Investment Comment
10th November 2023
Discipline
Investing success is apparently simple. A proven process repeated over the long run (assuming conditions that have enabled the success remain the same) and emotional discipline. The perfect investment process is useless without the discipline to stick with it. Consistency matters, especially when the market is not cooperating.
Sticking with a process is important. Consistency of approach is required in good times and bad. When markets fall, and bears growl, do good investors stick with their process, or do they sell-up and wait for a good time to invest, without knowing when that would be? When the market (or a sector of the market) is rising sharply and everyone but you seems to be making money do you join in or keep plugging along with a trusted process? Discipline, or lack thereof, may play a larger role than normally acknowledged in returns earned by investors over time.
Expected Value....good outcomes, probability and disciplined maths
The discipline to be extolled is the expected value of any situation. There is a story told about Warren Buffet playing golf (and in fairness Buffet has confirmed its truth).
Warren Buffet was playing golf at Pebble Beach with Charlie Munger, (Berkshire Hathaway vice-chairman), Jack Byrne (Fireman’s Fund chairman) and another person. One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks. If you don’t shoot a hole-in-one, you owe us $10.”
Warren thought about it and said, “I’m not taking the bet.”
The others said, “Why don’t you? The most you can lose is $10. You can make $10,000.”
Warren replied, “If you’re not disciplined in the little things, you won’t be disciplined in the big things.”
As you can imagine, the intuitive appeal of $10,000 gain against a potential cost of $10, seems a daft opportunity to turn down.
But Buffet understood probability and risk. That’s what we are trying to do. It’s imperfect but that is what it is all about when it comes to investing. Buffett is trying to figure out the Expected Value of each investment (or in this case golf bet). Expected Value is a way to measure what an investor can expect to win or lose on any decision.
The goal is to only invest when the Expected Value of the investment decision is positive.
The formula looks like this: Expected Value = (probability of gain x amount gained) – (probability of loss x amount lost).
Looking at Buffett’s hole-in-one bet through the Expected Value formula, you’ll find that it’s negative. Assuming the odds for a hole in one are about 12,500 to 1 for an average golfer (I kid you not that someone has done the Mathematics on this What Are The Odds Of Making A Hole In One? (hio.com))
Expected Value = (1/12,500 x $10,000) – ((1 – 1/12,500) x $10)
Expected Value = $0.8 – $9.99 = -$9.19
So for every $10 hole-in-one bet, you can expect to lose practically all of it. The negative Expected Value makes it a horrible bet despite the offer sounding enticing.
The good news is you don’t need to know the odds of a hole-in-one to figure out that the odds are against you for this type of bet. You only have to recognise that it’s worse than a long shot. An infinitesimal chance of success versus an almost certain loss suggests the bet is not worth it.
Of course, the real question is how many people would have bothered to think it through? The mistake begins with the fact that humans, in general, are horrible at figuring out probabilities. We also exhibit risk-seeking or risk-averse behaviour. The combination of the two leads us to chase losing propositions.
The propensity to gamble is always increased by a large prize versus a small entry fee, no matter how poor the true odds may be. — Warren Buffett
Emotions are pulled by the opportunity of a big payout and mess with the ability to weigh the odds — assuming that someone thinks about the odds at all. They bet ten bucks…and lose. Then they do it again and again and again.
Losing a small dollar amount doesn’t hit as hard as a large dollar amount. But do it often enough and the small dollar amounts add up. It’s why lotteries are so popular and casinos fill their halls with slot machines.
Thinking through this story I was intrigued at how the Expected Value changes when the odds of success change.
Expected value given different odds of success
Source: Artorius, Bloomberg
The goal of gambling and investing is to avoid permanent losses and bet or invest when the odds are in your favour. The hole-in-one bet had neither. It was a losing proposition with Expected Value of a permanent loss.
Democracy in action
With one year to the next US Presidential Election investors and others may be relieved by the results of a series of US wide elections that took place this week. With Trump ahead in the polls, the prospect of a return of Trump to the White House may start to return to risk radars. This week’s elections across the US, resulted in surprising and significant victories for the Democrats. The Republican agenda on restricting abortion rights appear to have resulted in an increased turnout for Democrats.
After a major defeat for the Republicans in Ohio, Rick Santorum, (a leading Republican) seems to blame it on ‘pure democracies’: “You put things .. on the ballot and a lot of young people come out to vote. It was a secret sauce for disaster in Ohio. …..Pure democracies are not the way to run a country.”
Gerard Lane Chief Investment Officer
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All expressions of opinion reflect the judgment of Artorius at 10th November 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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