Monday, August 24, 2009

The ultimate bet

This post is related to the last one regarding probabilities and payoff and how we should bet.

We often hear about people betting their life savings of $100k on the next property of say $500k, hoping for that 20% rise before TOP and make $100k return (with a capital base of $100k). Lets see how this works in that matrix thingy we used in the previous post:

Let's give the benefit of doubt and say this guy has 70% chance of making $100k, he has read the property market well, the cycle is turning, the stars are aligned. However, again in life, since nothing is 100% one, we have to think that he also has a 30% downside whereby he will lose $250k (ppty of $500k goes down by $100k, mortgage $130k, legal fees $20k all add up to $250k)

Probability payoff
0.3 -250k -75k
0.7 100k 70k
Expected return -5k

Now we see that the expected return is negative. Even if we tweak the no.s here and there, which I did, the expected return is not high. You can probably get to expected return of $80k - which is good if you use $100k as the base. But in reality the base is $500k, bcos the guy borrowed $400k from the bank. So you risked a life of perpetual debt for $80k, is it worth it?

In real life, and not just paper math, if the 30% probability becomes reality, this guy is stuck with a $500k 30-yr mortgage on a house worth significantly lesser, he may have cashflow problem and need to sell out some time in the next 30 yrs, or declare bankruptcy. As we know it, his life is over. Well at least financially that is. He will never achieved the much coveted financial freedom, a nice cosy retirement nest egg and the kind of crap Robert Kiyosaki likes to preach.

Anothe way to look at it, we can think of such bets as extreme as this Russian Roulette game:

1 shot of out six has a real bullet.

If you win, you get paid $5mn, enough for a lifetime. (Well at least for me, I dunno about you though)

If you lose you die.

Odds are in your favour: ok let's make it even better, we have a revolver that can house 20 shots.
So only 1 in 20 chance you will die.

19 in 20 chance you never have to worry about money in life.

Will you play?

Betting when the downside is something we cannot afford to happen is not a good way to bet. Think about this when you are faced with such choices.