Law of Averages

In college I had a friend I’ll call Jay. Jay lived in the apartment next door during my senior year. Our apartment complex was situated off a reasonably busy road. One day Jay drove me to class. When we pulled out of the complex to make a left turn (onto a two way road) he looked left, realized he was clear, then put the gas pedal to the floor. He did all this without ever looking right. On the day he drove me, fortunately there were no cars coming from the right. When I asked him about it he said that there were rarely any cars coming from that direction so he was fine. That was the last time I accepted a ride from Jay. Six weeks later, Jay totaled his car. He was making the left onto the street in front of the apartment and he got broad-sided by a car coming from the right. This is a great example of a “when vs. if” situation. Repeatedly taking that left, without ever looking right, will eventually result in a car accident. It was only a matter of when. It simply comes down to the law of averages.

Exposure

Exposure plays a role in determining risk. If you try skydiving once in your life, the odds are very low that skydiving will be your cause of death. If you jump out of a plane 5 times a week for 30 years there is a significant probability that one of those times something will go wrong, therefore the odds that you’ll die from skydiving are exponentially higher.

Don’t take big risks over and over again

There’s an old story about a couple honeymooning in Las Vegas. They go to the casino with $1,000 that they received from their wedding. They proceed to lose $995 but keep a $5 chip as a memento. At midnight the husband wakes up and sees a reflection on his nightstand. He notices that not only is it a reflection of the number 17, but it’s actually showing up on the chip they had saved. He immediately puts on his bathrobe, goes down to the roulette table, and puts the chip on number 17. It hits. He does this repeatedly until he has amassed over a million dollars. As he is about to bet it all once again the pit manager walks over and informs him that casino does not have the financial wherewithal to pay should he win again. He cashes out, hails a cab, and proceeds across town to a larger casino. He puts down his fortune on the number 17. It lands on 21. The man now walks back to his hotel and as he opens the door to his room his new wife asks, “How did you do?” His reply: “I lost five dollars.” This is an extreme story but the point is, if you continue to take big risks, no matter how good a streak you may be on, at some point your luck will run out. Think about entrepreneurs that continually put it all on the line for new business ventures. While this willingness to take on risk is typically the reason they become successful, if they continue down the path of betting it all, at some point the odds would suggest that they will lose.

Spread out your risk

If you are an investor and you put all of your money in one place, whether it is one stock or one specific asset class, you run the risk of losing most or all of your money. The more you spread things around to different investments across multiple asset classes, the more stable your portfolio becomes. While you may make big bets early in life when you are only responsible for yourself, as you get older and have other people dependent upon you, it’s important to spread your risk to create greater stability.

Minimize your losses

My favorite show is Shark Tank. If you watch enough episodes you will inevitably come across an entrepreneur that has an idea that is not working and probably never will. Despite the fact that every one of the Sharks is telling them it will never work and they are having difficulty already, they always want to continue the venture. It’s human nature to become passionate about an idea, a product, or a business that you have created. Unfortunately, sometimes passion can impede your judgment. A large part of success is knowing when cut your losses. Not every idea will work. Not every business will achieve profitability. The most successful investors don’t allow their emotions to impede their judgment. Sometimes the best way to maximize your profit is to minimize your losses.

I’m not suggesting that you avoid risks in life. There aren’t many financially successful people that have amassed great wealth without taking risk. The key is to become more calculated with the risks you take by understanding the law of averages and using it to make more informed decisions.