Marathon

Foreword

Unless you are extremely lucky, building wealth will likely be a long term process, something you work towards over long periods of time, possibly your whole career.

Once you’ve built your wealth, retaining it will require just as much, if not more effort. Without the discipline to control your budget, invest wisely and manage your risks, whatever wealth you may have built, can easily be squandered away.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Expected returns

Let’s say there is a game, where you have to bet your entire liquid net worth every turn, but the expected return to whatever you bet is 10% (i.e. the expected value of a $1 bet is $1.10). Would you play this game? And if you would, how many rounds would you play?

Given the positive expected returns, I’m guessing a large number of people will play at least one game, and a good number of people will play until they are rich enough to retire.

What if I say that every turn, you have a 99% chance of winning 11.11% of your bet, and a 1% chance of losing everything (expected return is still 10% per turn)?

I’m guessing that most of those who would play at least once, will still play at least once, but most people will only play a relatively small number of games, somewhere in the 1-50 games range, certainly not enough to let most people retire.

What if every turn, you have a 1% chance of winning 110x of your bet and 99% chance of losing everything (expected return is still 10% per turn)?

I’m guessing close to nobody would play the game now.

The key to remember here is that positive expected return is not nearly enough information to determine if something is a good bet. Volatility of returns is important too!

The longest race

From the day you start accumulating wealth, to the day you pass from the world, the need for financial discipline is constant — it is the race that never ends, until you literally do.

If you become fabulously wealthy, then yes, you can probably be more reckless and still get away with it. But not too reckless! History is replete with famous rich people who manage to gamble away unimaginably large fortunes.

But no matter if you have $500k saved for retirement or $5b, the fact remains that you need to maintain some financial discipline. Simply betting your entire liquid net worth on a lark is probably not a winning strategy!

If you are making a one time risky bet, you may certainly get lucky — even better if the odds are in your favor. But no matter how small the chance of ruin, if you keep making that same bet, and if every single bet is an independent event and thus has the same odds, then that small chance of ruin will eventually catch up with you — the law of large numbers practically guarantees it.

It is with this in mind, that I view with horror at how some people are betting large portions of their net worth on options. Yes, in the short run, you can quickly grow your money by a few multiples, maybe even a few orders of magnitude — as long as you remain lucky. But once your luck runs out, one bad bet can easily ruin you. To make matters worse, buying options generally has negative expected returns — options are generally priced such that options sellers have positive expected returns, while buyers have negative expected returns.

Viable strategies

That’s not to say that risky bets are totally off the table. The crux of the matter is that the event of ruin, no matter how unlikely, will eventually occur if we tempt fate enough times. So, naturally, the strategies to counter involve trying to reduce or completely remove the chance of ruin.

For example:

• Diversification
  • By spreading out your bets, the probability of all of them going sour at the same time is reduced, hence reducing your chance of ruin.
• Taking profits
  • For speculative bets, including investments that have gone beyond rational exuberance, taking some profits off the table gives you cash to redeploy as and when the markets regain some sanity.
• Buying insurance
  • Insurance in the financial markets tend to be expensive, but if you have a position that has a large chance of ruin, it may make sense to buy some insurance against that event. For example, if your portfolio is heavily concentrated in technology stocks, it may make sense to hedge that exposure by buying puts against QQQ.
• Rebalancing, position sizing
  • A combination of taking profits and diversification, regularly rebalancing your portfolio and making sure the value in each position is a limited part of your entire portfolio will ensure that no single blow up will wipe you out.

Marathon

At the end of the day, it is important to recognize that getting “there” and staying “there” are two sides of the same coin. It is a journey from the first dollar you make, to when you are laid to rest. It is a marathon, and you need to treat it as such — making rational, long term decisions, instead of trying to bet the farm on random whims.