Reckless speculators in the financial markets have some common traits.
Two developments in the financial markets in the last few years have given rise to a new breed of reckless speculators: the low volatility anomaly and digital securities, also known as cryptocurrencies and tokens.
Reckless speculators have some common traits:
- Wishful thinking
- Ignorance of risk
- Arrogant behavior
- Lack of experience
Below is a brief description of these common traits.
Most reckless speculators think that they will be able to profit from a bubble and still get out before it bursts. Usually they believe this because they have read or heard how some famous trader or investor managed to do it. However, this is selection bias and ignores the scores of speculators that were ruined by speculative bubbles. There are several examples from the Tulip mania to dot com bubble. A few made it but the majority of speculators lost, in some cases everything they had and even more.
Ignorance of risk
Many speculators are short volatility nowadays since they believe that this is a new market regime and volatility will stay low because of various factors, including algo trading, central bank intervention, etc. Even if volatility stays low in the longer-term due to a regime change, there can be occasional spikes that can cause uncle point to many speculators. Some promise very high returns by investing in volatility products but in the case of a volatility spike there will be a lot of pain.
In digital securities and tokes, also known as cryptocurrencies and ICOs, there are similar or even higher risks because of lack of regulation while a speculative bubble is evolving. In the chart above it may be seen that annualized volatility of bitcoin was at 77% in the beginning of this month and the high was about 140% in 2014. This translates to very high risk of losing nearly everything.
It is often easy to identify a reckless speculator by the arrogant behavior displayed. Usually they convey self-confidence and self-worth. There is an example of a reckless speculator that has produced videos where he appears to talk to prestigious groups and showing off with fancy cars and expensive houses. No serious finance professional will try to impress anyone with own status but only with a good investment plan. Arrogance is a sign of coming destruction.
Lack of experience
This is a common trait especially among young quants who think their knowledge of programming is the ticket to unlocking the secrets of financial markets. Quants will be replaced by machines. In the meantime, the lack of experience and the fact that most quants have no skin-in-the-game during major bear markets will lead many in the path of reckless speculation. This is evident in financial blogosphere by the strategies suggested by some quants: the emphasis is on returns, rather than on risk. Experience teaches us that only a small percentage of finance professionals that focus on returns survive a bear market. I had the experience while trading for a hedge fund during the financial crisis. In early 2008 I was accused of focusing on risk while other traders were focusing on returns. I had reduced “portfolio heat” (maximum risk on all positions at any time) to less than 4% of my allocation and I stopped using leverage when other traders were heavily leveraged. Only two of us made it, all the other were ruined. Knowing when to increase or decrease risk is not a trivial task and requires experience. Past data are irrelevant and can be misleading.
If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY
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