In 2002 Malcolm Gladwell wrote a profile of Nassim Nicholas Taleb (one of my favorite philosophers, if I can categorize him that way). The profile includes this description of how humans view risk, and I think it's important to digest it so that you can evaluate your own risk biases and how they affect your life.
What Empirica has done is to invert the traditional psychology of investing. You and I, if we invest conventionally in the market, have a fairly large chance of making a small amount of money in a given day from dividends or interest or the general upward trend of the market. We have almost no chance of making a large amount of money in one day, and there is a very small, but real, possibility that if the market collapses we could blow up. We accept that distribution of risks because, for fundamental reasons, it feels right. In the book that Pallop was reading by Kahneman and Tversky, for example, there is a description of a simple experiment, where a group of people were told to imagine that they had three hundred dollars. They were then given a choice between (a) receiving another hundred dollars or (b) tossing a coin, where if they won they got two hundred dollars and if they lost they got nothing. Most of us, it turns out, prefer (a) to (b). But then Kahneman and Tversky did a second experiment. They told people to imagine that they had five hundred dollars, and then asked them if they would rather (c) give up a hundred dollars or (d) toss a coin and pay two hundred dollars if they lost and nothing at all if they won. Most of us now prefer (d) to (c). What is interesting about those four choices is that, from a probabilistic standpoint, they are identical. They all yield an expected outcome of four hundred dollars. Nonetheless, we have strong preferences among them. Why? Because we're more willing to gamble when it comes to losses, but are risk averse when it comes to our gains. That's why we like small daily winnings in the stock market, even if that requires that we risk losing everything in a crash.
At Empirica, by contrast, every day brings a small but real possibility that they'll make a huge amount of money in a day; no chance that they'll blow up; and a very large possibility that they'll lose a small amount of money. All those dollar, and fifty-cent, and nickel options that Empirica has accumulated, few of which will ever be used, soon begin to add up. By looking at a particular column on the computer screens showing Empirica's positions, anyone at the firm can tell you precisely how much money Empirica has lost or made so far that day. At 11:30 A.M., for instance, they had recovered just twenty-eight percent of the money they had spent that day on options. By 12:30, they had recovered forty per cent, meaning that the day was not yet half over and Empirica was already in the red to the tune of several hundred thousand dollars. The day before that, it had made back eighty-five per cent of its money; the day before that, forty-eight per cent; the day before that, sixty-five per cent; and the day before that also sixty-five per cent; and, in fact-with a few notable exceptions, like the few days when the market reopened after September 11th -- Empirica has done nothing but lose money since last April. "We cannot blow up, we can only bleed to death," Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid. "Say you've got a guy who is long on Russian bonds," Savery says. "He's making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It's much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?" What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress. At Empirica, there is no feedback. "It's like you're playing the piano for ten years and you still can't play chopsticks," Spitznagel say, "and the only thing you have to keep you going is the belief that one day you'll wake up and play like Rachmaninoff."