The relationship between investing and profits seems simple enough. You buy low, sell high and your portfolio grows — or so goes the story.
In reality though, success comes down to something called “Gambler’s Ruin.”
Most investors have never heard the term but understanding its implications can mean the difference between heartache and success, especially now.
Gambler’s Ruin is a mathematical principle that deals with the preservation of assets — or, more accurately, the probability that you’ll lose them over time.
Here’s how it works:
Imagine that Player One and Player Two each have a finite number of pennies, which they flip one at a time, calling “heads” or “tails.” The player who calls the flip correctly gets to keep the penny.
Since a penny has only two sides, it would seem on the surface that each player has a 50% probability of winning – and that’s indeed the case for each individual flip.
But, if the process is repeated indefinitely, the probability that one of the two players will eventually lose all his or her pennies is 100%.
In mathematical terms, the chance that Player One and Player Two (P1 and P2, respectively) will be rendered penniless is expressed as:
- P1 = n2 / (n1 + n2)
- P2 = n1 / (n1 + n2)
In plain English, what this says is that if you are one of the players, your chance of going bankrupt is equal to the ratio of pennies your opponent starts out with to the total number of pennies.
While there are wrinkles in the theory, the basic concept is that the player starting out with the smallest number of pennies has the greatest chance of going bankrupt.
In the stock market the player with the smallest number of pennies is you… and me…and any other individual investor, for that matter, who is up against the big boys.
Investment Advice: Playing to Win
If you’ve ever been to Las Vegas or Monte Carlo, chances are you understand this at some level, if for no other reason than that the longer you stay at the tables, the greater the probability that you will lose.
Investing is much the same.
More often than not, that means they come out ahead because the smaller players get wiped out or, as is the case over the past decade, give up.
That’s why, unless you have some means of protecting your assets– whether you’re at the gaming tables or in the stock market — the principle of Gambler’s Ruin dictates that you will eventually give them up.
It may be through losses or the attrition of accumulated commissions and fees, but if you do not change your behavior, it will happen. The only question is when.
If you start with lots of money, it may take several generations, but the fact that it takes extra time doesn’t invalidate the math.
But again, and I can’t stress this enough — that’s if you do nothing but play the odds.
To win you just need to change up your game in such a way that the odds reflect the strengths we bring to the table.
Let me explain.
When you’re going through periods of high growth, opportunities come at you so fast that it seems almost incomprehensible.
In that kind of environment, an investor can easily conclude he or she is a genius. That’s very dangerous because the principle of Gambler’s Ruin is still at work.