Fri/20.09.2019 04:17


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A discussion of risk, intelligence and trading (3 parts)

Part 3 of 3 

If you want to read part 1, please click here...

If you want to read part 2, please click here...

If only a small percentage of people are risk-intelligent, would you agree that systematizing at least the probability estimation process (and therefore investment process) is a better solution?

For most people, I would say very much so. I think that unless you’ve got the time, resources, skill and energy to become really good at being highly risk intelligent in one particular domain, most of the time you would be better off following a robust process.

Do you think in general that most people are too risk averse and should embrace risk more?

For risk intelligence, you can objectively measure people who are better at estimating probabilities but with risk appetite, it ultimately comes down to personal preference. It doesn’t mean it’s better but I, for example, am ‘risk-loving’ but I find it sad when I see people who are so risk averse they are never willing to try or do anything new. It also depends on the circumstances. You often find that more risk-averse people can make better investors in a mundane market whereas someone who is more of a risk taker is probably more likely to profit from a crash or a raging bull market. But some prominent risk-takers in history such as Livermore or Paulson have made more money on the way down, perhaps because the market has a gravitational human characteristic.

What would you say is more damaging as a trader; overconfidence or under-confidence?

They are both equally damaging and will make you less profitable but as a matter of empirical fact, overconfidence is just far more common. So, given that it’s more common you should be more worried about it. Polar Bears and cars are probably equally dangerous to humans but which are most people worried about?!

In one of your other books on emotional intelligence, you were critical of the idolization of supposedly un-emotional characters such as Star Trek’s Dr Spock. Would you therefore disagree that un-emotional, logical people are better speculators than more emotional or emotionally intelligent people?

Well, at the time I was criticizing the view that the best decision maker would be someone completely devoid of emotion but that’s a bit of a straw man because the sort of emotionless Dr Spock character doesn’t exist. There are situations where it’s useful to have emotions but, having said that, one of the characteristics of good investors and gamblers is they can put emotions to one side when they need to. Good gamblers are cold and emotionless at times and do this naturally when they really need to. If you think about the process of a good speculative decision, you need to take two factors into account; 1) the numeric probability and 2) the expected value. In a way you need to multiply them together. When you’re assessing the probability (number 1), you need to be as emotion-less as possible about the cold hard facts, hence why systematizing this part can solve the problem most people have in this regard. However when you’re considering number 2, the monetary award, you need to work out how important that is to you and how it would make you feel if it worked out in your favour.

Given that on the risk-intelligence test you have in your book and on your website (, if you assigned a 50% probability to every question, you’d emerge perfectly calibrated. Does that suggest that your probability estimates should always be relatively constant?

Not necessarily because you can “game” the test that way. But we can measure how often people use intermediate categories such as 10/20/30/40/60/70/80/90% etc and we give people a point each time they use those intermediate categories, whereas every time they use 0/50/100% they get zero so that forms an index of how reliable their risk intelligence score is. So you can score 100 but get a K score that is very low so you can say that someone has scored well on the test but their risk intelligence isn’t necessarily reliable. On the other hand, if you scored 80 on the test and had a K score of 35-40, that would be very impressive as it forms a much more reliable guide to how risk-intelligent that person is likely to be. If you’re making predictions about geopolitics, assigning a 50% probability on a civil war for example, that wouldn’t really help us prioritise our resources very effectively!

How would you say most traders and speculators can improve their risk intelligence and get closer to this optimum frontier?

I have to say a logical process and plan is vital. Track progress, write down your numeric probability estimates and then monitor how they played out. Score yourself. There is even a spreadsheet that you can download for free from my website so that you can make up your own risk intelligence test and base it on your investment strategy. Keep a trading diary, write down your estimates and then review your performance. By doing this on a regular basis, you can become better at estimating probabilities and hopefully therefore trading as a result.

I quote from the book “By transforming low probability events into complete certainties, especially when the events are particularly scary, worst-case thinking leads to terrible decision-making”. Can you elaborate on this and relate it to trading?

This is the Cheney doctrine where he stated that even if there’s only a 1% chance that Iraq is going to acquire nuclear weapons, we’d better regard it as a 100% chance for the purposes of our reaction which is ludicrous. I think far too many people hugely oversize their bets on a worst case or best case scenario whether it’s a horse winning a race or a view on where the stock market will end up 12 months down the line. Basing your decisions, whether it be a bet, investment or anything else, worst-case scenarios are just as damaging as best case scenarios. It is far better to make a variety of scenarios and assign a numeric probability to each event occurring.

Thank you for the interview!

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