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Behavioral economists love to pose the following problem.
Please choose from the following selections:
A. a sure gain of $240
B. 25% chance to gain $1,000 and 75% chance to gain nothing
C. a sure loss of $760
D. 75% chance to lose $1,000 and 25% chance to lose nothing.
Given those choices the majority of people inevitably prefer choice A and choice D and economists inform us with supercilious delight at the stupidity of our selection and further pontificate that human beings are more risk averse than profit seeking. All of those conclusions are of course true, but they also miss the point.
The experiment, as set up, is almost certain to elicit the wrong answers. Why? Because of context. Very few people when given those choices think in terms of multiple samples. In decision one for example most people imagine a one time choice to either collect $240 or gamble on the prospect of making $250. Given those constraints of course you would choose A.
Indeed even the great Warren Buffett once remarked that,”I’d rather be certain of a good return than hopeful of a great one.” Most of us just don’t view life as multiple series of attempts. We believe (whether true or not) that we only have a couple shots to get things right and under those conditions the idiots are not us, but the pointy headed academics who have no idea how real people think.
But don’t pat yourself on the back just yet. When it comes to statistics we regular folk, are just as prone to making dumb decisions due to context.
The most common question I get from retail traders is – how can I double my speculative capital? Imagine you are typical retail trader and you have $10,000 of risk money that you would like to put to work in the market. You can afford to lose it, but of course what would really like to do is to double it in one years time.
Now in a world where a great trading return is 20% per annum you are not not going to get rich quick by playing it safe. Instead you use leverage (let’s assume 10X – a woefully conservative factor for most retail FX traders but I will give you the benefit of doubt). At 10X lever factor a -5% drawdown will cut your account by -50% and a -5% drawdown is almost assured over the course of the year. In fact at 10X lever factor your chances of getting fully wiped out are probably close to 90%.
But hey that’s ok. That was your risk capital. You come back next year and try to do the same thing. Let’s suppose that you do this for a decade and perhaps if you are super lucky two out of ten year you actually manage to double your money. At the end of the decade your “investment” of $100,000 would be worth only $60,000.
But what if you traded unlevered and added $10,000 each year and only managed to eke out a measly 5% annual return? Guess what. That $100,000 investment would be worth more than $130,000 and you would have tripled the initial $10,000 stake.
It’s all about how you perceive the problem. Doubling $10,000 is easy, if you have 10 years to do it :).