#28: My favourite way to think about investing, part 2

29th March, 2021

Welcome to the Idiot Money newsletter. The newsletter that knows that even if the crowd doesn’t have wisdom, when it makes the price, you need good evidence to bet against it.

This week: becoming wiser with money by understanding how odds create opportunities.

This is the second in a short series about how to choose investments in a way that isn't overwhelmingly frustrating. The first part is here.

All investments are gambles, but the house doesn’t have to win.

I ended Idiot Money #24 saying that my favourite way to frame the search for an investment philosophy, ‘all investments are gambles’, isn’t a message of fear, but a message of hope.

All investments are, by definition, hopeful. You put aside something now in the hope of getting back something better later.

We’re not talking – as is all-too-commonly, and all-too-dumbly done – about sacrificing current in-the-moment enjoyment in the hope of more future in-the-moment enjoyment. To do so would be to vote for a worldview that confuses consumption with a life well lived and make you sound like one of those idiots who believe spending your last penny on your last day is to somehow win the maths of life.

We’re merely recognising that every use of your resources, be it labelled a ‘purchase’, an ‘investment’, or even ‘yet another bloody meeting’ is an investment. Swapping potential stuff for an actual thing in the hope life is better with the actual than the potential. This goes for whether you’re using money to purchase your first home or your tenth beer, or using your time and energy to purchase that money with a job.

All allocations of all your money, time, and energy, are plays in the grand guessing game of your life.

Your brain is a prediction machine. It allocates your resources in the hope of yielding Goodness. This is why learning to see more clearly is at the heart of all practical financial planning – because while financial forecasts are usually a waste of time, money affects the predictions being made by your brain more than anything else.

Given this, it’s probably better to stop being scared of bets and start working out how to make better ones. Especially in the context of the two big questions of investing: how to start, and what to invest in.

Before we get to the strategy itself, however, we need to take a quick detour via the bookie’s.

Odds over outcomes

I gambled pretty extensively at university. A lifetime obsession with sports and stats met a communal subscription to Sky Sports and an heroically awful work ethic. I spent more time on betting forums than I did in lecture theatres and opened more online accounts than I wrote essays.

I got pretty good. If I’d had more money to start with, I could’ve paid for more than beer with the winnings. But betting to make money is tremendously boring and takes ages.

The first and most important thing I learnt about gambling was this: it’s not about picking winners. It’s about spotting mispriced percentages. It’s about odds, not outcomes.

You could win 99 out of every 100 bets, but if they’re all priced at 1/100, you’re going to lose money. Conversely, you need win only one in a hundred 100/1 bets to be in the black (because the odds say it won’t happen 100 times for every one it does, and you got one win and only 99 loses).

Successful gamblers know long-term profit comes from judging where the implied chances of each outcome happening are wrong, not from predicting the right outcome. Odds are simply percentages written in code. A 4/1 bet means something’s predicted to happen one in five times, or 20%. A 1/4 bet means it’s predicted four times out of five, or 80%. And so on.

In a betting market, the odds, once converted into percentages, will add up to more than 100%. The excess is the ‘overround’ – the bookie’s profit margin. For example, in a two-horse race, a single bookie will never price Horse A at 1/4 and the other at 4/1. They will maybe price them at 1/5 and 3/1 (a profit margin of 8%).

If the odds say there’s an 80% chance of something happening and you reckon it’s got a 90% chance, you play. If you’re right, over time you’ll make money. Above-average returns means above-average subjective predictions, not above-average objective results.

As Howard Marks (the big-shot investor, not the cooler one) put it:

The bottom line: the goal isn’t to figure out who the favourite is and bet on it. Rather, the goal is to figure out who the favourite is and whether the odds are fair or not. If the odds are fair, there’s no reason (other than sentiment) to bet on one team or the other. […] Success in investing doesn’t come from buying good things, but from buying things well, and it’s essential to know the difference. […] It’s not a matter of what you buy, but what you pay for it.

We’ll see why this is so important next time.

#30: My favourite way to think about investing, part 3