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.