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Who is more likely to be a successful trader? A risk taker, or a risk averse person?
Are you more likely to be a leader vs follower if you fall into one of the risk categories? If so which one? For example, if you are a risk taker does that automatically make you a leader? And if you are risk averse, does that automatically make you a follower?
Who is more likely to be a successful trader? A leader or a follower?
Neither. Willingness to take risk has nearly nothing to do with success as a trader in my opinion. Let's give you two scenarios (the events stated below are mutually exclusive, so the probability sums to 1). If you had to choose one of the two, which would you pick?
(A1) 1/3 chance of winning $300,000. 2/3 chance of losing $700,000.
(A2) 1/3 chance of winning $333,333. 2/3 chance of losing $666,667.
Most people would pick A2. This is quite obvious so you're going to start wondering if there's any point in even asking this, but bear with me and trust me there is. So let's start making this more interesting... which would you choose?
(B1) 1/3 chance of winning $1,000,000. 2/3 chance of winning $0.
(B2) 100% chance of winning $300,000.
Now people start to falter a little. But most people will pick B2. It's said that people find it difficult to deal with probability or uncertainty, or that there's a divide between risk-taking and risk-aversion. Untrue: everyone has a similar risk valuation, they just take different paths and amount of times to arrive at the same conclusions. You could argue that you pay a large risk premium in B1, so the stakes should be higher to compensate for it. The more discerning eye would probably reason that in a continued run, the maximum drawdown on B2 is $0, or that the Sharpe ratio is infinite... Right, how about:
(C1) 1/3 chance of winning $1,000,000. 2/3 chance of winning $0.
(C2) 100% chance of winning $1.
How many of you prefer zero drawdown, i.e. C2, now? What happens as we're lowering the stakes on the second choice? Most of you will still prefer the zero drawdown, sure-winning option for $299,999, $299,998... My point is that the risk valuations still have the same aggregate behavior, and the market is very efficient - most people know when and how to take a calculated risk, whether you're the world's best expert on drawdown analysis or just plain Joe like @artemiso. The divide between risk aversion and risk-taking is very, very small, and hardly discernible. I promised things would get more unusual. Now choose:
(D1) 100% chance of losing $666,667.
(D2) 2/3 chance of losing $1,000,000, 1/3 chance of losing $0.
Now, all you risk-takers will start showing up... people are more willing to take a bet to avoid a loss than to take a bet for an expected profit. And even more unusual....
(A1 = B2 + D2) 1/3 chance of winning $300,000. 2/3 chance of losing $700,000.
(A2 = B1 + D1) 1/3 chance of winning $333,333. 2/3 chance of losing $666,667.
It seems that most of you would pick B2 and D2, yet started off choosing A2... i.e. People easily fail even if they were presented with obvious choices to diversify their risk. And even more unusual....
(E1) I'm going to randomly draw a ball from an opaque box, containing 5 red balls and 5 black balls. You get to choose to win $1,000 if I drew a red ball, but lose $250 if I drew a black ball. Would you take this trade?
Again, all of you know this is a great opportunity and would go for it. Most of us can afford $250 for a shot at such a wonderful setup, so "risk of ruin" is out of the topic. Right. How about...
(E2) I'm going to randomly draw a ball from an opaque box, containing 10 balls that are each either red or black. You get to choose to win $1,000 if I drew a ball of your choice of color, but lose $250 if I drew a ball of the other color. Would you take this trade?
I just want to end off by saying that the {E2 - E1} is the space that, in my opinion, separates a successful trader and an unsuccessful one.
So personality type such as risk taker or risk averse has nothing to do with traders that wait for "confirmation" or traders unable to make a decision?
So from a personality point of view, does the constant obsession and focus on win percentage instead of focus on actual risk have to do with being a risk taker versus being risk averse?
I think I understand where you're coming from. In this case, I'd make a more general statement that the effects of your risk appetite is asymmetric: it can hurt you (make you 'unsuccessful'), but it cannot benefit you (make you 'successful').
The topic is really about what kind of qualities are desirable, and I think that depends on the type of activity you're involved in. There are many types of activities where risk aversion becomes almost completely inconsequential. Speaking from my own perspective, if I used the traditional 'risk-to-reward' or 'mean-variance' concept, I'd be risking something like 250 for every 1. I find that this is extremely fun and exciting - despite this, I'm probably the most risk-averse person that I know of. Since risk aversion is inconsequential (or at least that's my judgment), the people I look to employ are the ones who pay plenty of attention to detail, and are able to dissociate money from numbers.
interesting question. Sort of like are you a trend follower or a contrarian. Or does the tortoise win more races than the hare.
I think both are about equal as long they define the risk and take steps to ensure that the maximum possible risk (worst case scenario) doesn't wipe them out.
@artemiso, so the balls in E2 are randomly colored red or black, right?
Are you saying then, that the successful trader is such because he can deal with unknown input variables, because he is willing to make a choice of the color, or a combination of the two?
They could be colored in any way. Maybe I know your preference for red and skewed them towards all black to put you at disadvantage. Maybe it is random.
E1 and E2 actually yield the same expectation value, but most people are either ignorant of this or believe that they are put at a disadvantage and so avoid E2. My point is that risk is well-quantified. That's what actuaries are for. They are paid to take risk. And they don't make much. E1 has risk and positive expectation - they will take it. But E2 has something about it that separates a quant from an actuary. So the choice of taking more or less risk is inconsequential.
There are many ways to reach this conclusion. Another means is to observe that the SML guarantees no increase in alpha no matter how you adjust your beta or sigma.
@artemiso: Fixed-fractional betting is a way to maximize the growth of your account. Let us assume that you have put some capital aside, which you want to use as a stake to engage in favourable bets.
Would you take this bet, which is based on a simple Bernoulli distribution?
-> With a probability of 1/3 you will obtain a return of + 50% on your capital invested
-> With a probability of 2/3 you will make a loss of - 20% on your capital invested
