You know the TV show “Deal or No Deal”, right? If you aren’t familiar with it, here’s a basic rundown of the premise: the contestant is faced with 26 briefcases, each with a dollar amount inside, ranging from one penny up to one million dollars. At the beginning of the show, the contestant chooses one of the cases as her prize.
The amount in the case she has chosen remains secret until the end of the show. Then the contestant begins eliminating the remaining 25 cases – first in groups of descending amounts, then later one at at time. As the cases are chosen, the amount in each case is revealed. At the end of each round of “reveals”, a character called “the banker” offers the contestant a sum of money to drop out of the game.
The amount that the banker offers is statistically relative to the amounts that have yet to be revealed – if more high-dollar amounts are remaining to be revealed (which means a high-dollar amount could
be in the contestant’s prize case), a relatively higher amount is offered. If the amount offered is attractive enough to the contestant, she can choose to take that amount and quit the game. If not, the contestant will have to choose another case and reveal the amount.
As the match progresses, often we see the contestant choosing cases that reveal high dollar amounts in them – which prompts the banker’s offer to reduce. Even when faced with seemingly impossible odds against her, when this situation occurs, the contestant often becomes a risk-taker – moreso than you would normally expect.
This is because the contestant feels as if she has already lost something (the earlier offer from the banker) and somehow she must “make it up” by continuing the game in spite of the odds becoming less and less that they’ll “make it up”. Statistics will rule, and on average the contestant walks away with a much smaller prize than expected.
So what does this have to do with investing?
Quite often we see the same sort of behavior in the stock market: always trying to do better than the average, folks will use all kinds of methods, including paying extra to get the top dog stock picker’s advice – because they’re sure they can beat the market. And then, if the chosen stock shoots up in value, the investor hangs on, “knowing” that if it went up 10% it is bound to go up another 10%. But what happens when the stock goes on up to 20%? Yep, hang in there, cuz it’s bound to keep up.
Then suddenly the stock pulls back, and now is down 5% from the original investment – what happens now? This is just like when the banker on the show reduces his offer: the investor feels like she’s lost something that she already had in hand, so she begins to take more risks. Perhaps she’ll buy some more of the stock – again, “knowing” she’ll “make it up”. But it rarely works out for the hapless investor.
The problem is that the investor didn’t go into the investment with a plan – and the same would hold true for a contestant on the game show. If you decided that you were shooting for a 10% return from this particular stock, you’d have sold out at that level and could have gone looking for the next great option. Without a plan, you never know when to get out of the position.
If a contestant were to go into the show with the plan that she’d like to do better than average – the first time the banker offered more than $131,477.50, she should take it. ($131,477.50 is the average of all the amounts in suitcases) That would be an excellent strategy to take, especially when you consider the fact that 20 of the 26 cases have less than the average…
As an investor, the odds are much better for you, using history as a guide. If our investor chose to take a shortcut and get a return that is at least the average of the stock market – since in the last 40 or 50 years the stock market has only returned a negative roughly 20% of the time, using the average would assure you of a positive return 80% of the time. That’s much better than the results of the average Joe or Jane who plays the active stock picking game.
To get the average of the overall marketplace, the investor can choose to invest in broadly-diversified indexes, covering domestic and global markets. This is a very cost-effective way to achieve the average – and then you don’t have to worry about when to get in or get out, or even shout “NO DEAL”. Go for it. And if you want a fist-bump, fine, come by my office. But I won’t be afraid to actually shake your hand.
Photo by Muffet