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 have opined 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? Well, here’s what I propose.since you can’t know whether the stock market will go up or down…you are in a position not too different from Blaise Pascal when he tried to prove that God exists.
Ultimately, there was no way to know. But there were, like the difference between bull and bear markets, only two answers — either God exists or doesn’t. So, Pascal looked at the costs of one decision or the other. If he believed that God existed, and he led his life accordingly, he may be disappointed. But if he led his life as though God didn’t exist…and it turned out he was wrong…he would surely roast in hell. Since the latter cost was higher than the former…and the odds were 50/50…he had little trouble deciding the issue. The hope of heaven is the hope that people will get what’s coming to them. Maybe the market will go up…maybe it will go down. But I see a lot more to lose than to gain. Even at the fantastic rate of 15% upside profit…there’s a lot more than that on the downside. And even if it were a 60% probability that the market would go up rather than down, as we saw in the example of the gambling Ph.Ds, you would be crazy to put all your money in stocks. But that is exactly what people are being urged to do. Surely, if there is a God he will make sure that the people who urge you to put all your money in stocks roast in hell.
Paris, France July 27, 2000
*** As you know Bill’s floating with his family on a painfully slow ferry somewhere between Cherbourg, France and Waterford, Ireland. I’m told by his son Will, who’s still with me here in Paris, that the family’s off seeking distant relatives in the Irish town where Will’s great grandfather lived… before he fled to the more stylish digs of a Pennsylvania steel mill.
*** In the meantime, here’s what I propose: I’ll run the numbers for you briefly, then treat you to another rousing edition from the vast supply of Daily Reckoning Greatest Hits, 1999. Sound good? If you’re interested, stick around. If however, you’ve got more important things to do…like wash the family cat… this is your cue: skeedaddle.
*** Mr. Bear took the day off from sunning himself at the beach when he heard yesterday’s earnings reports: “Stocks Punished for Disappointing Results” is how a Reuter’s headline scribe phrased it. The Dow fell 183 points… a loss of nearly 2%, and its worst day in two months… finishing the day at 10,516. Down 8.5% for the year.
*** Less than impressive earnings in the semi-conductor industry are being blamed for the losses. But one analyst in the Reuters article thankfully stated the obvious for readers of the Daily Reckoning, at least: “Everyone is suddenly realizing that the last couple of years of profit growth we have seen cannot last forever.” Really.
*** That startling revelation weighed heavily on the Nasdaq, too. The great incubator of optimism and New Era exuberance gave up 41 points to close just over 3,987.
*** 1363 shares advanced, while 1474 declined on the NYSE.
*** The S&P 500 also fell 22 points to 1,452.
*** Bad news for Will and his CD burning friends, too. Napster, Inc. – the website where young techno-wizards have been congregating to pirate music from their favorite rock bands – was ordered shut down by a federal judge. No worries though, Will assures me, once I get my own “burner,” I’ll still be able to find plenty of Grateful Dead bootlegs out on the ‘net absolutely free, gratis… no cover charge needed.
*** On the other hand, reports filed by Amazon were optimistic. Although Bezos and crew are now losing 91 cents a share – double the 43 cents/share loss reported a year ago – they’re not losing as much money on each sale as analysts had predicted. Good news. Still AMZN fell… down nearly $4 in after hours trading to settle at $33.
*** Meanwhile, “if you can show a monthly income of as little as $1,000…or $2,000 from investment income… you could retire next week,” writes Kathy Peddicord from Belize. A law recently passed there allows you to “virtually retire,” live better than you ever have – even pay no taxes.
*** On this day in 1866, Cyrus Field helped usher in one of the “first order” innovations of the communications age. After two failures, he succeeded in laying the first underwater telegraph cable between North America and Europe.
*** Look for GDP numbers… they come out tomorrow. We expect more fuzzy logic and hedonic measures.
*** Allright then… onward and upward: “Rolling The Dice… and The Proof of God” below… was written over the course of several days during the first week of August, 1999.
Thanks for sticking around… Bill will be back soon – I promise,