compensating for no limits

There seem to be fewer and fewer limits to real estate speculation these days with 10, 5 or 0% upfront. The same principles that apply to risk management in any speculative investment will apply here :

“If you choose to be a speculator, you are free to do whatever you want with your capital. There are effectively zero exogenous limits to guide your behavior. You can bet all of your wealth and leverage on any potential market movement at any time you wish, period.

Limitless environments are glorious dreams. In real life, from the moment we are born until the time we die rules exist to protect us from ourselves and others.If you are a speculator who understands this and compensates for the great risks inherent in no limits, then you can win big over time and never risk completely blowing up and being blasted out of the game.

But if you enter a no-limit environment and don’t actively protect your scarce and precious capital, then sooner or later the probabilities will catch up with you and slaughter you. The first step in surviving speculation is ensuring that you have adequate safeguards employed.The fewer the limits and the greater the leverage the more one needs to internally compensate.

Speed limits protect us from ourselves, other drivers, and factors completely outside of our control. My only personal experience with limitless driving occurred in Montana a decade ago. Montana is a huge beautiful state with awesome interstate highways, many stretches arrow straight for miles on end. In the mid-1990s Montana abolished its set speed limit on controlled-access interstate highways, instead merely decreeing that drivers self-limit themselves to a “reasonable and prudent” speed. After a while they reinstated the 75mph limits, but the no-limit period was very interesting.

At the time I was driving a Porsche, and it was initially great fun to streak through Montana. I passed highway patrol officers doing 90mph and they never gave me a second look. On particularly gorgeous sunny days with very low traffic, I would sometimes run over 100mph. It was fun, an adrenaline rush, but limitless driving, just like limitless speculation, is very risky.

If I had hit one of Montana’s gazillions of deer grazing along the highways at 100mph+ in a little car, I would have been killed instantly. If one of my tires had blown, I probably would have died in a fiery crash as well. Regardless of how good any driver may be, the truth of the physics is the faster one drives the more ground he covers before he can react and the more catastrophic any unforeseen event could prove to be.

And it is always the unforeseen events that are the most dangerous for speculators, the market equivalent of a deer suddenly darting onto the road from nowhere or a catastrophic mechanical failure. The fewer limits you set on yourself in the markets, the higher the probability that an unforeseen event will totally wipe you out sooner or later. Countless speculators “blow up”, or lose it all, after taking far too great a risk.

In order to survive speculating in a limitless environment, you have to set your own internal limits. Speculators can get lucky, and not encounter an unforeseen event for a long time. But sooner or later the laws of probability inevitably catch up with aggressive speculators and drivers.

The wrong way to speculate is the way most new speculators start out. They come to the markets starry-eyed, convinced that they are good enough to wrest away huge gain after huge gain. They know way back in some dark corner of their minds that the markets are risky in general, but they are so confident that their own egos override prudence.

They start by making an investment. Then, as they watch this investment, they become convinced that they should bet even more on their great idea. They layer in the rest of their capital and sooner or later are fully deployed in one play. They dream of a perfect world where the best-case scenario happens and think of how they will spend the wealth that is certainly coming to them.

But, more often than not, something unforeseeable transpires. The new speculator is fully deployed in one play and the markets move against him. Soon his capital dwindles and his stress escalates exponentially. Odds are his psychological investment in his one play is so high that he will stubbornly ride it to the very bottom.

On the emotional front, never grow attached to any single play. Admit to yourself right away up front, before you commit capital, that even though a particular idea sounds good you are but a mere mortal who cannot see the future. No matter how much due diligence you do, no matter how sound your logic, no matter how sincere your effort to make a great investment, there are always events outside of your control that can obliterate the best of plans and intentions. Expect the unexpected.

You have to emotionally steel yourself so you never grow overly attached to any one play or idea. Since speculation is totally dependent on incomplete information and an unknown future, not every investment is going to win.

Losing investments are normal and expected for speculators. Just like buying food is a normal cost of business for a restaurant owner, for a speculator losing is a normal cost of business for this game. Not every investment will be a winner, so losses must be accepted without emotion. After all, you can make a great investment and still lose money simply because some unforeseen event moved your speculation in the wrong direction.

Don’t fall into the deadly trap of believing that being right all the time is a critical component of your self image. There is no dishonor at all in being wrong now and then. And when you are trying to predict the future, being wrong is inevitable. There is no way around it. So when you lose just shrug, learn a lesson from the markets, and move on.

After acknowledging that you cannot know the future before it happens as well as actively forgoing getting emotionally involved with your investments, you need to limit risk. Controlling risk, like putting on a seat belt, is done before you even make an investment, not once you are in it. If you wait until you are actually deployed to manage risk, then you have already lost the battle and are going to get obliterated by an unforeseen event sooner or later.

Capital very important to your emotional well being, such as retirement funds, college tuition, house down payments, etc., should never be used for speculation.

Position limits help keep you emotionally detached by preventing you from falling too in love with a investment as well as protecting you from the unforeseeable events. Position limits are one of the best portfolio management tools to utilize in a limitless speculation environment.

When speculating, buying is always the easiest part. Before you buy, you are out of an investment and emotionally neutral. Selling, however, is always the hardest part of speculating. You can only sell after your capital is already at risk, sucking you in emotionally.

This greatly magnifies the danger of succumbing to greed and fear, the greatest internal enemies of every speculator that dwell deep in all of our own human hearts. Greed mucks up sell decisions when an investment you own has fallen significantly. Greed clouds selling decisions, but so does its sister emotion of fear. Fear is a much more visceral and urgent emotion than greed so it is probably even more dangerous to a speculator. Fear cripples sound selling judgment when a sharp decline terrifies you into selling. Selling should never be emotionally based.

In order to let your profits run as long as possible and cut your losses as soon as possible, you have to totally eliminate greed and fear from selling decisions. When you have the emotional steeling, position-limited portfolio construction, and mechanical profit and loss management down, the next step is to understand just how random the tactical markets truly are.

Speculation is a lot like farming. A farmer sews his seeds in the spring but he doesn’t expect an instant crop to spring up overnight. Instead he patiently waits a quarter or two to see the results of his speculation begin to bear fruit. The farmer realizes up front that he is in for the entire journey until harvest, not for a quick hit-and-run miracle investment.

The farmer also realizes that one month of no rain or one week of heavy rain isn’t overwhelmingly important in the grand scheme of one growing season. A speculator has to think the same way.

All speculators need protection from their own greed and fear, from others’ greed and fear, and from their own stupidity. A speculator running without internal limits is like a driver running way over the speed limit without a seat belt. Sooner or later the odds will catch up with him and remove him from the gene pool.”

From : http://www.zealllc.com/2002/realest.htm