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.