The ability to manage money effectively is the most imp0rtant skill to have in a capitalist society, yet our education system does little to develop this skill in our citizens.
Notice that the most successful plumbing businesses are not necessarily run by the person who knows the most about plumbing, the most successful painting business are not run by the best painters, etc. All businesses that survive practice good money management. I don’t care if you are running a hedge fund, a Fortune 500 company, a small business, or just y0ur own household; you need to know how to manage money. What does that mean?
I have a gambler’s perspective on money management. That is, good money management means making sure that your bets are properly sized. I believe that everything you do with your money is a wager, and sometimes on many different levels. Even stuffing your money in a mattress is a bet against inflation and against certain types of robbery.
If you buy that big flat screen TV, you are betting that you won’t need that money to feed your family. If the cost of that TV is a small percentage of all the money you have, that is probably a good bet. However, you are also betting that you won’t need that money for retirement. For many people, this is nowhere near as good a bet.
If you view it this way, you are always deciding whether or not to make a bet. How do you decide whether or not to make a bet?
John R. Kelly of Bell Labs, one of the brilliant mathematicians that made our world-wide communications system possible, came up with a mathematical formula (Kelly’s Law) that is way over my head, but I have read a lot about it and gotten a lot of input from those who do understand the math. Here is what I have distilled.
Never make any bet in which you do not have a significant edge. That doesn’t mean that you have to be the favorite to win, but it does mean that the payoff has to be better than the risk. For example, if you are simply betting on whether a coin will come up heads or tails, the odds of winning that bet are dead even. However, it is a good bet if the amount you win is greater than the amount you lose, and it’s a bad bet if the the amount you lose is bigger than the amount you win.
Poker players talk about ‘pot odds’. That means your payoff for a bet is so good that the fact that you have short odds is beside the point. You might have a hand that has only a five percent chance of taking the pot, but it’s a good bet if the payoff on the bet is a hundred to one. Note that pot odds do not exiist if you have no chance of winning the bet.
In most cases, deciding whether or not to bet is comparatively easy. The hard part is knowing how much you should bet. Here again, Kelly’s Law provides difinitive guidance.
First, never bet more than fifty percent of your bankroll on any bet that is not a sure thing. Don’t get confused between a situation where the odds are 99 to 1 in your favor and a sure thing. As people in the property and causualty insurance business will tell you, it’s amazing how these once every hundred years events seem to happen every twenty years.
This implies that you should avoid betting borrowed money on anything less than a sure thing, i.e., no use of leverage. It also implies that you should not make two bets that may turn out to be correlated inf the total amount you are betting is more than fifty percent of yoour bankroll.
This also implies that you should always know how much you are betting. For example, you know how much you can win but not how much you can lose when you sell a call option. Kelly would call this a bad bet because you don’t know how much you can lose. In order to use Kelly’s math, you need to have the bet amount in order to the calculations. The math does not work if you don’t have exact figures for the amount at risk and the size of your bankroll.
There are few sure things, and most what is a sure thing is not obvious until the opportunity has come and gone. If you find a real arbitrage opportunity, that may be a sure thing but beware of what some people call ‘asynchronous arbitrage’.
Real arbitrage happens when you can buy a commodity and simultaneously sell it at a higher price. The longer the time required between the purchase and the sale, the greater the chance for loss.
Our banking community recently fell prey to the myth of asynchrous arbitrage. They were buying loans at one price, hoping to turn around and sell them down the road. Many weren’t interested in the quality of loans because the only purpose of their creation was so that the bank had something to sell down the road.
When customers started realizing that the banks were selling them crap, they stopped buying. Most banks could have avoided the overwhelming losses they faced later if they simply stopped making bad loans when people stopped taking them off their hands, but they were addicted to the income stream. That made it easy for them to believe that they would eventually find customers for the bad loans.
The banks simply forgot that every mortgage is a bet, and they stopped looking at each loan as a wager. A bank is by definition an instituion for making wagers, but they forgot that.
They thought that they were bookies, not gamblers. Being a bookie is a good business if you are smart and not worried about the law or the competition from organized crime. A gambler can win or lose while a bookie simply collects a service fee.
For example, if you ask your bookie about the odds on a particular game, he might indicate that it is a six to five pick ’em bet. This means that you have to bet six dollar to win five. If the bookie gets an equal amount of bets on each side, he makes ten percent of all of the money bet. The bookie can’t really win or lose if the bets are evenly distributed.
The smart bookie keeps the action evem by changing the odds, moving the point spread, and laying off uneven action to bigger books. money management for the bookie is simply avoing the chance of losing wherever possible.
Hedging is key to money management. If possible, you always want to be in the position of the good bookie. You don’t want to be greedy; you want to make sure that you win no matter what happens.
Nothing in life is without risk, but risks can often be chosen and managed. To do so is to reduce dependence on luck.