I'm going to do an amazing thing. I'm going to give you $300 in cash right now. One-hundred, two-hundred, three-hundred dollars. Go ahead, count 'em. Scratch Benjamin's head there. Notice the rough, intaglio printing only found on treasury notes. Neat, huh?
OK, now I want to play a little game. Knew this was coming, didn't you? Don't worry, you'll come out ahead on the deal. How much ahead depends on you.
Look here: I've got two more hundred-dollar bills on the table. I'll put 'em down right here across from your three bills. Here's the deal: I will give you one of these hundred-dollar bills right now, no questions asked, and you can walk away with $400. Or -- and this is entirely up to you -- we can flip a coin. If you win, you get both of these extra bills for a total cash gain of $500 -- not a bad day's work -- but if you lose, you gain neither of these extra bills, for a total cash gain of only $300.
So, what's it going to be?
If you're like most people, you'll take the Sure Thing: You'll take the extra hundred bucks, and walk away with $400, thank you very much. Of course, you're reading this column, so you may not be like most people, but trust me, that's the way most people decide. We'll get back to that in a little bit. Right now I want to play another game. (Hey, what did you expect from a guy wearing a jester's cap?)
Alright, starting with a clean table, I'll lay down $500. It's yours -- maybe. I'm going to give you two options: give me $100 dollars right now and you keep the rest -- $400 -- or we'll flip a coin. If you win, you keep all $500. If you lose, I take $200 of the pot, and your gain is reduced to $300.
Now what will you do?
Yep, you guessed it. Most people opt, when faced with this second game, to flip the coin. Seems like the obvious choice, right? Let's take a closer look at this.
Falsely minimizing risk
You'll notice that the expected payoff from each game is the same, no matter how it's played. That is, if you play either game 100 times, whatever decision you make doesn't matter -- you'll get an average return of about $400 per transaction. You may have noticed this while playing the second game, and it may not have influenced your decision. My point is this: The expected payoff doesn't influence our investing decisions nearly as much as it should.
Why is this? Because we tend to handle each investing decision as though it were the last decision on earth, when in reality it is one of many trades we'll make during our lifetimes. The question to ask yourself when making a decision to buy or sell isn't, "What's the best thing to do in this particular situation?" but rather, "In 100 situations like this, what would be the best decision?" Thinking of your trades in this way can make all the difference.
Everybody wants to protect themselves from losing investments, but you can't. The safer your investments become, the poorer your returns are, until finally you guarantee unacceptably poor returns by virtue of being afraid of suffering poor returns. Did I hear somebody mutter something about Social Security just now?
There's perhaps nothing more nonintuitive about the topsy-turvy investing world than the fact that most stock investments don't work out, and what's more, that's perfectly OK.
Peter Lynch put it this way, and in my experience he's right on: You research your brains out, and finally buy five stocks. You get one dedicated loser, three also-rans, and one winner. So, they cancel, right? Nope. The loser can only lose 100% of the money invested in it, whereas the winner can make much more than 100%. It can triple, and it can triple again. So the loser turns to dust, the also-rans tread water, but the winner carries the whole portfolio.
I'll say it again: You're not going to find only winners, no matter who you are, but the good news is that you don't have to. Warren Buffett, the greatest investor to ever live by most accounts, has taken a bath on any number of investments. Yet, he is a self-made billionaire. How is this possible? Because you may lose only 100% on any (non-margined) common stock investment, whereas you may make many times your original investment on a given stock purchase. Over a portfolio of a dozen or so investments, a few good winners can carry the whole portfolio to great gains.
The Rule Breaker portfolio, for example, has had mostly losers. It also has a phenomenal track record of growth over its brief lifespan (a 40% annualized return since Aug 5, 1994). Again, a few winners have carried the whole portfolio. The funny thing is, people think it's some kind of cheat, or that it somehow doesn't count -- but that's exactly how good investing works, for both the Rule Breaker portfolio and Warren Buffett. If you try to limit yourself to winners only you will lose, because in the end your investments will be so conservative that your return will be abysmal, and you'll still pick up the occasional loser.
Understanding this stuff is not easy -- far from it. Good investing is highly nonintuitive, because in our regular lives minimizing risk is what we are compelled to do, and it is generally the right thing to do. In investing, managing risk is key.
My thanks to Massimo Piattelli-Palmarini, whose book Inevitable Illusions: How Mistakes of Reason Rule Our Minds includes the classic money game example above. Oh, I'll want that money back now, but thanks for playing.