. What are going to be the sourcing of your ideas? Is it going to be from original research? Is it going to be from secondary research? Is it going to be from word of mouth? Is it going to be from transactions flow that you are able to observe because you’re sitting on a trading desk? How are you going to use those ideas? What is going to be the formal criteria for entering into a transaction and under what conditions both positive and negative will you exit that transaction?

DAVE: Wow, that is really a laundry list of things to ask yourself. All these questions become part of estimated portfolio exposure when you boil it all down?

KEN: Well, right. This is where the whole concept that I am discussing really becomes kind of an infinite loop. If you start out and you’ve never traded anything in your life and you begin to trade, then what’s going to end up happening if you follow the recipes prescribed in the book? Is it that you are going to start to develop an inventory of statistical information and that information is going to tell you a bunch of different things? These things include, at the most basic level, number one -- are you making or losing money? Number two -- at what pace? Number three -- at what cost, in terms of the volatility that you’re taking and other ways that such costs are define? Number four -- how that probability is distributing itself? So, with that information in mind you can, ask the types of questions that we’ve started talking about with a lot more precision. So again, let’s just say that you’ve got a certain amount of risk capital and you want to put it to work. And you say to yourself, just because it is a good finger in the wind estimate, I want to buy a million dollars of stocks and it seems to me to be a reasonably good idea to diversify those purchases of stocks such that I will set a maximum investment level of fifty thousand dollars or five percent.

DAVE: Ok, Ken, keep going with this thought.

KEN: Now once you have observed what the distribution of your actual results are, you can make a much more informed decision about whether that five percent was the appropriate level The next time you go through this iteration, you might say you know, I’ve done everything at five percent, but now I’m looking at my results and I can see that I, where I really have some conviction, I did better and where I was last unsure about my ideas, I did worse. So maybe you want to relax that constraint and say instead I still want twenty positions, but instead of uniformly distributing in five-five-five, twenty times, I will say that my low conviction positions, I’ll set at two percent, and my high conviction positions, I’ll will be willing to set up at ten percent.

DAVE: I see. You want to place more capital in those positions that you have conviction with and less with those you do not have as much. Speaking of asking the questions with more precision, narrowing your focus, can you elaborate?

KEN: Sure, the level of precision, and in that second cycle, you can determine and you can compare and contrast how you did in cycle one versus cycle two and whether that added value or that subtracted value. This again becomes an infinite loop of information and we’re not talking about doing you know differential calculus, are we? You know, we’re just talking about looking at how results distribute themselves.

DAVE: Right, it’s important to see a certain amount of success in a certain amount of time to make what you are saying statistically valid. Is this correct?

KEN: Well, yes, that’s the kind of universe I try to live in. I’m a little bit less of a stickler with these kinds of things than most people. I talk a good bit in the book about thresholds of statistical significance. I’m actually probably a bit of a heretic about some of these concepts. For example, all of a sudden God forbid your grandmother dies, and you’ve got a million dollars to use and you’ve never done a trade in your life. I don’t know why you wouldn’t want to look at your volatility after one week, so you can calculate a standard deviation. Anybody, who takes pride in their statistics, will tell you that you really don’t want to even begin to calculate a standard deviation until you have twenty observations. Well, I tend to be the heretic who says, “Why not calculate it after five?” Are you really less well off waiting for a full month to pass, or do you want to just look at those individual data points and say, “Well, I made fifty, I lost thirty, I gained eighty.” What does this look like on a sheet of paper? Where I would graph it? What is it telling me? How does it feel? Is it comfortable, or isn’t it comfortable? What are the sources of that volatility, that day that I lost eighty? Where did I lose that money? Well, you know you lost it in, for example, in BioGen, a day or two before it reported. Well, there’s a mistake I shouldn’t make again, even if it works in my favor the next time. The one key point that I am trying get across here is to just dive into the information that is available to you, use metrics that you fully understand and start to see what they tell you. And then the counterpoint to that is you don’t draw any hard or fast conclusions.

DAVE: You mention something in the book about fighting for every fraction of a point. You call it martial behavior. Can you elaborate on this concept?

KEN: Yeah, sure. At the highest level, there are a couple of important points, but I’ll explain it from a top down perspective. Where that concept derives from is really two related points. Number one is really the notion that whatever edge anybody has going up to the Warren Buffets of the world, or the Steve Cohens of the world, we are ALL very small and transient in nature. So, you know, the whole idea is that there is a certain pattern that you can establish that comes out of your brain, that is going to allow you to achieve superior results in this hyper competitive environment relative to everybody else. I think it’s one of the bigger fallacies that exist. It’s the hardest thing to do to be a better stock picker or to choose better financial positions in general. What is easier to do is to work a little bit harder, to dig a little bit deeper, to put a little more elbow grease into the process. To apply your energies and your wits in a way that is going to give you an almost guaranteed advantage over what we know empirically without a doubt is an enormous amount of risk taking that occurs without paying attention to the small details of the transaction. Basically, what am I saying is -- number one -- you are taking a pretty serious and questionable gamble to assume that by undertaking speculations that it is the brilliance of your speculations that is likely to allow you to achieve maximum success. Number two is that an awful lot of transacting in the markets is done with a lot of inefficiency. An example of this is the plastic surgeon who’s on the highway down in Miami, calling his broker with two babies in his car. Or much as it is, say the Bob Stansky’s of the world -- not to slight this individual in the least -- who are managing the Fidelity Magellan Fund and who have to rebalance their portfolio, but they’re actually constrained in terms of their ability to efficiently execute. There is an awful lot of low hanging fruit, which exists simply because you’re going to be tighter, you’re going to pay more attention, you’re going to have greater discipline in the execution processes, so those are the two key points.

DAVE: Lowering your commission cost, your execution cost is what you mean by being tighter?

KEN: Well, yes and no. Not commissions, I consider commissions cost to be one small portion of transaction costs. Let me explain. My feeling is people probably don’t pay enough commission, so they don’t trade actively enough, or they go to second tier transactions entities. I think people could pay a lot more. What I’m talking about is everything from picking your points of entry and exit correctly in terms of what you see on the chart to what time of day you are putting orders in, to looking and comparing and contrasting who is giving you good prices and who is giving you poor prices, to making sure whatever excess cash you have is effectively invested in overnight markets. It’s really just about saying, you’ve got a pool of capital, how can you minimize the cost and maximize the revenues associated with it?

DAVE: Ok, so what you mean is, it’s the entry, the exit, the time of day, who’s giving the best fill is more important that commissions.

KEN: Right, it’s everything that you would do. It’s the same thing that the mom and pop operation would do saving on staples and I think there is a perfect analogy there. I mean you could take this to an extreme and that’s a whole other set of conversations, but I don’t think that there is any doubt that if you don’t treat your portfolio management like a business, and seek to create an income statement and maximize that differential you are only hurting yourself. This goes way beyond commissions.

DAVE: You talk about pre-determined target prices for stocks. Can you delve into this idea?

KEN: Pre determined targets are extremely valuable from a pure risk management perspective. Think about it from a pure mathematical perspective. Think about it the same way someone who allocates capital to traders would. Let’s just say that you’re looking to achieve in the selection of the positions that you trade, to get a normal distribution of returns around those transactions. Let’s say you are thinking that it is also a reasonable objective to have a mean return on a unit basis of those transactions of no worse than zero. You need to have targets to determine what I am talking about. They are critical to the objective setting process.

DAVE: Your perspective on this is extremely interesting. Can you elaborate a little deeper on managing the distribution of results and price targets?

KEN: If you manage the left side of the distribution, i.e., the losing trades and make it smaller on a unit basis, than the right side of the distribution, then you really don’t have to do a great deal in terms of having tomorrow’s Wall Street Journal or anything like that to be successful. So one of the ways to accomplish that is to simply put on trades through whatever methodology you have. I don’t know why you would put on a trade where you would risk a dollar to make a dollar. Right? I think that stocks are the example, but you’re looking to buying a company, but you don’t know what that company is going to be worth in the future. What makes sense it to say is that I think that if things work our favorably, it will be worth X and if they work out poorly, they’ll be worth Y, but the differential between where you are right now and X is much greater than the differential between where you are right now when Y comes into play, so basically you got two things going on. If you have any skill at this and you express your risk in a way such that the criteria for selecting trades is that you think you’re going to make more if you’re right, then you give up if you’re wrong, than that’s an excellent risk management discipline. A secondary benefit is if you go through that exercise on every trade, you’re going to impose an investment selection discipline that I think can only work to your benefit. This really ties into a couple of other things and one of them is kind of the impact ratio versus the selection ratio, which I talk about, in subsequent chapters of the book. This is entirely consistent with that, so you know really it’s all about little tricks that you can do to impose discipline, not only in terms of risk management, but also in terms of the investment process itself.

DAVE: You stress the importance of leaving a certain percentage of capital free to be used only in “special situations.” What do you mean by this, what is a “special situation’?

KEN: I am happy you asked this. It’s not emphasized as much in the book as I would have liked. There are always good opportunities. There is always a landscape of opportunities. It’s important to have the capital available when one of these presents itself. Everybody tends to have the same ideas, and they tend to have the same ideas at the same points in price and volatility space, so there aren’t a whole lot of conscientious trades out there. When those conscientious trades go badly they tend to go badly at the same time and they tend to create patterns of price action that are caused purely by trauma that have to do with the fact there’s an awful lot of knucklehead traders that draw the same conclusions at the same point and they make the same trades at the same time, and then there is an awful lot of risk managers who are equally knuckleheaded and who cause liquidations at the exact point at those exact points and time. So, what this means for great risk managers is to really capitalize on price action that occurs for reasons other than valuation. And the main reason, the main driver of price action, other than the debate of valuation is risk control. The great traders that I know, tend to be buyers at the low, sellers at the high, not because they know what’s going to happen tomorrow, but because they have preserved capital. They watch price action, and when everybody else is liquidating because they have to, that’s when they are able to put their real risk capital to work.

DAVE: Absolutely, that is exactly the way it is. I know you have worked with many great traders, what differentiates the great traders from the average ones?

KEN: What it comes down to is as follows: there are good markets and there are bad markets. It’s difficult to know what constitutes a good market or a bad market, till after the fact. One perfect example is the later half of 2003. In retrospect, that was a great market, but when you’re sitting there and wondering whether you should be buying Chinese internet portals at a thousand multiple, it might not look like such a great market. So there are all kinds of ranges of opportunities out there. And what I believe is that there are certain recurring patterns that come from mistakes that average traders make and that great traders don’t make. Great traders capitalize on the mistakes of average and poor traders.

DAVE: That makes perfect sense. Can you go into the mechanics of how to capitalize on these “special situations” caused by the market’s group mind, and inept traders?

KEN: Basically, you have to preserve capital at all times and if you do a good job of preserving capital at all times, and you never draw down, to any real meaningful amount, and you are never in a situation of trauma, then special situations will present themselves. And those special situations typically take the form of liquidation happening by other market participants. So let me try to say this as clearly as I can, it is good to have some capital set aside for special situations, which are difficult to find upfront, but you sort of know them when you see them. But what I would say with more precision is that if you preserve capital at all times and you do a good job of that, then easy special situations present themselves, due to the liquidation of others.

DAVE: Moving on, Ken, what is your opinion on systematic trading? I know that most of the firms you have worked with are discretionary. Which method do you prefer and why?

KEN: Yeah, I think both of those methodologies are very viable. I’ve seen them both work. The two very big hedge funds that I’ve worked with have both had fantastic quantitative trading systems, including kind of momentum based CTA stuff, quant programs and other things. What people need to understand is that systematic trading runs the same risk as discretionary trading. This is widely misunderstood. Whatever inefficiencies the systematic traders exploit are typically not permanently embedded into the landscape. I think the trick with quantitative trading strategies is how do they evolve over time and how can they recognize when whatever inefficiency has really launched them has lost steam.

DAVE: Portfolio Insurance, you know, selling options to hedge your positions, etc. Do you feel that most traders overpay for this type of insurance to protect themselves from extraordinary events like we witnessed on 9-11?

KEN: I think that there are pockets of people who pay too much for that kind of insurance. I don’t know that the market does, as a whole, but let me try to answer that question by saying that I believe pretty strongly that a unit of risk is fairly fungible against any other unit of risk. And that that the way that it is expressed, too much attention is paid to this. So I run into all kinds of situations, where people, particularly investors will take a great deal of comfort in saying that a given portfolio has a certain level of balance. So, it’s either 50/50, long/short, or it won’t go more than 60/40 in either direction, whatever the case may be. It is still throwing off X amount of volatility. And that X amount of volatility portfolio to me, that is not an inferior type of volatility than one that achieves the same level of volatility through some sort of balance. I think there is an awful lot of false comfort taken in portfolios that have relative balance characteristics versus ones that are perfectly balanced. So going back to the core of the question, I believe that people ought to size their risks top down. I believe that it’s unlikely in most cases that people, even when they’ve gone through that exercise, even when they taken event risk into account, that they’ve done that with precision. So you got a portfolio of X and you’ve got a certain idea of what it could lose if you have another disaster scenario. So, are you better off grossing up your exposures, let’s say you think that number is 120 or is 20 percent? So, do you go 100 by 0 or do you go 120 by 20? You know I think that probably from that perspective people are overpaying. The answer to your question is yes. It would probably be more efficient to have sized your exposures with these things in mind without hedges and without paying for portfolio insurance.

DAVE: This talk of portfolio insurance triggered thoughts concerning Nasim Taleb and his theories on randomness. Are you familiar with his work, and if so, do you have an opinion of his theory? Taleb teaches that there is randomness across the board regarding money manager’s results. For example, take any 50 portfolio managers. Choose the one with superior results, Taleb believes that this superior performance is not because of any superior ability on the managers part, but merely due to random distribution. He calls this “Fooled by Randomness”, which is also the title to his book.

KEN: You know, I did some work on this when I was at Tudor. It has to do with the capital allocation process. It’s kind of fun and I’d rather keep this off the record, but you know, during the Long Term Capital Management situation, Paul came to me, requesting some empirical proof that this is the perfect time to fund these guys. There’s lots of mutual fund research that’s been kicking around for several decades that says no one really outperforms.

DAVE: Right, it really isn’t anything new—what is your opinion on the theory?

KEN: No, I don’t believe it. I do believe that there is Alpha out there. I think it has much more to do with people who do things that I talk about in the book, which is really superior risk management, superior efforts, a little bit more intelligence. You know I am from the University of Chicago. I do believe in the efficient markets hypothesis. I think that where that it breaks down a bit is there is lots of lack of discipline, a lot of slippage in the markets, and that certain people will outperform over periods of time. So you know, it really kind of depends on how you frame the question. I certainly would not want to take the greatest managers that I know and bet against them. However, I’m not entirely sure that I would want to go the other way either. You know along the lines of the example of what I said that Paul had wanted to do. I’m not sure if this is entirely relevant, but I do believe that through effort and discipline and intelligence, mapped into the appropriate framework, there is a possibility to systemically outperform from a risk adjusted perspective. You ought not beat the market as a whole, but I do believe that you can beat say the Sharpe Ratio or the Return Over Draw Down of the market through the methodologies that I have described. So in risk-adjusted space, I think I would disagree because the overall market does not adhere to the S&P 500. It does not cut its losses and trade smaller when it’s performing worse and trade more when it’s performing well. So, I believe it’s probably truer in absolute return space or risk-adjusted space than it is in raw return space. And the other thing that I would say, and I’m not sure how relevant it is, that the whole emergence of and kind of the whole embedded success of the hedge fund industry flies in the face of that argument. Most notably because pay for performance, I think it’s starting to empirically demonstrate it’s worth in terms of attracting the more, clear, pure unadulterated Alpha generators.

DAVE: Changing gears here, I have a basic question regarding the execution of a trade. This is an often argued point among traders. Do you believe that the entry into a trade is more or less important that the exit?

KEN: In terms of execution cost?

DAVE: No, I am talking about the execution itself. Should a trader place more emphasis on entering a trade or exiting the trade?

KEN: They are of equal importance. I believe there is more difficulty and I don’t think there is that much thought about this that there is more slippage and more trauma due to inefficacy on the liquidation side than there is on the initiation side, but that is not necessarily because the task is mechanically harder. I think it’s psychologically harder.

DAVE: Ken, this was a fascinating discussion. I would like to continue it in the future, a part two so to speak.

KEN: It was my pleasure. Feel free to call me anytime. I would enjoy talking again.

DAVE: Thank you for joining us.