Stories of the Institutional Past #10

Picking Bottoms

“Never catch a falling knife” is probably one of the most quoted sentences used in the investment universe. I have heard it many times over. While any logic would dictate that such an undertaking is generally futile, seeing how many investors fall victim to such an attempt is still amazing.

During the financial crisis, bank bonds started imploding. Senior paper (highest default protection) traded 60 cents on the dollar, then 40, with some of them trading in their mid-teens in early 2009. The funny thing was that credit guys liked them at 60 cents but not in their 10s. Default probabilities were just too high! Only a few weeks later, senior management forced them to sell their positions at those very suppressed levels. All those bonds rallied back to par, of course.

Source: Dall-E

“Only baboons pick bottoms” was the favourite saying of a colleague and good friend of mine. It made sense to me, yet I was intrigued by the fascination of many professional investors I witnessed who were after precisely this endeavour. I see this still everywhere, especially in the Fintwit space.

Why do traders, both novice and experienced, find the idea of picking bottoms or selling tops so fascinating? Is it sheer hubris, or is there a deeper psychological drive at play?

At a basic level, buying at the absolute bottom and selling at the very top represent the zenith of anyone’s trading success. It's the theoretical maximum profit a trader can make on any single position. The allure is straightforward: purchase an asset at its lowest point and sell it at its highest, reaping the most substantial reward possible. It sounds simple, and it is this deceptive simplicity that draws many into attempting it.

Beyond potential profits, picking the extremes also provides a psychological boost. It affirms a trader's skill, intuition, and analytical capabilities. There's an inherent satisfaction in believing one can outsmart the vast, tumultuous ocean of market participants and pinpoint the exact moments of reversal. Such moments, if successfully identified, aren't just profitable —they're also immensely gratifying.

Popular culture is replete with stories of maverick individuals who went against the grain, bucked conventional wisdom, and emerged victorious. The lone trader who goes contrarian, betting against the market consensus, is a modern-day embodiment of this archetype. Picking tops and bottoms becomes an act of defiance, a demonstration of independence from the herd. I will be the first to confess that I have never picked the bottom or top of any security. I wouldn’t be surprised if the likes of Buffet, Soros, and other very successful investors haven’t either. There is no need in order to manage money successfully. Being roughly right rather than precisely wrong is good enough for me.

Ironically, I believe that the very quest to pick tops and bottoms leads to sub-optimal investment results. I will dedicate a whole post on why I think most traders (as the statistics would have it) lose money, but there is mostly a psychological issue and overconfidence as to why the hunters for those extremes are destined to fail. On Fintwit, meanwhile, there is a plethora of many claiming to possess this very ability. Stay away from them.

While the allure of picking tops and bottoms will always be a tantalizing aspect of trading, it is more akin to a siren's call — enticing but perilous. The true skill in successful investing lies not in the rare moments of extraordinary insight but in the disciplined approach of risk management, adaptability, and consistent performance. As traders and investors, our goal should not be to chase the illusion of perfection in timing the market but to develop a robust strategy that can withstand the inherent uncertainties of the market. In embracing this philosophy, we find financial success and a deeper understanding of the markets and ourselves.

This and much more are the core pillars of why I have built Paper Alfa. Here, we transmit knowledge and provide tools to help build resilience and ultimately perform. Interested? Why not join the pack?

Best of Luck out there!