Wednesday, December 24, 2014

Gambling and Risk Aversion

Money was on the line, and I had a call to make. After sixteen weeks, I found myself in our league's fantasy football championship. (Yes, it is a dorky hobby, but it is mine. I like football, I like winning money, and now I had a chance to enjoy both.) But I am also risk averse. I, as most humans, feel losses more acutely, and for much longer, than I feel gains. Victory is fleeting. Regret lasts. So like I said, I had a call to make. Here are the details...

The winner of the championship game would win $650. The loser of that game would still win $300 for second place. So, either way, I was going home with something better than a kick in the groin. And my team was the favorite: throughout the entire year, my team had scored the most points by a good margin. Still, being the risk averse person that I am, I wanted a guarantee. I made the other owner an offer: I'll take home $550, win or lose, and you get $400, no matter what happens.

I figured I was buying some insurance: for the cost of $100 I was locking in a $550 pot. The other guy, who probably had a less than 50% chance of winning, was now guaranteed $400 either way. The rub was that he could win the game and still end up taking home less money than me. Ultimately, he didn't want to give up the chance of winning for just $100 more, and refused the offer. So whoever won would take home $650, and the loser would get $300. So, what happened?

I won the game: by a lot, too. In the end, my offer would have been bad for me. I should have simply played to win from the beginning. And this makes sense: being risk averse carries opportunity costs. I was trying to buy insurance: and insurance, in the aggregate, costs us more than it pays out. Looking only at the numbers, we should aim to be risk neutral.

But that sort of analysis ignores our emotions. Winning $650 feels good, of course. But losing, even a smaller amount like $350, somehow has a bigger impact on me. And I am not alone. Losing hurts more than winning feels good...if that makes sense. In some ways, the smartest thing I could do is to simply not gamble. Only one player out of twelve can be the winner each year. What I'm doing by wagering, on most years, is ensuring that I'll feel disappointed and have a slightly lighter wallet.

But small time gambling is probably not a big deal, either for my money or for my emotions. I am a big boy, and one who can lose a hundred dollars without crying into my big boy handkerchief. But risk appetite is a more serious issue when it comes to something like retirement investments, or paying off a mortgage. Being risk neutral can help avoid overly conservative approaches: like aggressively paying off a 4% mortgage, or carrying too much money in bonds or, baby Jesus forbid, cash.

On the other hand, maximizing gains is probably not the only thing one should consider. If you are naturally risk averse, you might not have a very good 2015 should your investments lose $100,000 in value over the next twelve months. Your spouse may not be very happy, either. And while your mood does not show up on a net worth calculation, it is a lot more important. A little risk aversion might make for a happier new year.

Which all goes to say: get to know yourself. Observe the way you react to financial gains and losses: ideally, with some small coin first. For those looking to dip their toes in the water, may I recommend fantasy football?


*Photo is from gchampeau at Flickr Creative Commons.

24 comments:

  1. Donebyforty

    Congratulations on winning your fantasy football league never an easy task. Interesting that you offered a settlement when you were the favorite. As a competitor I can understand not accepting the offer as there is nothing better than a chance at beating the favorite for the title

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    1. Hi, Captain Cash. (Great name, by the way).

      I agree with your take: most gamblers (and FF players are that, by definition) would not take the deal. Oddly enough, had I been in 2nd place and the underdog, I think I would have taken the $400.

      Merry Christmas!

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    2. Hmm... let's look at the odds:

      He was effectively betting $100 of the potential pot for a "return" of $350.

      Decimal odds of that is simply 350/100 = 3.5
      This implies the guy has 1 / 3.5 = 0.28 = 28% chance of winning.

      I guess from what you said this is about right or maybe even favours him turning down your deal, were you really a 62% favourite or just over 50/50 as you implied in the post? :)
      (I think I have the calcs correct there anyway)

      I've become more and more risk adverse as I've gotten older, I had a 10 year streak of pretty crazy gambling and I'd always go long shots, and you are right, the constant pain of losing small totally outweighs when you get a big winner. So I don't really gamble any more :)

      Great article, right up my alley as you can probably tell!

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    3. Grrr... Meant 72% favourite obviously! Hah! :)

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  2. My brother is a huge fantasy football guy too, and his team wins lots too, so I get it, kind of. :-) The older I get, the more I learn not to freak out at the market losses and gains. It's only money, after all. :-)

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    1. Merry Christmas, Laurie! I think it's great that you (and I, too, I think) aren't as impacted by market fluctuations as we age. It's a silver lining: learning that the ups and downs are just part of the ride.

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  3. Great work DB40! Winning is always exciting, but unfortunately that's often the only thing many people are thinking about, especially when it comes to investing. Your point about knowing yourself is so important, and it does take time and effort - but unfortunately many people only discover this the hard way (which is actually a pretty effective, albeit expensive way)!

    Hope you had a great Christmas DB40, look forward to hearing from you again in the new year!

    Cheers,

    Jason

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    1. Great point about life providing its own effective lessons, big stakes or small. There are often less expensive ways to get the wisdom, but we all get it in the long run.

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  4. I am a failure at all sports, real or digital, so best for me not to wade in. I'm fairly risk averse too, but I am able to surmount my fears through math. We're invested with a long term view, which helps me to not minutely analyze on a daily basis. At this point, it's just a fact for me that our money is invested and that we don't touch it. I do love compound interest...
    P.S. Congrats on your win!

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    1. I'm really jealous that you're able to overcome emotion with math. I'm often just the opposite: hence my infatuation with logical fallacies that impact my bottom line.

      Invest & forget is a fantastic approach: just buying and holding will win out against most people's strategies.

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  5. Want to talk dorky? There are people coming over to my house next week to play D&D. I have no idea how to play. But I'm so excited. So at least you're jockily dorky.

    My husband and I recently had one of these risk conversations. I was thinking about maybe putting our house savings into the Roth IRA. Maybe help speed things up a little. He did not like the idea. I can't say I blame him. Short term, we're not going to garner a ton of interest in all odds. And we could stand to lose some of the money we've worked so hard to save. And losing $100 would hurt so much more than gaining an extra grand.

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    1. D&D! I actually got a D&D board game for Christmas and I'm excited to try it out (though it looks like the most complicated board game I've ever played).

      We have had a very similar conversation (or five) about how to save/invest our house funds. We went round and round and, like always, decided to just split the difference between our strategies. She wanted all cash, so 50% of our money went into cash. I wanted a conservative investment approach, so 50% of our money went into that (60% bonds, 40% stocks, both indexed in Vanguard). In the end, we did make a good bit of money with those funds but it could definitely have turned out differently.

      Your wisdom is the really key bit: a small loss feels a lot worse than a decent gain feels good.

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  6. Dad and I have different risk tolerances, so what I do is put the more conservative investments in "his" accounts (403b, etc), and the riskier ones in "mine". We balance each other out well - I'm probably more risky than I should be at our age and stage, and he's a little too risk averse.

    I've found that you can override your risk tolerance related emotions with practice to some extent - I used to be very risk adverse, now, not so much. I think "life" has taught me that lesson!

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    1. That's kind of genius, Three is Plenty. Both parties invest along their natural tendencies. My guess is that you both might contribute more than you would had you split your asset allocation into both investment accounts equally.

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  7. My last post must have got spammed or deleted it because you hated it! My first thought on the FF was splitting was to much, it should have been $475 each, then I thought about it some more and realized that's about the right price if you had the advantage. Some people won't budget though either way, I never really understand that.

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    1. Sorry Even Steven! I promise that it was the blog that somehow ate your comment, not me. I'll never censor your contributions. :)

      An even split is tricky because, almost by definition, someone ought to be the favorite. As it was when we were children, it's hard to split the cookie in a way that makes everyone happy.

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  8. I'm pretty risk adverse too, though I am competitive. I'm not sure what I would've done in your situation. Good thing you won though!

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    1. Thanks, Kayla. Winning covers a multitude of sins.

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  9. Great job on winning the fantasy game! =)

    My husband likes to play craps from time to time. I don't gamble very often but I am GREAT at it when I do because I will simply get up and leave if I lose more than once or twice. Totally not worth it.

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    1. My dad was a big craps player but I never could get in to it. Maybe that's a good thing. I like that you can walk away after losing a couple times: that's a great attribute. Do you find you can walk away when you're up?

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  10. Great point about how we react to financial gains and losses. I see this with investing in stocks. I hate selling winners because I want to ride it higher and I hate selling losers because I'm holding out hope that it'll make a comeback. I'm not a big gambler...I do play fantasy football and was ranked #1 in my league. I ended up fourth place. I probably would have taken the deal though because I really didn't any time on my team this year (yet somehow had the best record). But didn't have as much confidence in my team. Though I can see how I'd have a tough time taking the deal if I was assured some of the pot. I mean I figure it's just a game so if I win I win big...plus my buy in is already covered so why not see if I can win big. I think you're the first person in fantasy football to try to hedge your risks!!! =) Happy New Year!

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  11. Re the FF we would call that 'laying off the bet' here. He should of taken the $400 guaranteed! I'm pretty sure that's what a professional gambler would have done.
    Anyway before you realise how much of an in depth knowledge I have of gambling, I'll wish you a Happy New Year. ;) I hope it's a good one!

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  12. A different way to do it could have been to split the money evenly, say 400 each, and left 150 for the winner. Alternatively, since you were the favorite, you could have split it 450 for you and 400 for him, leaving 100 for the winner. It's important on a psychological level that the outcome makes a difference (or else what's the point of the final game), and the chance to lock in more than 2nd place, PLUS still have a chance to end up with more than you might well have tipped the balance for him.
    If you don't think his judgment is affected by hindsight, you could always ask him what he'd have chosen with some of these alternatives--the more familiar you become with various "gamblers' insurances" and the psychology that makes people accept them, the better you can play it to your advantage in the long run ;-)
    In this case, of course, congrats that he refused :-)

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  13. Congrats on your winnings, Mr. DbF! I tend to be risk averse in general when it comes to gambling (I always tell myself just $100 or so in Vegas and then get mad when it's lost because that's like a week's worth of groceries lol), though I do tend to take things more with a grain of salt when it comes to investing/retirement accounts (though I'm definitely not aggressive when it comes to selecting my options... more middle of the road with a hint of aggressive ;)). I guess I'm still in the mindset that I'm fairly young and to look at the long haul, whereas that Vegas trip is probably one week so I look at the short-term aspect. I'm sure I don't make any sense, but I like your post and agree about having some sense of risk aversion (in the sense to not be too reckless about it!).

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