Rolling the Dice...and the Proof of God

“Never invest on a level playing field,” Doug Casey told me.

This advice came back to me as I read Peter Bernstein’s book, Against the Gods. It is a history of the mathematics of probability. And one of the first things we learn is that toting the odds on anything is not a simple matter…and that figuring out investment probabilities is particularly difficult.

Even when the odds are even, for example, it is not rational for you to play the game — at least, not from a strictly financial viewpoint. This is because of something known as the Petersburg Paradox developed by Daniel Bernoulli in the early 18th century. His cousin, Nicolaus, had proposed an idea which is the equivalent of the principle of declining marginal utility of money. That is “the utility of any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed. ” This insight led to the realization that when you win at a game of chance…the amount won will be worth less to you than the equivalent amount lost. You can see this by imagining yourself with $5 million. In a single hand of liar’s poker you have the chance — with even odds — of either winning another $5 million, or losing the $5 million you already have. It would be great to win another $5 million. But it wouldn’t change your life very much. On the other hand, going from a net worth of $5 million to a net worth of $0 would be a major change. Ergo…it is irrational to play the game. If you win…you win big. But if you lose…you lose bigger.

Even when the playing field is tilted in your favor, you can still lose. A remarkable experiment proved this. A group of PhDs were given $1,000 in play money and asked to play a game in which they could bet whatever amount they wished…with a 60% chance of winning each time. Despite the huge advantage, only 2 out of 40 of them had more money than they started with when the game was over. They bet too much. Betting $10 each time would have resulted in about $1,200. But even though they had a 60% chance of winning any individual bet, it was only a matter of time before a series of games went against them…from which it was hard to recover.

I opined in an earlier message that investors don’t understand the game they are playing. They think that because they are “investing” and because “stocks usually go up” that the odds of success are in their favor. In fact, they are wrong on both points. First, the activity they are engaged in could scarcely be called investing. It is much more like gambling. But it is gambling in a casino where the people you are gambling against are accomplished card counters, the decks are stacked and the drinks are $20 each.

I sat next to a woman on an airplane recently who advised me to buy stocks. It was the ticket to wealth, she explained. She was a member of an investment club and had become the group’s oil and energy expert. She recommended a particular oil company (I can’t remember which one…unfortunately I didn’t write it down…I’m sure it was a winner) because she had noticed that “they seem to be opening new gas stations all over the place.” It must be a growth company.

This level of analysis could hardly qualify a stock purchase as an investment. Similarly, anything that involves a guess about the future — whether it is the future of the Internet or the future of the gold price — is not really an investment. It’s a speculation. A gamble. But it’s far from a 50/50 bet. The “house” in the Wall Street Casino takes a huge cut. Someone has to pay for the brokers’ yachts…the homes in the Hamptons…the SEC…the lawyers…the accountants…and the people who call you at dinnertime and ask you if you want to give Warren Buffett a run for his money.

Warren Buffett, Graham & Dodd, and countless others have found that if they work hard enough — doing enough research and study on individual companies — they can tilt the playing field a very little bit in their direction. That’s the idea behind Buffett’s margin of safety. And that’s exactly what Mark Hulbert discovered when he analyzed the investment returns of newsletters. Most don’t do better than the market. But a very few do a little bit better.

Another way to tilt the playing field is the way Doug Casey does it. He’s worked for many years to become an expert on a particular industry…and a particular type of speculation. He’s become an industry insider, with a well-developed sense of not only where and how the money moves around, but also the psychological influences on the market. In fact, in his most recent issue, he quotes Keynes on this point. “My success in the market was in recognizing that the critical issue was not the business or economic cycle, but the psychological cycle.”

This insider’s knowledge of the mining industry and the psychological forces that drive mining stock speculation raises Doug’s end of the playing field just enough to give him an edge.

In either case, whether it is Graham & Dodd analysis or insider-style knowledge, the key to success is to exploit the small advantage over time. This is just like betting $10 each time in a game where you have a 60% chance of winning. Eventually, your winnings add up to big money and people come to think you are a genius. This is far different from what most “investors” do.

But what should investors do…when they have no edge in the market? I’ll address this in tomorrow’s message…and explain why Pascal’s argument for the existence of God should help investors figure out how to invest in a world of uncertainty.

Bill Bonner
July 29, 1999