By Jared Dillian
If you’ve ever taken a decision theory class (I have, and it was awesome), this is the first thing you learn.
Decision Theory
You have a 50/50 chance of winning $10,000. You have P = 0.5 of getting $10,000 and P = 0.5 of getting 0.
Or you can choose not to play the game and get $3,000.
What do you do?
The answer is: it depends on who you are and what your risk preferences are.
Rationally, the number to get you to walk away should be $5,000. But most people will walk away for less. Sometimes much less. Sometimes people will walk away for $500 or $1,000. After all, it’s money they didn’t have before.
Anyone who accepts less than $5,000 to walk away is known as risk-averse.
Loss Aversion
Here is where things get interesting. Turn the experiment
on its head.
Tell people they have a 50/50 chance of either losing $10,000 or breaking even.
Then tell them that they could either take their chances with the 50/50 game or they could lose a certain $2,000.
Faced with this choice, people will roll the dice. Every. Single. Time.
Nobody wants to “lock in” a certain loss. As long as there is a chance that they could break even, they will hope—except hope is not a strategy.
This is known as loss aversion.
If you understand this experiment, you understand half of behavioral finance.
Kahneman and Tversky, and Thaler
I started reading about this in 2004. Daniel Kahneman is quite famous, with his book Thinking, Fast and Slow, and Richard Thaler is perhaps even more famous, with his books Nudge: Improving Decisions About Health, Wealth, and Happiness and Misbehaving: The Making of Behavioral Economics. He is also an advisor to President Obama.
About 11 years ago, nobody outside of geeky financial circles had ever heard of these guys. I was reading their academic papers to get better at my job.
Pretty much all of the behavior of the financial markets can be explained through this framework. Particularly this correction.
This is why markets go up on an escalator and down on an elevator. People are taking tiny profits all the way up and letting the losses run on the way down.
I’m being serious.
Human beings are just not wired for risk. Both parts of the experiment are stupid. The first part is known as “taking profits too soon.” The second part is “letting losses run.”
People are guilty of both.
Trading 101
In some sense, this edition of The 10th Man is a lesson in Trading 101. But that’s fine, because most investors are barely literate 8th-grade dropouts.
Let’s talk first about letting losses run. This is the mistake beginners make.
I buy a stock at $50.
It goes to $48. No big deal.
It goes to $46.
I could have sold it at $48. I can’t sell it at $46.
It crashes to $40. Now I’m really in trouble. If I sell now, it would be catastrophic. I hope, pray, do rain dances that it will come back.
And then it goes to $20.
The professional sells when it goes to $48.
But the professional makes a different sort of error. He buys Apple at $10, sells it at $11, and then it goes to $700.
In many ways, this is much more catastrophic. Markets do go up over time, and frequently, beginning traders will get bailed out.
But you can’t undo buying AAPL at $10 and selling it at $11.
The best investors in the world don’t make any of these errors. My favorite, Stan Druckenmiller, talks about being a pig in the trade. He’d rather make a Type I error than a Type II error. Find his speech at the Lost Tree Club on the Internet for more details.
Sometimes I see beginners falling ass-backwards into great trades just because they never make the Type II error. Someone told me recently that he’s been long GOOGL since $250.
Nice job!
“But I was way too small,” he said.
And that, my friends, is the Type III error.
Trading 201: Position Sizing
Here’s an imaginary scenario: someone tips you that an acquisition is going to happen. Of course, that would be insider trading, which is illegal—but let’s pretend for the purpose of this exercise that insider trading were legal.
So someone tells you that Company A is going to buy Company B and is going to pay a 100% premium.
Question: how much of your money do you put in Company B?
If the answer is anything less than “All of it,” then you are an idiot.
We are talking about a 100% return in one day. Can you do better than that? No.
Also, assume that the guy who told you this is 100% reliable. The information is legit. There is no chance that it’s wrong.
Rationally, you should put every penny of your money into Company B stock. If you put in any less than 100%, you are behaving irrationally.
Got it?
Scenario 2: you have a vague idea that GE is going to go up. Just a hunch.
How much GE should you buy?
Answer: not very much. Maybe it should be the smallest position in your portfolio.
At this point in the story, think about your portfolio, or maybe even log into it.
My guess is you have some very high-conviction ideas alongside some very low-conviction ideas, and that everything is just about weighted equally.
People do this all the time. They have $100,000 in 10 stocks—$10,000 a stock—regardless of conviction level.
This is going to be hard for novice traders to understand. Novice traders pick stocks like I bet on baseball. I might bet against the Royals because Edinson Volquez wears his hat sideways, or I might bet on the Nationals because I am a huge Bryce Harper fan, or I might bet against the Red Sox just because.
Novice traders find it hard to believe that someone can be that sure about a stock. But I meet professional gamblers who are “that sure” about baseball games. I don’t understand how they do it, but they do it.
Soros and Druckenmiller were pretty gosh darn sure when they bet against the British pound. Imagine if they had been wrong!
But they knew they wouldn’t be.
Winner, Winner, Chicken Dinner
Let’s go back to about 10 years ago when Ben Mezrich wrote Bringing Down The House: The Inside Story of Six MIT Students Who Took Vegas for Millions. That was when the general public got to learn about advantage play in blackjack, that is, counting cards.
How does it work?
In one paragraph, you count cards so you can keep track of face cards (which are good) and low cards (which are bad), so if you know there’s a concentration of face cards left in the shoe, you will have a temporary statistical advantage over the dealer.
And how do you take advantage of that statistical advantage?
Duh, you bet more!
That’s what the card counters in the book did. When the count was high, they were putting in 10, 20, or even 50 times their normal bet.
In fact, that’s how most casinos know they’re dealing with a card counter. Average players don’t vary their bet size. They bet the same size all the time.
Average traders do too.
If you want to read more on this concept (and I highly recommend that you do), read David Sklansky’s Getting the Best of It. It’s a gambling book, but most people I know on Wall Street have read it.
Oink
So I’m going to preach what I practice. My highest-conviction position is about 80% of my portfolio (using leverage).
Now, that’s varying your bet size.
Most of my ideas are actually bad. Seriously. I knew a guy at Lehman who said he was wrong 80% of the time. I figured he was lying. The guy made a ton of dough. How could that be true?
If you bet the farm on the 20% of the time you are right, you can do very well.
This, I think, is one of the limitations of an investment newsletter. You have these ideas, and they are in a portfolio, but they are not weighted. Some are clearly better than others. And there they all are, line items in the portfolio update, and the good ones look the same as the bad ones.
A word of caution. Novice traders should not, absolutely not, make one position 80% of their portfolio. I do it because I have 16 years of experience. You should not do this any more than you would bet 80% of your money on a baseball game (unless you know a lot about baseball). Novice traders can’t vary their bet size because they don’t know enough to tell which ideas are bad and which ones are a “sure thing.”
It’s a good way to blow yourself up.
But at some point in your investing career, you are going to come across one of those really great ideas, and you will be tempted to weight it as 10% of your portfolio, along with everything else.
Diversification!
Screw diversification.
How do billionaires get to be billionaires? Funny, if you look at a list of billionaires, there’s not too many money managers in there. Some. Like Dalio, Tepper, Soros, Jones. But not many.
Most billionaires got to be billionaires by starting companies and growing them.
In other words, they had 100% of their portfolio in one stock. Their own.
You don’t get to be a billionaire by putting $10,000 in 10 stocks.
We all can’t be billionaires. But you don’t have to be a piker.
Jared Dillian
If you enjoyed Jared’s article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap
