Thinking in Bets

WELCOME TO RUFFER

All-weather investing

Seeking consistent positive returns.

Come rain or shine.

Ruffer provides investment management services for institutions, pension funds, charities, financial planners and individual investors.

London

Ruffer LLP
80 Victoria Street
London SW1E 5JL

Directions | Map +44 (0)20 7963 8100

Paris

Ruffer S.A.
103 boulevard Haussmann
75008 Paris, France

Directions | Map +33 (0)1 88 45 02 54

New York

Ruffer LLC
300 Park Avenue
New York NY 10022

Directions | Map +1 917 947 3003

Edinburgh

Ruffer LLP
31 Charlotte Square
Edinburgh EH2 4ET

Directions | Map +44 (0)131 202 1602

Articles by Charlie

Charlie King

Associate – Private Wealth

29 February 2024

”Gambling's for fools“ sang Ian 'Lemmy' Kilmister in Motörhead's 1980 classic Ace of Spades. But, for once, the sage of stöke may have been wrong.

Certainly, Annie Duke is no fool. She was studying for a PhD in psychology at the University of Pennsylvania before abandoning academics and taking up professional poker. It wasn’t a bad decision: she became one of the most successful female players of all time, winning over $4 million at official tournaments.

But not before she had used her psychology background to scrutinise her own decision making and recognise how random outcomes can really be. In poker – as in life – chance and hidden information can have an impact on outcomes which is significant but unquantifiable in advance. The challenge for any decision maker is to reduce this impact. Thinking in Bets distils Duke’s experience and analysis into a practical and accessible guide to improving decision-making in any sphere.

Not least for investing. After all, each investment is like a bet. The buyer is banking on prospective returns being greater than the ‘risk-free’ alternative of US Treasury bonds. The outcome will be determined by both skill and luck.

It will also often vary over different timeframes. As investment markets can move in random directions in the short term, luck can play a significant role. Over the long term, however, the fundamental drivers of the asset’s performance count, so skill is more likely to be rewarded.

To understand if a manager has been lucky or skilful, we first need to break down the relationship between decision quality and decision outcome. Just because the investment manager has had a few great years of performance does not mean they are necessarily skilful. Outcomes are often out of our control. We can make a bad decision and still have a good outcome, or vice versa.

If you encounter a sabre-toothed tiger, don’t think, run – and hope someone else is slower to react.

You win some, lose some

Imagine it’s New Year’s Eve 1999, and you are considering an investment in Microsoft. You have a high level of conviction (say 90%) that Microsoft will benefit from the coming internet revolution. And it turns out you’re right about that: since 2000, Microsoft stock is up over 900%, making it one of the best performers of the past two decades. But do you have the nerve to hold on to your investment when it loses 65% during the first year as the dot.com boom turns to bust?

Have you been unlucky? Or unskilful? Probably both – as Duke notes, “just as we are almost never 100% wrong or right, outcomes are almost never 100% due to luck or skill.”

However, as in all scientific endeavours, the sample size matters. Results will eventually revert to the mean, so it makes sense to evaluate the process irrespective of the end outcome. The risk in relying on outcomes as a feedback mechanism is that random, improbable results could wrongly lead us to change our framework or beliefs. Decision quality should therefore be judged on repeatability. The objective of decision analysis is to delineate luck from skill; to focus on the signal, whilst ignoring the noise.

Duke argues the best way to do this is through probabilistic thinking. She suggests envisaging different possible outcomes as the branches of a tree, with the size of each branch determined by both its likeliness and the impact of the potential outcome.

What does this mean for an investor? Nipping back to 2000, I have 90% confidence that Microsoft will benefit from the internet revolution, but I deem that outcome already fully priced into the shares. That complicates the risk/return picture – is it worth investing? Probably not, for now.

Duke also points out that, by deliberately considering alternative scenarios, we reduce our susceptibility to hindsight bias(seeing outcomes as inevitable once they’ve happened). The journey to today was once uncertain. What we struggle to recall are the branches lopped off by the passage of time. The past seems deterministic, whilst the future is probabilistic.

Counterintuitively, striving for accuracy in decision-making contradicts how our brains have evolved. Our prehistoric tendencies prioritise efficiency over accuracy. If you encounter a sabre-toothed tiger, don’t think, run – and hope someone else is slower to react. But, when making decisions, accuracy is vital: pick the poisonous berry, and your decision-making ability may be permanently impaired. Thinking in Bets seeks to marry these two otherwise competing modes of thought.

To think in bets means entering a state of perpetual learning. Challenging our existing tenets by seeking objectivity through truthseeking and belief calibration. Changing our minds as the facts change. Only then are we more likely to improve our chances of favourable outcomes. And favourable outcomes can compound, allowing the skilled poker player – or investment manager – to prevail over time.

Your privacy matters

Thinking in Bets