In most instances, the act of buying and selling results in two reasonably content parties. A person goes to the grocery store for some bread and milk, he or she purchases them, and both that person and the grocer go on with their days. In select instances, both parties come out of an exchange mutually pleased. Think of eBay, where one party unloads some old junk and the other party finally locates a sought-after board game from their youth. The key aspect making both parties happy is unquantifiable; the nostalgic tug adds value for the purchaser while the seller feels as if they struck gold. An economist might say both parties derive positive “utility” from the transaction.
But then there are transactions that automatically imply a winner and a loser. In such cases, one side might derive negative utility. In these much more common dealings, there is no emotion involved whatsoever and, for one party to come out ahead, the other must lose. Generally, these involve insurance contracts, gambling and, yes, investing. There’s no nostalgia attached to investment performance and payouts are fungible. Delineated so absolutely, this may sound harsh. But investing isn’t a game. And it shouldn’t be treated as such.
Picking Winners is a Loser’s Game
Visitors to a Las Vegas casino are under no illusion that they’re investing. The artifice is a remarkable piece of marketing when you think about it. Here are perfectly rational people taking their hard-earned money and placing bets despite the knowledge that the odds are stacked against them. On its face, it’s completely illogical. But when one adds enticements such as alcohol, bright lights, and a social element, suddenly casino-goers view it as “fun.” People come out and admit it, in fact. It’s an honest acknowledgment to the fact that the “fun” of gambling is worth the cost of likely losing.
Strip away the glamour, the roulette wheels, and atmosphere that many associate with the live casino experience, however, and people approach things much differently. At home behind their laptop, while pondering retirement options, people believe they’re investing. As they dutifully read a prospectus while tapping a pen on their reading glasses, they recognize the endeavor is not designed to be fun. They simply want to find the best way to make money for retirement, pure and simple. Yet, as they make their choices, they rely on questionable fund rating systems and track records that aren’t predictive They are left to speculate on the reasons a fund holds specific securities rather than understanding the methodology used to select them. Inadvertently, by failing to know what they own and why, they have turned an investing operation into a gambling one.
The reality is that gambling and investing are utterly different activities…yet people persistently confuse the two. In fact, studies have shown that people are hardwired to prefer the thrill of winning But, unfortunately for such speculators, just because they aren’t pursuing such activities inside a casino doesn’t mean they’re not gambling.
Gaming the System
The board game, Monopoly, is a game, of course. But it’s also an illustrative example of the market itself. In order to win, others must get knocked out of the competition. And over the course of the game—just like in the market—there are things you can control, such as decisions to buy a property or which to trade. But then are things you can’t control, such as dice rolls or what Community Chest card you pick (Idiosyncratic Risk, essentially). We believe, however, that within this Idiosyncratic Risk lurks the danger of human behavior. This is the risk caused by humans impounding vague and ambiguous information into the market or the game, as the case may be. And—SPOILERS—we believe there’s a way to mitigate it.
How can vague and ambiguous information be mitigated in Monopoly, a board game that’s been played for decades? The same way it has in the stock market which is, putting it lightly, quite a bit older. Quite simply, a Monopoly player needs to focus only on the known information and ignore the unknown. And the vital piece of information not commonly known in the game? The orange properties are the most landed-on property set. By focusing your efforts on acquiring New York Avenue, Tennessee Avenue and St. James Place, you’re effectively using quantitative analysis as your guide while others are gambling based on hunches and feelings.
This analysis is very similar to the approach utilized by the insurance industry. Like casinos, they improve their success by focusing strictly on known information rather than unknown information. Think of it this way: insurance actuaries don’t ask if you intend to go to the gym or if you intend to quit smoking. They simply ask if you smoke or if you go to the gym. They underwrite risk only on known available information. Then it’s simply a matter of tipping the odds ever so slightly to their own advantage. While no industry is ever 100% guaranteed to turn a profit, a cursory summary of key segments of the insurance industry over the years is striking:
Are you rolling the dice with your portfolio?
In every exchange of goods or services, there is a buyer and seller. In the eBay example discussed previously, think of it as the buyer going long on a nostalgic board game and short on cash. This exchange was mutually beneficial to each party because the boardgame was valued more greatly by the buyer while the cash was valued more greatly by the seller.
In virtually every other exchange in life, however, you want to be a seller, not a buyer. The casino tips the odds in its own favor…the insurance companies ensure they remain profitable. They neither presume a fair board exists nor claim to represent one. Rather, they offer enticements such as fun or safety that encourage people to follow their emotions. Then people pay a premium for such options. In essence, “the House” prevents them from winning by offering something else in its place. But this begs the question: who is “the House” when you’re investing? Without such attractions, you may be paying for something you’re not getting.
Casinos offer “fun” as a substitute for one’s cash. Insurance companies offer “protection” or “security.” But what excuse does a speculator have when forking over their hard-earned money?
New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to inure investor portfolios against an idiosyncratic risk caused by human behavior. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behavior. Through our research, we have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to our investment approach, we have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behavior.
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