31 Jul 2015 What Las Vegas Can Teach Us About Investing
“People call it luck when you’ve acted more sensibly then they have.”
When we invest or expend money to make a profit, we start from one of two vantages: Confidence or Luck. The first requires effort, competence, and a thorough understanding of what is controllable and what is not controllable and we plan contingencies for those things that are not controllable. The second perspective is the veritable flip a coin. Luck-dependent investment decisions are based on things like past performance, colorful brochures, and influential arguments.
Las Vegas provides an excellent analogy of the two. In Vegas there’s the HOUSE where people come to gamble. And there are the gamblers who come to be entertained, and if luck permits, take away some winnings.
When we first walk into a gambling house our senses are flooded with the cool, clean, oxygen-infused air, bright lights, attractive staff, pretty colors, sounds and bustling activity around the expanse of tables and screens. Even if we notice, we scarcely mind being manipulated at every turn. As we take it all in we notice the significance of order in the place. Dealers, boxmen, wait staff, pit bosses, and floor bosses (don’t worry I looked them up) all go about their duties with polite, yet diligent proficiency.
Across the huge floor are hundreds of gamblers playing their games, calmly laying down their money only to watch it be whisked away by an emotionless dealer or boxman. Amazingly, everyone knows the odds of winning lie overwhelmingly with the HOUSE, but something inside them whispers ‘on the next spin, the next throw, the next hand, I could win big!
We do in fact know that the HOUSE holds all the cards, so to speak, when it comes to odds of winning. But gambling houses do not hold a monopoly on HOUSE-like thinking or operating. Warren Buffet, for instance, thinks and operates like the HOUSE. He wins consistently by buying great companies made cheap by former managers whose big bets didn’t pay off, or from managers who failed to recognize the unique HOUSE-like qualities their businesses possess.
In baseball we know that sluggers swinging for the fences strike out far more often than they score, while lead-off hitters get to first or second base with amazing regularity. Olympic downhill racers skiing under control win by shaving milliseconds from their times and staying healthy to win more often than their flashy risk-taking counterparts who must make up full seconds to compensate for a moment’s loss of control.
When we are accomplished at a thing, whether baseball, skiing, or some other pursuit, we perform like the HOUSE. We know what it takes to win or to accomplish a great thing. We have learned what we can control and what we need to plan for and adapt to if things don’t work out.
On the other hand, we get into serious trouble when we fail to recognize or admit that we don’t know a thing well, yet proceed anyway, as though we were quite accomplished at it. At that point we walk into someone else’s HOUSE and accept an outcome that is further from our control than we dare admit. The bright lights, sights, smells, and sounds dull our senses to the reality that our odds of success are significantly tilted away from us the moment we walked through those glistening doors.
Many people compare stock market investing to Las Vegas gambling – and they are right to do so, given their experience. The ‘market-beating’ mutual funds they were sold (by the HOUSE) appealed to their natural ‘animal spirits’ to win. Unfortunately they were positioned more like gamblers given their odds of success. Actively managed mutual funds fall short of beating market averages nearly two thirds of the time. Another way to put it is they are positioned to lose two times out of every three.
So how can an investor think and operate more HOUSE-like? The answer is simple, but most ignore it because HOUSE-like thinking is not as exciting as CHANCE-like thinking. To those who remain in the latter camp, we say ‘luck be a lady tonight.’
House-like investing is achieved by stacking the odds in our favor. We do this controlling what we can and understanding and contingency planning for what you cannot. The process starts by defining the purpose for investing. Without targets, there’s no way to measure progress.
Rates of return targets, green lines, dollar goals all fall short because life is too uncertain and changing for them to be helpful. Rather, house-like investing starts by understanding goals in relative importance to one another. Ranking goals allows us to to maximize the most important goals to their ideal levels by ‘spending’ from goals that are not as important. For instance you may enjoy your work enough to continue a bit beyond your ideal retirement age in order to travel more, leave a larger estate for the kids, or spend more freely in retirement.
You can actually boost the odds of reaching your most important goals to 100% by controlling which goals get funded to the max and which ones are compromised when surprises come. We all understand prioritizing allocations when tough times bring scarcity, but planning in advance for those contingencies, when reason is not clouded by crisis, can be quite powerful. We make better – HOUSE-like – decisions.
But optimal allocation of goals is rarely enough to fund out entire plan. We require the growth power of the capital markets to fund the remaining needs. Yet, the returns of the capital markets are anything but certain, right? How can we employ the returns of uncertain capital markets in a house-like manner to confidently meet our goals?
The answer is: CONTROL WHAT CAN BE CONTROLLED, i.e. minimize investment expenses, taxes and under-performance, and PLAN FOR WHAT CANNOT BE CONTROLLED. This is how the HOUSES of Vegas operate.
The control part is simple to execute, but many find it comparatively dull. Invest as efficiently (broad, low cost index funds) as possible to reduce the drag of expenses and to ensure you will achieve nearly all the return offered by each capital market component – stock and bond. The index fund by definition achieves returns very close to the market index it represents. Take no more risk than is required to meet your goals so you will be more likely to remain invested through market storms. AND a less volatile portfolio reduces the odds that market misbehavior will unduly impact plan confidence when large spending amounts occur.
Planning is considerably more important than the first because it defines your purpose for investing. Your plan should accurately and fully describe your goals and priorities. It becomes the standard against which we measure your progress and confidence of achieving its goals.
We use probability analysis described by many in the industry as Monte Carlo (yes, Vegas designed it). Simply put, it runs your life plan and assets through random market returns a thousand times to provide varied outcomes. The results offer the probability that your assets will grow sufficiently to meet or exceed every goal you value for the rest of your life.
The process is ongoing. When markets do better than expected, we call you with advice to capture the opportunity to do more of something you enjoy doing, like travelling or less of something you don’t like saving. The opportunity is unnoticed or not quantifiable in chance-based investing.
When markets misbehave more than expected, and confidence drifts below acceptable levels, we call you with advice to ‘spend’ from a goal you don’t mind using to increase confidence (remember allocating in scarcity mentioned earlier?). An example might be that you are willing to take a little more market risk, or delay funding a beach house for a year or two.
House-like investing involves a partnership between client and advisor in which the client actively reviews and adjusts his and her plan to reflect changes in their lives and goals. The advisor controls every controllable aspect of the investment process for the efficient growth of assets and continually stress tests the plan for all kinds of possible market conditions to ensure adequate confidence of meeting its goals.
Investing like the HOUSE is indeed more businesslike than entertaining, but it is the odds on favorite for a financially abundant life. Sure, we hear occasional shouts of glee from the gambling HOUSE floor or cocktail parties, but the HOUSES go about quietly building wealth that is built on purpose and confidence.