Saturday, June 9, 2007

When Is $1,000,000 Worth More Than $1,000,000?

This article will be the first in a continuing series about randomness and luck in the financial markets.

I pose the question, "When Is $1,000,000 Worth More Than $1,000,000?" as I believe it is a good jumping-off point for this discussion.

Let's first consider two people, both who have recently reached retirement age with $1,000,000.00 in the bank. We have a small business owner who managed to save and participate in a retirement plan over the last 20 years of his career, and we have a man who was rear ended by a drunk-driving UPS truck operator. The jury awarded him the prize just as he was hitting retirement age. Both men are in possession of $1,000,000; however, is the money worth more in the hands of the small business owner or the victim of a DUI?

We often hear stories of the men and women who win multi-million dollar lotteries, and are then broke and in great debt within a few years of winning the prize. What is our reaction to those stories? Do we sometimes feel that they deserved to lose the money because they never really deserved to have it in the first place?

Let's examine how this might apply to traders and investors.

Again, lets compare two traders. One averages $1,000,000 per year by using complicated options strategies. These strategies could be described as low-risk; yet, like many low-risk strategies, the rewards will not be absolute and are limited by the strategy. Our second trader can best be described as a gunslinger. He is no stranger to 7 figure returns. He typically seeks out bio-tech companies with drugs in the approval process and puts down a significant portion of his capital as the testing nears completion, betting on a new homerun drug.

Both traders finish the year with $1,000,000; however, is the amount worth more than $1,000,000?

If the option trader were to lose everything (not very likely, as he has quantitatively identifed almost every scenario that could affect his strategies) would we feel any sympathy for him? How about the gunslinger? Would we feel any sympathy for him if he lost his $1,000,000 due to making a bad bet on a company like Dendreon?

Do we unconciously assign more worth to the 7 figures in the hands of the option trader?

Let's go back to our two individuals, the retired small business owner and the DUI victim. The small business owner has proven that he can manage his money. He is likely to leave the money he has saved in an interest bearing account of some sort. The DUI victim has no track record of saving or investing. Before his accident, he believed he may have to work until he was 70. What are the chances that he will be a good steward of his prize awarded by the jury? Which sum is worth more?

Luck and Randomness

It should be clear that in each hypothetical situation we have an individual who arrived at his 7 figure sum by a strategy which is probably able to be repeated across different times as well as different fields. Whether the small business owner was a doctor, or a lawyer, or even a teacher, his strategy of saving and investing is likely to be replicated by many with similar success. However, our DUI victim and our gunslinger have gained their 7 figures through a series of events which can only be described as luck and randomness.

Do we as traders and investors place a value on the method of earning money? Does the method used to earn the prize assign a value on the prize that is higher than its intrinsic worth?

The questions are important to consider. If we often win money in the markets through luck and randomness, are we then more likely to place a lower value on this prize? Does assigning a lower value mean that we are more likely to use high-risk strategies when the capital is deployed? Can we also describe one trader as being "better" than another, even if they earn simliar returns?

As I continue my articles on luck and randomness, we will consider the above questions and begin to explore alternate histories.

Although I've been considering these issues for some time, my thinking has become more solidified on these issues as I read Fooled By Randomness, by Nassim Nicholas Taleb. I will be borrowing some of his ideas and thinking in order to examine luck and randomness. You can find the book under "My Favorite Trading Books" link.

12 comments:

gmak said...

"$1,000,000 Worth More Than $1,000,000?"

Please explain what this means, thanks.

Ducati

Woodshedder said...

Hmmm. Is gmak Ducati? If so, gmak has been answering Ducati's posts on Ducati's site. I will give Ducati the benefit of the doubt that he has not been making posts, and then answering his own posts as someone else.

This issue I've posed here is directly due to some thinking that has been sparked from discussions on Ducati's site. I'll write more when the kids get in bed.

Anonymous said...

Does gmak stand for Grant Macdonald, Ducati's name?

ShortDaBull said...

if it's converted to any other currency it'll be worth more than 1,000,000 USD the next day. :-)

Cruxmonger said...

HAHA!!! That's pretty funny, shortdabull! The USD is going down faster than some San Diego St. hoochie on the illustrious danny, who did a nice job on Fly's site this weekend. I digress.....I'm intersted in your upcoming post, 'shed. I think it's going to be "the feel good story of the summer!"

Broker A said...

Ducati is a transvestite and his nick is gmak, too.

ShortDaBull said...

great post woody.

The gunslinger mentality is just gambling really so it has its own highs and lows, feelings wise.

The option trader thing is real trading and thus doesn't have the highs and lows, feelings wise. just a strategy.

A gunslinger when faced with a big loss will try to double up or do something without even thinking, the loss will effect him greatly and rattle him.

The option trader will not get rattled because a) he didn't lose big, b) he followed his strategy c) he accepts losses as part of trading.

in this scenario you posed, the gunslinger will have a drawdown so big one year that he'll be wiped out. The options trader will never allow himself to suffer such as loss.

So yeah, the gunslinger's $1,000,000 is just a ticking time bomb and the options trader's million is wealth accumulation.

Brent said...

I just got done reading "The Operator", a biography on David Geffen. If you have not read this, get it, it is absolutely one of the best books you will ever read. Geffen is one crazy,ruthless, and smart "Homo". Guy was and is behind everything in Hollywood.

Dinosaur Trader said...

Great post, Wood.

I haven't read a new market book in awhile, but that Taleb book sounds interesting.

As for your question about the million bucks, I kind of think that once someone banks the money, a million is million despite how it was earned.

-DT

Isalex/Gmak said...

Dear Woodshedder:

I can assure you than I am a distinct individual. It is an unhappy coincidence that Ducati's name has the same initial and beginning of last name as mine. Further, I find it slightly disturbing that he chose to use "Gmak" as the name for his post.

Obivously, I will have to use another name.

I hope that Ducati is not being malicious but simply trying to keep "ownership" of what he perceives as an id that belongs to him.

Regards,
Graham.

grant said...

wood-

Interesting post. The analogy however is not comparable. The winner of the $1M insurance payout had an isolated single occurance.

The gunslinger trader however has I assume more than one trade. The more trades that he has, the greater will be the data accruing with which to base a judgement.

If there are enough trades, you might even get a statistical result. Failing that you could run a Monte Carlo analysis on his strategy to gain some insight.

Next topic.

Some bizzare people visit your site claiming to be people they obviously are not.

I have never signed myself "Ducati" if I used an alias to sign, it was always "d998".

However, I just use my own name.

jog on
grant

Woodshedder said...

Ducati- you misread and/or didn't understand. I did not compare the gunslinger with the guy who won the insurance settlement.

The point was to provoke thought about whether money earned through luck/chance vs. skill has a difference in perceived value.