There are averages but relying too much on the “average” can lead to ruin. And uncertainty is behind it all.
A good example of this was laid out in an old book about making investment decisions on drilling oil wells. It turns out, wildcatting is a risky endeavor.
A wildcatter can gather every bit of information possible but they’ll never be certain if there is oil under the ground until they drill. The key to successfully drilling oil wells is to not bet so much money on any single well that a string of bad bets ruins you.
In the frequency sense, what does a probability of success of 1 in 9 (the national drilling success ratio) mean?
Some operators assume it means that if 9 wells are drilled, there will be 1 success. This is not so. It means that if an event, such as well drilling, is repeated over and over, the frequency of successes will tend to approach the 1 in 9 ratio. And how many times it is necessary to repeat the event to approach this ratio is not definite, but subject to variations…
The amount of variation depends to a great extent on the number of trials — the smaller the number of trials, the greater the percentage variation from the success ratio. The greater the number of trials, the smaller the percentage variation from the success ratio. Thus, an operator who can drill only a small number of wells may expect large variations from the “average.” The implication for a man with limited funds are clear. If he had unlimited funds, or even a very large amount of funds, he might be able to survive these variations — early losses or long “runs” of failures — while waiting for the “average to come in.” But with limited funds, an operator may be ruined before the “average” is realized. It would be similar in example to the man who drowned while crossing a stream with an “average” depth of two feet.
Investment in oil wells is no different than investing anywhere else. The odds may be different but uncertainty remains.
Most investments have some historical pattern that can be used to produce a probability, odds, or average. For instance, every market index has an average return based on a limited past. The average is all the good and bad years combined.
But we can’t live by the averages because we also have a future that is unknown. Adding unknowns to the investing equation introduces the potential for variations we’ve never seen before.
Take the S&P 500. We know its average annual return is about 10% since its inception in 1957. We can break that down further by weeks or months if we want. We know what its best and worst year has been. We can find out the same for 3, 5, or 10-year periods too. But all that data tells us little about what happens next.
So those averages become only rough guides to what might happen — with an asterisk attached reminding everyone that nothing is guaranteed. The future is not bound by the past.
The question you must ask is: can your portfolio be ruined by a series of surprising events or bad bets? Because all it takes is too much money concentrated in too few assets combined with a couple of unlucky outcomes to destroy decades of compounding.
The risk is being so focused on the “average” return that we ignore the lesson in the variety of returns that produced that average. Your portfolio must be built to survive the variations it’s guaranteed to experience over the years. Specifically, the worst days.
Your portfolio must also be built to limit the emotional toll the inevitable bad days might have on you to keep you invested. The solution begins and ends with diversification.
This post was originally published on March 4, 2022.
Source:
Decisions Under Uncertainty: Drilling Decisions by Oil and Gas Operators
Related Reading:
Peter Bernstein on Hidden Variety in Averages