Recall:
The size of the risk premium in an asset is proportional to the divergence between the risk-neutral embedded in the price and the real-world probability.
It follows then that this lens can help you reason about whether an asset is cheap or expensive!
If risk premiums imply risk-neutral probabilities that do not align with real-world probabilities then:
Risk-neutral probabilities are the fair (not real-world) probabilities. They are fair because they are the probabilities implied by a well-priced game for which there is no excess return per unit of risk.
Traders measure what’s implied in markets by comparing normalized prices. They find disagreements in what’s implied and construct portfolios that offset these disagreements in ways such that their profits converge to the difference between the disagreements regardless of what actually happens in the real-world.
This is a business
Trading positions are not investments. They are the outputs a business process. Trading is a business in the same sense as Dunkin’ opening early every morning to make the donuts.
[While the trades themselves are not a business, one could invest in the business of trading just as one can invest in the abstraction known as a donut shop]
The distinction between trading and speculation can sometimes be blurred. A trader is a bookie trying to balance bets around a fair betting line. A speculator is the bookie who maintains an unbalanced line because they find actuarial value in opposing one side of the proposition with their own capital.
<aside> 🌙 Personal example of the blurry distinction
I used to do relative value arbitrage between options on ETFs vs futures… but i also had signals.
Even though a price of X was “market fair”, i might be a buyer for X because it had edge to my proprietary signal — if someone paid more than X, I’d sell a small amount because there was an arbitrage profit, but I’d try to keep my exposure or position targets leaning in the direction of my signal.
My opinion of price X also had a Bayesian component.
Suppose I’m accumulating a position at price X and now someone was now paying more than X AND I thought this was a “liquidity clearing level” — meaning they had size to buy.
[They are also likely to be vol smart in the sense that they are seeing what my signal saw…this is more common than you think — if you are in a seat that sees lots of activity you will have a better sense of fair value than others. Your assessment of a good trade is going to correlate strongly with other traders who pay close attention to flows. Large market makers usually agree.]
At that point I probably wouldn’t sell this new buyer anything as I now believe that market fair is going higher, closer to my “signal fair”, and the old X will be the new bid. I might gain conviction, try to increase my long position because I got confirmation that I’m right and now it’s time to step on the gas.
I’m speculating within the context of a trading business.
</aside>
We will focus on the speculator/investor.
As a speculator, ask yourself:
Large bankrolls and diversification are both risk absorption mechanisms that boost asset prices in turn boosting risk-neutral probabilities, sometimes independent of the real-world probabilities. In other words, idiosyncratic risks are underwritten by lower required rates of return than you might expect.
When we bring these ideas together, we should default to the understanding that idiosyncratic risks that are:
do not offer much hope for superior risk-adjusted returns.
Buying rental properties off MLS, which everyone can see, and anyone can understand just looks like a poor use of time for someone simply interested in financial returns.
<aside> ⚕️ Prescriptions For What You Should Do Based On This Knowledge