Why Traders Need To Focus on Asymmetric Returns 2
Understanding how to go about making asymmetric returns is simple enough, but actually being able to do it is not.
Since no one knows with certainty beforehand whether or not a trade will be profitable, much less be able to produce significant returns, one has to treat every trading opportunity as if it can.
This means that within whichever framework traders use to identify asymmetric trading opportunities (trend following, distressed debt investing, etc.), they have to be prepared to take losses.
Of course, this necessitates disciplined risk management, in order to keep the losses small enough so as to not limit their ability to make it all back when they do hit their asymmetric trade.
However, incurring many small losses is emotionally exhausting, and most traders give up and either stop trading, or change strategies before they ever hit a trade that produces asymmetric returns.
In addition, human traders are also susceptible to the disposition effect. This results in them exiting their winning positions too early, while letting their losing ones run for too long – the exact opposite of what they need to do when trading for asymmetric returns.
Sir Isaac Newton provides us with an excellent example of such behavior.
As the South Sea Bubble was inflating to epic proportions in 1720, Newton took the opportunity to sell off some of his holdings, and made a fortune in doing so. However, as the bubble kept growing larger, Newton got swept up in the market euphoria and went back into the market to buy more shares.
Unfortunately for him, prices turned down soon after (turns out he bought the high), then proceeded to plummet.
Instead of selling his now heavily loss-making position, he held on to them, and even bought more shares as prices fell (although not for himself, but for an estate of which he was an executor). As a result, Newton ended up losing a lot of money – the fortune he had made on South Sea stock previously, plus more.
From this anecdote, we can see that when Newton first sold his South Sea position, he was doing so too early, i.e. not letting his winners run. And, when the bubble began to burst, he held on to his losses for too long, instead of cutting them short.
In other words, one of the world’s greatest minds succumbed to the disposition effect, and it cost him dearly.
Intelligence clearly isn’t all that is needed to succeed in the field of trading and investing. Understanding oneself, and the nature of asymmetric returns are just as important.
To be continued…
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