No. of Recommendations: 4

Pursuit of an Edge, in Steroids or Stocks

New York Times, October 4, 2008


The forces that produced the current crisis actually reflect a powerful dynamic that afflicts all kinds of competitive endeavors....

This particular type of market failure occurs when two conditions are met. First, people confront a gamble that offers a highly probable small gain with only a very small chance of a significant loss. Second, the rewards received by market participants depend strongly on relative performance..... unregulated financial markets, easy credit terms almost always produce an asset bubble. The problem occurs because, just as in sports, an investment fund’s success depends less on its absolute rate of return than on how that rate compares with those of rivals....

The invisible hand breaks down, however, when rewards depend heavily on relative performance. A high proportion of investors are simply unable to stand idly by while others who appear no more talented than them earn conspicuously higher returns. This fact of human nature makes the invisible hand an unreliable shield against excessive financial risk....
[end quote]

Occasionally, someone will post about needing "cojones" to make or keep an investment. This not-so-subtle pressure to take on more risk than someone is comfortable with is a red flag that the investment is too risky.

Any risky enterprise where the risk taker enjoys the upside, but doesn't suffer the full downside loss, will encourage excessive risk taking....especially when competition is strong.

This is very relevant for METAR. Each METAR has a different risk tolerance and a different time frame.

The more the METAR defines his/her risk tolerance and time frame, the better other board members can judge whether an investment is right for their own portfolios.

Any investment result should take risk into account. And we should be careful to avoid competition against each other, because competition increases risk-taking behavior.

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When Life Gives You Lemons
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