Caveat… The inlaws have taken Rockstar off my hands and they stock Nescafe 3-in-1 in the house… Welcome to the World of What Happens When Aileen ODs On Caffeine And Sugar…
In another life, I opened product presentations to Relationship Managers (RMs) with, “I can create a 1 year 100% principal protected product that could pay 1,000% return (no cap) on your client’s investment.”
How?
Place the client’s money in 1 year fixed deposit with a bank. With the fixed deposit interest, buy a lottery ticket.
The catch, of course, is the probability of getting that massive payout. Most people prefer the high probability of small gains to the low probability of massive gains.
In psychologist Walter Mischel’s study performed on 6 year olds, the children could ring a bell when they wished for a small cookie, or they could wait til the experimenter came in the next 20 mins and rewarded their wait with a large cookie.
Guess which was harder?
Couldn’t find the cookie video but here is a cute marshmallow one (you will get the idea):
[youtube http://www.youtube.com/watch?v=6EjJsPylEOY]
The study was to illustrate the beginnings of self control and discipline. 6 year olds sitting on their hands, singing to themselves, intently examining the bell, anything to keep themselves from caving and taking the smaller cookie. Not that different from us parents.
Nassim Taleb, author of The Black Swan and Fooled By Randomness, is….. a guy whose books I try to display impressively on my bookshelves because they make me look smart. (Ok, not really.) He runs Empirica, a hedgefund that buys cheap out-of-the-money options, betting on the low probability of making massive gains. (Except his team of PhDs number crunch to increase their odds of picking the right lottery and ticket and make sure they don’t pay too much for it.)
No brainer? Buying options limits your loss to the amount you spent on the option, selling options exposes you to unlimited potential loss?
Try watching truckloads of options you bought expire worthless (slow bleed) 364 days in a year, hoping to make it all back and much more 1 or 2 days a year. Every instinct is telling you to flee. Or do the opposite – sell options for instant gratification, ignoring the possibility that a plane might plough into the World Trade Center and blow up your entire trading position. It’s also why Mr Taleb of the slow bleed, when watched closely, displays the toll steady losses and working against your natural instincts (albeit number crunching can prove said instincts wrong) can take – by purportedly developing a dislike for Mahler (which was playing when his fund lost money), parking in the same lot during winning streaks, and various other superstitious tics.
In other words, it’s why markets teach us to pray.
You can do everything right, and someone could still drive a plane into a tall building.
And it doesn’t even have to be a plane.
Smallpox has been eradicated for the last I don’t know, 50 years? No one has an immunity anymore – to smallpox, or any other number of diseases we wiped out of circulation decades ago…
A little rubber cap on the top of a test tube in a lab somewhere, slowly being eroded by time…
Then there’s when you find the options you want too “expensive” to shell out for. So then you figure you can cheapen that by selling a few options of your own.
Maybe you’ve heard of a certain investment product that fits that description?
They’re called Accumulators.
(If you didn’t get that, accumulators killed a lot of investors few years ago – because in order to afford the relatively expensive (ie attractive) options of buying stocks or currencies at a cheaper-than-market price, you had to sell options that required you buy the same stock/currency if the market instead tanked.
But that’s not all. Pre latest crisis, people believed the market was going up and up. Options that bet on the market going up and up therefore cost a lot more than the ones betting the market would go down – in other words, you had to sell a lot more options than buy, to afford some accumulator structures. Which means if you were wrong, you lost money twice, thrice as fast as the attractive options you bought would earn you.
Guess what happened, last financial crisis?)
Economist Eugene Fama once concluded that if you charted the ups and downs of the stock market in a normal distribution, it would have a “fat tail”. In an ordinary normal distribution, a “really big jump” is something like every 7,000 years. In the real life stock market however, he observed jumps of that magnitude every 3 or 4 years.
Why?
Investors are nuts. They don’t behave in any kind of “statisticial orderliness”. When it’s their money at stake, they change their mind. Get greedy. Copy each other. Panic. Do stupid stuff. There’s a reason they coin the phrase “the stock market can remain irrational longer than you can remain liquid.”
Am I just high, or can today’s parents, so emotionally invested in their children, be as tempted to behave in that way?
It’s also a good argument to pray for your children, and to teach them to pray.
Another – probably better way – to answer Fama’s question is that the assumption of normality is wrong. Lots of things in the financial, economical and natural world don’t follow a normal distribution. The primary reason for assumption of normality is it makes most calculations easy. Maybe it’s an argument to teach the children to learn financial mathematics and avoid gambling on the markets?
Or teach them to avoid jobs that require selling kinky financial products, and to listen to people in those jobs with a pinch of salt because they talk rubbish…oh no, does this mean don’t listen to mummy & daddy?
Anatomy – thanks for your comments, really appreciate.
HWL – very funny. I love derivatives. Must respond further in a later post!
The thing about statistics and derivatives pricing models is there is no way to factor in the human element. Some of the best vanilla traders I know are very un-quant. They don’t even have to be very “smart”. Instead, they have memories like elephants – “last time the economic data released was this, other traders did that.” And they are very in tune with how other traders behave.
But the point was, when it was money at stake, people behaved nuts. How much more would they be tempted to do a nutty, when it’s to do with their children.