If You Can’t Beat the House, Join The House

If You Can’t Beat the House, Join The House

Understand a classic probability experiment to help build a durable portfolio

By Longboard Staff
Category: Research

Economist and Nobel Prize winner Paul Samuelson has a famous quote about investing: "Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."

That’s true – a balanced portfolio means you can apply the “sell in May and go away” principle at any time if your investment allocations truly are accessing different types of risk – and therefore hopefully different return streams, at different times.

But there are some Las Vegas-like principles you can apply to your understanding of investments to put you head and shoulders above the rest.

The odds aren’t always what they seem

People intuitively know that the odds are in favor of the house at a casino. When it comes to basic portfolio math though, most investors still think more risk always means more reward.

In reality, fortune favors more cautious portfolio construction.

The simplest of 50-50 odds proves my case: a coin flip.

With odds that good, it would be natural to just bet it all every time. Ten flips equals 10 chances to double your money, right?

Taking half the risk each time actually makes you more in the end. What’s more, the ride toward higher returns will be smoother as well.

That paradox is due to a principle in portfolio math called volatility drag.

If your account suffered a 20% loss in the front half of the year due to volatility, gaining 20% in the back half still puts you behind. You suffered a 2.25% loss—even though your average return was zero. That’s why Wall Street reports annualized returns so frequently.

Now imagine that happening in your portfolio quarter after quarter and year after year. Good performing investments, poor portfolio results.

Probabilities aren’t just for card games

Someone heading to Vegas might think of poker or blackjack when considering card games. However, Three-card Monte – that classic game of finding the Ace – might be one of the most educational when it comes to something called conditional probability.

This game is a take on the Monty Hall problem, a concept that academics have debated for 80 years, and it’s still a powerful teaching tool. When you pick one card out of 10, you have only a 10% chance of being right, and a 90% chance of being wrong.

Those probabilities don’t change when I start to reveal the cards they didn’t choose. There is still only a one in 10 chance they picked the right card to begin with.

Imagine if you played this game 1,000 times. How often would you expect the first pick to be right?

One Harvard-educated player of the game told me that she had figured out the probability she was wrong was 90% whereas the odds she was right were only 10%. But she then revealed that if she switched — and ended up being wrong because she switched — she would not be able to sleep that night.

Humans are hardwired to like consistency and commitment. But that bias often prevents us from calculating conditional probability correctly. Our emotions get in the way. It’s just too painful to switch and be wrong, even when the math overwhelmingly says it’s the right thing to do.

So investing may be a little more exciting than watching paint dry and a little less exciting than rolling the dice. Maybe it’s more like watching the water show at the Bellagio: a great result that takes a bit of understanding, but at the end of the day, the best thing to do is simply sit and watch.