 | | ILLUSTRATION: TAMMY LIAN FOR THE WALL STREET JOURNAL | | |
Week 3: Curb Your Enthusiasm | | |
| Gamblers could teach investors a thing or two. Let's see how. Say you want to bet on some Yankees games. Love 'em or hate 'em, the Bronx Bombers have the best all-time record in the history of Major League Baseball. | | |
| Over the course of their 100+ seasons, they've earned a winning percentage of around .570. So regardless of how they are doing in any given season, let's assume their chance of winning each future game is also 57%. Pretend a bookie accidentally gives you even odds for the next 10 Yankees games. Even a Red Sox fan would seize the once-in-a-lifetime opportunity to beat the house, but how much would he or she wager? The answer isn't obvious. Today's challenge is all about how to react when you think the odds are in your favor—for example, a stock or a fund about which you feel fairly confident. —Laura Forman, former Heard on the Street columnist | |
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| This week's challenge teaches you about: Risk management. | | |
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| ⏰ Suggested time: 20 minutes Step 1: Bet. Here's your chance to win a virtual bundle with $100 in play money. Step up to the plate and bet as much or as little of it as you want on each game. | |
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| Step 3: Hate the game. What did you win or lose? Not the grand slam you'd hoped for? Don't hate the player, hate the game. Many people who are given an edge bet way too little or way too much on a single event the same way they do with stocks. | |
| Step 4: You're not alone. Don't feel bad if you didn't earn much—you're in good company.
In 2016, Victor Haghani and Richard Dewey published the findings of a similar experiment where they gave 61 college-aged students and young professionals—most of them focused on economics or finance—the opportunity to bet a total of $25 for 30 minutes on coin tosses biased to land on heads with a 60% probability. The maximum payout was $250 in real money. Those are even better odds than I gave you, but one-third ended up with less money in their account than they started with and 28% went bust. Only about one in five players ended up with the maximum possible payout, despite the fact that almost everyone would have profited by employing a consistent, calculated betting strategy. | |
| Step 5: Meet Kelly. Based on the odds, players often overbet, underbet or bet erratically, hurting their own results without even knowing they were making mistakes. The findings reminded the paper's authors of a line from Ernest Hemingway's "The Sun Also Rises" about how one goes bankrupt: Gradually and then suddenly. Allow me to introduce the Kelly Criterion, a mathematical formula developed by former Bell Labs researcher John Kelly back in the 1950s. Mathematically, it tells you what percentage of your capital to put into a single trade taking into account the odds and your historical win/loss ratio. In practice, it can save investors from their own enthusiasm, keeping them from making too many concentrated bets and going bust. The equation is below, but don't get wrapped up in the math—you aren't a high stakes gambler. The point is to have a consistent strategy that is neither so reckless that you could suffer a painful loss nor so small that you barely move the needle. Percentage to bet = Odds - (1-Odds/Your win/loss ratio) The Kelly Criterion is good enough to influence the likes of financial legends Warren Buffett and Bill Gross, who are purported to have employed a variant of the strategy professionally, clearly with much success. Given these odds, Buffett and Gross might bet about 14% of their bankroll every time on the Yanks. It is no guarantee of winning, but it would keep them from catastrophe if the Bombers really bombed. | |
| ✨ Bonus Points: Tell a friend. Ask a friend to do this exercise and tell you how they did. Did they win? Lose? How much? | |
| | ❓Questions to Ask Yourself❓ | | |
| 🤔 Have you ever had good reason to buy a stock or a fund but were afraid of risking too much? 🤔 Or has the opposite happened, with a nearly sure thing blowing a big hole in your portfolio? | |
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 | | PHOTO: EVERETT COLLECTION | | |
| My favorite movie about money is the 1999 American comedy "Office Space" starring Ron Livingston playing malcontent office worker Peter Gibbons. Gibbons and his fellow cubicle workers devise a computer virus meant to steal fractions of pennies from Initech to discreetly stick it to the corporate man, though an error in their code causes them to conspicuously steal far more. Attention to detail matters! | |
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| 💡 COMING NEXT WEEK: Eggs in a basket. | |
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