Lenny Dykstra: Smart Guy, Nightmare Advisor

Great athletes, by definition, have great brains. Forget the stereotype, this is inarguably true. Great athletes may or may not be great, good or even fair-to-middling intellectuals. What they possess innately and perfect through focused effort are mental models of the physical world which give them the ability to make complex decisions impossibly quickly based on tiny, tiny amounts of information – an anomaly in the swirling pattern made by the red strings and white leather of a baseball going 90 miles an hour; a twitch in the leg muscle of a forward setting a pick as he over-commits slightly, a momentary break in the cadence of a cornerback's stride 25 yards away. Based on these fleeting hints, great athletes take actions with correctness that stuns us as we watch the ball fly over the fence, into the basket, or land like a perching dove into the outstretched hands of a sprinting receiver. Part of what they do is simply unapproachable. Great athletes regularly describe high-speed events with such detail and richness it's as though these things took place within a space-time continuum other than the one we inhabit. They just see the physical world differently.

A huge part of it, of course, is practice. They refine and refine and refine their mental models of the physical world until they are incredibly precise and sensitive. And then, as they rise through the ranks of athletics, they learn to keep placing faith in their modeling process – in that combination of endless practice and innate ability – and ignore emotion. This ability to concentrate, focus and discipline yourself to stick with what works is a tremendous asset – most of the time. So when Lenny Dykstra - formerly of professional baseball, now of TheStreet.com (TSCM) – tells his readers to stick to their guns, it's probably a good idea for them to listen – at least some of the time. As he writes in his column, Dykstra is a person who has tremendous practice ignoring emotion and sticking to what works – in athletics. But even with all its variables, the baseball field is a very controlled environment. The stock market is not and those who would try to control it by modeling do so at their peril. 

This is because in their desire to control the uncontrollable, people inevitably lie to themselves. The most deadly and common financial lie is the martingale. Martingale systems are deadly because they always, always work – until they don't. The contrast of incremental success versus the threat of total, catastrophic failure is one the human mind does not handles well. We tend to completely dismiss the possibility of total failure in the same way we tend to overvalue things like lottery jackpots (the emotional equivalent of total success). Ponzi schemes depend on the human tendency to believe in the promise implied by incremental reward, and disbelieve the possibility of total failure.

But who am I to criticize? What talent have I shown, other than the ability to say things are “inarguably true”, thereby assuring people will disagree with me? Well, athletes are not the only ones who can make correct judgments from partial information. When I read that Dykstra sells with a $1000 profit and/or when he is “back to even”, increases losing bets and does not employ stop-loss, I know there is an implicit or explicit martingale in his system. Therefore it is doomed. It's just that simple. My guess is that Dykstra has such a focused mindset he can't see that as volatility expanded quickly, his system would inevitably seem like a “sure thing” even though he is option-leveraged and long-only in a down market. I'm sure he makes some pretty good picks as well. He seems like a smart guy. Nevertheless, I confidently predict disaster for anyone who follows his system. I don't believe in the “reversion to the mean” fallacy, but the mechanisms of the market will inevitably create a situation of both falling volatility and generally falling equity prices. At that point, the Dykstra “system” will completely explode. The structural time limit of the options will lock in losses made huge by “averaging down” - otherwise known as “increasing your bet”.

But this is trivial and I'm sure even Lenny Dykstra himself will see his own folly unless ego prevents him from doing so. The more important point is one about the martingale. From the DotCom bubble to LTCM to the political bravado of the Bush Administration to Greenspan's rate cuts to the tragedy of credit default swaps, the last decade or so has proved not to be the “End of History” so much as an “Era Of The Martingale”. It has been an era where people believed they could come up with a system that was a lock and win forever. If there is one useful thing that watching financial markets has taught me, it is that the moment you come to believe you have it all figured out, you're very likely in terrible trouble. 

Martingales appeal to us for a very good reason. We are social animals. When we see something that works, we feel instinctively that other Homo sapiens will see what we're seeing. We know innately that all human progress is made when large numbers of our species embrace good, new ideas and use them to build the world we share in common. Bad ideas also build a following, but eventually they hit the limits of their self-contradictions. At that point, the new ideas are the only ones that make sense. So we change our assumptions, evolve, get stronger...and ultimately dare to increase our bets even in the face of doubt.

Like I said, martingales really do always, always work…until they don't.

Disclosure: none

Comments

[leh:]

I take it you're saying LD never buys puts? Seems odd. Is this accurate?

2008 Nov 07 11:51 AM

[dlaw:]

So far as I understand, Dykstra's is a "deep-in-the-money calls" strategy.

2008 Nov 07 01:43 PM

[TA:]

I've been commenting for years that Lenny is a disaster because he has no risk management. Everytime people comment about it, he avoids the question.

He started out free a couple of years ago, disappeared for months right around the start of the bear and then comes back as subscription only. I'm quite certain he flamed out with severe losses before coming back as a subscription.

I really think that your are being nice with all your compliments. I've used a few different words...

2008 Nov 07 06:57 PM

[ambuilder:]

Lenny .........hard to believe anything from a guy who doesn't pay his bills....he is burnibg bridges in Ventura Ca. He has bounced checks for materials and welched on his deals with contractors......He gives new meaning to the nickname "NAILS".....

Feb 17 11:01 AM

[Michael Comeau:]

I know this article is old, but if anyone reads it, be sure to catch my April 5, 2009 piece on Lenny's strategy:

www.longshorttrader.co...

Apr 06 06:26 PM