Monday, May 11, 2009

Slumdog Millionaire & Investment Strategy

This weekend my wife and I watched Slumdog Millionaire on DVD (it's a good movie), and personal finance geek that I am, I started thinking about why contestants on game shows keep playing for ever-more money instead of locking-in what in, many cases, are life changing prizes. Is it greed? Is it stupidity? Is it the belief that some supreme force will intervene on their part? I simply don't get it. Here is the way that I think about these situations and what it means for our personal investment strategy:

Let's take a specific example to make things more tangible. Say I am on "Who Wants to be a Millionaire", and I just answered correctly the $100K question. Now $100K does not make you rich, but for most people (myself included), this is a huge amount of money to win. The next question is worth $250K, and let's say I narrowed down the field to two possible answers, but have no more lifelines and now have to choose between those two. Do I go for it or take the money and run? If I take the gamble, 50% of the time I will get the answer right and 50% of the time I will lose. If I win, I will have $250K. If I lose, I will be left with $16K (those are the rules, I guess). My expected payoff is therefore $133K (the average of those two prizes). If I walk away, I will have a guaranteed $100K.

Now, the seemingly rational choice is to go for it i.e. guess the right answer.  This is the rational choice because the statistically expected payout is $33K higher when taking a guess than it is when taking the money and walking away. Yet, I would never take the gamble. The main reason for this is the diminishing return I would get from the larger prize, compared to the guaranteed but smaller prize. $100K in the bank means a lot to me. $133K is better, but the variability (or risk) of $250K vs. $16K is just not worth it. My answer would probably be different if I stood to win a MUCH larger prize by taking the gamble. Say, if the expected value of the gamble was more like $1 million. That much larger prize would be life changing, and I would probably be willing to risk the loss of my guaranteed prize.

Now let me explain how this answer effects our personal investment strategy. When investing our portfolio I am not necessarily going after the highest possible payoff. The highest possible payoff is typically associated with the highest possible degree of risk. When investing our cash,  our objective is to guarantee ourselves a certain level of security and a degree of financial comfort. We are NOT trying to be as wealthy as possible, we are trying to maximize our wealth given a certain degree of risk which we are willing to accept. Maybe we could make more money by being more aggressive, but it's simply not worth it, even if the expected payoff is higher.

I am sure that some people are willing to make such bets with their savings or with their retirement funds. Maybe those are the ones that keep playing in those game shows. Or maybe they're just stupid. I don't have the answer to that question. You decide.

Here are some other investment related posts you may find interesting:

The Dough Roller has no problem with Suze Orman investing her money in bonds while advising others to go for stocks. I don't share his opinion, and I left a comment on his post, saying just that. Maybe I'll write a post on the subject to clarify my position.

My Wealth Builder calls bull**** on the stock market rally. Yeah, I don't know. I think it's for real, but if it turns euphoric, as the post says, I too hope to have the presence of mind to cash out before it goes boom.

Boston Gal comments on women's investing strategy vs. men's. It's true that there are academic studies that show that women typically get better returns... it's usually ascribed to lower trading costs.

Finally, take a look at this post from Investoralist which talks about topics relevant to those of this post: how loss aversion can "help" you make bad financial decisions.

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Rob Bennett said...

We are NOT trying to be as wealthy as possible, we are trying to maximize our wealth given a certain degree of risk which we are willing to accept. You're hinting at something that has huge significance re all sorts of personal finance questions, Shadox. We are NOT seeking maximum wealth. You are absolutely right about that. What we are seeking is maximum life fulfillment. That's something very different.

The reason it is so different is that the extent to which wealth adds to life fulfillment VARIES depending on your life circumstances. If you don't have enough money for your next meal, $20 makes a big difference. If you have $10 million in the bank, even $1 million doesn't mean much. To analyze money questions properly, you always must factor in the effect of your Life Goals and your financial circumstances.

Most analyses don't do this. For example, we tell everyone that they should be saving 10 percent. The reality is that the proper saving percentage varies from person to person. We tell everyone that stocks are worth the risk involved. But whether that is so or not depends greatly on the individual's personal Life Goal and financial circumstances. All one-size-fits-all responses to money questions are wrong because they do not factor in what is needed by the particular person to achieve life fulfillment.

Young people are often criticized for not saving enough. What if the young person involved has hopes that by spending on clothes and restaurants and vacations he is going to make the contacts and impressions he needs to make to get a job making millions? Should he really be saving in that circumstance?

I am not saying that the young person is right not to save. I am saying that the decision not to save probably makes sense to the young person on some level of consciousness. People are not stupid. They do the things they do for reasons.

We should all make more of an effort to understand the true reasons for human behavior rather than to assume that people who do not buy into the conventional way of thinking don't do so because they are not capable of understanding the reasoning behind it. Often it is because they are reasoning from a different starting-point premise.


Sanjeev said...

I have found your posts to be really refreshing, different, and better than many other PF Bloggers whom I have been following for a couple of years. In my opinion, you should be getting lots of comments and feedback than other PF sites (I don't mean that other sites are bad), but that does not seem to be the case. May be you need to network more with other bloggers. Regardles, keep up the good work.

Shadox said...

Rob - that's exactly right. The key to all advice (financial or otherwise) is that it must fit the recipient... Now, that doesn't rule out the fact that some people (even young ones) make really bad mistakes...

Sanjeev - Thank you for the really kinds words. I enjoy getting comments from my readers, and I certainly enjoy getting traffic on my blog - otherwise I wouldn't be writing it. Having said this, marketing this blog has never been my strong suit. I have always believed that if I write good enough content the readers will find me. Yes, a pretty naive point of view, especially from someone whose day job is in marketing and business development... nevertheless, I continue to hold out hope :-)

Feel free to spread the good word, and thanks for following Money and Such.