Playing Roulette

Saturday, September 13, 2008

Research has shown that betting on the roulette wheel significantly increased when casinos began posting a list of previous outcomes. Gamblers clearly believed they had gained an advantage by seeing past occurrences. After seeing ten reds in a row, gamblers believed they increased their chance of winning by betting on black. Yet, they failed to realize that, on a proper wheel, all outcomes are independent of each other. So, absolutely no advantage is gained by seeing past outcomes. In fact, the suspicious gambler would begin to wonder if the wheel actually had a defect making it produce more red outcomes.

I recently had a discussion with another trader who argued that if you owned Fannie Mae from $70 and held it down to $4, you might as well keep holding it because you had already lost 94% of your investment. This is obviously foolish as your money invested is still real money. But, the human tendency to see losses in this manner is strong. The man worth a million dollars who worked is whole life to save a million dollars is likely much more proud of his accomplishments than the man who worked to make ten million, yet, lost nine million to end with a million. Even though the end game is the same, the second guy will be mocked by friends and feel like a failure.

I am not arguing that stock prices are independent of past prices. In fact, I would argue exactly the opposite otherwise I would not have a job. But, investments themselves must be seen as independent from day-to-day. Money managers must consider the desirability of their positions on a day-to-day basis without consideration of losses or gains on the position. The money invested in a stock is still real capital regardless of whether the position has sizable capital losses. Seeing ten reds is much like seeing a 70% loss on an investment. It is foolish to rationalize that you are more likely to see a black or a positive run because of the past. Rather one should think that the wheel is broken, that the company may have fundamental problems.

Investors holding Fannie Mae and Freddie Mac into last weekend were gambling their capital. While there was no risk of a government takeover when Fannie and Freddie were trading in the $60-$70 range, there was the risk when they were in the $5 range. The market had essentially made the assumption that the takeover was inevitable, yet, many investors were still duped into holding or buying more shares. Investors should have forgotten about the significant losses on their positions and realized they were gambling that the government would not intervene. There are unknown risks in investing, of course, but there are also known, incalculable risks. Investors need to avoid these incalculable risks especially when that scenario leads to a loss of the entire investment.

I'm not sure if this post is entirely coherent but I think the thoughts may be useful to consider. And, if the government had not taken over, perhaps I'd be the fool for not recognizing an amazing buying opportunity. But, with the beauty of hindsight, we can see that they were bad investments and maybe the final losses could have been avoided.


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