Why We Underestimate Risk by Omitting Time as a Factor

Suppose I offer you a simple gamble. Throw a dice: If you get a six, you win $10; if not, you lose $1. The loss is more likely; the win brings more money. Willing to play? The generally accepted way for deciding in such cases -- developed originally by the French mathematician Blaise Pascal in the 17th century -- is to think of probabilities. The outcome will always be a win or loss, but imagine playing millions of times. What will happen on average?  

Clearly, you’ll lose $1 about five times out of six, and you’ll win $10 about one time out of six. Over many gambles, this averages out to about 83 cents per try. Hence, the gamble has a positive “expected” payoff and is worth it, even if the gain is trifling. Play a million times and you’re sure to win big.  

But here’s something odd. Suppose I offer precisely the same gamble, only scaled up. Roll a six and you now win not $10, but 10 times your total current wealth; if you roll anything else, you lose your entire wealth (including property, pensions and all possessions). Your expected profit is now far bigger -- equal to 83 percent of your total current wealth. Still want to play?  It turns out that most people won’t take the latter bet, even though it will, on average, pay off handsomely. Why not? For most of us, putting everything on the line seems too risky. Intuitively, we understand that getting wiped out carries a brutal finality, curtailing future options and possibilities.  

‘Risk Averse’ 

Economic theories generally ascribe such cautious behavior to psychology. Humans are “risk averse,” some of us more than others. But there’s a fundamental error in this way of thinking that still remains largely unappreciated -- even though it casts a long and distorting shadow over everything from portfolio theory to macroeconomics and financial regulation. Economics, in following Pascal, still hasn’t faced up honestly to the problem of time.  

Anyone who faces risky situations over time -- and that’s essentially everyone -- needs to handle those risks well, on average, over time, with one thing happening after the next. The seductive genius of the concept of probability is that it removes this history aspect, and estimates the average payoff by thinking of a single gamble alone, with two outcomes. It imagines the world splitting with specific probabilities into parallel universes, one thing happening in each. The expected value doesn’t reflect an average over time, but over possible outcomes considered outside of time.  

This is so familiar that most of us take it as the obvious method of reasoning. That’s a mistake. As the physicist Ole Peters of the London Mathematical Laboratory has shown in several recent papers, averages through time and over probable outcomes aren’t the same, and the latter calculation offers a dangerously misleading guide to risky choices. Especially whenever downside risks get large, real outcomes averaged through time are much worse than the expected value would predict. Even in the absence of risk aversion, there can be sound mathematical reasons for being unwilling to take on gambles (or projects), despite wildly positive expected payoffs. (To learn more, see my blog).  

So what? Well, the assumption of the equality of these different averages -- technically known as the assumption of “ergodicity” -- is considered a given by most of contemporary economics. It makes the mathematics easier in the financial portfolio theory that influences countless investors and in frameworks for designing regulations to keep financial risks at acceptable levels. Unfortunately, this error systematically underestimates prevailing risks.

Confidence Brake  

It also may encourage overly optimistic ideas about the ability of an economy to recover from a crisis. For example, those who support policies of fiscal austerity believe that companies, in seeking to maximize their profits, will naturally drive an economy back to steady growth. The economy will spring back if companies and individuals have confidence that their investments will pay off. If that’s the case, why aren’t businesses investing globally when interest rates are at historic lows. What’s holding them back?  

The fairly obvious answer is serious downside risk, which makes the reticence entirely sensible -- if you live in the real world where time matters. Such behavior is in fact sensible in this “balance-sheet recession” -- the term coined by Nomura Research Institute Chief Economist Richard Koo to describe what happens after big asset bubbles burst, leaving companies mired in debt, their assets worth less than their liabilities. Low interest rates won’t encourage borrowing -- even to finance positive-return investments -- because companies need to pay down their debts, and fear going bust altogether.  

Unfortunately, errors of analysis embedded within core theories can ultimately become errors of intuition for the millions of people educated in those theories. It’s ironic -- and a little alarming -- that so much of our thinking remains founded on aspects of Pascal’s ideas that are still largely unexplored.

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Low risk investments- ETF

There is simply too much risk for retail investors to buy single stocks. If you spend a large portion

of your savings in one of these “stocks” because you have some insider information – from who ever,  you run the risk of saying good bye to  your hard-earned money .  Besides when such information reaches you, you can be sure, it's totally outdated & it's best not to follow it!!!!

Many experts are now suggesting novice investors to stick to exchange-traded funds (ETFs). These are baskets of stocks created by big time fund managers,  which aim to replicate the performance of widely watched market indexes, such as the S&P 500, Hang Seng Index and Straits Times Index.

The advantage  is their low management costs, which can go as low as 0.09 per cent in the case of SPY - the ETF tracking the S&P 500. 

There is also no risk of the investor losing his shirt as his investment is spread out over the large number of stocks that make up the ETF, thereby mitigating the potential fallout that the failure of one counter would have. Besides that’s something quite similar to how billionaire Mr Buffett does it by his ‘buy-and-hold strategy’. Of course his is much more complicated but hey.... it's something like that...lol.....

If we want to follow in his footsteps  to buy into local blue chips, we can buy an ETF traded on the Singapore Exchange, such as the SPDR Straits Times Index ETF or the Nikko Asset Management STI ETF. And if you make some money, think of me!!!

Vitamin C Whitening Jab & Nose Filler 

Hedge Funds? You're Better Off buying Toto

The reasoning of most lottery players is, “Well, it’s only a couple of bucks.” It’s true that a dollar or two won’t really make a dent in your long-term picture. You will spend more on fancy coffee this morning, surely.

Consider, then, the quandary facing so-called “sophisticated” investors. They put far more than a dollar into the assumptions behind hedge funds. Try “2 and 20” on for size. Hedge fund managers expect investors to pay 2% of assets and 20% of profits, if any.

The “if any” part is the most amusing. As Goldman Sachs recently pointed out in a broad analysis of the industry, just 13% of the funds were beating the S&P 500 in 2012. The point of “hedge” logic is to make money in any market. Except, apparently, a market that mystifies the supposed smartest money on Wall Street.

Try for a moment to picture what 2% and 20% really means. Say you have $1 million under cover. That’s what many hedge funds require of you to invest in the first place. Remember, too, the dreaded “gate” clause. You can’t take money out on a moment’s notice, particularly if the fund is losing ground.

So your $1 million is locked in a safe, for all intents and purposes, and you can’t touch it. So far, that sounds like a certificate of deposit.

Except it’s not. There’s no guaranteed return at all, just your faith that a given manager is going to demolish the benchmark and not be in the 87% group of losers. If that happens, you might think it was a worthwhile gamble. Then the manager comes for his or her piece of the action.

Let’s say your hedge fund returns 10% in a year that the broad stock market turns over, say, 7%. You’re feeling pretty good, right? Now add in the 2% annual fee on assets under management. And the 20% performance fee.

Hedge fund analysis is tricky. The 2-and-20 can vary to as high as 4-and-50 in some cases, but the back-of-the-envelope number works out like this: $1 million plus a 10% return gets you $100,000 in profit for the year.

Subtract the performance fee and you’re down to $80,000. Now take out the annual management fee on your million bucks (the hedge fund gets this win or lose) and you’re out another $20,000. Your take is down to $60,000.

Now picture $1 million sitting in passive ETFs, properly allocated and simply earning their respective benchmarks. It earns 7%. There’s no performance fee and your average cost for the ETFs is not 2% but 0.2%.

On a million bucks, that’s $2,000. Your return for the year is $68,000 — way ahead of the hedge fund holders in a relative “losing” year. You beat the hedgies by 12.5% in dollars returned.

 Vitamin C Whitening Jab & Nose Filler

Time is a very Powerful Financial Tool

In terms of money and retirement:

While rapidly rising medical costs are a legitimate concern, the fact remains that young people very much have it in their power to prepare for the financial realities of retirement.

It’s not just saving more and being disciplined about spending, although that helps. No, the advantage of youth when it comes to retirement is twofold: immunity to volatility and the simple, wealth-building power of compounding.

First, as a young person, you can afford a huge market drop. Many beginning investors see an event like the 2008 credit crisis and get spooked. They quickly move to conservative holdings and never assume an ounce of risk again.

But the fact is, stocks recovered. A major decline and a subsequent recovery, even one that takes a few years, is really a blip when you’re talking about a multi-decade investing trajectory. Focusing on paper losses means you tend to ignore the consecutive years of double-digit gains before and after the down year.

Secondly, you have a multi-decade investing trajectory. That means you really get to enjoy the effect of compounding. Simply put, a properly allocated portfolio can double in 10 years or less.

 Vitamin C Whitening Jab & Nose Filler