Have you ever been to a casino? Wouldn’t it be nice if the odds were in your favor, so that you’re more likely to win than to lose? How would you behave, if you were in that position? Aha, hold that thought, because it can teach a lot about investing, as this post shows.
It’s time to learn about how investment markets operate. It’s actually quite simple. All you need is to use your imagination. It’ll teach you a lot, so it’s worth taking your time over it.
What we’re going to do today is to make a trip to a virtual casino, a casino that exists only in your mind. And all of us together are taking over the casino tonight. Yes, it’s our own private function. Even better than that: the good news is that the odds at this virtual casino, unlike at a real one, are stacked in your favor. Does this sound like easy money? We’ll see. Anyway, let’s enter.
What, no slot machines? No, all we see are three doors, cheerfully decorated, with the labels Game 1, Game 2 and Game 3. OK, then, let’s enter into the spirit of the evening and head for Game 1.
Here’s the casino official. He tells us it’s a simple game. He’ll toss a coin. If it comes down heads, every player will win $1,000. If it comes down tails, every player will win $500. Yes please, you’d all like to play! One of you says: “This really is easy money!”
But wait, the casino official hasn’t finished. He adds, “Before you play, I have three questions for you. The first question: would you pay $400 for the right to play this game?”
You’re all still cheerful. “Of course,” you all agree. At that price you’re still certain to win.
“The second question: would you pay more than $400?”
A moment’s hesitation; then, realizing that you haven’t been asked what’s your limit, you all agree: “Yes.” You know that any price up to $499 still results in a certain win.
And so to the third question: “What’s the most you would pay?”
Oh, that’s more difficult. The shout starts: “$401.” “$450.” One wit calls out, “$800!” Everyone laughs: he can’t be serious (or he has such a lust for gambling that he’ll pay anything just to experience the thrill).
The bidding (yes, that’s what it has become) settles down at $749 – just enough to keep the game in your favor, though it’s far from a certain win. (You could win $251 or lose $249, with equal probability.) Some have backed out. It’s hardly worthwhile at $749. They want a better margin in their favor. One in particular says: “That’s too much. The game is still in my favor at $749, but I can get a better return with complete certainty with a bank deposit.” Oh, he’s a spoilsport – he’s making this an investment question rather than fun.
Actually, the game is over at that point. The game was not really to toss a coin. It was to see how much you’d bid and how the bidding developed. Oh, this is a learning game, not a gambling game. How disappointing! Well, we’re here, we might as well continue.
Let’s go to Game 2. Another casino official. He’s going to toss a coin. If it’s heads, every player wins $1,000,000. If it’s tails, every player wins $500,000. Might as well get to the point quickly: what’s the most you would play for the right to play this game?
One of you shouts out: “$740,000.” He pre-empts the bidding. Nobody challenges him with a higher bid. Nobody goes to $749,999, even though the game is still marginally in your favor at that level. You’ve evidently taken the spoilsport’s bank deposit comment to heart; there are easier ways to make money, with much less risk.
The casino official has one more question: “Why do people typically offer to pay less than 1,000 times as much to play Game 2 as to play Game 1?”
One of you says: “Well, Game 2 is like playing Game 1 1,000 times, so I’d be willing to pay 1,000 times as much, as long as the margin was a bit more in my favor, like $650 for Game 1 and $650,000 for Game 2.”
Yes, but you were willing to pay more than $650 for Game 1, weren’t you? “Yes.”
So then, if your limit for Game 2 is $650,000, your bid is less than 1,000 times your bid for Game 1. “Right.”
“OK,” says the casino official, “I accept your offer of $650,000. Let’s play Game 2. Put up the money.”
Our friend says: “It’s virtual money!” No, it needs to be real money. “What d’you think I am, crazy? I’d never risk $650,000 at one time.”
And there endeth the second game.
We’ve already learned two important lessons.
- In a free market, there’s no easy money. As long as people have enough information to understand the game, and anybody can play, the price gets bid up to the point where there’s no easy money, just a risk-versus-reward calculation.
- The higher the potential loss, the higher the potential gain that people demand in order to be willing to play the game. People don’t like losing, but their aversion to losing increases as the potential loss increases, so the bigger the risk, the more they want the payoff tilted in their favor.
Remember, there’s still Game 3 to be played.
Another casino official: “I’m going to draw a card from a standard deck of 52 cards. If it’s an ace, every player loses $100. If it’s any card but an ace, every player wins $100.” That sounds like the odds are heavily in your favor: twelve chances to win, for every one chance to lose.
This might be starting to sound familiar, but no, this time the question is different: “What’s your reaction if you win?”
Several cries: “It was bound to happen.” “This is too easy.” “Let’s play again!”
And one final question: “What’s your reaction if you lose?”
A quick shout: “It’s a fix!” Laughter, then silence. Then several of you say, “Let’s play again!”
Two more lessons.
- Even good strategies can have bad outcomes. Playing Game 3 for no entry fee is clearly a good strategy, because it’s tilted so strongly in your favor, and even if you lose, the loss is bearable. But there’s still a chance that you’ll lose. That’s just bad luck, but bad luck does happen sometimes.
- With a good strategy, the more often you can play the game, the more likely you are to win over the long term. That’s why you said, “Let’s play again!” even if you lost Game 3 the first time it was played. The chances are so much in your favor that you’re highly likely to come out ahead if you play, let’s say, 10 times, and even more likely if you play 100 times.
There you are. Our virtual tour has ended. And, even if you didn’t realize it, you now understand four profound investment principles. We’ll see these principles in action in future blog posts.
There’s no mystery to investment principles. People behave just the way you’d expect. They’ll play the investment game (many times) if they think they’re likely to win. They don’t like to lose, particularly not large amounts. Put a lot of people together figuring out the chances, and there won’t be any easy money to be made.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.