Randomness and luck affect your investments more than you think
Mitchell Barr, Client Associate
The last horse was loaded into the gate and the crowd focused in with only moderate enthusiasm. It was the 131st running of the Preakness stakes. The race was not thought to be a close one. The reigning Kentucky Derby winner, Barbaro, was a very heavy favorite at 3 to 5 odds. It was as close to a sure thing as you will get in horse racing … until it wasn’t. The gates crashed open and Barbaro didn’t even make it twenty yards after he shattered his leg on the side of the stall. There would be no Triple Crown winner for the 2006 season.
Barbaro was the safest bet someone could have made that day at the racetrack. (He won the Kentucky Derby by six and a half lengths). If you were forced to throw down every dollar you’ve ever made on that race, it was a no brainer who you would choose. And yet, at 3 to 5 odds Barbaro was thought to only have a 62.5 percent chance of winning. In the stock market, many investors gravitate toward stocks that are similar to Barbaro. They want the sure thing and trick themselves into believing that an investment is safer than it actually is. This attitude stems from the fact that investors are supremely overconfident in their ability to make prudent investments and partly explains why so many people pile into the horses leading the race right now in the stock market like Amazon (AMZN), Apple (AAPL), and Facebook (FB).
The trouble with that logic is all investments carry risk and sometimes those risks aren’t even known. Who could have possibly guessed that Barbaro would break his leg coming out of the gate? Just like nobody dreamed that the 2008 financial crisis could wipe out all the profits the banking sector has ever made since the beginning of modern banking 1! Let’s not kid ourselves into thinking that there is ever a such thing as a safe investment when events like this are not only possible, but are mathematical certainties over long periods of time.
It also can’t be overstated how much luck and serendipity is involved in trying to choose the winner of a horse race or an investment. Imagine how lucky you must have felt if instead of betting on Barbaro, you had placed a large wager on Bernardini at 12 to1, the eventual winner of the 2006 Preakness. So many things had to go right. The favorite broke his leg on the way out. One horse slipped here. Another one stumbled there. There were a million variables at play. Don’t treat your financial future like a horserace. The best thing an investor can assume when considering a new investment is that he or she knows absolutely nothing and has no control over the outcome. In thinking this way, you may not be so quick to bet the house on the heavy favorite.
- Taleb, N. N., & Investments, L. P. (2009). Report on the risks of financial modeling, VaR and the economic breakdown. Report presented on Committee on Science, Space and Technology, 9.
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.
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