Playing with the House's Money
May 2016
“The house doesn’t beat the player. It just gives him the opportunity to beat himself.”
~ Nick the Greek
For this month’s commentary we are following our colleague Brian on a field trip to the casino. Being the responsible gambler that he is, Brian has predetermined that he is willing to play with $500 (high rollers, please hold the snickers). After a series of well-played hands and bit of luck, his stack sits at $1,000. He takes a moment to slip the original $500 stake into his pocket and continues to play only with his winnings.
At this point our friend is relaxed, loose and fancy free. He orders a round of drinks for the table and starts making more aggressive bets and takes on bigger risks. After all, he’s now playing with the house’s dough. While Brian may have suddenly made some new friends, he is breaking one of the fundamental principles of money - it is fungible. The house’s money is still money, and the $500 on the table has the same purchasing power as the $500 in his pocket.
A similar phenomena occurs in the investment landscape. Suppose Brian bought a stock at $50 and it’s now trading at $100. It might not bother him if it dipped down to $80, as he would still be in the black. But if he bought that stock today at $100 and it dropped down to $80, he would not be too pleased. The same applies to portfolio managers, who can become more aggressive and take larger risks following a period of strong performance. This is because optically and psychologically it is much more palatable suffering a 1% loss on a year when you are up 10% than in a year when you are up 2%. But once again, the net effect is a loss of 1% and the impact on long run returns will be the same.
To avoid this trap, one must disregard the past and maintain discipline irrespective of the starting point. As investment managers we must apply the same rigour in our process regardless of our performance to date. At the casino, Brian needs to play based on having $1,000 not on having started with $500. When evaluating an investment we own, we must consider the current price and conditions, not where we got in. After all, profits are profits and losses are losses regardless of whether one is already up or down.
