Category Archives: probability

The Pruning Effect

I’ve talked and written at length about the necessity of recognizing that we are imperfect and how our natural tendency to fight that reality harms us as investors. When we deny that a loss is really a loss (see The Paper Loss Fallacy) we allow the problem to potentially grow into something meaningful and dangerous. By becoming comfortable with the reality of imperfection we give ourselves the opportunity to keep losses small while letting winners grow unconstrained. Rules that allow for the generation of a lopsided relationship between the size of wins and losses are the key to generating long term growth.

Recently I conducted a review of a client account that has been here since January 2008. Every transaction was examined Continue reading

The Correlation Problem

What are the odds of flipping a fair coin and getting tails four times in a row? There are 16 possible outcomes for four coin flips:

H H H H   H H H T   H H T T   H T T T
T T T T   T T T H   T T H H   T H H H
T H T H   H T H T   T H H T   H T T H
T H T T   T T H T   H T H H   H H T H

The odds of flipping four tails in a row are 1 out of 16, a 6.25% (or .5^4) probability. Unlikely, but not that unlikely. In a hundred coin flips, the odds say that you’ll probably see it happen six times.

Now let’s say that you have an investment approach that you feel confident will produce Continue reading

Win Thumb Lose Thumb

A few nights ago, I was watching a show about people that have been attacked by various forms of marine life. There was a man that was stabbed by a marlin’s bill, another man that was bitten by a beaver, that kind of thing. The best segment though, was the one where a giant moray eel bit a diver’s thumb off and ate it. It seems that the diver had built a ‘relationship’ with this particular eel by feeding it sausages. Flesh colored, thumb shaped sausages. The diver answered the question of why he was surprised by the, seemingly obvious, outcome by stating, “I was shocked because there had been no problems up to this point.” Fortunately doctors were able to replace his missing thumb with one of his toes. Unfortunately, there was nothing they could do for his tragic lack of imagination.

The diver made a classic blunder. He assumed that not having body parts eaten the first few times held some significance. He confused a winning bet with a good bet, which is often not the same thing. There are four types of bets: Continue reading

Luck Eventually Runs Out

Bloomberg View just published a great Nathan Myrhvold piece on our human tendency toward complacency in the face of threats that aren’t actively killing us.

One could recount many such examples, but people’s eyes tend to glaze over when you talk about something that last occurred in 1783, much less 934. Surely things are different now, they say. The unfortunate truth is quite the opposite — a millennium ago was yesterday as far as the Earth is concerned, and the relevant phenomena operate as vigorously as ever. Proud as we are of the many technological achievements of modern society, we are actually more vulnerable than ever because we live more densely, within a complex and sometimes fragile web of buildings, roads, bridges and the like.

There is an obvious investing parallel here, as investors in Iceland, Japan and Greece could attest to. An unusual, but mortal, threat is worth your attention. If you are willing to insure a $40,000 car but have no risk management plan for a million dollar portfolio, the time for a strategy session is now.