The Cost of Not Knowing Enough

I read a very interesting post (hat tip to JD) by Carl at behaviorgap.com

It's  entitled 'The Simplicity Premium.'  This post is based on Carl's.

Background:  When someone doesn't know any better, he/she often pays an 'ignorance premium.'  That phrase refers to an extra cost associated with overpaying because the buyer lacked significant information.

Is it worth the effort to save that premium?  There's no correct reply because it takes research.  If you spend too much time learning what you need to know, saving the ignorance premium may not be worth the effort.  Or, it may be worth far more.  It's not so easy to know, in advance, if the deal you are being offered is reasonable or overpriced. This situation occurs frequently – when you buy a car, home, or furniture.  When you shop at a flea market or farmer's market.  When you shop online, there's an increased risk of  paying for a counterfeit. 

The ignorance premium is used by salesmen to convince consumers to overpay for almost anything.  I'm thinking of those over-priced, over-hyped, multi-thousand dollar option seminars.

The Simplicity Premium

Carl has coined the phrase 'simplicity premium' to represent the added cost of valuing simplicity.  The idea is that people are willing to pay a premium to make their lives easier.  We hire people to do tasks we can easily do ourselves.  But sometimes, the premium is really inexpensive – and you get good value and an easier life. 

Carl's prime example:

"Investing is simple. But… not easy.

There really are only a few things that you have to get right
(simple), but because there are so many ways to get it wrong, it seems
complex.

It’s simple, but not easy…

There are so many ways to invest. So many people willing to
sell you crap. So many entertainers pretending to provide advice."

It's true.  That's one reason why investors buy front-end load funds instead of no-load or index funds.  They take advice from a broker who makes a living by selling funds with loads (up-front sales commissions).

The financial industry is loaded with people (some aim to harm you deliberately) who look out for themselves first.  That means they want their fees and/or commissions, and if the customer doesn't buy something appropriate, too bad.  Just look at those mortgage brokers who convinced the ignorant to buy homes they could not afford and/or trade fixed rate mortgages for variable-rate mortgages, with incredible interest rate leaps.  True, many home buyers did it to themselves, but not all.

It's the same in my world.  There are those who love taking large sums to impart knowledge that's available for little or no cost.  They sell pricey lessons and materials at very high prices to those who don't know where to get good information for next to nothing.

I live by the simplicity premium, when it's affordable.  I just never gave it a name.  And that's how I operate when helping others learn to trade conservative option strategies.  There's plenty of free material in this blog, or on my website

Thank you Carl.

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2 Responses to The Cost of Not Knowing Enough

  1. Dear Mark
    In your book, you always refer to the comfort zone as a way to get out of a trade in case the underlying approaches too much to the sold strike. I can understand that, and to me this comfort zone could be aprox the ATR of 3 days.
    But If I read well (you know english is not my first lenguaje) you don´t refer to a situation it´should be possible:
    I buyed an IC (JUN RUT 480/490) for a credit of 0,9$, and (JUN RUT 280/290) for 0,9$ too.
    To me the problem is that yesterday the price of the hole IC was 2,45$ more than a 30% of the credit. ¿what can we do in this situation? ¿which could be a limit loose if IV continues growing? ¿should I sell the IC or just a vertical? ¿should I roll? …but it´s expensive¡¡………or stand??

  2. Mark Wolfinger 03/31/2009 at 9:00 AM #

    Where to set the boundaries of your comfort zone is something you can decide for yourself. I believe it should be something that changes over time – as you gain more experience with trading option positions.
    In my opinion, the most important factor is NOT that the value of the iron condor increased and you are losing money. To me it is: Are you concerned about the safety of your position? RUT is 416. The calls you sold are 64 points, or 15%, out of the money. Does that feel unsafe to you? Are you worried about that position? If the answers are ‘no’ then there is no reason to do anything.
    You are losing money in this position because implied volatility (IV) increased.
    The puts are further out of the money. 126 points, or 30%. Are you worried about this position now? Only you can answer this question.
    I cannot tell you how to manage your risk, but for me, you own a perfect position and I would not do anything at this time. But, please know that is a decision for my comfort zone. I cannot spak for yours.
    Other questions:
    Yes, IV can increase and you may lose more money. But, unless you have no position, that risk would be true for any iron condor. Right now you have a good position.
    I would not close the position if I owned it. I would keep it.
    I’m not sure what you mean by ‘just a vertical.’ If you are suggesting that you close one side of the iron condor and keep one vertical, you can always do that. It would no longer market neutral, and you must ask yourself if that is the position you want to own at this time.
    Roll? I don’t see any reason to roll. That feels wrong to me.
    I would stand. But please remember – something that is suitable for me, may not be good for you.