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A 2016 @ElmPartners experiment provides what I think to be a powerful reminder that active investors should perhaps spend less time looking for investment opportunities and more time stressing over issues like probabilities, correlations, position sizing and behavioral biases 1/n
In the experiment, 61 (mostly) finance students & professionals were given $25 to knowingly bet on flips of a 60/40 heads-biased coin for 30 minutes with the right to keep their winnings at the end. Under these parameters, the expected value of the winnings of a fast bettor
employing theoretically optimal bet sizing (20% of her money on heads each flip) is over $3 million. Fearing this payout risk, the researchers imposed a $250 payout cap. If the participants used something even in the vicinity of optimal bet sizing, 95% of them should have
walked away with this cap. Instead, only 21% reached the cap. Worse yet, 33% lost money, with 28% going bust. . The rest averaged an ending sum of $75. Among other follies leading to these seriously suboptimal results, 67% of subjects bet on tails at times (apparently largely
on the logic that a tails was “due” after a string of heads) and 30% of participants at some point went all in on a single flip.
It is remarkable that persons betting on the exact same sequence of opportunities could have such wildly different results—ranging from a potential 120,000 bagger to certain bankruptcy—based on a factor like bet sizing alone. It is even more astounding that you could place a
string of nothing but winning opportunities with explicit, known odds before a group of educated and undoubtedly intelligent people and expect that 1/3 will lose money, 1/4 will go bust, and pretty much everyone will walk away with a mere fraction of what they should have
obtained. For all the time we spend looking for favorable investment opportunities, an experiment like this suggests we probably don’t even really know what to do with one once we find it. The issues that plagued the participants—position sizing, managing uncertainty, behavioral
biases, etc.—are only more intense and complex in the securities investment context. If you care about making money or not losing money and haven’t begun seriously sweating these issues, you may want to start. I’ll share some of my personal reflections in a blog post soon FWIW.
Full experiment details here: https://elmfunds.com/lessons-from-betting-on-a-biased-coin-cool-heads-and-cautionary-tales/">https://elmfunds.com/lessons-f...
