by Jim Paul
Think of the differences between discrete events and continuous processes this way: Would you lose more money or less money at the racetrack if they stopped the race in the middle and re-opened the betting window? That is to say, you had the opportunity to either: (1) leave your bet, or (2) make a second bet on another horse. You sat down before the race, looked at the racing form and said, “Okay, number 4 is obviously the class horse, but he’s 3:2 and I’m not going to bet the favorite because there’s not enough payoff. I kind of like number 7 and he’s 5:3, but 9 looks okay and he’s 7:1. I’ll go with 9.” Half way through the race who’s in front? Number 7. If they could stop the race and let you bet again, what would you do? You would say, “I knew it! I liked 7 to begin with. I should have picked 7.” You would go to the betting window and make a new bet on number 7. Who wins? Number 4. In the markets they never close the window. It’s open all the time, so you continuously get to re-make that decision and constantly make new “bets.”
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When I was in Cleveland managing the office for Jack Salmon’s regional firm, I had an experience that demonstrates this concept of internalizing external losses. One time a lot of my customers got short the lumber market. They were big cash lumber hedgers and knew that market as well as anybody. Their analysis, and mine too, was that the market was over-priced and due for a fall. So we got short. Well, the market rallied sharply. The market opened limit up and stayed limit up for four days in a row. There was no trading in the futures so we couldn’t get out of our shorts. On the fifth day, the market started to trade but we didn’t get out. We wanted to watch the market to see if it would start back down. Well, it didn’t. After a few more days of the market trading during the day but closing limit up, we all got out of our shorts. God, it was awful. It had wiped out 90% of the office equity run.
I called Jack Salmon down in St. Louis. “Look, I just blew up the office. There is no more money; no more business. It’s all gone. I’ve destroyed it.”
“What happened?”
“We were short lumber, and the market kept going up and —”
“Well, whose idea was the trade?”
“It was the customers’ idea, but —”
“Okay, how many lawsuits do we have?”
“We don’t have any lawsuits. These guys are good guys; they’re not going to sue anybody. But —”
“How many debits do we have?”
“We don’t have any debits! Don’t you understand? We lost all the money!”
“Wait a minute. Let me see if I understand this. We have no lawsuits, no debits and no customer complaints.”
“Right.”
“Well, that just means you’ve got to go back to work, boy. You’ve got to pick up the phone again. This is part of the business. This is part of the deal. People get on the wrong side of the market and they lose all their money. Then the broker has to decide, ‘Do I want to stay in the business or get out of the business?’ Want to get out? Get out. Want to stay in? You don’t have any problems — you just have to go back to work.”
Not only had I failed to see that losses were just part of business, but I had gone so far as to personalize someone else’s losses. If only I had known then what I’m writing now. . . .
7
The Psychological Fallacies of Risk
“Most people who think they are investing are speculating. And most people who think they are speculating are gambling.”
Unknown
One day in the summer of 1981, my partner Larry Broderick and I met in Las Vegas with one of our best customers — Conrad Pinette, a French Canadian and the manager of a very large lumber company in Canada. He was very wealthy and a big baccarat player. We got to Vegas and checked into the Hilton, since that’s where Conrad liked to stay. This was the first trip to the Las Vegas Hilton for Larry and me, and they didn’t know us from Adam’s off ox; but they knew Conrad. He was a very big player and they loved him. All they want in Vegas is a guy who will play, and Conrad would play.
We met Conrad in the hotel lobby and the first thing he said was, “What kind of a line do you boys want?” I said, “I don’t know.” “Well, why don’t I just get you set up for ten thousand?” “Ten thousand? Dollars?” I really didn’t want to lose $10,000. “Ah, we’ll just set you up with a line. Don’t worry about it.” So when I got to the casino all I had to do was sign a piece of paper and they gave me two or three thousand dollars in chips. I just signed and they gave me chips. “Hey, this is kind of neat,” I thought to myself. It’s not like I even had to have the money.
Conrad wanted to “warm-up” before going to play baccarat. His warm-up was to sit down at a blackjack table with a $50 minimum bet. Now this was at a time when I might have been trading 20 or 30 or 40 contracts at a crack as a local trader. On 20 contracts I might be making or losing $1,000, $3,000 or even $5,000 in an hour in the pit. Serious money. So in context, $50 blackjack wasn’t a lot of money. But when I sat down at that table, $50 sure seemed like an awful lot of money. I said to myself, “What am I doing betting $50? This is nuts.” But he was the customer and Larry and I wanted to make him happy. Well, in half an hour I was down about $500 playing warm-up. I said, “Eh, this is not good . . . I’m not having fun here. I’ve had it with this warm-up stuff. Let’s go try this baccarat thing.”
Baccarat was neat. It’s been a game for the rich in France and Italy since the 15th century. I was rich in 1981, so I wanted to play. In the casinos it’s always off to the side. It’s roped off and they have to unfasten a velvet rope to let you in. It’s where the big guys play. The riff-raff was out there throwing craps and playing roulette, and the big boys were in here at the fancy table where the waitresses catered to you and got you anything you wanted to drink. They served you brand name drinks at the baccarat table. I liked that.
A guy met us at the velvet rope and said, “Mr. Pinette, Mr. Paul, Mr. Broderick, we’re glad to have you.” We sat down and signed a little piece of paper, and the guy shoved a whole bunch of chips in front of us. I had never played baccarat before, but I’d read about it in the James Bond book Goldfinger. The first thing you learn about baccarat is that there really are no decisions to make other than which way to bet (Player, House or Tie) and how much to bet. In blackjack, you’re making choices — do you want a card or not? — in addition to how much you want to bet. In baccarat there are no decisions about the cards; the rules make all the decisions. The game is determined entirely by chance. The dealer deals two cards to the two sides (House and Player) and the rules dictate whether or not a third card is drawn. The object of the game is to draw cards adding to nine (tens and face cards count as zero). The dealer makes sure the bettors follow the inflexible rules.
The strategy of baccarat players is similar to what traders use in the markets; they look for trends. The players get a little scorecard. Across the top it says House, Player and Tie, and it has columns under the headings. After every hand they put a little “x” under the appropriate heading, depending on who won. What they’re looking for is a run of wins by either the House or Player. So if the House wins 3 straight hands, for instance, they will bet on the House on the 4th hand. Conrad was explaining all this stuff, most of which made little sense to me. But he was the hot-shot gambler and supposedly knew what he was doing.
So I started playing the “look for the run” routine and betting the minimum $25. Well, somewhere along the line I was down about $2,000 with this Mickey Mouse looking for runs. I was getting very bored and more than a little upset. Two thousand dollars is real money. I don’t know what else I would have done with two grand but I can think of a lot of things I could have done; like bought two pairs of Lucchese boots or a new shotgun.
Well, at about three o’clock in the morning we got a new dealer and a new dealing shoe. The first two hands in the new shoe came up Player. Conrad looked at us and said, “Guys. This is it. I feel it. This is it.
We’re gonna get a run.” So he doubled his bet (he was betting $100 or $200 at a crack). I still bet my $25 and we bet on Player. Player won the third hand. I left the $50. Player won again. I left the $100. Player won again! Well, before the run ended Player had won sixteen straight hands. Luckily for us, somewhere around the tenth or eleventh hand we started taking some money off of the table and lowering our bets. Conrad made about $40,000. Broderick and I each made about $7,000.
Now, it was four o’clock in the morning in Las Vegas and we had all this free money that had just shown up out of the sky! You can get into a lot of trouble in Las Vegas with that much free money that you don’t need, didn’t expect to have and don’t care if you have the next day.
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Life is fraught with risk. Crossing the street is a risk, driving a car is a risk, getting married is a risk and so is having children. Needless to say, starting and operating a business is a risk and so is participating in the markets. Risk is defined as the possibility of suffering a loss. (It’s called probability only if you can assign a numerical value to the likelihood of the loss occurring.) In none of life’s activities is there a guarantee of success or of having things turn out the way you want. Obviously, the types of risk we are interested in are financial in nature; risk which produces monetary losses.
Most people don’t know whether they are investing, speculating or gambling and to the untrained eye the activities are very similar. Looking back on my trip to Vegas I can see the similarity between the casino and the brokerage house. The brokers are the croupiers. The commissions are similar to the house percentage. The boardrooms are the casinos themselves. The stock exchange and the ticker tape are the gambling devices.25 However, the markets and gambling games are similar only in that they each involve the possibility of monetary loss. They are different not only in the legal sense, but also in the economic sense. The big difference is: gambling creates risk while investing I speculating assumes and manages risk that already exists.
Inherent Risk
Inherent risk is a natural occurrence in both unorganized markets and organized markets. Management guru Peter Drucker calls it “risk which is coincident with the commitment of present resources to future expectations.”26 Unorganized markets are the everyday markets in which we participate as consumers, such as the department store, the grocery store and the gas station. The producers bear the financial risks associated with getting the product to the consumer. Organized markets, on the other hand, are the centralized exchanges and over-the-counter markets for stocks, bonds, currencies, options and futures contracts.
Created Risk
Created risk involves the arbitrary invention of a potential monetary loss which otherwise would not have existed. Created risk is risk that is not a natural by-product of an activity itself. The roulette wheel could be spun, the football game played and the horse race run without monetary loss occurring.
Generally speaking, that’s as far as people distinguish between inherent and created risk. However, a closer examination reveals that what determines whether someone is engaging in created or inherent risk is not the activity itself, but the characteristics the person exhibits when engaging in the activity.
Let’s define what those five activities are and the characteristics associated with each.
1. Investing is parting with capital in the expectation of safety of principal and an adequate return on the capital in the form of dividends, interest or rent. Since the return on capital takes the form of periodic payments of interest or dividends, investing indicates an intention to be separated from the capital for an extended period of time. Therefore, investing is usually associated with relatively long time horizon. Buying stocks in a pension fund with the intention of holding them indefinitely, or buying bonds with the intention of holding until maturity, is investing.
2. Trading is basically an activity in which someone (usually called a dealer) makes a market in a given financial instrument. Traders try to extract the bid-ask spread from a market. An example of a trader is the specialist on the floor of a stock exchange. He matches orders, maintains an orderly market and is willing to buy at the bid and sell at the offer. Traders on the futures and options exchanges make two-sided markets, trying to buy at the bid and sell at the offer. Traders in the over-the-counter stock and bond markets do the same thing. In its most basic definition, trading is market-making. The trader essentially tries to stay net flat (neither long nor short) and makes money by extracting the bid-ask spread. In this sense, Stu Gimble, my friend from the lumber and Eurodollar pits, was the consummate mechanical trader.
3. Speculating in its simplest form is buying for resale rather than for use or income as is the case for commodities or financial instruments, respectively. Speculating is parting with capital in the expectation of capital appreciation. This capital appreciation is the sole extent of “return” for the speculator. He does not anticipate return in the form of periodic dividends or interest payments, because he does not intend to hold the position for an extended period of time. The word speculation is derived from the Latin word specere which means to see. Speculating means vision, perception, the faculty of intellectual examination.
4. Betting is an agreement between two parties where the party proved wrong about the outcome of an uncertain event will forfeit a stipulated thing or sum to the other party. Therefore, a bet is about being right or wrong. For example, people bet on the result of an election or a football game. More often than not, they bet on whom they want to win rather than on whom they think will win. I always bet on Kentucky in basketball games. If I took into account the point spread, that would be speculating. If I had been a bookie taking bets either way, trying to keep my exposure even and extracting my commission, I would have been more like a trader who tries to stay net flat and extracts the bid-ask spread.
5. Gambling is a derivative of betting. To gamble is to wager money on the outcome of a game, contest or event, or to play a game of chance for money or other stakes. Gambling usually involves a game or event of chance; sometimes it involves games of both skill and chance. While gambling is popularly regarded as a vice that is injurious to public morals, it is actually a form of entertainment. Compulsive gambling might be injurious, but so is compulsive behavior of any kind. Gamblers may make money, but they are not deprived of enjoyment or entertainment if they do not make money. Individuals who lose a couple of hundred dollars in casinos are paying an entertainment fee, and they know it and have decided it’s worth it. They engage in the activity for the action and the excitement of participation.
Behavioral Characteristics Determine the Activity
Don’t make the mistake of assuming that just because you’re participating in the market, that you are automatically investing, trading or speculating. The markets don’t make you immune from betting or gambling. Determining which of the five activities you are doing is a function of the behavioral characteristics you exhibit. Gambling, investing and trading are not defined by any particular activity itself (i.e., playing cards, buying stocks or trading futures) but by how the person approaches the activity. All card playing is not gambling, all stock purchases are not investing and all futures transactions are not trading.
Gambling and betting are most often associated with contests or games, such as casino games, sports games, horse racing, slot machines and bingo, to name a few. Bettors and gamblers can be either spectators or participants in the event on which they wager. But the distinguishing characteristic of a bettor or a gambler is whether he wants the satisfaction of being right in his prediction or the entertainment of participating, respectively.
The bettor is interested in being right. His ego is on the line. He has a stalwart fealty to a team, a market position or an opinion. Very often, market analysts are subject to this pitfall. Having expressed an opinion either on market direction or the value of a particular stock, it becomes difficult, if not impossible,
to abandon that opinion. The analyst doesn’t want to be wrong or look stupid; he wants to be right. He is betting.
The immediate aim of gambling is entertainment; betting for excitement. People gamble to escape the humdrum of everyday life. It fulfills the desire for stimulus (e.g., increased adrenalin and a rise in blood pressure) replacing the painful boredom of everyday life with thrill or excitement. The distinguishing feature of gambling is that it deals with the unknown, with pure chance. Money is only the ticket to this game and, therefore, winning or losing is relatively unimportant. It’s the excitement that’s important in gambling; the way right and wrong are important in betting; the way money is important in investing, trading and speculating. In gambling, winning is desired only in that money is needed to enter the game or continue playing; money is good for only one thing and that is to gamble.
