Column: The right moves

Written by K Vaidya Nathan | K Vaidya Nathan | Updated: Nov 24 2013, 00:06am hrs
Late into the fifth hour of play in his sixth game last week, Viswanathan Anands eyes looked moist. With a second successive defeat staring in the face, the challengerMagnus Carlsen had succeeded in tormenting the championAnand. Before long, a hapless Anand extended his hand, acknowledging the youngsters superiority. Even though, as Indians, the outcome of the 2013 FIDE World Chess Championship match taking place in Chennai may not be to our liking, it is a fair one. Champion chess players, like consistent performers in financial markets, win based on superior ability than on chance.

Thats the beauty of chess. You have perfect knowledge. There is no dice or other random chance. Yet the number of possible moves and games makes it impossible to analyse completely. Similarly, the number of forces in the financial markets are too many to be evaluated comprehensively. Even looking several moves ahead is beyond the capabilities of all but the most accomplished Grandmasters in chess. It is even more difficult as an investor to think of the dynamics of market forces and predict price movements. More often than not, anything unexplained is termed as random. But as the American statesman, Mark Helprin said, Nothing is random, nor will anything ever be, whether a long string of perfectly blue days that begin and end in golden dimness, the most seemingly chaotic political acts, the rise of a great city, the crystalline structure of a gem, the distributions of fortune, what time the milkman gets up. Of this, one is certain. Similarly, we can be certain that nothing is truly random in the financial markets or in chess.

For instance, Carlsens win, more often than not, looks accidental as it did in the fifth and sixth game where the games seemed to be heading for a draw and Anand lost in the relatively boring endgames. But Carlsen has a consistent record of winning the end-games even with a feeble advantage. It may look like chance, but much like consistent alpha-generating traders in financial markets, there is a plan to what seemingly looks unplanned.

I like to liken the process of investing in the financial markets to the game of chess in slow motion. There a few differences though. Chess is a zero-sum game: someone wins and someone loses. In the markets, everyone can win and everyone can lose, and the stakes obviously are a lot bigger, because chess at the end of the day is just a game. However, what is similar is that you make a move, and then in slow motion, say six months later, you go back to analyse if it was the right one.

As a chess player one needs to ask four simple questions before one makes any move: What did my opponent do What can my opponent do What can I do What should I do These simple questions are as pertinent in financial markets as in chess. Perhaps the markets dropped precipitously. But what specifically did they do What dropped the most What can they do going forward Perhaps they will drop more, or perhaps they will rebound.

Chess teaches us to separate the question of what my opponent did, from what my opponent could do. Similarly, the question What can I do is separated from the question What should I do In investments, one can sell and get out of the markets entirely after a market drop. But other choices are available. And only after analysing all the options can the investor make a good trading decision.

With the advent of faster computers, both trading and chess, have changed for better and for worse. The biggest advantage is that you dont need another person to play chess. Most people these days play chess with the computer. Since, computers dont make silly mistakes, it trains you to play with fewer silly mistakes. Similarly, you dont need to have a fundamental view on markets to take a position. One can trade algorithmically these days using machines. It allows you to profit from patterns in high-frequency data, so long as you are able to uncover a trend. The downside is that playing with a computer trains young chess players less about patient strategy and more about the reaction time of twitchy neurons. Similarly, algorithmic trading has made young traders more adept at minutely analysing high-frequency data than taking patient fundamental trading strategies like say, what a Warren Buffet did over five decades. Even though algorithmic trading may seem lot more cool than fundamental investing, in the long run, the latter turns out to be a better investment strategy. One can at best draw a game by not making mistakes, but to win, one needs to patiently ponder over those four questions thoroughly. And as algorithmic trading becomes more pervasive, investors are realising that they need to learn to strategise their trades over the long run.

Lessons learned from playing chess are useful in financial markets even today. Slow down. Be patient. And learn to stop and analyse all the possibilities and all your potential responses before choosing a course of action. In markets, as in chess, good judgement comes from bad experiences, and a lot of that comes from bad judgement.

The author, formerly with JPMorganChases Global Capital Markets, trains finance professionals on derivatives and risk management