Finance Your Liberty Rotating Header Image

November, 2017:

Finding Expected Value in Unusual Places: an example

One day, on a Sunday afternoon, I was sitting at a friends house watching and New England Patriots game. I’ll be the first person to admit that I know very little about football, and could care even less. And while I do fancy myself as an “unusual investor”, I am also not opposed to throwing down small five or $10 bets on a game just so I have somebody to cheer for.

But as fortune would have it, as I was looking around at some of the strange side bets, such as which player would score the first touchdown, or whether the first score would be a touchdown or field-goal, I came across something interesting.

The bet was this, would the game go to overtime? If so, you would be paid at 11 to 1 if you took the bet, and if you wanted to bet that the game would not go to overtime, you would have to put down $13 to win a single George Washington.

Now the thing about bookmakers is that they do not set the odds on bets on based on the likelihood that something will or will not happen, they set their odds based upon how much money is coming in on each side.  And I don’t know about you but putting down $13 to win one does not sound like a bet that is going to be really popular amongst the masses.

So, I spent the first half of the game on the website, checking the game results for the last three years. And sure enough, only about one in 17 games went into overtime. So on average, I could place this bet 17 times, win 16 times for $16, and lose once for 13.

So the next question was, how much was the maximum bet? And it turns out, that the maximum bet was around $1700. There were three games each Sunday where this that was available, and one game on Monday night.  And at that point in the season, there was probably something like 25 games left to bet on. Meaning if more than one game went to overtime in those 25 I would be taking a loss. On the other side, I could also go 25 for 25, and end up taking a straight up $2500. After determining using an Excel spreadsheet that going 25 for 25 was more likely than losing two or three (yikes!), I was ready to go. But, and this is a big but, you still have to be prepared to lose. Most likely $900, but possibly $2600, and a very, very outside (less than 1%) chance of losing over $4000!

So the question I had to ask myself is no longer whether this is a good bet, we have already determined that it is. The question is, can I afford to lose $4000?  This is the most important part of determining how much you should be placing on any given investment…  What if I lose?  Even if there is only a 1% chance I could lose everything, I have to take that into account. Therefore, I can only play with an amount of money that I can afford to lose every single dime. At that point in my life, $4000 was not a game stopper, so I decided to go ahead.  A 4/17 edge is much better than any mutual fund is going to get you.

Now here’s the strange part:  what happened after the point that I decided to move forward does not matter. If I won money, it was a good bet. And if I lost money, it was still a good bet.  If we decided that we had made a mistake if two games had gone to overtime, we would be in a mode of thought referred to as results – oriented thinking.  And results – oriented thinking is a mode of thought that gets human beings to believe all sorts of ridiculous things which are patently untrue.   After all, the games can’t possibly be rigged, the bookie can’t possibly know in advance who is going to overtime or when.

We just have to get used to the fact that, not just in investing, but in life, that we can do the right thing, make the most optimum decision, and still lose.  In fact, that is one of, if not the most difficult part of investing (as opposed to gambling).  The ability to emotionally handle losing, especially when you lose six, seven, 10 times in a row.  Which, statistically speaking, has to happen sometime.

Because those emotional roller coasters can lead us into bad decision-making, which lead us to make “investments”which aren’t really investments at all.  And that is the greatest enemy of every investor.

(fwiw, while I won’t tell you exactly how I did, the bookie did take down the wager at the conclusion of the second season of my playing that strategy.)

The Key to Investing: Predicting the Future (a little more often than the next guy)

Have you ever thought about what kind of power you would really possess if you were able to predict the future? You would be able to do a lot more than just impress your friends by being able to predict esoteric events such as handing someone a handkerchief before they sneeze or winning your celebrity death pool every year.

Actually take a moment and think about it. What is stock trading? What is Forex? What is poker? For that matter, what he is gambling? Deep down at its basic most fundamental level? Three words. Predicting the future.

Imagine that if you knew in advance that out of the thousands of companies involved in computers in the 1980s, you knew that Microsoft would become the biggest, most successful company of them all. How much money do you think you could have made? If you had just a small sum of say, $1000, how many times over do you think you could have multiplied that?

Imagine, for a moment, that you knew that the new England patriots were destined to lose their last two Super Bowl games. Imagine you knew the final scores. You could do a lot more than with that then just when the betting pool with you and your friends watching the game. Online bookies take all sorts of strange, weird, and outlandish bets on everything from the final score to who wins the initial coin toss. And if you knew to 100% certainty the result you could bet everything you owned on those outcomes.

Okay, but enough fantasizing. You can’t tell the future, I can’t predict the future, and nobody can. Or can we? How accurate do you need to be before you can start to treat outcomes as certainties? If my girlfriend comes up to me one day and says “do these pants make me look fat”, I can make a fairly accurate prediction in that my immediate future is about to take a downturn.

And more pertinently, what if, for example, I offered you at that in which we flip a coin, and you guess whether it comes up heads or tails. Guess correctly, I will give you a dollar. Guess incorrectly, you pay me $.90. How accurate does your future predicting have to be to make money? 50-50 starts to sound pretty good doesn’t it?

And while I’m certainly not going to offer you a dollar versus $.90 to predict a coin flip, believe it or not, those kinds of propositions are not uncommon. In fact, they are everywhere. But they are cunningly disguised. Which is actually a good thing. Because if they were easy to find, then everyone would be abusing them.

In the poker world, that is what we call expected value. More specifically, it is the difference between the risk of losing times the amount you stand to lose, versus the amount that you stand to win should things work out in your favor. If the upside is bigger than the downside, you have positive expected value, and thus, a damn fine bet.

This, generally speaking, is the difference between gambling and investing. Investors have a very good idea of what they’re expected value on a bet, a trade, or an investment is. Gamblers just slap their money on the table based on hunch or a feeling, and hope for the best. It is absolutely vital that we always remember this distinction. Warren Buffett, one of the greatest investors of all time, made his fortune by knowing the difference between his risk and his reward. And the city of Las Vegas was built off of the money of people that don’t.

Making Retirement Work Tip #5: Autodidacticism is the Most Fun You Can Have With Your Clothes On!

I’ll save you the dictionary look up.  Self-Directed Learning.

We’re (I’m) all about that here at Liberty.  That’s job #1.  Self-directed learning is the reason I’ve never worked for someone else, but still have way more in the asset column than the average person my age.

Risk is essentially variables that you cannot account for.  Unknowns.   The more you learn, the less unknowns you have, and the more returns you can safely go after.  But the more you know about a particular subject, the more accurate your predictions on it, and the less risk you take when it comes time to put your money where your mouth is.

Self-Directed Learning is the way that you can break yourself out of the cycle of crappy mutual fund returns that are at the mercy of inflation and management expense ratios.   Autodidacticism can provide you a way to dramatically reduce your tax burden in a lot of situations.  It can lead you to uncover sources of income you never thought possible.   It can lead you see things coming like the American housing crisis.   You can identify investing opportunities that have great returns but next to zero risk.

But here’s the thing.   Learning is not just reading a few articles here and there, and being able to repeat them.   The internet just like TV and every other medium out there is full of spin, hackery, sales pitches, and other forms of complete and utter bullshit.  The key is to be able to determine which parts are true, and beyond that, which parts are useful.

One of Peter Lynch’s main tennants in his terrific book “Beating the Street” was very simple.  Invest in what you know.   Pick an industry or two.  Preferably ones that have a fairly positive future outlook.  Consumer electronics?  Good.  Newspapers?  Bad.   Learn all you can about it.  Read company quarterly reports.  When you find something you don’t understand, look it up.  In short, get a nice, healthy hobby going.   If you want to kill the market’s returns, simply put in as much effort into your stock-picking as your chest-painting neighbor follows his favorite sports team.

Because here’s the thing about teaching yourself.. and probably not the way you did it in school.  It’s fun.

When you find yourself using new knowledge and skills to get ahead, you’re going to end up stopping at some point along the line, look back, and say “I did all that?  Holy crap!”   You’re going to find that you are acquiring all sorts of new techniques, knowledge, and skills that most people simply do not have, simply because they’re not pursuing the path of self-improvement as aggressively as you are.   And it can be applied to a lot more than finance. You can improve your social skills, mental toughness, temperment, physical stamina… the list is endless.   You can learn techniques to make yourself a faster learner, to acquire languages very quickly, to become more attractive to prospective friends, employers, and lovers… even to improve your performace in the sack!

And really, who doesn’t want to be the last of the red-hot lovers?

Making Retirement Work Tip #4: Don’t Get Attached to “Stuff”.

One thing I learned about moving to Mexico was how little I actually needed to happily live life. When I came down here two years ago, I came with clothes and a laptop. I rented a furnished apartment, hung up my clothes, and voila! Home. I have since got a comfortable office chair and a monitor for my laptop, but that’s really about it in 2 years. When I return north, I find myself in awe of how much useless stuff I have squirrelled away that I don’t think about at all while I’m gone.

All that stuff was bought somewhere, sometime. And the vast majority of it, I now realize, was totally unnecessary.

Decorative samurai swords for my wall are not making me happy. The just make points with people who judge others based on the stuff on their walls. (which is who, exactly?)  A fancy glass-topped kitchen table does not make my life more fun. My girlfriend makes me happier. Shooting the shit with my friends while taste testing a bunch of foreign beers from the local import store makes my life more fun.

Cheaper, too.

It pays to identify what are things that improve your enjoyment of life, and things that either make us less happy or don’t impact it one way or the other. And if it’s not a necessity, and it’s not increasing our enjoyment of life… what’s the point of buying it? That simple shift in attitude alone can save hundreds a month.