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Chasing upside risk

In life, it's a good idea to look for small chances of big gains. In investing, however, it is not.
April 19, 2018

Investing is not like the rest of our lives, in at least one respect. In life, it’s a good idea to look for big upside risks, but in investing it often isn’t.

In our everyday lives, we should seek out what Nassim Nicholas Taleb calls positive black swans – small chances of events that could significantly improve our lives such as meeting a life partner or somebody who could give us a great job or business opportunity. Joseph Campbell famously advised people to “follow your bliss” – to take a path to genuine fulfilment rather than stick with the daily grind that offers only low material and spiritual rewards.

Many of us, however, do not heed this advice. Evidence for this doesn’t just come from the countless numbers of us – including myself – who regret the roads not taken. It also comes from sport. Economists have shown that, in a variety of professional sports, teams do not in fact maximise their chances of winning.

For example, Clifford Asness at AQR Capital Management has recently shown that ice hockey teams that are a goal down do not replace their goalkeeper with an attacker as often as they should even though doing so increases their chances of winning. David Romer estimates that NFL teams don’t pass the ball on fourth downs as often as they should. A team of Israeli academics show that in football goalkeepers don’t stand still when facing penalties even though doing so would (for a while at least) increase their chances of preventing a goal. And in cricket, teams don’t maximise their chances of winning one-day internationals because they choose to bat first too much.

All this evidence is important. It shows that people don’t maximise their chances of big gains – sporting glory in these cases – even when they have big incentives to do so. If this is true in sport, it’s likely to be true in life as well.

Shouldn’t we therefore apply the same principle to investing, and look for the potential for big gains?

No. In finance, the hunt for huge rewards often backfires.

One clue that this is the case comes from sports betting. In both football and horseracing betting on longshots loses you money much more quickly than does betting on favourites.

The same is true of equities. Nicholas Barberis at Yale School of Management shows that lottery-type stocks – those offering unusually large upside potential – tend to be overpriced on average and so offer poor returns. This is consistent with the fact that the Aim index, which contains many speculative shares, has underperformed mainline stocks since its inception in 1995. It’s also consistent with the fact that stocks that are in bankruptcy or on the verge of it do badly on average. Investors pay too much for the small chance of big returns in the event of such companies being rescued.

The same is true for ordinary shares. My chart shows the point. The horizonal axis shows one measure of big upside potential for the 26 main FTSE sectors; the number of annual rises of 50 per cent or more in monthly data since 1987. On the vertical axis, I’ve plotted the ratio of returns to downside risk, measured as the standard deviation of annual losses. It’s clear that there’s a negative correlation between the two, whether we include or exclude the IT hardware sector. This tells us that it doesn’t pay to chase upside potential simply because shares that can rise a lot can also fall a lot.

All this is just another way of saying that defensive stocks tend to outperform – that 'get rich slow' is a better investment strategy than 'get rich quick'.

Which poses the question. Why is investing so different from life so that the pursuit of upside risk is sensible in one but not in the other?

It might be that my premise is wrong or at least overstated. Maybe lots of people do regret following their bliss by dropping out of the rat race, moving to the countryside or going to lots of parties.

But there’s something else. In finance our perceptions of the world change the world. If everybody were to back an outsider its odds would decrease. Backing it at those lower odds would then be a bad idea. The same is true with shares. Chasing those with upside potential drives up their prices to levels from which subsequent returns are, on average, poor.

In life, however, the pursuit of upside risk is not in practice so self-defeating. In theory, it could be. If everybody wanted to follow their bliss by becoming (say) a yoga teacher in Rutland house prices here would become unaffordable and many would-be yoga teachers would be unemployed. This, though, isn’t really the case in practice.

In fact, in some cases if everybody pursues upside risk, it might even become easier for each individual to achieve it. For example, if everybody decides to get out more, it will be easier for everybody else to meet more people and thus make friends or find 'the one'. Dating sites, pubs and all types of social clubs benefit from network effects.

For me, finance is interesting not because men in suits advise us how to make money – that’s boring – but because the judgements and misjudgements we make in investing have counterparts in the judgements and misjudgements we make in other aspects of our lives. Sometimes, though, what’s a good idea in one is a bad idea in the other. The difference lies in one of the key concepts in the social sciences – that sometimes (and only sometimes) individual actions can be collectively self-defeating. In the case of chasing upside risk, this is true in investing but not in other aspects of life.