Sunday, September 28, 2008

Gamblers and Entrepreneurs: A Further Look at Financial Risk-Taking

In the second post in this series (here is the first post), we took a look at personality traits that are associated with risk-taking, particularly in the financial domain. This final installment in the series will examine some of the conclusions of that research.

One of the most important conclusions of the research is that financial risk-taking is negatively correlated with both "deliberation" and "self-discipline". In other words, the risk taker tends to be action-oriented and, as the investigators found, sensation-seeking. Risk takers tend to not be overly analytical and deliberative about the risks they're taking. The findings also suggest that risk takers are not highly disciplined and rule-governed. Interestingly, however, the researchers report that financial risk taking is also negatively correlated with "impulsiveness". What are we to make of these seemingly contradictory findings?

Good research leads to new hypotheses; it doesn't just provide data regarding old ones. This is a great case in point. My hypothesis, were I to follow up this line of investigation, is that the category of financial risk-takers is actually mixing together two types of decision-makers;

1) Impulsive Sensation-Seekers - These are the undisciplined gamblers who trade because they like the action and risk. They are not prone to deliberation and have little interest in aesthetics or ideas. I would predict that these market participants would be unusually prone to blow ups and negative returns over time.

2) Entrepreneurial Idea-Generators - The research found that one of the two trait facets associated with financial risk assumption was "ideas". The entrepreneurial trader is one who derives particular interest and satisfaction from idea generation (developing views on markets, building trading systems) and, out of a commitment to those ideas, is willing to assume risk. We would expect these participants to be more disciplined and, to the degree that they are actually skilled in their idea-building, more successful in their trading and investment outcomes.

This is why, in the recent post, I emphasized that "financial risk-taking is aided by the ability to generate novel ideas." The entrepreneur is not going to be satisfied by applying old ideas; nor will he or she want to simply mimic the holy grails offered by self-appointed gurus. Rather, it is novelty--the ability to see markets uniquely and creatively--that lies at the heart of the entrepreneur's ability to generate the ideas that inspire risk-taking.

This distinction between the "gambler" and the "entrepreneur" helps explain why the capacity for risk-taking is associated both with great blowups and with great career success among traders and portfolio managers. Depression is negatively associated with risk-taking, because depressed individuals can neither muster the drive to gamble nor the optimism to generate and back one's own ideas. Discipline and risk management are important components of trading success, but if the entrepreneurial hypothesis is correct, the ultimate source of success among market participants is the ability to see what others don't and act decisively upon those perceptions.


Beanieville said...

Excellent post!

Marc said...

Hi Brett,

A while back you wrote that those traders who are emotionally involved tend to do better because they are more motivated to improve. How do you distinguish between emotions as motivation and emotions as hedonistic pleasure seeking traits? It seems we all seek pleasure in one form or another.

As a parallel, I found that having had my share of failed romantic relationships, those that were the most exciting (at times) also had the most drama. Yet they also lacked a certain depth. The trades that I remember the most are the ones that had the highest drama (ie. entering an option order for 1000 contracts instead of 1000 shares! or clicking "place order" without reading the screen and buying the wrong thing, etc)

I like to find that balance between trading on the edge and putting everything in a savings account. It's not always easy.

Sorry for the ramble.


Bryan said...

Very interesting. I'm glad that you not only outlined the puzzle but were also able to provide some good possible solutions. I was a bit worried there for a minute that I was a just a sensation seeker.

Dr Bruce Hong said...

Nicely done. My criticism with the article that you cited was that they took a cohort of "traders" and found certain traits. But they did not look to see how those traits correlated with trading effectiveness. The psychologist in that study didn't seem to know much about trading, and the economist, as economists tend to do, lumped them all together. After all, it is the economists to came up with, and persist in defending the "efficient market hypothesis" even though there is ample evidence (the tech bubble, the housing bubble, the current financial crisis, Long Term Capital Management - I could go on an on) that we humans do not efficiently price in all the relevant market information.

So in this case, they lumped together a group of people without any interest in identifying trading effectiveness, trading styles or strategies, time horizons (weeks or months if they are trading stocks, options or bonds, versus minutes, if they are trading index funds or FOREX) or whether they were using one-tailed strategies versus hedging strategies.

That's why their results were internally contradictory. I maintained that discipline was an essential characteristic of THE SUCCESSFUL trader. And you answered that point very nicely.

ken said...

Dr Brett: Thanks for all you do, you give a gift of great service to fellow traders. I was thinking of Buffett's blend of risk-taking and measured decision-making today while I was reading your essay, and was observing the following:

Trim Tabs reports an extraordinary panic selloff by the masses in September, driven by fear. Banks are collapsing left and right. The public is outraged by their ostrich-like elected leaders in the House and Senate and pressure the Congress into aborting a terribly framed corporate welfare/bailout bill. Market volatility, as measured by Average True range %, is at historically high levels. Buffett himself says he has never seen as much fear in the market in his adult lifetime (which shows how well calibrated is his market sense). Soros is floating white papers for alternate rescue plans to sympathetic members of Congress.

Certainly these are extraordinary times. And yet it is precisely at this time that Buffett's true genius for decision-making under staress comes to the fore. He carefully weighs and mesures with his unerring eye for risk adjusted value, and makes an excellent play to buy an interest in the Goldman Sachs brand under truly favorable conditions.

Now today he makes a play to add a sizeable chunk of GE, another great brand, to his portfolio.

He was able to do this because of the large cash position he had carefully developed over the past several years when he frankly observed that there werent many, if any, good values out there. He even was venturing into China and emerging markets in search of value. We probably won't read much about the downside of those poorly timed moves, but this looks like an important policy statement from Uncle Warren about the relative state of the US markets.