The Perfect Bet

What are financial markets?  Financial markets at first apprehension are simply places where borrowers meet lenders, or where risk-takers meet investors. But these markets do more than channel what economists call “savings” into claims on the (profitable) outcome of “investments.” Savers shift their consumption from the present to the future; borrowers often do the opposite when they shift future consumption to the present. Investors and lenders absorb the “foregone consumption” of savers into “capital accumulation,” which, if deployed intelligently, would yield future interest or profits. This process feeds the engine of economic growth, while giving meaning to the idea that market participants should be able to shift their consumption patterns over time according to their individual preferences. There is thus also embedded in this process that concept made popular by Adam Smith, the idea of the Invisible Hand.

The process is not always perfect. The plans of mice and men often go awry. The markets then adjust to these changes in fortunes. Debt papers get discounted to reflect the lessened ability of a borrower to repay, and stock prices drop on expectations of a cut in future profits.

Underlying the adjustments, or even the initial transactions, are acts that constitute betting. The lenders bet that the borrowers will repay, while the (stock market) investors bet on the actual or eventual profitability of the business of the corporations that issue stocks. At times the betting does not even relate to these economic “fundamentals.” There are also those who bet on the basis that there would be, at some point in the future, a “greater fool.” For such bettors, the wait can take forever, although successful practitioners are usually “gurus” who can inspire the “greater fool” following, and who get out soon enough. The gurus win at the expense of their followers. It seems unfair, but there is rough justice meted to the greater fools in this story. The motto should be “know your guru!”

Is there a perfect bet?  In such an imperfect world, can there be a perfect bet? This is like saying we’ve experienced hell or purgatory, and then asking if we will get to heaven. A religious bettor would bet his soul on it, but can expect the payoff only in the afterlife.

Despair not. Philosophers, mathematicians, and diehard gamblers have at various times achieved success. To do this, they’ve had to set the bar a bit low. A “perfect bet” is definable as one that beats any other in the circumstances. Often this ranking of bets is simply based on an arbitrarily chosen aiming for the highest return for a given level of risk, or for the smallest risk for a target rate of return. And typically, the perfect bet is revealed after the fact, but not before!

If risk avoidance is valued highly, insurance can be a perfect bet. Indeed it is one that can go on forever because insurer and insured do not play a zero-sum game. Both parties to the insurance contract “win.” The insured avoids an unbearable catastrophe, while the insurer, who pools the risks from individual contracts, gets a more or less steady income. This means that stock in good insurance companies, those who employ honest actuaries and whose managements are kind enough not to engage in Ponzi schemes, are great long-term (though somewhat risky) investments.

Religion is akin to insurance. The high priests play the role of insurer; the faithful are the insured. No one is being taken for a ride, except perhaps for those cult religions where the believers give up too much on Ponzi-like fraudulent claims of their leaders. By and large, mainstream churches are institutions that promote social good and order on earth. Whether religions should escape taxes is, however, another story. My own view is that if insurance companies, doctors, dentists, and fortune tellers like Warren Buffett pay taxes, then so should churches.
Are lotteries perfect bets? No, because innumerable studies of winners tend to conclude that the winners get a brief high from a temporary surge in income or wealth; but they soon go back to their pre-winning miseries. Humans are decidedly social beings who prove time and again that misery loves company, and company soothes misery. But lotteries are perfect bets for those who benefit from the house edge, typically governments and charities.
When the game is a simple one in the mind of an individual investor, it is pretty much a zero-sum game. Cash or short-term government paper becomes the perfect bet when the likely foreseeable event is a rise in interest rates or a fall in stock prices. The problem is that interest rates and stock prices are inherently unpredictable. If they could be predicted, the acts of capable individual investors acting on their “predictions” would cause interest rates and stock prices to move in directions that would eliminate the profitable trades that might be envisioned from such predictions. The next time somebody comes to you to tout his (past) great stock market performance, just ask if he thinks he can replicate that performance forever. His honest answer has to be in the negative. He could do better because of luck; or worse, if the future is one of “reversion to the mean.” The mean in this context is also not a fixed thing; it depends on how long a time frame you take to calculate the mean.

What about the risk of ruin? Or the risk of missing the “next great move”?Can an individual nonetheless learn to avoid the most egregious errors when investing his hard-earned savings? This is a difficult question requiring a definition of what an egregious error is. The answer to this question will be for another column.

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