Edward Drinker tracked the lineages of thousands of species and showed a clear bias towards animals evolving to become larger over time. Horses went from the size of small dogs to their modern height. Snakes from no larger than an inch to modern boas. Dinosaurs from 10cm lizards to a brontosaurus. This shouldn’t be surprising, explained Morgan Housel at Collaborative Fund. Bigger species are better at capturing prey, can travel longer distances and support bigger brains. So why hasn’t evolution made every species huge?
As Aaron Clauset of the Santa Fe Institute and Doug Erwin of the Museum of Natural History explain: “The tendency for evolution to create larger species is counterbalanced by the tendency of extinction to kill off larger species. Big animals are fragile. An ant can fall from an elevation 15,000 times its height and walk away unharmed. A rat will break bones falling from an elevation 50 times its height. An elephant falling from twice its height splashes like a water balloon.
“Big animals require lots of land ... the end game in a famine. They can’t hide easily. They move slowly. Their top of the food chain status means they usually don’t need to adapt, which is an unfortunate trait when adapting is required. The most dominant creatures tend to be huge, but the most enduring tend to be smaller. And so we no longer have T-Rex but still have the cockroach. Size is nature’s leverage — sought for its benefits up to the point that it ferociously turns against you.”
Body size in biology — like leverage in investing — accentuates the gains but amplifies the losses. It works well for a while and then backfires spectacularly at the point where the potential benefits are at their highest but the losses are lethal.
Edward Thorp, a well-known personality on Wall Street, has spent time as a mathematics professor, hedge fund manager, blackjack player and author. When asked if he thinks the effort required by individual traders to try to beat the market is worth it he says: “That depends on the person. I think to myself, ‘Gee, if I were 25 and I got interested in this, what would I do?’ And I’m not sure, but I’d say the Warren Buffett way is a good way if you want to put your whole life into it.
“I’d probably decide not to want to put my whole life into it. So I would say if you wanted to get really rich and you wanted to trade your whole life for getting really rich — a trade I wouldn’t necessarily recommend — then I’d say that’s the way to go. But if you just want to make lesser amounts of money, I think inefficiencies are there, but they are hard to find.”
Thorp’s advice for traders: “Increase your trade size as the probability of winning increases in your favour. Trade smaller during losing streaks, trade bigger during winning streaks. It is difficult to find your own trading weaknesses, so before you start to trade you need to set a stop loss on your drawdown. This is the amount of money lost that will show your trading system is not as valid as you thought it was.”
Andrew McKay at Morgan Stanley says the most important advice he can give is to never let a loser get out of hand. “You want to be sure you can be wrong 20 or 30 times in a row and still have money in your account,” says McKay. “When I trade, I’ll risk perhaps 5% to 10% of the money in my account. If I lose on that trade, no matter how strongly I feel, on my next trade I’ll risk no more than about 4% of my account. If I lose again, I’ll drop the trading size down to about 2%. I'll keep on reducing my trading size as long as I'm losing,” says McKay.
We tend to underestimate the impact of sample significance, whereby we make decisions on the outcome of too few trades; we don’t allow for the fact that, at a 50% win rate, at some stage we’re more than likely going to experience a losing streak of 16 trades in a row; we miscalculate our ability to take losses by assuming we’ll be safe provided we don’t put more than 2% of our money at risk on any one trade, overlooking the fact that a losing streak of 16 trades will compound to a 32% loss, which is likely to prove difficult to deal with.
“When you buy something at 27 and it goes to 29, you know you are showing a profit,” says Edward Toppel in his book, Zen in the Markets. “Conversely, when you do the opposite, you know that you are sitting with a loser. Don’t rationalise and say that you don’t have a loss until you sell. And don’t say that you know it will come back. You don’t know that, either. You know the difference between a profit and a loss. That’s the easy part. Doing something about it is where the difficulty lies.”
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