Tuesday, February 23, 2010

Investing Lessons from Hockey

I don’t claim to be an expert when it comes to hockey, but being a Canadian and a long-time fan, I have an opinion about Canada’s Olympic loss to the US hockey team. Some of the mistakes that can be made in hockey related to risk and reward carry over to the investing world.

There is no doubt that the Canadian team is absolutely packed with talent. However, they seem to play each game from start to finish with the desperation of a team trailing by 3 goals. By taking chances and pushing hard to score, they seem to be increasing the risk of giving up goals.

This is the right strategy when you are trailing toward the end of a game, but is unnecessarily risky at other times. Taking a risk that increases the odds of scoring by 5%, but also increases the odds of being scored upon by 10% is a formula for losing games over the long run.

The same principle carries over to money. For most people, the best hope for making $10 million quickly is to buy a lottery ticket. However, a $2 ticket usually has an expected return of less than $1. So, buying lottery tickets is a formula for losing money over the long run. This is true despite the fact that so many lottery players claim to have won more money than they’ve spent.

In investing, the best bet to make a lot of money fast is to borrow to the maximum and buy some highly volatile stock or option. But the odds of financial ruin are frighteningly high with this strategy as well. The potential reward just isn’t worth the risk.

It is important to take risks when the odds are favourable. This is why we choose to buy stocks instead of just bank GICs. For those who buy individual stocks, you have to ask yourself whether you can live with one or more stocks losing most of their value permanently. For those who are broadly diversified, you need to ask yourself whether you will be able to ride out steep declines in stock prices and wait for the eventual recovery.

If your answer to these questions is that falling stocks prices will lead you to financial disaster, the potential reward isn’t worth the risk. If I’m right about the Canadian Olympic hockey team’s problems, here’s hoping that they start to choose better calculated risks.

6 comments:

  1. If you are Canadian. :-)

    In life you need to sometimes take chances, but you need to know why you are taking the chance and what the consequences of the risk is.

    As the Dalai Lama said about religion, but it is usable for Finance which is "Self-discipline with an awareness of the consequnces".

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  2. Big Cajun Man: I always found there were more consequences when I lacked self discipline :-)

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  3. Tom Bradley also wrote about the parallels that sports has with investing. There is one difference though: in sports, the results are readily apparent. In investing, the results won't be known for decades.

    http://www.steadyhand.com/globe_articles/2010/02/20/taking_calculated_risks_can_win_the_gold_medal/

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  4. What's the investing analogy for having three of your stooges smack into each other and fall down in a heap? Hedging costs, and trying to go in too many directions at once will leave you nowhere?

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  5. The lesson I take from the hockey matches is the importance of riding out the ups and downs. The key is not to panic, give into despair and quit at the bottom. Gretsky said on TV last night the Canadian team is avoiding that emotional state. Maybe they'll be able to stage a comeback like Canadian teams have done in the past.

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  6. CC: Sometimes there can be delays in sports (but much shorter feedback delays than you get in investing). Overly risky play against weak teams often leads to winning by a wider margin than more prudent play. It isn't until you face a stronger opponent who can exploit your recklessness that you pay the price.

    Potato: That takes the analogy further than I can go.

    Larry: Hopefully Gretzky is right. However, I think the problem so far has been too much enthusiasm. In the drive to get the puck up the ice quickly, Canada has been taking too much risk of odd-man chances coming back the other way.

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