A realistic assessment of risk is key to investing, as it is to any business transaction. However, it is something that we humans are not terribly good at. Our emotions, attitudes, biases and preconceptions get in the way, distorting our views and affecting our decisions.
You only have to think of the fear many people have of flying, when getting into a car presents a significantly higher risk to life.
Risk is the probability of loss, and probability is a mathematical function. In some cases, the probabilities are relatively clear-cut. If you deposit money in a bank, you are almost 100% assured of getting your money back, plus interest, at the end of a specified period. Almost 100%, because there’s a very small chance that the bank will go belly up during that time.
Another example: you have a 50% chance of doubling your money (or losing it) if you place your chips on red (or black) in a game of roulette.
Or do you?
In fact, the odds are stacked slightly against you, because a roulette wheel contains a zero, which is neither red nor black; it’s green. The actual probability of you winning is 18 divided by 37 (not 36), or 48.65%, and the probability of the casino pocketing your money is 51.35%. On an American roulette wheel, which has a zero and a double-zero, the probability of losing rises to 52.63%.
Which raises an intriguing question: could gambling hold lessons for investors? I’m not for a moment suggesting that investors should gamble with their savings. Investment risks are more complex and hence more difficult to assess, and they’re generally - unless you’re investing in a Ponzi scheme - much lower than gambling risks. But might the principles be the same?
Maria Konnikova, a Russian-American writer, speaker, psychologist and professional poker player, thinks so. She says if you can train yourself to think more accurately about probabilities, the better you will be able to assess risk, and the better investment decisions you will make. Essentially, you should try to distinguish between luck and skill, recognise the limitations of your ability to control outcomes, and guard against human biases.
In a presentation at the recent Allan Gray Investment Summit, Konnikova shared fascinating insights about how a poker player approaches risk.
A quick question: if you flip a coin and it lands heads five times in a row, is there an improved chance that on the sixth flip it’ll land tails?
The answer is no - it’s still 50-50, because each flip is an independent event, and probabilities don’t have a memory. If you answered in the affirmative, you have fallen for what is known as the gambler’s fallacy, whereby a gambler on a losing streak feels sure his luck is about to turn.
Conversely, gamblers on winning streaks are often confident that their luck will continue, or, in the case of the coin, that it would continue to land heads.
Note that in both instances the gambler believes the outcome will be positive.
Over-confidence and optimism are two of the worst failings of gamblers and investors, Konnikova says. She quoted Daniel Kahneman, an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, who said that over-confidence and optimism “form a potent brew that causes people to overestimate their ability to control events”.
Konnikova cited a study that compared the investment performance of professional investors and lay people. The professionals generally fared worse than the lay people, and this is because they had become overconfident in their abilities, and when market conditions changed, they had difficulty in adjusting to the new conditions. The lay investors did not have the same attitude and “went with the flow”.
It is particularly difficult to detach yourself from an outcome if you have high stakes riding on it.
The sunk cost fallacy is when you have sunk so much of your time, energy and/or money into an investment or project, that you cannot bear to bail out and cut your losses. This is why investors (and gamblers) regularly throw good money after bad. And it is why meteorologists, who are not personally invested in a particular outcome, tend to make fairly accurate weather forecasts, Konnikova says.
You need to recognise that loss is part of the game, and many things are beyond your control, she says. Relinquish the things you cannot control and remain focused on those you can. In a world of uncertainty, you need to make the best decision you can with the information at your disposal. If it turns out to be wrong, which it may, you can take comfort in the knowledge that it was the best decision you could have made in the circumstances and put it behind you.
Poker, unlike most other gambling games, but like investing, involves skill. You can be dealt a bad hand and end up winning, or be dealt a good hand and end up losing.
“If you play enough rounds of poker, you learn that the only thing you can really control is yourself,” says Konnikova. “But perhaps the most important lesson is that the hand you’re dealt is less important in determining your future than how you play it.”