Luck and taking a flyer

The individual investor

No joy in throwing away money

Incurring additional risk does not earn you a better return unless the reward more than justifies the additional risk. Even then, position sizing is critical for higher risk investments.

The question in this post is whether investors are ever justified in taking a flyer. A flyer might be thought of as a very high risk – very high reward investment. It typically has little chance of success. Is there a time to let lady luck work her magic for us for a big payoff?

Low percentage shots

It is dangerous to use analogies. But, let’s try one. In sports, such as squash or golf, there is a constant choice to be made as to the risk to be taken on any shot. The best policy is usually to avoid high risk/high reward shots. What is high risk depends, of course, on your ability level. Let’s think about golf for a moment.

One of the most important ideas in golf is the use course management in playing a round. One is almost always better off to attempt to play a shot that is within your skill level. One almost never attempts to play a shot at the limits of one’s ability, let alone beyond your skill level. Once in a career one might be able to playing a shot that has to get over trees and over a lake, to a small green at the limit of your distance ability. This is a very low percentage shot.

Most of the time the ball will end up in the lake or in some other disaster. If a golfer plays this shot and succeeds it is most certainly a very lucky shot. And so in golf it is said, one is much further ahead playing the high percentage shots. These shots have a reasonable probability of success. If one of these shots succeeds it can be said to have been a shot that depended on skill and some component of luck. There is always a component of luck.

However, there are times to try the low percentage shot. If succeeding in the high risk shot wins you the championship and not trying it means you have no hope of winning the championship, you try the shot. The reward is great enough to take on the additional risk. But if you make the shot, it was very much a lucky shot. Of course, the downside risk is pretty small. You don’t win the championship, but then you weren’t going to. The cost of the failed shot was a lost golf ball. There, the crazy high risk shot is worth it. It meets the risk/reward test.

In football the super high risk move is called a ‘hail mary’. This is the desperate long pass that has little chance of success but may win the ball game in the last minute if it does.

Skill level

A shot that for me is high risk might be low risk for Tiger Woods. The level of risk can depend on your level of expertise. Warren Buffett is always talking about sticking within your area of competence. Of course, with experience, one’s level of skill will increase. One’s area of competence will change. But, no matter your level of skill and experience, there are many investments that are simply bad bets.

Taking a flyer

Let’s say you invest in an IPO with great plans for a new music streaming service and the shares drop by 50% in the next six months. That is not bad luck. The original investment decision was flawed. Why was it flawed? The investor was sold on a concept, on a story. If the same investor in the streaming service company had made a tidy packet from the investment, it would have been very good luck. The investor might not have viewed it as good luck, but a high reward from a risky investment. This would perhaps lead to repeating the mistake again, which would most likely have led to a substantial loss.

So, the issue is whether we should ever occasionally take a flyer with something like a new music streaming service with a great story to tell. We might persuade ourselves that if we give luck a chance to work for us, we might just make a killing.

But, relying on luck in such a situation is like ‘investing’ in a lottery. One doesn’t ‘invest’ in a lottery.

To my way of thinking, a crazy high risk golf shot to win the championship is worth it. But, I wouldn’t put a nickel into a lottery.

A lottery is simply a gamble where the potential reward doesn’t justify the risk. There is a name for it. It’s called risk seeking behavior.

We can define some terms here. Risk seeking behavior is behavior where the potential reward does not justify the risk taken. The flip side is risk averse behavior. That is where the investor is unwilling to invest even though the potential rewards amply justifies the risk taken.

It’s all about probabilities

Warren Buffett explained this at the Berkshire Hathaway Annual Meeting in 1989: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”

With a flyer, the expectation of loss heavily outweighs the expectation of gain. So, why do investors do it?

Investors love a story

They are often called concept stocks. They are the next big thing. The product is described in glowing terms. The ‘addressable’ market is huge. All the product has to do is capture one per cent of the market and the company will make a fortune and all its shareholders will be rich.

Kahneman writes: “The most coherent stories are not necessarily the most probable, but they are plausible, and the notions of coherence, plausibility, and probability are easily confused by the unwary.” (Kahneman, Thinking, Fast and Slow. 2011) p159

It seems that given a choice between two outcomes with different probabilities, Humans have a tendency to choose as more probable the one with a more plausible story rather than the one with a more probable outcome. This is another example of how we are lazy in our System 2 thinking and are content to accept erroneous answers offered by System 1. (Kahneman, Thinking, Fast and Slow. 2011) p164

This bias might be thought of as the Plausible Story Bias. Investors must be alert not to take a Plausible Story at face value. Investors need to reflect on the inherent probability of the situation. It is easier said than done.

Mad money

I’ve heard it said that there is no harm having a small pot of money to put into high-risk flyers. It is supposed to allow investors to have a bit of fun on the side. To me there is no joy in throwing away money on something like this.

Venture capitalists

A successful venture capitalist might say: ‘Wait a moment. That’s what I do and it works.’ My answer is that venture capitalists and angel investors have different skills from the type of investing described in this blog. I can’t speak to the kind of skill one needs to be a successful venture capitalist or angel investor. No doubt they have their own area of competence.

Conclusion

If the potential reward doesn’t justify the additional risk, the investment is not worth it. There is really no room for taking a flyer in the world of investing.

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For readers wishing to dig a little deeper into the subject of investing and luck, take a look at these posts:

Can investors improve their luck?

Experience and becoming a really successful investor

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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