The Psychology of Risk

I have just finished reading “The Zurich Axioms“. I was drawn to this book because I have seen it recommended in a number of different places. The book supposedly describes the secret principles behind how the Swiss, despite living in a country with no natural resources to speak of, became the world’s most wealthiest bankers and insurers. The book does a very poor job of that, if it does it at all. I would have expected a book replete with Swiss history and great stories about famous swiss speculators. I have just finished reading “The Zurich Axioms“. I was drawn to this book because I have seen it recommended in a number of different places. The book supposedly describes the secret principles behind how the Swiss, despite living in a country with no natural resources to speak of, became the world’s most wealthiest bankers and insurers. The book does a very poor job of that, if it does it at all. I would have expected a book replete with Swiss history and great stories about famous swiss speculators. Instead the book just recounts some anecdotes that some Swiss guy’s Dad’s friend who trades on Wall St shared with him and a whole bunch of stuff the author read somewhere else. The majority of the book is just a repeat of the usual dribble I have seen written elsewhere, but the discussion of the psychology of “risk” is one of the better discussions I have seen around.

The first Zurich Axiom basically goes as follows:

“Worry is not a sickness but a sign of health. If you are not worried, you are not risking enough. Always play for meaningful stakes and resist the allure of diversification“

The first axiom is an interesting recount of how we are taught from a very young age to never take risks and we should just get a 9 to 5 job and put our money into the bank. The biggest single speculation the average Joe or plain Jane will make will be on his/her family home. Most people rarely speculate in any meaningful way beyond their home purchase. For example, if they have some spare money to “invest” into stocks they will plough most of it into blue chip stocks and they might speculate with a couple of grand on some penny hopeful mining or biotech stocks. They are basically treating speculative stocks in the same way they might gamble in a casino. They put some money on the table they feel they can afford to loose (perhaps a couple of hundred dollars) and if they win or loose at the end of the night it is just entertainment.

This is in sharp contrast to those who are less risk adverse (this is the Swiss apparently …). Such people are willing speculate with meaningful amounts of money using leveraged portfolios of riskier stocks or they will use a chain of mortgages to control a property portfolio or they build a small business up into a franchise and have a chain of stores on a fat line of credit. Some of the time many of these people blow it all, but what everyone of them knows is they will never get rich by just holding a day job, they need to speculate if they are ever to get ahead of the pack. These speculators also understand that rather than diversifying, they need to specialize. They find an edge and then they use leverage and reasonable amounts of money to turn the small stake into a much bigger one. For example, some property speculators will specialise in the home reno, buy 2 or 3 properties a year, put a lick of paint on it and perhaps a new kitchen, flip it and then repeat until the property market sours.

If you look at forex trading, you see the same behaviors happening. Many traders who you meet at local trading groups or on the forums are trading with a demo account or a small account (less than $2000) and the bulk of their investment cash is diversified across one or more managed funds and blue chip stocks. They are taught to “trade with money they can afford to loose”, hoping they might hit the jackpot and walk home lucky. They are trading in a risk adverse fashion, just like our average Joe or plain Jane. However, none of them seem to get ahead. This is just because we are not trading with a meaningful account size.

The typical advice we hear is to trade at such a level that you can sleep at night. According to this first Zurich axiom, this will not help you get ahead. The very fact that you can’t sleep at night is a sure sign that your money is working hard enough for you. Of course the axiom did not go as far as saying that your level of risk should be so high that you will jump off a building if your trade fails. It just says that you should play for meaningful stakes and being worried about your positions is healthy.

Okay so now what? Well if you have got a reasonable track record with trading a small account, what is holding you back? It is only cultural training that teaches us risk aversion that is keeping you from success …

Macrotactics is a blog devoted to recording a part time trader’s journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has

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