How a Gambler Taught Me an Important Investing Lesson
During my first year of college, I worked for a man with a gambling problem. He would bet primarily on NFL football games. One night, instead of working, he offered to pay me a part of his bet if the Chicago Bears won the Monday Night Football game. So, instead of working, we watched the game. The Bears lost.
But this got me to thinking about a system that could beat the odds. I reasoned that I could take a sum on money, bet part of it, and then if I won I would bank some of it, and if I lost I would just keep doubling down until I won.
It seemed foolproof to me at first glance, but it’s important to test ideas before putting real money into play. I wrote a computer program to simulate the idea. And I learned why it wouldn’t work.
Assume you have a 50% chance of winning each bet, which is pretty reasonable. Over the course of many bets, on average you are going to win back about as much as you lose. Except you always have to pay a commission, and that’s why gamblers tend to lose in the long run. I thought I could beat the system with my double down strategy.
But here’s what happens. If you have a 50% chance of winning, you have a 25% chance of having a two-game losing streak, a 12.5% chance of a three-game losing streak, and a 6.25% chance of having a four-game losing streak. Do this long enough, and you might have an eight-game losing streak (0.4% chance). Doubling down eight times would be incredibly costly.
If you are doubling down your losses, those long losing streaks will add up to tremendous losses over time. And that’s why doubling down won’t work. You would eventually run out of money. You can’t beat a system like that. (I would later take statistics and learn a lot more about this stuff.)
I was also able to extrapolate this knowledge to other situations. In any population, there will be some people whose success is based purely on luck. I know some very lucky people who attribute their success to their cleverness, when it was really just winning on a random number at the roulette wheel.
This taught me a lot about “systems” for beating the odds. It’s very easy to deceive yourself — and others — if you don’t do your homework. It’s also easy to confuse real expertise with luck. In any large system, some successes will be attributable to pure luck.
This lesson applies to investing as well, with some important caveats. First, although commissions and managements fees (in exchange-traded funds and mutual funds) will erode your returns (just as with gambling), investing isn’t a zero-sum game. The losers and winners aren’t equal.
I often say that we want to win more than we lose, but that statement is missing some important context. The reality is that you could win 40% of the time and still make money over time, and you could win 80% of the time and still lose money over time. In that way, investing isn’t quite like the coin flip of a football game.
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The reason it is different is that the magnitude of the wins and losses aren’t the same in the stock market. You could have a loss of 10%, and a separate win of 1,000%. Or, you could have many small wins, and one enormous loss that is greater than all of those small wins.
This is why it’s important not to just look at an advisor’s win rate. I can easily devise a system that wins 70% of the time. The wins will be small, and you could occasionally get hit with a huge loss. So, you have to dig deeper than just the win rate.
Investing is a probability problem though. Within the best portfolios, you are going to have winners and losers. Some of those will be big winners, and some will be big losers. You just have to learn to manage your portfolio in such a way that the big losers don’t ruin your overall track record.
The best way to do this is to limit the size of your bets. Make many small bets and spread them around. As long as your portfolio isn’t full of big losers, you should be OK over time.
I have learned these lessons over the course of a lifetime, but it all started by watching the experiences of an unsuccessful gambler in Oklahoma.
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