Imagine I offered you a bet.
Let’s say I’m an eccentric millionaire (not such a stretch). I’m going to toss a coin. If it comes up heads, I pay you $7000. If it comes up tails, you pay me $4000.
Would you take it?
Would the prospect of winning 7 grand of my money be worth the prospect of losing 4 grand of your own money, when both have an equal chance of happening?
Would you do it?
Now, if you’re like most people, this bet simply just isn’t worth it.
I’m not saying ‘like most people’ because I’ve actually been out there roaming the streets trying to play odd gambles with strangers, like some cross between Willy Wonka and Donald Trump. Psychologists and economists have studied gambles like these (mostly in the abstract), and found that typically, people just don’t go for bets like these.
But why exactly don’t we like this bet? The ‘expected value of the bet is:
(50% x $7000)
(50% x -$4000)
That is, it’s positive. The expected return of this gamble is positive. In economic theory, you’re taught that people like gambles like these. From a purely economic perspective, it’s a good bet.
But again, economics has given us something that is true in theory, but wrong in practice. So it’s over to the psychologists to come up with an explanation.
There’s a few related constructs that help explain this future of the mind, but central among them is a concept called ‘loss aversion’.
Studies show that losses loom much larger in our mental view of the world than similar sized gains.
Know the saying ‘a bird in the hand is worth two in the bush’? We value things we have much more (2x more according to that proverb) than things we don’t have, but could have.
And we’re hard-wired to hate losing things.
This can create some interesting quirks. What if I put on my Willy Wonka hat again and offered you a gamble that offered a 10% chance of winning $95, and a 90% chance to lose $5.
Would you take it?
What if I offered you a lottery ticket that had a 10% chance of winning $100, and a 90% chance of winning nothing. The ticket cost $5.
Would you buy it?
If you’re like most people (in the experiments) you’re much more likely to go for the second bet than the first.
But check the maths again. Those two gambles are exactly the same. They’re just framed in different ways.
In one, there’s the prospect of losing $5. In the other, there no prospect of losing anything, but there is a small expense.
There’s no practical difference, but when the mind is distracted from the prospect of a loss, it takes a more objective view of the bet.
As humans, we just don’t like losing. And we’ll go out of our way (even avoiding favourable gambles) to avoid it. It’s a principal called ‘loss-aversion’ in economics, and if you look for it, you’ll see it everywhere… (insurance, anyone?)
But losses are also a relative concept. If we were talking 7 cents rather than 7 grand, you’d probably feel differently about the bet (though perhaps not about the weird Willy Wonka dude hassling you on the street.)
Or what if I was offering the bet to poor little orphan Annie? What would you recommend? What about if I was offering the bet to David Koch? What then? The perceived weight of the losses changes, and with it, so does the attractiveness of the bet.
Now I’m not saying that there’s anything wrong with being loss adverse. In fact it seems entirely rational, and if you weren’t loss adverse there might be something wrong with your brain.
But as investors, we need to know that our brains are hardwired this way. And we need to be on our guard in case overly focussing on the losses blinds us to some attractive bets.
Now, let’s come back to our bet for 7 and 4 grand. What if I said I was going to run the bet 100 times? Flip the coin 100 times. Then what would you say?
Suddenly this border-line dodgy bet seems like a great deal. Your mind has probably already intuited out the kind of gain you could expect.
100 coin tosses is going to come down somewhere pretty close to 50 heads, 50 tails. The expected value is now $150,000. You’ll definitely lose individual tosses from time to time, but there is a very small chance that you’ll actually lose money over all.
It’s a no brainier. Of course you’ll take the bet. Thanks Willy Wonka dude.
But the odds of any individual bet haven’t changed. Only the number of times the bet is taken.
In my experience, successful investors can do this. They’re able to put their bets in the context of a long series of bets, and this makes them more likely to take the opportunities that arise.
Think about it this way. What kind of returns would you need from an individual property investment? What about if you imagine a lifetime of property investing, maybe over 100 properties? What kind of odds would you need then?
See how it changes?
Of course it’s easier once you actually have 100 properties under your belt. But there’s nothing to stop you thinking like a pro, straight from the get go.
That’s what I do. I approach every investment, not just on it’s individual merits, but as if it were just one of a life times worth of investments (which I know it is).
I know I’m not going to back a golden winner with every investment. But I know if I get a good system in place, over the long run, I’m practically guaranteed to come out way, way ahead.
And certainly more than if my loss-adverse brain kept me on the sidelines.
Yep, that’s my motto: Party like you’ll die tomorrow. Invest like you’ll live forever.
You can quote me on it.