Date: 2015-03-25
0% versus 0.000...001%
By now, it should be clear to investors that asset prices could easily land in the territory of tens of standard deviations away from the mean. Also, some legendary investors' investment returns lie few hundred standard deviations away from the mean, so there is a chance of someone's being the big loser who ends up lying in few hundred standard deviations away on the opposite side of the legendary investors. However, hubris is a norm. Accordingly, the difference between the 0% and 0.000..001% is taken too lightly in the investment community. Some very smart professional investors argue that it is worth taking 0.000...001% chance of having an infinite loss. These investors either lack imagination, or they do not care enough about the wealth preservation, because the multiplication of a finite-minuscule number and an infinite-positive number still results in the expected value of positively infinite loss. This means that asymmetry created by a 'false' market consensus should be a necessary condition for the use of options (while few synthetic exceptions exist, if they work just as it is supposed to work), if they are used at all. Also, investors must have a truly strong conviction on the direction of the underlying of the options, to decide which side of the infinite magnitude of exposure they wish to have. This is troubling. Another trouble is, market consensus rules in the short run, due to the mechanical link between the bid-offer activities and the resulting prices. For this reason, the more profitable a correct-speculative-option-involving trade is, the more difficult to time it. I suppose the speculator could make a list of triggers to observe and diligently check on those to see if he can survive until the market consensus turn around. The rest is left to luck. This way, the speculator can at least focus on one thing at a time: attention distribution of 100% to the market view on the first step, and then 100% to the trade design, even though the trade designs will need to be adjusted as the market view changes over time. Because I find it more difficult to time the market than to have a conviction on the medium to long term direction of it, I do not favor holding options without holding the underlying to be hedged at the same time. Even though the parts constructed for the hedging (which is another name of speculating) purpose are probably a relatively small portion, this part becomes very interesting because the true market view of the investor is expressed here, while the rest of the portfolio serves the purpose of the reconciliation between the investor's contradictory market view and the tentative market consensus.
So far, the investment model that's most appealing to me is long-only value investment in equities with focus on cash flows and assets with a touch of special situation elements. For speculation, recovery trade is so much easier and more efficient particularly in terms of the time value than the disaster trade. Low frequency valuation arbitrage or market microstructure trade and distressed debt play are also very interesting. The more style added the better it gets, because different styles do better in different times and steady performance is popular. Then.. human capital management becomes a key issue.