Finance seems designed to maximize feelings of regret at every turn. If you buy a stock and it goes down, why did you buy it? If you buy a stock and it goes up, why didn’t you buy more? And all that’s before you even exit the position. Given these feelings, winning can seem out of reach.
What would a “win” look like? You leverage and borrow everything you own, put it all on at the bottom, liquidate at the top, and watch with glee and schadenfreude as the market tanks afterwards. Now, what do you do with your winnings? If you retire, you’ll always know you could have had even more if you had only done it again.
It might seem impossible to win. But it is possible to lose less.
Losing is easy to imagine. You’re broke. You’re so broke that you can never trade again. You’ve rolled the ultimate gutter ball and there’s no way to crawl back onto the lane.
One goal of finance might be to avoid bankruptcy, so you can stay in the game. This means that the most important thing to think about isn’t how good life will be if one of your forecasts turns out right, but how viable you will still be if a lot of your forecasts turn out wrong. It’s not the alpha that matters, but the risk.
Finance can be thought of as the study of risk, much as biology is the study of life or physics is the study of matter. But that’s not how most people treat it. Too often, finance is far more concerned with alpha than risk. That would be like biology focusing exclusively on births over deaths, leaving little room for adaptive selection through genetic mutation. Or physics focusing only on the big shiny dots in the sky and ignoring the tiny quantum magic. In all these cases, it’s a mistake to focus only on your dreams and ignore the monsters lurking under your bed.
Biology and physics went centuries without what we’d now consider their foundational theories of evolution and quantum mechanics. Finance hasn’t been around as long, but it may provide the clearest picture out of all three disciplines of why it’s so critical to focus on the imagination of the bad over the imagination of the good. There’s a sad, simple truth about any good alpha, about any trading strategy that offers an attractive average return: add enough risk and you’ll start to lose money.
Consider a strategy that alternately makes 35%, then loses 30%. Over two periods, its average return is 5%, or 2.5% per period. And yet the amount of money you have at the end is less than what you started with! This is because 135% times 70% is only 94.5%. Instead of being up 5% after two years as you might expect, you’re actually down 5%. It’s hard to imagine a starker example of the primacy of risk management in finance.
Which superpower would you rather have: the ability to find alpha or the ability to manage risk? Remember, the genie is a wily demon and will try to surreptitiously outwit you without revealing himself to the world. If you pick the alpha superpower, all the genie has to do is raise the risk to defeat you. That’s fairly easy to do and perhaps no one would notice anything except you and your shrinking wallet. But if your superpower is risk management, all you need to do is find any positive alpha, and then manage the risk to ensure positive compound returns. What could the genie do? Make all alphas negative? Then you’d just reverse the trade and risk manage that. Make all alphas zero? That would be too noticeable. All markets would cease and all assets would earn the same risk-free rate. No, if you choose the second superpower, the genie would have little choice but to stomp his little genie feet in frustration for a little while, then ultimately concede and nod at you, his worthy opponent, with reluctant appreciation.
Alphas are a fickle art form. Risk management is a robust science. As a bonus, it also turns regret upside down. If you bought a stock and it went down, as long as you’re managing your risk properly, you should feel no more regret than a dancer who takes two steps forward and one step back. And if you bought only a little bit of the stock and it went up, you should feel no more regret than a race car driver who slowed down to safely take a turn.
Chasing alpha can bring tears. Managing risk can bring peace.
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