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A tale of two games

Lesson in Course: Medes Newsletter (advanced, 10min)

"We have a stock market which some people use like a gambling parlor." - Charlie Munger

Most people would consider themselves logical and even pragmatic. I can go as far to say that many people like to think of themselves as better decision makers compared to others around them. What if money is at stake? Does that change anything?

Let's find out by going through a fun brain teaser.

You've encounter a mysterious (dare I say wizardly?) but approachable man on the way back from work. He proposes a game for you to make some money.

To play the game, you need to pick one of two choices.

Choice 1: Flip 8 coins. If all 8 are heads, you win $255. If any comes up with tails you lose $1.

Choice 2: Pay $1 upfront to flip the same 8 coins. If you get all heads, you win $256.

 

Which one would you rather play?

Already, we have a divergence of choices. A large group would choose to not play altogether. The memories of Vegas or carnival games have increased your suspicions. Or the aversion to loss is not worth the slim chance to win.

Enticed players make up a second group. Risk takers, gamblers, and some math nerds make up this second group. Their decisions to take part all vary as does their choice. Among this group, the math nerds have actually realized two very crucial things.

1.) The proposal is a fair proposal. The statistics of winning is 1-(0.5)^8, or 1 in 256 and there is no advantage or edge on either side.

2.) Both choices lead to the same outcome. The statistics remain the same and the possible outcome is either -$1 or +$255.

The results of the game is not important. Instead, the example serves as an introspective look. Pragmatic decisions around money, even with small stakes, gives way to emotion.

Dollar cost averaging and psychology

For investors in the stock market, bear markets and recessions take a toll on emotions. It is hard to see your net-worth drop and even harder to admit that there's nothing you can do about it. Many self-directed investing books and financial advisors suggest dollar-cost-averaging as a tactic.

The problem? Dollar cost averaging doesn't always work.

The concept of dollar-cost-averaging is simple. Instead of laying all our eggs into one basket, we lay eggs among many baskets. In the case a squirrel finds one of the nests, the future is not lost. Now replace eggs with dollars, nests with different time frames, and squirrel with a market drop.

Simplicity as the premise

Passive investors believe it's impossible to time the market. There is a famous saying:

Time in the markets beats timing the markets.

Supporters of dollar-cost-averaging say you don't need to guess when it's best to invest. By spreading your investments over time (let's say once a month), you can sidestep going all in right before a big drop in prices.

For the last decade when Stonks only go up, this worked. Throwing your money into stocks periodically was an easy and winning strategy. Sure, there were some down days but losses waned against new monthly highs. A lot of passive investors slept well as the tactic was very forgiving and resulted rarely in losses.

So why does xnx from HackerNews think dollar cost averaging is not a financial strategy? He or she could be referring to academic literature with math that show you can make more money investing in a lump sum. Doing so in an up market would result in buying at the lowest price. This common criticism of dollar cost averaging is wholly academic and unrealistic. Average Americans don't have a big chunk of cash available to invest at all time. Dollar cost averaging is more reflective of income from wages paid out semi monthly.

But what happens if Stonks get clonked?

If stock prices recover right away, you were able to buy in at lows. This is the scenario where dollar-cost-averaging makes you look like a hero. After all, every hedge fund out tries to "buy low sell high" and you're doing it among the best.