probability

Lose small, win big

In many situations, you'll noticed that all you need is one big break that pulls you out of a string of failures. The huge win that wipes out all your losses. You see this in investments, businesses and games. But of course, it also works the other way round more often than it should. You probably know someone who lost everything in a bad bet. After all, losing is part of the game so someone got to take the hit.

It is best to expect losses and aim to reduce its damage but Nassim Nicholas Taleb took it a step further and used the inevitability of losing as his strategy to win big. He planned his investment strategy around the fact that sooner or later a financial disaster would occur and aims to cash in on that.

He used a financial instrument known as options where you can make bets against the future of the stock price. You can obtain options to buy or sell stocks at a certain price. He systematically purchase options to buy stocks at a price which is most likely higher than it will be during a market crash.

Obviously the market doesn't crash that often, so most of the time he is slowly losing money. (due to the transaction cost of trading options) But when the day comes, he will exercise his options to recoup his losses and more. He limits the money he can lose while leaving the opportunity to make a much larger amount.

I think this is probably the best strategy you can ever adopt. You should try apply it not only to your investment portfolio but to everything in your life. We can't prevent failures and losses. So losing is fine as long as it's small but remember to leave the door open for yourself to win big.

Don't be the turkey

This is an example from The Black Swan that highlights how we can not rely on the past to predict the future. I find it extremely funny and pretty disturbing at the same time.

Farmer feeds his turkey everyday. He makes sure the turkey is well-fed and taken care of. The turkey is happy because it's well fed and loved.

As time goes by, the act of being fed and loved makes the Turkey feel that this is how things should and will be. Looking back into the past, this is how it has always been. Fed and loved. This is the life of a turkey. Each passing day reinforces this thought.

Come thanksgiving, farmer butchers the turkey

Woops. If you are the turkey, you will be confused because you thought the future is bright and filled with love. But if you were the farmer, you knew this day will come. You fed the turkey for this day. Each passing day reinforces your belief that one day you will have the turkey for dinner.

What comes as a surprise to the Turkey is not for the farmer. Thanksgiving is an event that's completely random and unexpected (Black Swan) if observed from the Turkey's perspective but to the farmer that's what happen every year.

So what should we do? For starters, realize that there is a lot of things that we can't predict using data from the past. If you need to make a prediction, try to identify areas that are vulnerable to these Black Swans. Minimize the negative impact of random events and position yourself to benefit from the positive ones. If you are interested in this subject, read the book and remember, don't be a turkey.

Probability is dangerous

Having read books like The Black Swan and Fooled by Randomness (both by Nassim Nicholas Taleb), I'm somewhat terrified by how often we misunderstood probability and randomness. Consider these scenarios.

Probability of getting head tossing a fair coin is 1/2

Probability of tossing 5 heads in a row is 1/2 * 1/2 * 1/2 * 1/2 * 1/2 = 1/32

Probability of getting heads after tossing 4 heads in a row is 1/2

The last scenario is where most of us make the mistake of thinking, since there's already 4 heads before this, the chances of getting another head is pretty slim.

This is known as the Gambler's fallacy. The probability is 1/2 because that is probability of getting head tossing a coin. It doesn't matter if we get 4 or 100 heads in a row, the probability remains the same because those events have already occurred and the last coin flip can be viewed as an independent event like the first scenario.

It should be obvious by now that, misconception on randomness and probability can be very dangerous to a gambler but what about the rest of us? With today's ever more complex financial instruments, we are all exposed to certain degree of risk with our investments.

In order to minimize risk, we need to understand probability. Nothing is certain in our lives and not knowing that is dangerous.