It took me a while to return to terms with it professionally. In fact, I wrote about this inevitable point for the primary time in these pages, but avoided the main points for fear of the implications. It is these details which might be the topic of my latest essay, soon to be published in ,[1]. The article delves into the query of when and the way gambling is rational (the plot above is taken from this text).
What I find – and this part is a little bit of a surprise – is that gambling may be rational or irrational depending on the circumstances. Even more surprising: whether a game of probability is rational or irrational depends not on the characteristics of the sport of probability itself, but on the goals of the person considering it.
In other words, what could also be a rational gamble for you might be an irrational gamble for me. Even more confusing: What could also be a rational gamble for one in every of your goals will not be rational for an additional goal.
Goal-based investing is amazingly – and frustratingly – individual.
I find this surprising because orthodox economics has taught us to judge investment opportunities in a vacuum. For example, if Apple is a great stock, then it’s a great stock for everybody (with sufficient risk tolerance). If Bitcoin is an irrational investment, then it’s an irrational investment for everybody.
However, goal-based investing teaches us that investments are only tools to get a job done. Of course, we want to know our tools thoroughly, but ultimately it’s the task we’ve been on condition that determines which tool we reach for. In this regard, orthodox economics is unsuitable: investments must at all times be evaluated within the context of an investor’s goals.
Every practicing financial advisor has direct experience with investors’ willingness to sacrifice returns to extend volatility. How often do clients buy penny stocks as lottery tickets (like mine!) while they’re upset with us because their retirement account dropped 8%? What may surprise financial advisors is that it is a completely rational approach. If risk is defined because the probability of failure, there are occasions when increasing volatility is rational, namely times when losses could also be excessive.
So what does this mean for skilled financial advisors and asset managers? Should we recommend a client jet to Vegas and put half of his retirement account on red? Of course not (well, probably not). Still, we cannot escape the conclusion from the mathematics: high-volatility, low-return “investments” can have a spot in goal-oriented portfolios.
Perhaps we should always at the very least reserve our initial judgment on high volatility trades favored by some retail traders. An excellent next step may be to initiate due diligence on some “gambling-like” portfolios, with a full understanding of when and who they might be suitable for. I admit that is difficult for me, as I grew up with the orthodox “gambling is stupid” attitude. Nevertheless, it is precisely what the mathematics dictates.
However, what the mathematics also makes clear is that gambling will not be nearly volatility; The expected return can be essential. Every goal-oriented portfolio has its own rational trade-off between return and volatility – a marginal rate of substitution. We should play sometimes, but we should always play fastidiously and calculatingly, never wildly.
* * *
About 4 years later. I’m on my technique to lunch and this customer calls me. He asks if I’ve seen any of those penny stocks he didn’t need to eliminate that morning. He got into the SPAC trend and went as much as $1.80, he tells me. He owns over 400,000 shares. In his Roth IRA. That means he just remodeled $700,000 on a $100 “investment,” completely tax-free. If I hadn’t seen it myself, I’d have dismissed the story as just one other improbable water cooler story. Or perhaps one in every of those one-in-a-million gambles that just repay.
What I do know now could be that my client was right. Gambling is usually completely rational.
References
[1] Parker, FJ (forthcoming) “Yes, you should play (sometimes).” Investment Magazine
