Pete Wargent blogspot

CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Monday, 15 May 2017

Decisions, decisions

Tunnel vision

I went up to the not-so-sunny Sunshine Coast this weekend, and was disproportionately pleased to see in this week's Budget that the Bruce Highway will receive funding for an upgrade.

It certainly could do with it in parts, I mused, while sitting bumper-to-bumper in traffic on the way home.

I usually take the Airport Link tunnel when heading north. Although a tollway, it's motorway grade and I've almost never seen a traffic queue in there, so when faced with that fork in the road, I nearly always take the toll option.

We tend to make decisions like this all the time, without thinking too much about why we make them. In this instance, the thought processes are unconscious, but they probably go something like this: 

"It might cost me four or five dollars, but if it's a work trip I might get a tax deduction for the toll. I don't really like being in tunnels, but at least I won't get snarled up on Sandgate Road, so stuff it, I'll pay the five bucks and probably get to where I'm headed quicker".

Playing the probabilities

Here's a hypothetical question: if you're playing Texas Hold 'em poker and you have a nine and a Queen, and you calculate from the communal cards showing that you have a one in five shot of getting a flush, do you play the hand?

Or do you instead accept that four times out of five you won't get a flush, and therefore, do you fold?

It's a trick question, really - the answer likely depends on what your opponents are up to and how much you might win, being the pot odds.

Expert poker players don't care so much about the certainty of winning, but they do ensure they get comfortable with the odds of what they do and don't know.

In this instance, for example, if the pot odds are 10 to 1, meaning that they might win 5,000 for a $500 wagered, they will likely play the hand. They take comfort in the knowledge that if they played this same hand 100 times over they would probably come out ahead. 

On the flip side, as a trader or investor you may think twice about a bet which apparently presents a high chance of winning, but also carries the potential for a material loss. 

In other words, think carefully before trying to pick up pennies in front of a steamroller.

No certainties

Lots of people are looking for certain outcomes in life, which is understandable, but the price of certainty can be extremely high.

For investors, many of the important decisions include a degree of uncertainty and thus require some kind of forecasts to be made.

While learning from successes is important, most accomplished entrepreneurs and investors are at least as interested in mistakes, missteps, and failures, and what they can learn from them.

Base rate assumptions

Now I'm dead set rubbish at Poker, as you can glean from the example presented above, but if I wandered down to the Star Casino to participate in a tournament, I'd naturally try to assess the other players and how they might approach their playing strategy.

If a 20-year old surfer dude came to the table in thongs with dyed blonde hair and an earring, I might assume he'd make a few mistakes, play too many hands, and hopefully burn up his chips.

But if he was then joined by a calm-looking Asian businessman in dark glasses, with shiny shoes, and wearing a Rolex watch (or a business lady with a Gucci handbag), I'd probably assume that he or she had deep pockets, and would play a very deadpan game with a strong sense of timing.

You may say that these base rate assumptions are prejudices - and they sort of are really, potentially being way off track. But the difference with base rate assumptions is that I will attempt to update them as more information comes to light and as the game progresses.

Bayesian analysis

A bit like my bi-monthly grapple with whether to take the tollway tunnel, humans can often make pretty good decisions intuitively without the need for exhaustive analysis.

And we're usually quite good at updating a hypothesis as more information comes to light. Inevitably, we sometimes make mistakes, though.

Most weeks I go down to a favourite cafe of mine on Oxlade Drive, and although it's only open five days of the week, it always seems to be packed out.

Because of this I tend to assume that the entire café industry is booming, but the statistics tell me that this isn't quite right.

Partly I'm getting blinded by survivorship bias, as I'm not taking into account all the cafés that have closed down and that I therefore never see. I'm also living in an upmarket suburb populated with many potterers and flaneurs, so I'm not seeing a true representation of the full population.

Improving the odds

Nobody is right all the time, which is both great news and useful, because it makes life interesting, and presents opportunities as well as threats. 

We can, however, improve the quality of our decision making, through regular practice, considering the decisions we make thoughtfully, and by resolving to learn from our mistakes, while updating the base rate assumptions along the way.