Thursday, December 27, 2012

How the filthy rich handle drawdown

I'm halfway through reading Theo Paphitis' (BBC Dragons' Den) autobiography and noticed that the self-made ultra-rich have something in common. Almost all of them came perilously close to bankruptcy at some stage, usually early in their "career".
In trader parlance, you can say that their drawdown came close to 100%. In fact, many of these millionaires / billionaires took on astronomical levels of debt at the lowest point of their careers, so you can say that drawdown exceeded 100%.
Can traders learn something from this? Trading is just like any other business. You have suppliers and customers (both from the market), you buy low and you sell high, you use other people's money (OPM) via leveraging and you have overheads that you want to minimise (spread and overnight swap rates).
Quite often these self-made entrepreneurs would fully invest themselves in a single enterprise. That would be the equivalent of putting in 100% equity into a single trade. A big no-no.
So are entrepreneurs like Theo Paphitis and Richard Branson stupid? Did they fail to manage their risk? Or perhaps the risk they took fits their psychological profile?
I'm not saying I have the answers. But drawing a parallel between entrepreneurship and trading is interesting and I think valuable lessons can be gleaned from this.
To be fair, these entrepreneurs began to manage their risk better as their wealth accumulated. These days Richard Branson segregates each of his businesses into autonomous units so if one blows up, it doesn't affect his business empire. That's like risking 1% equity per trade. It's a very managable level of risk. Reading their biographies, you realise that many of these entrepeneurs were somewhat naive when first starting out and I guess got "lucky" when their 100% equity trade won. We don't read the biographies of those who lose everything.
The journey to wealth usually goes like this:
1) Risk big early on
2) Hit a home run or lose everything
3) Once you're rich enough, slow down and manage your risk
"Losing everything" isn't the end-all, be-all. I guess these entrepreneurs accepted such a possibility. As long as you have two hands and a brain, you can always regather some skin to get back into the game.
But no-one ever got filthy rich by being conservative. If you do play it safe, you may end up as a single-digit millionaire by retirement. It's not a bad position. But to get into the hundreds of millions and above as a self-made man, I don't think there's any way around taking large risks.

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