What role do randomness and luck play in investing? When we venture into the financial markets, we need to factor random events out of our investment strategy. We need to break certain myths about high returns sustained over time, because in investing, a high return always comes with higher risk.
Often, a high return on the stock market isn’t the result of our great investing skills, but of the reckless way we invest. The opposite would be to invest with discipline and, even if we earn less, keep risk under control. In other words, it’s about keeping your head when other investors are losing theirs.
That’s why today we’re telling the story of two traders, Nero and John, a story every investor should keep in mind.
Luck and randomness in financial market investing
This story was told by Nassim Nicholas Taleb in his fantastic book Fooled by Randomness, a book that, although it isn’t included among the investing books because it isn’t an investing book, I highly recommend. Nicholas Taleb gives us invaluable investing lessons even though the book’s subject is randomness and chance.
Nero: a smart investor who looks mediocre
Nero had a degree in ancient literature and mathematics from the University of Cambridge and a doctorate in statistics from the University of Chicago.
He started out working in academia, but ended up leaving it for two reasons: literature didn’t pay much, and besides, it was rather boring. After growing tired of writing academic papers, Nero concluded that he needed action.
That’s when he found a trainee position at the Chicago exchange. Thanks to his skills and knowledge of statistics, Nero was soon promoted in the stock market world, getting his own office with the rank of independent trader. From there he moved to New York to work for a brokerage firm.
He specialised in quantitative financial products, where he proved his worth and talent, to the point that he became a professional much in demand by many firms in New York and London. He began to stand out on Wall Street, something that, according to Nicholas Taleb, didn’t really suit Nero’s character. He turned down several job offers with large guaranteed bonuses so that he could carry on in the financial markets away from the stardom he was achieving. Nero was looking for quite the opposite: anonymity.
See also: Safe investments with low returns: alternatives and financial education
In the end, he changed career paths and moved into proprietary trading, where traders receive between 7% and 12% of the profits they generate for the firm. It’s a way of being self-employed without the drawback of having to run your own business. You can set the hours you want, make the decisions you see fit, and so on. In other words, you work for a company but you’re the master of your own life and time, as long as the firm is satisfied with your annual results.
Put simply, this was paradise for an intellectual like Nero.
Nero’s investing style
Nero is an extremely conservative trader with a very high aversion to risk. Although this kind of trader doesn’t seem to fit in on Wall Street, the truth is that they’re the ones who end up achieving steady returns year after year and reach the end of their careers with their heads screwed on, but let’s not get ahead of ourselves.
This trader has the talent and the knowledge needed to outperform any trader on Wall Street. In fact, he may well have passed up the chance to take home bonuses of a couple of million dollars.
For more than a decade, Nero had good years and not-so-good years, but no bad years, and he has been content to earn half a million dollars a year after tax, money he automatically puts into his savings account.
Nero’s worst year for returns, and what came of it
In 1993, Nero stuck with his conservative investment strategy. It was a year in which the other traders had achieved high returns, and this led the firm he worked for to start questioning Nero’s ability as a trader.
This made Nero uncomfortable, and he didn’t hesitate to look for another firm where he could work in exactly the same position, sticking with his highly conservative strategy.
The following year, in 1994, financial markets fell worldwide. The traders who had achieved high returns the year before failed that same year. They even made huge blunders that cost them their jobs and turned them into “pariahs” on Wall Street.
Nero, on the other hand, kept up his usual returns.
Nero’s investing mantra in trading
We need to understand that on Wall Street there are many fund managers and traders who have earned the nickname of legends without really being investing legends (I don’t remember exactly who said this).
See also: How Warren Buffett multiplied his money tenfold in 1963 thanks to the salad oil scandal
When an investing legend triples his colleagues’ returns and the following year costs the firm money, there’s no legend as such, just a reckless trader who took a risk and won once, and then took a risk and lost the next time. Calling it luck would be far more accurate, especially considering that there are traders who keep their returns steady over time. Now that is skill, even if they aren’t considered stock market legends or superstars.
Why doesn’t Nero seek wealth or fame on Wall Street?
First, because Nero’s intellectual ability is far above that of most traders. And his studies in statistics and probability help him understand the stock market business.
If we add his personality and his aversion to risk, let’s say that Nero’s goal isn’t to maximise his profits, but to avoid a move that would put him out of the business.
Failing in the stock market isn’t like failing in other sectors. And by failing we mean what’s known on Wall Street as “blowing up”. When a trader is said to have blown up, it doesn’t just mean he has lost more money than he should have with his investment decisions. It means he has lost more money than expected, more than the firm allowed, to the point of being out of the business. Quite possibly no firm will ever hire him again for the rest of his life.
Nicholas Taleb draws an analogy here. It’s as if a doctor were so reckless that he lost his licence to practise for life.
And unfortunately, on Wall Street many traders end up blowing up. Nero’s strategy and method focus simply on avoiding this.
Part of his investment method is:
- Quickly closing out his position after incurring a set loss.
- Never selling naked options (he avoids leverage with options, since it can lead to huge losses).
- Whatever the event or the chances of profit, never taking a risk that could make him lose more than X amount of money (the amount varies according to the profits accumulated during the year).
- Nero has a high exposure to Treasury bonds, so bear markets in stocks don’t worry him as much as they do other traders.
See also: Investing in emerging markets: investment ideas
This aversion to risk and this conservative investing style stop him from earning as much money as other traders known as the superstars of Wall Street, such as the great John, whom we’ll talk about shortly.
At 39, with more than 14 years in the stock market business, Nero can be considered set for life. His portfolio holds several million dollars in medium-term Treasury bonds, which is more than enough to remove any worries about the future.
He has a stable job that gives him plenty of free time, he’s better paid than many people in other professions, and he sleeps soundly at night because his investments hold up perfectly well through the market’s ups and downs.
What’s more, thanks to his lifestyle and simple tastes, he has personal savings that would let him retire at 40 with enough money to live the rest of his life without having to worry about money.
He owes his financial freedom solely to discipline and method
If we look at these lines closely, we conclude that Nero’s success can’t possibly be down to luck. His success is due solely to discipline.
While other traders lose their heads in bull markets, Nero sticks to his method. When the other traders lose their heads in downturns, Nero carries on with his method.
When Nero has the chance to earn more, he earns the same. When everyone starts losing money, Nero keeps earning the same, thanks to his discipline and his method.
Not comparing his results with other people’s is what makes it easy for him to apply his discipline. It must be said, too, that his advanced understanding of probability and statistics makes the job easier, because he’s able to see “luck” where others see “mastery”.
And all of this was about to change for Nero the day his neighbour John arrived, a trader who earned more money than Nero, had a better house than Nero, and so, we deduce, was a better investor than Nero. Or perhaps not.
Keep reading
Part 2: Then came John, the successful investor who ignored the role of luck
Featured image: eirikso, CC BY-SA 2.0, via Wikimedia Commons.
