Managing investment uncertainty
Whether we like it or not, there’s a lot uncertainty involved in predicting the future. Despite the increasing availability of information, our ability to predict has not improved. This means that we have to learn to live with an element of chance when it comes to managing our investments.
You can manage this element of chance by managing the level of investment risk you hold. An appropriate strategy will consider a) how much risk is appropriate and b) how you will manage this risk exposure over time (or across varying market conditions).
In this article we look at another area of life where the need to manage elements of chance arises and make some comparisons on how we might apply this experience to investment management.
Games of chance that are played with skill
Take for example card games such as bridge and blackjack. There is an element of chance involved in how the cards are dealt yet those that play the game consistently well have learned to stack the odds in their favour. The important point to recognise is that games of chance can be played with a degree of skill.
Let’s look specifically at the game of blackjack or 21 as an example, where the aim is to get the highest value hand without exceeding 21. There are two ways of playing the game – one based on emotion (or gut feel) and another based on the systematic approach of “counting cards”.
The card counter uses a system to keep track of the cards that have been revealed. There are usually up to 6 packs of cards in the starting deck which means there are 24 of each card number in the deck and 120 cards with the value of 10 or Ace. Card counting helps understand the odds of knowing what cards remain. (Good bridge players use the same approach). The odds will change for or against them according to the remaining cards in the deck. If, for example, they can identify that a lot of 10s and Aces remain in the deck, their odds of success improve – because “blackjack” (which pays a 50% bonus) becomes more likely.
To be successful, the card counter also needs a smart and systematic bet size (or capital management) strategy. Blackjack betting strategies aim to increase the bet size in proportion to the player advantage (as dictated by the changing odds).
The intuitive player, on the other hand, relies more heavily on their emotions when making decisions. They are not burdened by what are considered to be cumbersome rules, (or the realities of probability).
Consider the following example. Of the 312 cards in a 6 pack deck, one possible combination is that all 2’s will come out first, followed by all the 3’s, then 4’s and so on in numerical order. Of course, this is highly unlikely but it is possible. An intuitive player would never bet in advance on this sequence of cards occurring. Yet, should the above sequence commence, they become swayed towards the continuation of the sequence. Their emotional pattern seeking bias takes over. Despite the fact that the odds of the sequence continuing remain highly unlikely, no amount of logic can dissuade them – over confidence prevails.
A casino will reduce your chances of success by taking a house edge of around 0.5%, yet it’s been estimated that the card counter, who uses an appropriate bet size strategy, will have a 1% advantage over the casino. Given that casinos generally achieve their “cut”, this means that the non-card counters will be the losers.
Card counting is a systematic approach that works on the logical premise that as the proportion of low cards played increases, the proportion of low cards yet to be played decreases. The odds of a low card being played therefore decrease.
Investing can be viewed in a similar way. If the long term expected return of shares is around 10% per annum, there is an implied daily average return of 0.04%. But we know these daily returns can vary between ±10%. Just as with cards, we can think of these daily “returns” as being dealt from an (infinite) deck of returns and we really have no way of knowing their sequence in advance.
Would you use an intuitive or a systematic approach for playing this game of “returns”?
Emotional versus systematic investing
Good investors display a number of characteristics that good card players display.
- Their decisions are unemotive and calculated (systematic);
- They have developed a well calibrated understanding of risk. They recognise the dangers of the behavioural tendency towards over confidence in decisions of chance;
- They understand the “paradox of control”. They focus on the things they can control but recognise that giving up the illusion of control actually increases the genuine control they have over their lives;
- They take a long term view and are more concerned with where they get to in the end, not a myopic obsession with the gains or losses along the way. They know it’s more important to win the war and understand this involves losing some battles along the way. They’re not shackled by the need to win every battle.
If your investment decisions are based on emotion (yours or someone else’s), then you’re likely to be on a costly path. A smart investment approach should employ a disciplined and systematic strategy for managing investment risk. One that incorporates a dynamic approach to capital management that allows adjustment for changing market conditions and for changes in personal circumstances and objectives. This approach avoids the emotion driven desire to predict the short term sequence of returns and places the long term odds in your favour.