Prospecting Risk

From my book Financial Speculation

One aspect of financial losses that is often overlooked is what we may term prospecting risk. Drilling for oil, mining for metals or for that matter producing theatre shows and films all have the same risk profile, and also have some lessons for financial investment.

Typically,prospecting risk has two main characteristics: first, the risk should be spread over a number of ventures, for example a number of theatre shows. This is just normal common sense and simple portfolio diversification, and helps guard against the fact that a high proportion of them are likely to be failures. Indeed in the film industry in any ten
projects it is likely that there will be five or six total failures, three or four that barely cover costs and hopefully one or two big successes (though not necessarily blockbusters) that cover all the costs of all the films plus a healthy profit margin. Second, the timing of where the successful 10% or 20% comes in the run of projects can be vital. This may seem irrelevant, after all if say you have divided your capital up into ten equal portions and allocated it accordingly to say ten drilling projects; it shouldn’t matter whether the pay dirt strike is first or last. True but there is a very large caveat. It is vital that you stick to only using the allocated capital for each project, if you overrun your resources you may run out at, say, drilling attempt number eight, and there is a chance that the big winner would have been number nine or ten. With these types of risks containing your costs is vital, and cost overruns are the nightmare of any mining prospector, movie producer or theatre impresario. The parallel in trading is our trading losses. If we fail to exercise sufficient discipline whilst experiencing losses there will be no chance to stay in the game to catch the big winner.

Unfortunately the world is full of romanticised stories of how down on their luck business heroes conquered all by betting their last cent on the one project. (The early oil prospecting experiences of J. Paul Getty make an interesting read in this respect.) But we only hear of the great successes while the silent majority of failures disappear into the land of losers anonymous. This survivorship bias plagues the investment world.
So the lesson of losses is learn to accept them as a normal part of the investment business, but be ruthless in containing them because if you don’t the market will be ruthless with you