Condor Options

Dr. Brett is writing a series on the personality traits associated with risk-taking (as examined in some academic research), and in his second post, he reports on a trait that might not immediately jump to mind when you think about risk:

2) Entrepreneurial Idea-Generators – The research found that one of the two trait facets associated with financial risk assumption was “ideas”. The entrepreneurial trader is one who derives particular interest and satisfaction from idea generation (developing views on markets, building trading systems) and, out of a commitment to those ideas, is willing to assume risk. We would expect these participants to be more disciplined and, to the degree that they are actually skilled in their idea-building, more successful in their trading and investment outcomes.

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This distinction between the “gambler” and the “entrepreneur” helps explain why the capacity for risk-taking is associated both with great blowups and with great career success among traders and portfolio managers.

There are at least three personalities discussed in this post: the gambler, who takes on risk in an undisciplined way for the pure stimulation of it; the depressive, who lacks the optimism and creativity to generate and pursue new ideas, and the entrepreneur, who is able to generate novel strategies but is also disciplined enough to carry them out successfully.

Beta vs Alpha vs Human Nature

Recall that, in finance, beta refers to the correlation between the returns of a given strategy or portfolio and the returns of the market as a whole.  A portfolio with a beta of one will move in step with the market.  A beta of zero indicates that the portfolio’s returns are independent, while a beta above 1 indicates that the portfolio is actually more volatile than the market.  Beta is easy to achieve: any broad index fund will have a beta of 1, or something close enough.

Alpha, by contrast, refers to the excess return of a given strategy or portfolio as measured against its benchmark.  Their claim to be able to generate significant alpha – that is, to produce returns far in excess of what the market naturally achieves – is the justification that drove so many investors into the arms of hedge funds.  Alpha is just one of several ways to measure risk-adjusted returns – r-squared and Sharpe ratios are also important – and they all help determine whether a strategy or portfolio is achieving the goal of returns in excess of and independent from the market average.

But consistently generating new ideas is hard.  This is the fact that Steenbarger is honing in on.  There will never be a shortage of traders who dazzle themselves with the speed and intensity of market action, and who don’t hesitate to take on enough risk to make even the Lehman risk management desk blush.  It is easy to be undisciplined, emotion-driven, and to depend on the stimulation of winning and losing (painful losses, after all, do provide a unique sort of stimulation; de Sade was on to something).   And, of course, the alternative to undisciplined risk taking is usually just disciplined avoidance of risk – dumping it all into index funds and walking away, for instance.  That’s a reasonable approach for most investors, but it’s not a successful approach to trading, unless you define success as “beta=1, r-squared=100.”

So the three personalities seem to break down like this:

• gambler: undisciplined risk-taking
• entrepreneur: disciplined risk-taking
• depressive: disciplined risk-avoidance

The disciplined risk-taker is clearly the optimal type.  Where do such personality traits come from?

MBA or PhD?

We wonder whether the “entrepreneur” label is the best one.  This is a tiny point, barely worth mentioning, but the kind of education offered in most business programs today seems to offer very thin coverage of the kinds of reasoning skills that make idea-generation (of the sort Steenbarger is talking about) possible.  Friends who soldiered through M.B.A. programs have reported more conformity than creativity, and we wonder whether most putatively entrepreneurial graduates aren’t, in truth, merely the franchisees of other people’s ideas.

Critical thinking can be taught; intellectual discipline can be inculcated.  But any profit-driven educational program will have disincentives to produce students who can think independently.  After all, corporate America requires a steady diet of workers who can do only one or two things, but can do them well – and this seems to be true also in all but the highest levels of medicine and law.  In contrast, the arts & sciences, to the extent they still have any independence from market forces, have a mandate for the formation of persons that reaches farther than the professions, toward seemingly archaic concepts like truth and justice and beauty.

Of course, “entrepreneur” doesn’t necessarily refer to someone with one or more degrees in business.  Some entrepreneurs are just naturals.  But for those of us not blessed with innate genius and creative power, education is necessary, and the best education for success in trading may well come from programs other than business and finance.