By: Don Shaughnessy
People are not intuitive about probability. It would help if they were.
That is one of the reasons lotteries work.
In Canada, Lotto Max requires you pick 7 numbers from a pool of 49. There are 85,900,584 ways to do that. Google quickly supplies the answer to “49 choose 7” or any other combination. You could experiment.
The odds of winning the lottery are vanishingly small. But each ticket has 3 sets of numbers so 1 in 28,633,528 if you own a ticket. 0.000000034. To seven decimal places the probability of winning without a ticket is the same as with one.
For perspective, if you want to phone a friend in Canada and you know their area code, you are about 3 times more likely to reach them on your first try than win the lottery.
But we still play.
In games there are rules that permit only certain things to happen. You can know “the risk.”
In life, there are no such rules. You cannot know the odds of a new business succeeeding, or of the stock market being up 3% this month. These situations are uncertain. You cannot assign a probability. You can say, in the past such and such happened 10% of the time. That is not a probability because the conditions in the past are not those that will appear in the future.
People usually equate uncertainty with risk, and the financial press and the gurus make it seem like the same thing. It is not and we make weaker decisions when we treat the two ideas as equal.
People think of risk as risk of loss. One dimensional.
Under uncertainty, two conditions must be present. A) the adverse event must occur, and B) you must need the money back that day. If you don’t need the money back, you can wait for the adverse condition to pass and you may have no loss at all.
Unfortunately, the loss on that day will feel real even though you only make it real by selling your position.
These are different from the defense to risk. Risk is one dimensional. It happens or it does not. It is usually insurable or avoidable because it is a single thing. Uncertainty is harder.
Defense #1. Understand the idea of uncertainty.
Know the returns in the stock market are unpredictable and can vary widely. If you look every day, you will see down almost as often as up and our emotions don’t deal well with losses of that frequency. Buy stocks for reasons you understand and only sell when the reasons change. The stock market price is just the opinion of all the people participating at that moment. Their reasons for their choice may have no relationship to your reality.
Defense # 2. Support
You might still need someone to talk you in off the ledge if the drop is large enough. Be sure you have someone to protect you.
Defense #3. Hold some cash.
People who are always fully invested have more “risk” than those who hold some cash. Recall the risk of loss depends on two facts. The market is down and you need your money. How often would you need all your money? Not often. Some cash might be enough. If you don’t need it and the market is down, you have buying power.
Liquidity is a valuable defense to uncertainty.
Defense #4. Match your investment to your purpose.
If you are saving to pay for education, or buy a house or a car, the need date will be closer than if it is for retirement. Plus, the need may be 100% of the money. Because the need is near and total, you cannot rely on a recovery in your time frame. That is risk. The future market price is unknown for any given future day. As you come closer to the target date, you cannot rely on the market to deliver the right amount of money. You should be out of the market and into something highly predictable.
Joachim Klement is a self-described cranky, German, economist. I don’t know if that is true, but he writes interesting articles at Klement on Investing.
A recent one deals with how people assess numbers and words and how that affects their decisions. Not encouraging. You can find it here. Likely Plus Likely Equals Very Likely? Be sure to notice the question mark.
You will find the article helps you understand how you relate to the market rather than worrying about how the market works. Understanding ourselves is crucial to success in investing.
I help people understand and manage risk and other financial issues. I use tax efficiencies and design advantages to help them achieve and exceed their goals. The result: more security, more efficient income, larger and more liquid estates.
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