In our first piece on risk we introduced the concept and importance of determining your risk tolerance as well as introducing the fact that we face innate behavioral challenges. These challenges can prevent us from acting rationally regarding risk, especially when money is involved. Human beings often say one thing and do another when reality faces them. Humans also have a natural inclination to be more averse to losses than to pursuing gains - all things being equal. Below, we discuss the concept of probability matching which further demonstrates how we can be flawed when thinking about risk. Understanding our natural biases and tendencies towards risk can make us better investors simply by being more self-aware.
As it’s March, we figured a “March Madness” example may be appropriate. In Andrew Lo’s book, Adaptive Markets he demonstrates probability matching by referencing a New York Times article regarding “March Madness”. For those who are not familiar, “March Madness” is a term for the NCAA men’s college basketball tournament in which millions of people place bets to predict matchups and fill-out brackets. The tournament consists of four regional brackets of 16 teams (not counting play-in games). Each bracket is structured so that initially the highest seeded team plays the lowest seeded team, and so on and so forth. People anticipate that the greater the disparity between team rankings, the greater the odds that the higher ranked team will win. A strategy of picking all of the higher seeds over the lower seeds throughout the tournament may be considered “chalk”.
Lo notes that two psychologists, Sean McCrea from University of Wyoming and Edward Hirt at Indiana University researched how well people did when betting on March Madness compared to if they had simply utilized the chalk strategy of picking the better seeded team in each matchup. Their research showed that over millions of entries, those betting they could pick the winners from the losers better than the chalk system did considerably worse than if they just used the chalk strategy. Bettors would also utilize a strategy where they attempted to predict the probability of certain upsets (where a lower ranked team beats a higher ranked one).
Actively picking proportionate upsets and deviating from the method of choosing the clear favorite is a form of probability matching. While it may lead to a correct upset or two, searching for a differentiating result, on average it will yield worse results than the chalk strategy throughout the tournament in most cases. This analogy holds true when investing as well. When most investors actively pick and choose, rather than allow the power of broad, diversified markets work in their favor, they often times will get burned in the long-run. As a result, many investors end up reacting to investment news and results, rather than proactively having structured a viable investment plan. This is a basic signal of not properly understanding the risks involved and which you were willing to tolerate. Investing is hard enough to begin with, we must do our best to avoid temptation. We need to be more thoughtful about the odds and risks we assume with our capital.
a or b?
Lo references yet another helpful example in his book in which probability matching can be used to clearly display our struggle of being honest to ourselves about risk and understanding basic odds.
Imagine yourself sitting before a monitor and once every minute “A” or “B” appears on your screen. Your goal is to guess which letter is to appear next before it happens. The monetary risk/reward paradigm is equal in that correct answers yield $1, while incorrect answers result in losing $1. Over a long enough sample size and assuming a random generation of “A” or “B”, you’d expect to finish about even - neither making nor losing a material amount of money. This we can agree on as we know from our last article on risk, that even though the odds are never explicitly communicated, a random generation of a population of two should yield relatively equal outcomes over a large sample size.
If you are told however that the odds are for A to appear 75% of occurrences and B will occur 25% of the time, but each event is unrelated to the previous or the next occurrence - what would your strategy be? Most participants (and our natural instinct) is to guess “A” approximately 75% of the time, while choosing “B” for the remainder of occurrences. After all we know A is going to appear 75% of the time. why not align our bets with that figure? This, is not the optimal approach. You’d be taking more risk than you intended or was necessary. Further, you will almost certainly result in being right no more than 50% of the time.
The highest probability approach is to select A 100% of the time knowing that over a large enough sample size you will be correct 75% of the time, securing a much higher rate of success. If the probability is accurate, over a 100 occurrence sample size, by selecting A each and every time would expect to finish $50 ahead ($75 correct less $25 incorrect). Selecting a specific amount based on probability in this instance is an example of probability matching at work.
what does it all mean?
So what does all of this conversation surrounding risk really tell us? We know that just as in our daily lives, investment portfolios and other financial decisions come with risk/return trade-offs. Adding money, our natural proxy for security and utility, into the equation causes us to be even more behavioral than we otherwise may normally be. Developing a basic understanding of risk with regards to probability and choices however can help us become more aware of our tendencies and biases. Risk aversion is not necessarily a bad thing at all. It can be healthy to maintain a level of skepticism and aversion to risk. By educating ourselves on our portfolio risk characteristics and our own psychology we can make more informed and confident decisions. Decisions that are consistent with our financial goals and optionality.
Risk becomes a balancing act of comparing the likelihood of success and failure in relation to a goal that is not necessarily static; therefore neither should an investment portfolio. Part of our role at Hudson Oak is to coach our clients through this process up front and adapt the portfolio over time, consistent with the risk capacity and needs of our clients. We help clients better understand risk and gain a level of appropriate comfort around what an appropriate amount of risk assumption may be for them. With this basic understanding in place we can determine an appropriate portfolio to best fit the wants and needs of an investor which is hopefully consistent with a detailed financial plan.
At Hudson Oak, we don’t believe that the measure of a “better” investor is simply in chasing market returns in the hopes that sometimes we’ll be successful. At Hudson Oak Wealth Advisory we are committed to the concept that being a “better” investor is through discipline, education and perspective built into a repeatable process that leads to success over time. We do believe that having a real understanding of risk leads to a better way to intelligently invest. This is one small piece of what makes a “better” investor.
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