Are You Risk Savy?
In our previous article we discussed the perils of approaching trading with a gambler’s mindset, and how easy it is to fall into addiction. It seemed only fitting that we also discuss the flip side of the coin: the world of expert gamblers and what makes them so different from the rest.
As you will notice, the world of professional gambling and the world of professional trading are not so distant after all.
Traits of Successful Gamblers
The basis for this article was taken from Prof. Evans’ work on “Risk Intelligence”. He detailed the work in his book “Risk Intelligence” which is an insightful read.
Evans divides gamblers into 3 groups. Notice how similar these categories are, to the groups of aspiring traders that we often talk about:
- Problem Gamblers, who bet more than they can afford to lose, and lose it. Their finances, health and relationships suffer as a result.
- Leisure Gamblers, who bet only what they can afford to lose, and lose it. They believe the fun is worth the price.
- Expert Gamblers, who win consistently and earn.
Stephen Ceci and Leffrey Liker did a study in the late 1980s on expert gamblers (who are usually ignored by the academic community for some reason) and found that there was no correlation between gamblers’ success at horse races and IQ. But what if the kind of intelligence that is required to estimate probabilities was different than the traditional IQ testing?
Dylan Evans sought out to verify this more recently and coined the term “Risk Intelligence”. Evans’ thesis is that if we all had a slightly higher risk intelligence, we would be able to downsize financial crisis, and make more accurate decisions in the realm of uncertainty. The reality is that people generally disregard probability when making a decision under uncertainty and even when they do take probabilities into account, they make many errors when estimating them (for further reading on this, I would refer you to D. Kahneman’s “Thinking, Fast and Slow”). Risk intelligence is the capacity to estimate probabilities accurately.
Evans’ studied professional horse race gamblers, poker players, bridge players, and weather forecasters. His research found that expert gamblers:
- are good with numbers;
- don’t necessarily have strong formal education but instead are “street smart”;
- have the ability to put aside their emotions;
- get less of a kick out of winning, and get more pain from losing (“Capital preservation is paramount” vs. “I was just unlucky and will make it back”);
- get a different kind of kick from winning – more cognitive (“I was lucky to get this strong hand, and I correctly assessed the probabilities” vs. “Wow I made a killing!” or “Wow I’m a genius and I’m owning it”).
- are very disciplined and work hard;
- keep good records;
- are very much grounded to reality;
- have a tendency to “annualize” good habits, bad habits, good bets, bad bets…they keep a long-term perspective which enables them to separate good tendencies from bad.
I wish I could be half as sure of anything as some people are of everything – Gerald Barzan
Low risk intelligence is a problem in today’s society and I have seen signs of it everywhere:
- in the “paranoid parents” that are always on the lookout for their children, expecting the worst. Thus, the parents suffer from hypervigilance (a form of anxiety) and the child learns that harm is everywhere;
- the irrational fear of crime or disasters that is stimulated in people after watching the news too often;
Risk Intelligence is the capacity to gauge our own level of uncertainty regarding a certain outcome, rather than knowing a bunch of facts (which is more the realm of traditional IQ). Risk intelligence means understanding one’s own knowledge-limitations and an understanding about when to be confident about our decisions and when to be cautious. People are usually rewarded by knowing facts, and that gives way to overconfidence and arrogance. Risk Intelligence actually punishes overconfidence (and underconfidence). So people with high IQs tend to underperform in Risk Intelligence tests.
Evans summarized 3 ways to make decisions:
- Set a threshold: this is like using a checklist in trading, and only taking the trades that meet certain criteria.
- Bet sizing: the stronger your confidence, the more you bet (and vice-versa). But this will only work if your level of confidence is well calibrated by experience. (In trading I usually suggest to treat each trade as a random extraction, essentially betting the same amount in accord with your risk-limits, and only enhance your position sizing if you achieve your monthly target well ahead of time).
- Calculate the expected value of your decision. Most casino games have negative expected value. Instead, in trading it is possible to create trading systems with a positive expected value or expectancy.
And all the way through the process, acknowledge that luck will always play a role in the distribution of the events. Even though you may be trading with a positive expectancy, the actual short-term results can diverge quite significantly from that expectancy. You can have periods of overperformance and periods of underperformance. The key is to keep your eye on the long-term and just make sure your edge is still alive and well (i.e. that these periods of underperformance fall within historical standards).
Now compare this with most aspiring traders who focus on the maximum profit or the maximum loss, but ignore the probabilities of actually achieving either scenario. That mindset is what we discussed in the previous article.
The way Risk Intelligence is ascertained, is through a questionnaire. The results are then recorded on a chart much like this. On the X-axis are the respondant’s estimate/guess. On the Y-axis is the actual frequency of the event occurring.
- The Blue line represents the correct answers.
- The red line reperesents an overconfident individual, because the answers are not well calibrated and overconfidence leads to polarized probabilities (i.e. always tending to be closer to 100% or 0% than in between).
- The black balls are an ideal calibrated individual (high Risk Intelligence).
- The white balls are from a calibrated individual with low risk-tolerance (lack of confidence).
Source: Risk Intelligence – Introduction – Youtube
There are 2 kinds of tests I’d like you to try. The first test will tell you something about your risk-tolerance. This is important because in order to be a trader, you do need to have a certain tolerance to risk. But not so much that you become a risk-seeker. You can find a decent test here by the university of Missouri.
The second test is all about Risk Intelligence. Unfortunately Prof.Evans’ website with the actual Test is no longer functioning. But you can google the answers to find the correct probabilities and answers.
- How likely is it that most twitter users post less than one update per day? (True, 85% of users update less than once per day)
- How likely is it that Yale University is located in the US state of Conneticut? (True)
- How likely is it that Canada was the largest Crude Oil exporter to the United States in 2018? (True)
- How likely is it that Singer Diana Ross’s middle name is Emily? (False)
- How likely is it that hydropower is one of the most common renewable energy sources in the USA today? (True)
- How likely is it that average temperatures have climbed around the world since 1980? (True)
- How likely is it that Black Mamba bites can potentially kill a human within 20 minutes? (True)
- How likely is it that one year after having quit smoking your chances of a heart attack will drop by half? (True)
- How likely is it that Leverets are not Hares and do not belong to the Lepus genus? (False)
- How likely is it that the tough outer layer of a seed is known as the seed shell? (False)
- How likely is it that the Jewish Calendar consists of 12 months? (True)
- How likely is it that most charity donations from the US come from religious congregations? (False)
- How likely is it that Neptune has more than 10 moons? (True)
- How likely is it that the flag of Estonia does not include the colour black? (False)
- How likely is it that over half the world’s HIV infections occur in sub-Saharan Africa? (True)
- How likely is it that Bill Gates was born before 1950? (True)
- How likely is it that in Egyptian mythology, Nut is the goddess of the sky? (True)
- How likely is it that the cerebral cortex refers to the junction between the top of the spinal cord and the brain? (False)
- How likely is it that Muhammad Ali was stripped of his heavyweight title and boxing licence? (True)
- How likely is it that by 2007, HSBC had fewer UK branches than it did in 1988? (True)
- How likely is it that Portugal had a higher credit rating than Spain in 2011?
In this second test, it really doesn’t matter whether you get the answer right or wrong. This is not about knowing stuff. This is about knowing yourself! For example, I have more experience in the financial sector so I was well aware the HSBC had been consolidating it’s offices and had fewer branches in 2007 than 1988. It was a global trend. So I was fairly certain, and I placed a 90% probability on that. I had confidence in my own experience and knowledge. Same for the Portugal vs. Spain credit rating. Same for Bill Gates. If my own father (same generation) was born after 1950, then most likely so was Bill Gates. I put a 70% probability on that being false. Of course, I know nothing of boxing so whether Muhammad Ali was stripped of his title or not was unknown to me, and I was aware of this fact. So I simply put 50% (coin toss).
Over to You
What I noticed when doing the Risk Intelligence test myself was that my decisions closely mirrored my trading habits. Here’s how:
I am a rules-based discretionary trader. Around 70% of what I do is systematic, with 30% being discretionary. But that 30% can make the difference between a positive or negative equity curve. So in knowing this, I don’t blindly follow the system. I am always using my experience to evalaute whether it’s the case to follow the system, or not (when you operate from a certain angle for a certain length of time, you start to develop a gut feel, which is what I’m talking about here); whether to enter at market or wait for an actual setup (the probability of missing the train); whether there could be sufficient volatility in the hours ahead of a news event or whether it’s best to wait until after the event; whether the market will be surprized by a certain data print, etc.
But I noticed that I also do it when driving: I’m always evaluating the behaviour of the drivers and people around me, “estimating” the probability of crossing into my lane without notice; or not watching the old lady crossing the road in front of them (hence coming to an abrupt stop); or children playing, without an awareness of the cars approaching.
Basically I noticed that I’m always taking into consideration the information available alongside my own perception of probability. I believe that simply being aware of this fact is an advantage.
How do you score on the above questionnaires? What kind of Risk Intelligence honestly emerges from your assessment?
Get in touch, and let’s discuss!
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals and Education from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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