Financial Geekery

Be the casino: rules for winning at finance in an uncertain world

March 5, 2018

It's widely understood that there's a very clear way to win at gambling, one that cuts through all the stratagems, card-counting, and statistical analyses that are fascinating to look at but ultimately unprofitable. And that is this: be the house. 

 

And why is that? It's straightforward: in order to win, the house just has to stack the odds of any given game slightly in its favor. The Law of Large Numbers (yes, that's a thing) says that over the long term, over hundreds or thousands of games, the house will win more than it loses, and thus turn a profit.

 

And yet there are many, many people who are determined to win at Vegas by being a player in the casino. "The rules don't apply to me", they say. "I'm smarter than all those other rubes." I don't doubt you are -- but if you're not smart enough to be the house, it doesn't matter. Eventually, probability will catch up with you. 

 

The same is true in finance.

 

Every smart person thinks they know something everyone else doesn't. (Yes, engineers: even you. Randall Munroe has your number.) Ultimately, though, the best you can do is tilt the odds in your favor; if you insist on being a casino player, rather than like the casino house, over the long term you will lose.

 

To those of you whose solution is not to play: I'm sorry. In finance, you are always taking risk. You may be surprised and dismayed to hear this, but the sooner you understand and accept it, the sooner you can tilt the odds in your favor. Putting all of your investments in cash? The risk (a near-certainty, actually) is that inflation will eat your returns alive. Purchasing an expensive annuity policy? The risk (again, actually a near certainty) is that the money you spend on it far outweighs the benefit you get from it -- and you lose flexibility besides. 

 

So how does one play like the house? 

 

Rule #1: Don't make bets you can't afford to lose

 

The odds may be in their favor, but the house loses bets every day. That's what keeps gamblers coming through their door -- visions of quick, immense riches. The trick is that the house can afford it; there's always a maximum bet size (if they're the ones betting; poker is a different story) such that a lucky stroke won't wipe them out.

 

You can do the same in finance. The chances are relatively small that your house will burn down, or your car's engine seize, or you die unexpectedly, or you require surgery, or you become disabled...but the chances are significantly nonzero, and if you lose that bet, it could be a catastrophic setback to your financial plans.

 

This is where insurance comes in. If a risk has a low probability but high severity (like all those items mentioned above), they're a prime target for insurance. The insurance company can afford to take the bet. Like the casino, the Law of Large Numbers is working for them, so it's well worth the price to let them have the risk. 

 

Now sometimes whether or not to insure isn't so clear. Long-term care insurance is a prime example. On one hand, if you take out a policy, pay the premiums, and then never have to use it, you're out the (considerable) money you paid the insurance company, to the point where it could significantly impact your financial goals. On the other, if you don't take out a policy and do need long-term care, you're out the (even more considerable) money you have to pay the care provider. Worse, the odds of you needing long-term insurance? 50%-70%, depending on who you ask. For a single bet, without the Law of Large Numbers on your side, there's no clear Right Answer. In cases like this, the best choice (assuming you can afford both scenarios!) is the one whose negative outcome you can best live with. For some, that means paying premiums for something they never use; for others, it means potentially having to pay for their own long-term care out-of-pocket. 

 

I can't reiterate this point enough:  do not make bets you can't afford to lose. This was where world-renowned investor Warren Buffett was coming from when he said, "Rule #1: Don't lose money. Rule #2: Don't forget rule #1." Hedge funds are famous for leveraging themselves into positions to reap fantastic returns...and then imploding completely when the market swings the opposite way. Don't be them! 

 

However, when you can afford to lose the bet, that's another story entirely. Which leads us to:

 

Make bets others can't afford to lose

 

Switching away from the casino analogy, this is how Warren Buffett makes his money. Back in the 2008 recession, he calmly surveyed the scene and invested in companies like Goldman Sachs and Mars, and reaped huge benefits. When everyone else was proclaiming the end of history, he simply saw opportunities for bargains, and took them.

 

That's not all. Buffett's company Berkshire Hathaway is one of the largest reinsurers in the world, by being the company that other insurance companies go to for insurance in the case of a catastrophe even they couldn't handle. While disasters like Harvey and Irma do hit Berkshire hard, they don't wipe them out -- and in good years their reinsurance premiums more than make up the difference.

 

Now, you won't be able to negotiate with Goldman Sachs for favorable terms on preferred stock during the next Great Recession. But remember that "low probability/high severity" case I mentioned above, where you pass along the bets you can't afford to lose? There is an alternative scenario: where you can afford to lose the bet, and the odds are in your favor, go ahead and take it yourself.

 

The obvious example, of course, is to stay invested (and/or keep investing) during a market downturn. Your Investment Policy Statement should be your key to "keeping your head when all about you are losing theirs". By implementing systematic rebalancing, you will find yourself naturally buying low and selling high, as you rebalance into out-of-favor assets and out of popular assets that have had a large run-up in price. While you may not have negotiated directly for the deal, you're still getting discounted prices.

 

Another example: keeping enough money in liquid savings to cover a high deductible on your health, homeowner's, or auto insurance will reduce the premiums you have to pay each month. 

 

And another: keeping enough money to fund your living expenses for 3-6 months means that you can forego short-term disability insurance altogether, and can take a long-term disability policy with a high elimination period (and thus a lower deductible). Not to mention the fact that if you ever get laid off, you can then afford to take your time finding a good replacement job, rather than jumping at the first offer that comes to you.

 

And another: rather than paying for expensive annuities in order to guarantee income in retirement, you can use what I call Adaptive Financial Planning to fund retirement directly from your investments. In Adaptive Financial Planning, you periodically run Monte Carlo projections over the lifetime of your plan, which allows you to see potential problems coming 10+ years in the future. If a potential problem does arise, it's far enough in the future that you can make small adjustments now to stay on course -- and you have avoided the high cost and greatly lowered flexibility that come with an annuity.

 

Be systematic in your bets

 

Consider a weighted coin, such that if you flip it, there's a 60% chance it will land on heads, and a 40% chance it will land on tails. What's the best way to maximize your chance of winning a toss? The answer, of course, is simple: always, always, always bet on heads. Sure, you could try your luck and occasionally bet on tails, hoping to win more than 60% of your time -- but all you're doing in the long run is throwing away your advantage.

 

Being unsystematic in your bets is one of the biggest ways you end up being a player, rather than the house. A player attempts to time the stock market, jumping in and out based on various factors, most of which are unfortunately noise that can't be profitably acted upon. The house places bets on long-term factors of outperformance -- more stocks than bonds, more small companies than large, more value companies than growth, more profitable companies than unprofitable -- and keeps those bets active long enough to bear fruit. (Stocks don't outperform bonds every year, after all.)

 

Again, this is where an IPS comes in handy, allowing you to be thorough and systematic in your investing approach. Don't limit it to investing, however; you should include your approach to taxes, insurance, spending, saving, and all other aspects of finance in your system.

 

Make as many (good) bets as possible

 

To those of you who are risk-averse, this may seem counterintuitive. What I mean is this: the Law of Large Numbers helps the most when you make a large number of bets. On the positive side, the more bets you make when the odds are in your favor, the more bets you win, and hence the better off you are. Don't forget the negative side, though: if you only make one bet, the model falls apart. 

 

This is where diversification comes into play. Per above, any given small company is likely to outperform a large company over time -- but if you act like a casino player and put all your money into a single small company, that company might completely vaporize (even large companies might do this -- ref. Enron and WorldCom). By purchasing shares in every publicly-traded company you can lay your hands on, and tilting your portfolio in favor of the factors of outperformance I mentioned above, you put the Law of Large Numbers on your side.

 

In the Vegas of personal finance, that's how you become the house: by not taking bets you can't afford, taking bets that you can afford but other's can't, being systematic in your betting, and setting up a system such that every financial decision makes as many bets as possible in your favor.

 

Now go forth and win.

 

 

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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