Investing success is simple. It takes a solid investment strategy built on a proven process repeated over the long run. But it can be undone if you don’t control your emotions.
For instance, the perfect investment process is useless without the discipline to stick with it. Consistency matters, especially when the market is not cooperating.
When times get tough, what do you do? Do you give in when bear market doomers grow loud and sell out of fear? When times get boring, do you cheat (trade) every now and then to keep things interesting? When the bull market is raging and everyone but you seems to be making money do you join in or keep plugging along because you know the process works?
Discipline, or lack thereof, plays a big role in your returns earned over time. Yet, its importance is often overlooked. A great example of why is found in a story told by Walter Schloss.
Warren 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.”
I spoke with Warren and it’s a true story.
A $10 bet for a chance to win $10,000 sounds like a great deal, right? And it’s only $10. He can afford it.
I’m sure Buffett had a good sense of his golfing skills that day but he understood probability and risk.
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That’s what we are trying to do. It’s imperfect but that is what it is all about. — Warren Buffett
Buffett is trying to figure out the expected value of each bet. Expected value is a way to measure what a gambler or investor can expect to win or lose on any bet. The formula looks like this:
Expected Value = (probability of gain x amount gained) – (probability of loss x amount lost)
The goal is to avoid bets when the expected value is negative.
If you run Buffett’s hole-in-one bet through the expected value formula, you’ll find that it’s negative. All you need to know is roughly the odds of a hole-in-one — which is about 12,500 to 1 for the average golfer. Maybe Buffett’s a scratch golfer and his odds are slightly better.
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 bet, you can expect to lose practically all of it. The negative expected value makes it a horrible bet.
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 recognize 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 behavior. 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
The big payout gets everyone drooling and thinking about what they might do with an extra ten grand and how easy it might be. Since it’s only $10, why not? Their emotions mess with their ability to weigh the odds — assuming they think 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.
You can take this a step further and consider the opportunity cost of betting on numerous losing propositions instead of winning propositions over time. And that’s why Buffett is richer than all of us.
The goal of gambling and investing is to avoid permanent losses and bet when the odds are in your favor. The hole-in-one bet had neither. It was a losing proposition with permanent loss assured.
The fact that Buffett turned it down is a testament to the importance of discipline and how you should view risk.
Outstanding Investor Digest