How to get the investing odds in your favour

In 1654, the French aristocrat Chevalier de Mere had a difficult problem to solve. He was a gambler, and liked to play two different games.

In the first game he would roll a dice four times, and if at least one six came up then he’d win. In the second game, he would roll two dice 24 times, and if two sixes came up, he’d also win.

But what de Mere had noticed, was that in the first game he won more times than he lost, and in the second game he lost more times than he won. But he didn’t know why.

So, he called in mathematician Blaise Pascal and his mate Pierre de Fermat to solve the problem, and through their investigations they founded modern probability theory.

By applying this newfound theory, Pascal could confirm that de Mere’s gut feelings were correct, as the chances of winning the first game was 52%, and the chances of winning the second game was just 49%.

Probability theory went on to be used in applications such as insurance, statistics, gaming, the weather, political strategising, sports and investing.

Charlie Munger views probability theory as one of the most important ideas that investors should know.

He said, “It’s not that hard to learn. What is hard is to get so you use it routinely almost every day of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it’s fundamental truth. So, you simply have to have the technique”.

So, what can an investor do to move the odds in their favour?

Favourable odds

There are five ways that investors can improve their odds of success:

1. Diversification. The easiest way to invest is in a highly diversified portfolio of stocks, that represents the market. Jeremy Siegel, author of the book Stocks for the Long Run, calculates that since 1802, the long-term real return from investing in stocks, after inflation, is 6.7% p.a. This percentage has remained remarkably durable to this day, and is due to factors such as population growth, innovation, and continual productivity improvements. One of the key benefits of diversification is that it helps to reduce any unpleasant surprises from any one company or sector. If you are buying into a broad-based ETF, you will get the return of that market (less a small fee).
2. Invest for the long term. One of the biggest mistakes that investors can make is trying to time the market. Due to our natural biases, we often sell out of the market when it’s at its lows, and buy back in when it’s at its highs. As it’s always hard to predict the short-term direction of the market, our probability of success increases if we stay in the market for the long term, and ride out the bumps.
3. Avoid games of chance. Probability is central to understanding games of chance, such as in casinos, lotto and pokies. Whenever there is a ‘house’ involved, money is sucked out of the system, and over time the punter will always lose. Having an occasional small punt for fun is fine, but as a general rule it makes good financial sense to avoid games of chance.
4. Educate yourself. Warren Buffett says the best investment is in your own education. This not only applies to your career where a higher education often leads to a higher paying job, but also applies to financial education. Read investment books, listen to podcasts, subscribe to investment periodicals, or enrol in Bootcamp. The better we understand investing concepts, the higher the probability of investment success.
5. Good money habits. Benjamin Franklin said, “A penny saved is a penny earned”. And the more we can save, the more we’ll have to invest. This can lead to our wealth growing and compounding over time. Saving and good money habits give us more options, and are key to increasing our probability of financial success.