Preston Pysh  8:18  

So Jos, I’ve got a question for you because this one’s kind of burning after reading Flash Boys by Michael Lewis. The big claim to fame that all these high frequency trading companies say is that they’re adding value is in the liquidity realm, they’re saying that they’re adding a lot of liquidity. Is that a true statement? Is that really what they’re doing? Or is it the opposite of that? Because you hit it on with smaller companies, and you said something about the liquidity. What were you getting at with that?

Jos Schmitt  8:44  

Yeah, it’s a complex answer. You know, I wish I could say things, like Michael Lewis, in black and white. Sadly enough, the world is not that that simple. But, I would put it this way. The first thing that we need to always remember is, What is high frequency trading? That’s the starting point we need to think about. High frequency trading is not a strategy. High frequency trading is not a way that you buy or sell securities. High frequency trading is what I would define as a methodology. It’s a tool. It’s being able to very rapidly have access to data and very rapidly react upon that. Now, like with everything, think about the internet, it’s a good example also. With everything, with all new technologies, you can use it in a good way and you can use it in a bad way. If you use it in a good way, you can apply it to provide better quality to the markets, better liquidity in the markets by managing a multitude, for example, of securities that are correlated. 

Think about someone who is making a market in index exchange trade events. Well, he’s not only making a market in that ETF, he also knew to be present in the related futures, the related options. If you want to do that in today’s world, and you don’t have the right technology in place, you can not provide a quality service. High frequency trading is a tool that can help you. Another example is arbitrage. If you want to make markets very efficient, having the technology that allows you to really do efficient arbitrage between a multitude of markets that are correlated, it is going to be good for liquidity. So those are good usages of high frequency trading technology. 

Now, as I said, like always, what you see is that some people will start to figure out well, wait a minute, I can also use that in a different way. And for me, a good example of what probably is the most pervasive use of high frequency trading in a negative way is leveraging information to technologically *inaudible* of the market participants. 

Let me give you 2 simple examples . We know today that certain firms are just sitting in the markets looking at what’s happening in that market. And as soon as they detect that there is an order coming in, whether it’s a large institutional order, or even a retail order, as soon as they detect that the order comes in, they will try to run it on a multitude of other markets. And you have to put this in the context of a world where today, one security, the same security, can be traded in a multitude of different marketplaces. 

So think about the US. There’s 50 marketplaces where you can trade, I don’t know, IBM, the 50 marketplaces where you can create Microsoft Oracle. So they sit in those marketplaces. In one of them, they’re going to see that someone is coming in. They know that he’s going to hit some of the other marketplaces, and then they are going to try to trade the head of the arrival of that order in the other marketplaces, front run it, and then sell back at a higher price. 

Another way is that they leverage some of the latest technologies, microwave technology, which allows to move data in a few milliseconds faster, for example, between Chicago and New York, or Toronto and Chicago, Toronto and New York. So they know a few milliseconds before everyone else that there’s a price change in the commodity, there’s a price change in a correlated security in the US. And then, they front run everyone else in the market in Toronto. 

And by the way, when I say they are a few milliseconds faster, you have to put that into perspective which is that, when you blink your eyes, when I blink my eyes, it takes us about 300 to 400 milliseconds. So by playing those games, by leveraging technology where they can gain three to four milliseconds, they are front running other players who have no ability to react to it. Those behaviors are the bad ones. And those are the ones that need to be counted. So I think that is a very important element to think about. So can they provide liquidity? Yes, if they apply HFD in a positive side. Can they negatively impact liquidity? Can they create an unlevel playing field for other market participants when they apply their negative way? Yes, also. So, it can go both ways. 

The last element that I would like to add to that, talking about liquidity, because you referred to my earlier comment about smaller securities or mid-sized securities, one thing that we have also noticed and that was part of that original analysis, when you look at the high frequency trading, you will see it concentrated in the most actively traded securities. I don’t know if you ever noticed that. It’s quite fascinating. When they say they add liquidity, one thing that I find fascinating is, why don’t you do it in securities that really need it, rather than those where we don’t need it? Many of the transactions, for me, are more driven by creating more volume than creating real liquidity.

Preston Pysh  13:57  

It seems like they would use the larger volume stocks because they’re baiting. So let’s just take the Chicago to New York example that you were talking about in that arbitrage example. So, if the stock is IBM, I have an expectation if I’m a high frequency trader. I have a high expectation that there are people out there with a very large quantity of shares. So I would expect somebody to own 100,000 shares of IBM, they know that they’re not going to be able to fulfill that, maybe, completely in Chicago. 

So, they’re baiting and are going to pick up on that, and then they’re going to be able to beat them or front run them to New York in order to have that done. But if it’s a small volume stock, most likely I would suspect this is how they’re thinking, I might be wrong. You would know better than I would know. But I would suspect that if it’s a low volume stock or something that doesn’t have a large volume of shares from a single person or a single entity, you’re gonna have a harder time finding more examples, more exercise of, basically, front running them and beating them to the other exchange. Would you agree with that?

Jos Schmitt  15:04  

You’re absolutely right. I think your analysis is 100% correct. Those strategies only work in securities that are liquid where there is investor interest. So if there’s no investor interest, and you try to do that, you put yourself at risk when you are technologically front-runned, because you’re not sure you’re going to be able to sell it back. 

Always think about it this way, it is that type of strategy, that technological front running strategy is a no risk strategy. They will only do it if they are sure that there’s going to be interest that will allow them to revert their position once they’ve taken it based on their symmetric access to information. 

And what does that mean? What that means, which in my eyes is quite fundamental is that, the less liquid securities get less and less attention, or they don’t get any attention from them. But what you’ve also seen is that the market makers, remember the concept I talked about earlier, market makers were stakeholders in the industry. 

We took up on them an obligation to provide liquidity at all times and they had a certain number of advantages in doing that. But how did the model really work? They made money in liquid securities because that is the same as an HFT, probably, would do today and then that gave them the compensation to put capital at risk. That gave them the compensation to sit on positions, if you want in less liquid ones, and act as a provider of liquidity. 

But they have been totally crowded out in the act of securities by HFTs. They can not make money anymore. All they are left with is better rates and less liquid securities. So they started to pull out and we see liquidity in the smaller and mid cap securities, slowly but surely deteriorating.

Stig Brodersen  16:52  

Jos, I just need to be sure. So, what you are doing at your exchange is that you are slowing down these orders from the high frequency traders. Is that what you’re also saying?

Jos Schmitt  17:03  

Well, we have a set of tools. So if you look at our model, our model is different from a pure trading perspective. Now, that’s what we’re talking about. It is different to the model that Brad has been using at IEX. 

So, he has a model where he slows everyone down. We have a model where we say, “You know what? We can identify who high frequency traders are.” We, I would say, tend to know who they are already, but we have a clear definition that allows us to spot them and identify them. 

And then, when they trade securities on our platform, we apply a series of mechanisms to prevent, or try to prevent,  I’m not going to say, we’re perfect, 100%. I wish I could say that, but I’m trying strategies about preventing privileged access to information that allows technological front running to take place. 

It’s a combination of tools. So one of the tools that we use is, when they want to take liquidity in one of our trading books, as you just said, “Yes, we drove a speed bump in front of them, and we slowed them down, believe it or not, not for more than five to nine milliseconds.” 

It is something that is random, because if it’s not random. We know they can adjust to it, and that advantage that they had, they knew something, or they detected something before anyone else, will suddenly [become something] they can’t execute upon anymore. 

But other mechanisms that we use, if they are sitting in the book, I’m sure you must have heard about layering the books where you see lots of small orders put in the books that are sitting there and waiting as part of detection mechanisms or as part of a strategy where you can sell at a higher price. 

Whether they do that and you have a long term investor sitting next to them at the same price, usually much further in the queue because the trading book is based on the first-in-first-out principle. 

So, you always have the HFTs sitting at the front of the long term investors. At the back at the same price, where we say, too bad to set. If it’s a long term investor, he’s going to jump the queue. 

Even if you were in that *inaudible* before him, he’s going to jump the queue. So those are two examples of the things that we do. Having analyzed all the various types of strategies that we know they deploy, we didn’t gain with solutions to tackle that. 

But at the same time, we didn’t want to punish anyone who was a long term investor. So, I don’t see the benefit of slowing down a long-term investor. Why would we do that? So we have been very selective in identifying the strategies and apply[ing] a cure, a solution, to prevent the predatory strategy to be deployed.

Preston Pysh  19:48  

That’s fascinating. I’m just blown away now. So, what you’re talking about is basically, I know who the person is that’s coming to me. And if it’s a person with the long strategy, we let them execute as normal. But if you’re a person who’s a short timer or has a really short strategy, we’re going to assess whether we allow you to come in immediately based off of a random time delay. Did I catch it correctly? And if so, are there any legal ramifications with doing that? 

Jos Schmitt  20:19  

Well, probably a couple of comments to add. So your assessment of what we do is correct. And it is, as I said, one of the strategies that we use, and we use many other ones. And by the way, what I would add to that is that, we apply this to anyone we define as a high frequency trader. And before I answer your legal question, it’s probably interesting to talk about that because remember, I said that there are good behaviors and bad behaviors. 

So, are we then impacting them both? Well, no. That is the beauty of the approach that we took. Our approach is not trying to prevent a high frequency trader to trade in our market. Our approach is to prevent them to roll out certain strategies on our market that we know are predatory in nature and detrimental to all the other investors. 

A beautiful discussion, and I give you that as a quick anecdote with a market participant, who joined our venue and said, “Well, I want to be a real market maker on your exchange. I don’t do any predatory strategies. I will just provide real liquidity. I’ll take up an obligation in the liquid securities and the less liquid securities. 

So, I assume that I’m not going to be subject to your speed bump.” And I said to him, “Well, you are a high frequency trader.” He says, “Yeah, but I only deploy good strategies.” I said, “If you only deploy good strategies, you shouldn’t have a problem with the speed bump.” And the discussion was over. 

But, why do I give you that anecdote? It’s because, I think, it clearly defines what we seek to do. So we are not in any way, shape, or form, anti HFT. Again, as I said earlier, high frequency trading is a methodology. Some people use it in a good way and some people use it in a bad way. And what we just try to counter is the best strategies. 

If you use it in a positive way, you will have the ability to be successful in our market and we will welcome you with both arms open. Because I do fundamentally believe that the electronification of the markets has been beneficial to the liquidity of the markets. But, like always, some people abuse it. 

Now, let’s come to the legal question. And I would probably define it more as a regulatory question. When we started this initiative, and I gave you a little bit of the history and the background earlier today. All of that started at the end of 2012. And the seed funding from those eight organizations, they came in, I think, it was May or June 2013. 

And then, we had a period of 8 months focused on discussing and presenting solutions to the regulators. Because the solutions that we came with, you’re absolutely right, are totally different. When you say, I’m going to slow certain participants down; when you say, I’m going to change the way priorities are taking place in a market, well, something to do with the way that things used to operate in the past. 

The model in the market is everyone does whatever he wants. You typically trade them on a first-in-first-out principle, so this went against a lot of established traditions and ways of working, and we got some reactions, discussions, and questions about it. 

Before we initiated the formal start of this exchange, we even went to a common process, an official common process, in Canada, where the regulators put forward the principles of our exchange; not the ask for a recognition of a new exchange, but the principle of the exchange to see how the market would react. Lots of debate, lots of discussion, and you know what? I thought it was great.

Preston Pysh  24:20  

What I like about this, Jos, [is] so many people are polarized in their opinion on this. They hear about it, they have very fine surface knowledge as to how it works. I mean, that’s how I classify myself. I know a little tidbit, but I don’t really understand it at any level that you understand it. 

I think most people have this surface knowledge, and they immediately say it’s good or it’s bad. And without a lot of discussion without bringing these topics up and putting them out there, I think that you have such a balanced opinion and balanced argument that that’s where the truth lies. 

Also, I think that when people are trying to say, “Hey, there [are] good pieces to this. That’s what we need to focus on. And then, there’s bad pieces of this. That’s what we need to stop.” I really give you huge kudos for seeing things from that perspective and keeping a nice balanced argument. 

I think that that’s why your exchange is going to be successful. It is because you’re taking that approach. You want it to be good for the investor, the person who’s conducting those trades, that’s who you have your interest in. And I know that that’s in your mission statement. 

Also, it’s great to hear, as we’re talking to you, I can see that coming out, that you live that mission statement. It’s really quite refreshing. So, I’ll go on with the next question here. Sorry for the prelude there. What is something that happened during your adventure of creating this exchange that would really surprise a lot of people in our audience? Maybe a funny story or something that people would not expect.

Jos Schmitt  25:48  

Well, I almost introduced it already in what I was saying earlier. And that is when we went through that what we would, in technical jargon, call pre-filing government process. So, that government process before we even said we want to become an exchange, but that process where we went for public government with the regulators to just discuss principles of what we want to do. So that is something very unique. You don’t see that, you’ve never seen that before. And that was something very exciting. 

And then it was showing you that clearly there was an understanding that there is something that needs to change. There is something that needs to evolve and no one is really 100% comfortable with what that should be. Well, we had our very strong views and opinions about it, but you could see that the regulators wanted to get feedback. That was quite unique, but this is not what really got me excited, to be honest. 

When we started that process, something very unique happened. And that was that a stakeholder that has always been silent in any common process or in any debate around how markets operate, suddenly emerged. And that was the public companies. That was the capital raising companies. 

Think about it this way, if you are a corporation, you need money. You got a number of options. You can go to the bank or you can go private or you can go public. So you can list your company on exchange. We know that banking funding is a bit tight for the moment. If you go private,  there’s often an issue where you may lose substantial control over your cooperation, so going public is a great option. 

However, going public will only work if your security is going to be traded in a liquid way so that you have volume. Because if it is not, investors will look at it and your future cost of capital is going to go up less. You will not be able to use it in a successful way as a currency if you want to do some merger and acquisition and things like that. What more and more corporations start to realize is that the way that markets have evolved, is negatively impacting the liquidity of their security. And they do suddenly, with us emerging, say, wait a minute, those guys are hitting some key points that are at the root cause of the problems that we start to observe in the markets and have never seen before. 

Suddenly, we see those corporations starting to make governments with limited knowledge. You can’t expect the company that has a business to run to be an expert in market structure. But they started to say, wait a minute, there are issues, indeed.

These guys are not 100% sure what they’re doing and how they’re going to solve the problem because that’s a bit the kind of comments that you got, but at least they are raising the right issues, and they are coming with a number of solutions. So, we should support that kind of innovation and that kind of transformation of capital markets. 

That was extremely exciting and with a bit of a funny component to it, because indeed, when you talk with them, it is very complex for them. I don’t really know what we do. They don’t really know how we do it, but they say, “You hit the big issue that we are facing as corporate companies.”

Preston Pysh  29:10  

I mean, just trying to wrap your head around this stuff, it is very hard to do. And if you’re focused on the corporate side, you’re running your business, like you see somebody like yourself and your exchange coming in here. Like, I don’t really necessarily understand everything you’re doing, but I like it. I see the value you’re adding, but I don’t know how you’re doing it.

Jos Schmitt  29:32  

Absolutely. And it takes you back to how complex markets became and how complex things are. As you said earlier, I think it’s a very important point that you make, without getting into a black and white analysis of the scenario, I mentioned it earlier, I would love to go out and say, HFTs are bad and we don’t have HFTs. That would be an absolutely false statement. 

And if you would have that approach, you would have more of a detrimental impact on markets than anything else. But if you get into the new house, then it becomes all very, very complex to explain. Even at the beginning, people were labeling us, Oh, this is the anti HFT Stock Exchange. And I said, No, we’re not. We are anti predatory behavior. We are pro liquidity. We are pro doing what is right for the investor and the issuer or the capital raising company, and that is how we will build our solutions.

Stig Brodersen  30:36  

So, Jos, I was just thinking, the interrelation between those exchanges, I think that was also some of the really good things in Flash Boys, the book about Michael Lewis that I would really encourage everyone to to read, perhaps, even before they listened to this interview. But do I understand you this way that, say, I want to buy stocks in highly liquid stock like Rollbahn Canada, then I can just go and buy from your exchange and not use the the Toronto Stock Exchange, instead? Is that how stock exchanges work, that I can pick my favorite exchange, or how does it work?

Jos Schmitt  31:12  

Yeah, that is an interesting question and  a very critical question. When you want to buy a security today, you can go to your discount brokerage platform, or you can go to your dealer. But at the end of the day, the decision on where that order will be executed is going to be subject to two things: one, the fact that the trading desk that is going to place the order in the market needs to make sure that you trade at the best prices available in the market. 

There’s a regulation that is in place in the US, t’s called *inaudible*, it’s the OBR rule in Canada. You can operate at a price that is below the best price available in the market, so that is the first element. That place.

Preston Pysh  32:04  

And just by market, you mean, any of the markets?

Jos Schmitt  32:07  

Any of the markets. So in Canada, you have nine marketplaces now where you can see prices. So you always have to send your order to the marketplace that has the best price. Now, what often happens due to arbitrage and other reasons, that is that those marketplaces tend all to be at the same price. 

And then, the second element kicks in and that is the decision of a trading desk. They’re going to say, “Well, I’m going to send my order, rather here than there.” And what drives that? Well, what should drive it is the market I go to. Which one will have the highest probability that my order gets totally filled in one shot? What is the probability that the price is not going to move before I hit that market? And so on. 

So the key consideration that should drive it as best execution, but what we also see, Mary Jo White made a beautiful comment about it a couple of days ago when they started a new market structure advisory committee in the US, sponsored by the SEC, where she said, “Why is it that 90% of all the retail orders are being sent first to the marketplaces that gives the biggest rebates to the dealers?” So what we see is that that’s a very important element in that process also. And the risk with that is that high frequency traders know that. 

Also, they know that an order is going to go first to a marketplace where there’s an incentive for the trading desk to set it. And then, what is a typical strategy, they’re sitting there, they see it coming in, they trade a very small part of it. 

[Likewise,] they know that something else is going to come in all those other marketplaces and they are going to cancel their orders there. They’re going to front run it, cancel the orders, and then sell it back at a higher price. That is typically, again, that technological front running. 

Can you now as an investor, influence that? Well, it’s very difficult because you cannot say, if different marketplaces have the same price at which I can trade, I want to go to the Aequitas Neo Exchange first. you don’t have that on your discount brokerage platform, and if you work with your investment advisor or whatever it is, he cannot say send it to Neo Exchange first because that decision is taken centrally. 

So, you cannot impact that directly. But you can do two things: one, you can say, gentlemen or ladies, I want to understand how you are handling my orders. Ask for transparency. Start to raise the issue. When I look at the confirmation receipts of my own orders, I see exactly where they trade, what the first marketplaces they trade on, and also, how the price evolves. Can you explain to me why this is happening? And I would like this to change going forward. 

So I think it is very important to start showing the industry that as an investor, we understand more about what’s going on. When we see things that we don’t like, we want our instructions to be followed. And at the end of the day, we are the owners of the shares and no one else. So I think it’s very important to raise the issue, ask for transparency, and start to feel empowered about doing it today. 

It’s not something you can control yourself, but you have to start putting pressure on the system. The second element that you can do, and that is very exciting in what we see again around us. That is, we see some dealers starting to go public and say, by the way, we give you a choice. If you work with us, you can decide where your order is going to go first. And that is the beginning of Tomorrow’s World.

Wow, that was really insightful. This is a question I’d like to ask everyone that we have on the podcast. Looking at what you have said about the change in the vision, also the mission about exchange, do you have any books that have shaped your life, personally, that you really think is something you want to give to all the people if you could?

I’m going to take you by surprise because I’m going to talk to you about a book that has nothing to do with the industry. But you can link it back to our vision and mission. And the book probably impacted me most, and  I’ve had the opportunity to read a few in my life, many linked to the industry, which were usually quite boring, to be honest with you. 

However, I think it was probably a good five or seven years ago, short history of the world, which was a book written by H.G. Wells in the early 20s. And what that book is doing is giving a bit of a holistic overview based on the knowledge and scientific knowledge at that time, so we’re talking early 1920s, of the evolution of earth and mankind since inception until then. I remember that it ended pretty much just after World War One. 

What struck me with that book is how it was showing the entire continuum of history–how history evolves; how it predicts things; and how things can go in a good direction, can go in a bad direction. And then it was showing that, globally, not just focusing on our Western culture, but looking also to what was happening in Asia. If you think about the entire period of enlightenment of the Greeks in the sixth century BC, something very similar happened at the same time in China. 

But the point that I want to make is, it shows you big things, a large continuum. And it shows you at the same time that we, as important we may think we all are, are just a very small piece in a history, in a time space continuum, that has a very small amount of time. We have a very small amount of time to do something that is going to be really valuable for the evolution of this earth and for the evolution of mankind. 

Now, [it all] sounds…very nice. [That’s] what I say. So, why did that impact me and how did it impact me? Well, it impacted me by making me think a little bit about, what am I doing? What are we doing? What are we seeking to achieve? Is there anything in my industry where I can be more meaningful than just trying to develop another business that is going to seek to be successful from a financial perspective solely, make shareholders happy, can I do something else? 

And I would say that type realization of who we are and what continuum we live, made me think a bit about, can I do something more? Can I do something different? Can I do something transformational that can represent at the end of the day, some form of legacy for the better of the industry that I know and that I’m good at? And if you want to be meaningful in your life, you have to do something that is really about making things better. 

And when I didn’t take that back to the Aequitas Neo Exchange, the Aequitas Neo Exchange is not something I did because I wanted to have a job. It’s not something I did because it is something that could generate big returns. It’s something I did because I fundamentally believe that we have issues. I fundamentally believe there are solutions. And I fundamentally believe that it’s an incredible opportunity to do what is right.

Preston Pysh  40:03  

I’ll tell you what Jos,  that was fantastic. I love the book recommendation. I love how you put your perspective in there of “Go after it. Make a difference.” And I think for a lot of people, they can be inspired by listening to a person like yourself who, I mean, you’re a big dreamer. I mean, you don’t stand up your own stock exchange on a whim. This is not an easy task and to do it in such a highly complex and highly technical industry. 

It is an inspiration for people listening to this that they can take that same motivation and take it as you the listener out there. You have that thing that you know you can make a difference in. And it might be something really big. and look at Jos, look at what he’s doing. He just went after it. 

And I think for all of our listeners, that’s exactly what they can take away from this interview. They can go after it, They can make a difference and shape the world around us. It is just awesome. I love this interview. I really, thoroughly, enjoyed hearing your perspective on this. It was kind of neat to hear the other side of the coin to Flash Boys because I think Flash Boys definitely paints HFT in a very bad light. 

It’s kind of neat to see a person like yourself, basically, combating the high frequency trading the negative piece of it, and then also having the courage to talk about the positive pieces of it too and how it is adding liquidity but maybe, just maybe in the wrong areas, rather than the wrong types of companies. So that was just fantastic. I really enjoyed this.

Jos Schmitt  41:38  

Thank you. The one comment I would add about Flash Boys, and the way to look at that book so Stig, you made a comment earlier, people should read it. Well yeah, I will recommend the same. I sometimes get reactions back [about] why you tell people that they should read it. This is too negative. This is someone who’s saying markets are rigged. This is not good for investor confidence. Just name it. And my view is, you should read it because in that book, there are a lot of elements that are correct. 

When you look at the way that some of the strategies are being depicted and what kinds of things are happening in the markets, it’s absolutely true. Don’t tell me that that’s not true. But then the problem, of course, with a book is that a book needs to simplify. It needs to turn the world in black and white. 

You want people to read the book; get excited about the book. You don’t want them to read 20 pages and then put it down and go, “Jesus Christ, I don’t know what’s what’s going on over here. I don’t understand it.”

So, it is a simplification of things, but at the same time, there’s a lot of truth behind it. And by the way, yes, we have an investor confidence crisis. Let that be very clear. It’s not going to help us by saying the markets are Rick, I think what we should say is that, there are issues in the markets, the markets have a fairness issue. They need to be transformed into more of a level playing field. And there are solutions to do that. 

Those solutions are being put in place today. But what the book has done, and dare I say, thank you to Michael Lewis, what the book has done, it has put these issues at the forefront of everyone’s mind. It has initiated a wave of transparency. 

What we need to do now is make sure that that transparency is really translating the reality of what’s happening And not just being an oversimplification of things Because then we are negatively impacting, as you just said, all the value that can be brought by high frequency traders to the markets.

Preston Pysh  43:46  

Well, thanks, Jos. We really appreciate you coming on the show and sharing your knowledge and expertise, just our audience to learn more about what you do in your exchange and we’ll have Jos’ stock exchange the link to it on the web, right in our show notes. So, if you want to just go and kind of read through some of the stuff that they’re doing, we’ll have a link in our show notes for you to do that. So Jos, thank you so much for coming on the show today.

Jos Schmitt  44:10  

Thank you, gentlemen. That was a pleasure.

Preston Pysh  44:13  

Alright, so this is the point in the show where we take a question from our audience. And this question comes from Eric Frank Hauser.

Eric Hauser  44:19  

Well Preston and Stig, my name is Eric Hauser, and I’m an engineer by trade who is trying to get started in buying investments. Thank you both so much for all the great work you do with the website and podcast. So I have a question. What metrics do you use to know if your portfolio is performing well or poor, and how do you calculate? Thanks.

Preston Pysh  44:39  

All right, Eric. So fantastic question. I think the obvious answer is, well, what’s your return? But I think that people need to be very patient in the way that they judge their performance. If you’re looking at it as my performance over the last year, that’s very short sighted in my opinion. 

I think that you probably need, at least, almost 10 years of a track record to really say, Hey, I’m underperforming or over performing the market. And I think that if you use that as your benchmark, I think that you can say with a little bit of confidence and probability that you are exercising good strategies. 

So, that’s kind of hard for a person if you’re just starting out. Let’s say you beat the market by 20% in a year. You might think, “Man, I got this thing figured out, and I am great. I’m the best value investor. I’m going to be 10 times more valuable in my life than Warren Buffett is.” 

But the fact of the matter is that’s just one sample in a much larger data set that I think that you need to take. So, I would tell the person that if you are beating the market and you’ve only been doing it for a few years, you probably need to be more cautious than the person who’s not beating the market because you might have this overconfidence in your abilities. I think that that’s probably a bigger risk than having less confidence. 

For the person who’s maybe not beating the market, I would tell that person to continue to read as much as they possibly can. If there’s one thing that we’ve learned from Warren Buffett probably more than anything else, it’s that he’s a total learning machine. The guy never stops learning. He reads pretty much all day long. Book after book, he is significantly older than us. So, the thing that I’ve really learned from Warren Buffett [more] than anything else is that he is a learning machine. 

And for that person that’s underperforming the market, I think how you start outperforming the market over the long haul, is you’ve got to continue to educate yourself. And you’ve got to continue every single day to read something more and to learn something more. When you do that, the truth is going to unveil itself on how you can capitalize on the markets better than the average. So Stig, I’m assuming you have something you want to say.

Stig Brodersen  46:48  

Yeah. So Eric, I really thought it was an insightful question. It’s also a question I’ve been asking a lot of times, how well do you perform? So back in the days, back when I was a college student, I was forced to calculate alpha, beta, and sharpe ratio, especially sharpe ratio. It is an extremely powerful measure of how your portfolio is performing. 

And just as a side note, back in the days, even though I’m not that old, I was actually forced to do it by hand. It’s really not that fun. So, what does my intense study of all these different methods [say]? What do they suggest? And I can tell you that it is really, really simple. The way I mainly *inaudible* performance is just by looking at the S&P 500, and that might be something that’s confusing you. 

Why I’m saying that is because all of these different methods, they are looking at volatility as one of the key things. I don’t think volatility is that important if you invest like most investors do. I’m a pretty simple investor. 

I mainly buy equities, and I don’t use derivatives *inaudible*. So, when you’re not doing that, it’s really not that important, at least in my opinion, if you are investing for the long run to just compare it to S&P 500. 

Now, this might be used to something like sharpe ratio that is including the risk free rate and volatility. I think that’s important. If you are looking at other strategies, I would not say more advanced strategies, because it sounds like it’s a necessarily better strategy. 

If you’re looking at some of these hedge funds, when they were going long, some position shorts other positions, and they might be using derivatives to, I guess…it does make sense to use a look at volatility because you can’t stand the same volatility. But I think that if you buy equities and you hold them for a long run, I think the market is actually a pretty good indicator.

Preston Pysh  48:53  

So I just want to highlight and this doesn’t necessarily have to do with how you measure yourself versus the S&P 500 or whatever. But Stanley drunken Miller is a person that I really like to read what he has to say, because he’s very colorful in the way that he talks and the things that he describes. 

Also, he’s a billionaire. I think his net worth is $2-4 billion. If I had to guess he worked for George Soros [and] made a lot of money for George Soros. And one thing that I read on him, he said, “The first thing I do when I’m assessing a person’s past performance, I go to a down year whenever the market really had a strong crash, and I look at their performance during that year. That’s where I make the determination of how good somebody is.” 

I found that kind of an interesting quote by him or a statement by him, because if you think of it from this perspective, let’s say the market goes down 50% this year, let’s just say it has a crash. If you’re literally flat and you didn’t lose 1% on your portfolio, let’s say you were 100% in cash, and I’m not saying that’s what you should be in. But let’s just say that that was the scenario, and everyone else in the S&P went down 50%, you just beat the market by 50%. 

Also, I think a lot of people don’t think about the importance of protecting their downside. And when you talk to really high-end money manager guys that have really made it and made it consistently, they are all about protecting their downside. Warren Buffett has a quote, “Rule number one: don’t lose money. Rule number two: don’t forget rule number one.” 

Okay, and I think that that’s a really important thing to gauge yourself off of and to think everyone wants to think and positives like I beat the market by 2% when it was up 12%. Okay, so you got a 14% return, but what they fail to talk about is how well did you beat the market whenever it crashed, or it tanked or had a bad year? 

And so, I think when you look at both of those, I think you’re going to find that you’re maybe a little bit more of a successful investor because you’re constantly weighing what’s my upside versus my downside. Okay.

Stig Brodersen  50:53  

Yeah, and I just want to add another thing because I think it is a really good point that you’re having here. Preston, what happens when the market is crashing? Because a lot of these strategies that you hear out there, if you really dig into the real thing about these strategies, you will actually go broke. For instance, during 2008. 

And I know it sounds strange, but some of these very fantastic strategies, you should just do this and go long this screenshot that and, by this *inaudible*, sell this call, whatever. If you look at how some of these headphones [are] actually performing, they went broke because they couldn’t stand the volatility. 

Yeah, so that’s why I’m saying, in my opinion, I might be comparing to S&P 500, or the world index, whatever I’m investing in, but I do think it makes a lot of sense if you look at all the types of portfolios and definitely funds to look at some of those metrics when you include this, the volatility, because a lot of these fantastic strategies, and I’m saying fantastic because I don’t mean that they can withstand all that volatility. And I just think that’s something to remember now, when *inaudible* stops everyone.

Can they make money and that’s really not the time to compare. Just look at Berkshire Hathaway. They thrive when the market is crushing because they don’t drop as much. And that’s extremely important. 

Preston Pysh  52:12  

Yeah, Buffett even says that during a shareholder meeting…he specifically said that in up markets, we might underperform just a little bit. But in down markets, we will outperform the market. So, I think that that’s an important vantage point to look at as a value investor. 

And when you’re analyzing yourself and how well you’re beating it or underperforming the market, I want to highlight something. So, we talked a lot about this book, Flash Boys by Michael Lewis In this episode, and that’s a book about high frequency trading and how it works.

If you haven’t read that book or you’re not really familiar with high frequency trading, this episode might have sounded like a lot of Greek and [something] like, “What in the world are they even talking about?” What [I’m telling] you is go out and read that book. The book is highly entertaining. 

If you don’t know Michael Lewis, he’s the same author of Moneyball. Like a lot of these books that were turned into Hollywood movies, so he’s a fantastic writer. He makes finance [fun]. He’s probably the best finance writer in the world right now. So if you don’t want to read that, guess what Stig and I wrote a summary on it. 

So, if you sign up for our reading list, or our email list that we send out two times a month, no more than two times, you can download our executive summary of flash boys as well. So just sign up on our list at our website, the investorspodcast.com. 

If you’d like to record a question and get it on the show, go to asktheinvestors.com, and you can record your question and get it played on the show. And if you’re like Eric, we will send you a free signed copy of our book, the Warren Buffett Accounting Book if your question gets played live on the air. So, that’s all we have for you this week. We really want to thank Joe for coming on the show. I mean, that was just a fantastic interview. 

And I think anyone who’s listening knows that he knows his stuff, not only from a technical side, but from a finance side. It was just I was very impressed to say the least, and I know stick was too. So thank you so much for being on our audience. 

If you have time, go to iTunes and leave us a review that really helps us out and we just really appreciate everything that you guys do for us. We’ll see you guys next week.