Finance 101: When wildness lies in wait

Would you prefer to be 100 percent correct 50 percent of the time or 50 percent correct 100 percent of the time?


“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”
–G.K. Chesterton, ”Orthodoxy”

Let’s say you had to choose a way to make decisions on an ongoing basis. Implied in this is that you hope to make good decisions consistently. Everyone probably agrees that they won’t be right all the time, but seek to be right more than wrong over time. Making consistent decisions would give a person some sense of certainty in how they were progressing. It would support their faith in how they were doing.
But we all make decisions in different ways. We all have different values, approaches and aspirations. To parse this idea, I pose the following question for the reader to consider: Would you prefer to be 100 percent correct 50 percent of the time or 50 percent correct 100 percent of the time? Let’s also assume you could simply take these odds and get the results they project. These odds are assured by an omnipotent probability god. We will think along the lines of a 30-year time horizon in which this exercise will take place. We’ll also assume we have high conviction that the outcome we choose will in fact come true. And just to make it interesting, let’s also assume the 100 percent/50 percent approach would give us somewhat better results. Which would you choose?
Both of these approaches seem to give us a chance to make good decisions with some sense of consistency and certainty. Mathematically, it appears, you would get success half the time for each over that 30-year horizon. But that ignores how probabilities actually work.
What if you chose the 100 percent/50 percent approach? It is perfectly within the probabilities that you could fail for the first seven years. If that were to happen, how strongly would you adhere to your method? Many would start to question the wisdom of that approach. How about after 12 years? Most would have given up by then. And I can’t blame them. It’s pretty sane to question something we were told would happen but didn’t. So while the probabilities were pretty low in striking out for 12 years, they still suggested it was possible.
Compare that to the 50 percent/100 percent approach, and a couple of truths emerge. First, you know you are getting results, albeit of a modest nature. Second, you would know fairly quickly if the approach you chose isn’t working, regardless of the power you were told to believe you had to choose and get results. The probability gods can be vexing and mercurial.
So what has this got to do with personal finance? Quite a bit, if you consider how you choose to invest your savings. If you choose the 100 percent/50 percent approach, you are seeking bigger returns, even if they may not be as regular. You like home runs, and you don’t mind striking out. If you are the 50 percent/100 percent person, you are content with modest yet more consistent returns.
You may say to yourself, “Why should I care? I’d rather make more even if it is more of a rollercoaster at times.” Sadly, that won’t be true for most people. Those seeking the big returns will invariably hit an extended period where they are striking out. As noted above, if you were seeking a bigger return you would have a hard time sticking with your approach, even if the probabilities said it would be OK.
This is why people need broad diversification in their investments. In any given one-, five-, or even 10-year period, a whole lot of random events can happen. Making sure that some parts of your investment portfolio are different from the others gives you a chance at getting some return when other parts aren’t working. This can keep people engaged in their approach through what may be disappointing times. Even if we made zero, we did not lose money over a five- or 10-year period. It’s nice to have some baseline of certainty, even if it isn’t perfect or predictable.
And that is where the miracle of compounding your money happens. Staying with a reasonable approach for a very long time can produce pretty amazing results.
Where this doesn’t happen is when people become frustrated or scared of their losses. In seeking more risk, they also set the stage for a possible failure. They jump out of their investments and try to figure what their next steps should be. Maybe they do this quickly or maybe they do nothing, maybe for years. This is exactly what interrupts the compounding cycle.
Getting OK results over time can power your savings in ways that are hard to imagine. That is why it’s good to be half-right all the time.
And probabilities generally work over time. The example above, where the 100 percent/50 percent folks abandoned that approach after 12 years? They would have gotten incredible results over the next 18 years. But they weren’t there to enjoy them. They lost faith and left. And I don’t blame them. Having a greater measure of certainty can keep you on track. Take it.