Monday, August 08, 2005

The Jackpot Trap: The Danger of Big Wins Early

You can choose your expression: "A rising tide lifts all boats", "Never confuse brains for a bull market"... one of my favorites is "When the tide goes out, then we'll see who's been swimmin' nekked".

A Texan told me that one.

These aphorisms are all a variation of an investing truism: favorable market conditions tend to provide good returns for investors regardless of their skill levels.

In the late 90's we saw many of these "success" stories. In 1999 it seemed you couldn't open a major newspaper without encountering an article on day traders and the remarkable returns they were achieving. The message was seductive. "Easy money", they'd say. "Work from home! "C'mon everybody's doing it..." It was enough to tempt the most austere of investors into leaving that 9-5 job.

But the market is a stormy sea. And that seductive call of the trading firms (and their media accomplices) turned out to be a siren's song leading investors onto the rocks like so many helpless sailors. Portfolios were shattered. Lives were changed forever.

Hidden in these "rags to riches to rags" stories is a quirky and counterintuitive phenomenon -- the relationship between big wins early in a gambling career and subsequent pathological gambling.

It is more common than not for a pathological gambler (I'm talking about the type of gambler who ruins his/her life, not merely people who have a weakness for Vegas) to have a huge windfall in the first year of his/her career (typically 1/3 to 1/2 of a year's income).

This comes as a surprise to many people. How can a big win be a bad thing?

Well, for many people it isn't. But for a subset of the population it is the equivalent of the bait that springs a life-ruining trap. The problem plays out on several levels.

1) You can't get a big return quickly without a big risk, so the behavior is usually remarkably reckless.

2) People cite the windfall as evidence of their brilliance. (After all, they picked those stocks!)

3) When people experience that rush in the infancy of their investing/gambling career it acts as a formative experience. Though the odds of hitting such a jackpot are roughly the same as David Hasselhoff sweeping the Oscars, it is VERY difficult to let go of the notion that it will happen again.

What seems like a blessing becomes a curse.

The take-away is two fold.

1) Should you be fortunate enough to get huge returns on early trades in your career, put it in its proper perspective and recognize the risk that accompanies your success.

2) The other is beware "wunderkind" money managers who generate huge returns in their first year. The people the media tout as the "next big thing" are often precisely the sort of investor you should look out for. It may well be that they are simply budding Peter Lynches or Bill Millers, but neophyte money managers who generate returns well beyond what could be reasonably expected are also high risk for the Jackpot Trap. Do your homework before they lure you in.

Take the quick and confidential Marketpsych Gambling screen (second test on page) if you think you might have a problem.

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