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Investing - Irrational tossers

2016-11-02 09:10:29

Nov 1st 2016, 16:10 by Buttonwood

THERE are few sure things in investing. But the chance to bet on a rigged coin

sounds like a good one. Alas, a paper by two fund managers, Victor Haghani of

Elm Partners (and co-founder of the collapsed Long-Term Capital Management) and

Rich Dewey of Pimco, shows that it is possible to get even that wrong.

The paper invited 61 people, a combination of college-age students in finance

and economics and some young professionals at finance firms (including 14 who

worked for fund managers), to take a test. They were each given a stake of $25

and then asked to bet on a coin that would land heads 60% of the time. The

prizes were real, although capped at $250.

Remarkably, 28% of the participants went bust, and the average payout was just

$91. Only 21% of the participants reached the maximum. 18 of the 61

participants bet everything on one toss, while two-thirds gambled on tails at

some stage in the experiment. Neither approach is in the least bit optimal.

Apparently the right strategy is to use the Kelly criterion, named after a

researcher at Bell labs. Based on the odds in this experiment, the right

approach would be to bet 20% of your pot on each throw. So if you lose, you cut

the size of your bet; if you win, your stake increases.

Your blogger had a go himself, and being a cautious Yorkshireman, never bet

more than 10% of the pot. But I got to the $250 with a few minutes to spare. It

is a frustrating process at first; literally three steps forward and two back.

There was more than one run of four tails. You can try it yourself here (there

is no prize money; this is just for intellectual interest).

Is this a fair test of the real world? Well, real money was involved and the

people being tested should have had a greater knowledge of finance than most.

But even smart people can be blindsided by dumb luck.