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.

1. Hi Eight % per annum,

You've got an interesting blog. I would like to exchange links with you. My blog address is http://www.beginningwithf.blogspot.com. It is a blog on personal finance and frugal living.

Cheers.

2. It might be easier than you think to find people who would take that bet...

3. Hi Jay,

It is interesting that your previous 2 posts covered Kelly's formula (Odds over Edge). Here are my thoughts about it too. Would like you to ponder through and hopefully give some comments.

Yours is the very first blog I visited when I am still fresh on value investing during 2006. Printed out the articles on FS ratios/analysis and read through them many times. I've personally benefited from your postings. Many thanks! :D

4. Interesting. This concept is very much like Nassim Nicholas Taleb's "Fooled by Randomness - The Hidden Role of Chance in Life and in the Markets". He is also the author of the "Black Swan".

5. Taleb basically reminded us that human beings are terrible at making decisions based on probabilities because we tend to make all the human bias errors that skewed the actual real likelihood of things exploding in our faces.

One example was subprime. All the quantitative financial traders and their risk models couldn't forecast the reality of the entire credit derivative mortgage market meltdown and its wider impact on the global financial sector and global economies.

But hey, those financial traders who got big bonuses before being fired and clawed back by the US Federal Government lucked out.

CAVEAT EMPTOR.

6. I do think the concept is really from the book "Fooled by Randomness".

Well, i guess, it is always good to remember not to bite off more than you can chew. Buy making such big bets all the time, there will be an occassion "luck" will catch up on you. :)

thanks for the post!

7. 20 shots russian roulette? There's a higher chance to win than anyone think. Check out the liar game.
After all, life a big bet. =]

9. Hi Cheng,

Thanks for the compliment. You have a nice blog too! We can always learn from one another. I don't know everything.

10. On Taleb, I have read the Black Swan but not Fooled by Randomness. And I am not sure what concept are we referring here.

The Black Swan talks about highly improbable events that has huge impact - like Lehman shock, 1987 Oct crash etc and how all models fail.

So basically, I guess the argument here is that using such simple probability and payoff model means that we never even get somewhat close to the true expected return.

This means that at the extremes, property prices can skyrocket to very, very high - when Singapore becomes like Monaco, where \$ psf will be on average S\$5000 psf. Or the other extreme that it will crash dramatically back to S\$500 psf like in 2002 and 2003.

Then the models I used simply becomes meaningless.

However as Paul mentioned, it is always good to remember not to bite off more than you can chew. And be very wary of the negative Black Swan event which can ruin your life.

11. Actually your post is most valuable for every investor. I am interest to link exchange with you. My new blog address is given below.