Betting The House On One Trade

By: ispeculatornew
Date posted: 11.07.2011 (5:00 am) | Write a Comment  (0 Comments)

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A couple of years ago, I read an interesting piece about a guy from Britain who decided to go all in. Not all in as in betting whatever he had in his pockets. Rather, I mean that the guy had sold his car, his house, his clothes and everything that he owned which ended up being in the six figures from what I can remember. All for what? To go to Vegas, wearing rented clothes and put everything on a single roulette game.  Crazy? Stupid? Brave? You could probably argue that he’s a bit of all of those and probably a lot other things. Fact is that for most of us (at least for me!!), going all in is not something we seriously consider.

That being said, it’s a common temptation for smaller, medium and big traders or investors. You start by investing using a method that usually includes some level of diversification. Whatever your trading method, there usually is something that prevents you from going all in. For dividend investing it’s all about having sector diversification and holding 10 to 20 different dividend stocks. In my long and short technology stock picks, it’s about having only 20% of the portfolio in one given trade and using a stop loss on each position. All of these rules serve two main purposes; capital preservation but also risk/return optimization.

The “Ah-Ha Moment”

It happens to each and everyone. At one point, you get a temptation to break those rules. To go a bit bigger. Several reasons explain such a behavior.

For some, it’s a feeling of desperation. After losing on a few different trades, some become desperate enough to make one big bet in an attempt to win back all of those losses in one single trade.

Conviction: For others, it’s about being certain. Sometimes it’s because they know something or they think that they do. Think that this mining company just found gold and is about to disclose it taking all of its shareholders to being millionaires? Sometimes a neighbour, in-law or a good “friend” will give you free stock

Nothing To Lose: While it has lasted for decades and led many to achieve incredible returns, the compensation structure for hedge funds creates an environment where some managers have nothing to lose. Why? Suppose you manage a fund of $100 million and you will get paid in the following way; 1+20. What does that mean? It means being paid 1% of assets under management and 20% of the performance over a certain treshhold. For simplicity purposes, let’s call that benchmark 5%. Let’s suppose that the manager has costs of $600,000 associated with running his business (trading, back office, systems, etc).

Example #1 – The manager takes a low risk approach that will return 7% on average

Compensation would be: $100M x 1% + $100M x (7%-5%) x 20% = $1,4M
Profits = $1,4M – $600,000 = $800,000

That is certainly a great compensation and he would likely be more than happy to take that home. However, if instead he took a higher risk approach, one that would return -10% 3 times out of 4 but would return 30% on the other occurrence. The average return of this strategy is clearly inferior. Why? The average return is 0%!! However, let’s look at his compensation:

3 out of 4 times the manager would earn : $100M x 1% + $0 = $1M
Profits = $1M – $600,000 = $400,000

1 out of 4 times the manager would earn: $100M x 1% + $100M x (30%-5%) x 20% = $6,0M
Profits = $6M – $600,000 = $5,400,000

Average expected return = $1.65M (more than double!)

As you can see, this manager has short term interests that are very different from his client’s. In fact, he has a lot more to gain by having a lot more risk in his portfolio if he wants to go for a “home run”.

Enter Man Financial

You might have heard about Jon Corzine in recent days, the once Goldman Sachs co-chairman who was also Governor of the State of New Jersey became CEO of Man Financial Global, one of the largest futures brokers in the world, that was active all around the globe. Man’s business was mostly about being a platform for clients to trade futures but at some point, that vision changed and the Corzine led company started making big bets on European bonds. They were buying the bonds figuring that the market was foolish to believe in any type of sovereign risk on these bonds. The ECB would come to rescue if needed right? It’s unclear how much of that belief was that these assets were truly misunderstood by investors or if it was simply about taking a risky bet to make quick profits. In any case, what could have been just a very bad bet turned out to be enough to cause Man to collapse last week. How in the world do large institutions, especially in this post-Bear/Lehman world still risk enough on one type of bet to go down if that bet turns out to be wrong? How is that even possible?

Have You Ever Gone All-In?

I personally have sometimes briefly broken some of my own trading rules which I always discuss on here but have been much better about that and I can’t imagine how someone could take so much risks with their personal investments. Can someone help me on this?

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