(written in collaboration with Annie Duke)
About 30 years ago my father and I decided to hike and camp in the Sawtooth Mountains of Idaho. Since neither of us had the skills or experience to survive in this kind of wilderness, we hired a professional, Dave Bingham, to show us the way and to make sure we didn’t get lost or worse. Beyond competent, Dave had a calm positive energy that made my Dad and I feel both safe and adventurous. We followed Dave deep into the mountains, trekking a dozen miles each day, as he led us to pristine alpine lakes where we would catch trout for dinner and camp for the night. It was a wonderful trip and a source of great memories, but it was also a trip where I came face to face with questions that I still constantly ponder.
Throughout the day, Dave took good care of us and made sure we didn’t get into trouble, but he also needed some “alone time” and so every evening after cleaning up, while my father and I struggled to set up our tent, Dave would head up to one of the nearby peaks and do a little “free climbing”, arriving back in camp just before the sun set. The first couple of days, my Dad and I were too distracted with our struggles with tent technology to notice where he was going, but on the third day, we spied him scrambling up an impossibly steep cliff about 500 yards away. Watching his progress through our binoculars, we stared in fascinated horror as Dave climbed higher and higher — without ropes or partner — to heights where any slip would be catastrophic, leaving him broken and us stranded in the wilderness. This was risk taking far beyond anything I had witnessed in my career as an actuary and I simply could not understand why or how someone would act so cavalierly with no apparent awareness of the possible consequences of their behavior.
When Dave returned to camp, refreshed and only slightly winded, we sat him down for a serious talk. I started by asking why he took such an incredible risk with his life and our well-being. He didn’t seem to understand the question, and so my father tried a different tack. First, he asked Dave what probability did he think there was of him falling and dying when he set out. He simply shrugged, said he hadn’t really thought about it, but was very comfortable on the rocks. He said that he had no doubt that he would get down safely as he had done similar climbs many times before and never had a problem. Seeing that Dave still wasn’t getting it, my father posed a different question:
“Suppose you knew that you had a 1 in 1000 chance of falling and dying, would you still climb that peak?”
“Oh sure,” he said.
“What if the chances were 1 in 100?”
“No problem” he replied immediately.
Now my father was getting concerned that we were in the hands of a lunatic and that our chances of getting back in one piece were lower than he had originally thought.
When he next asked “How about 1 in 20?”, Dave finally paused and said, “well maybe if it was that risky, I would reconsider.”
At that point, we dropped the subject, but spent much of the next few days contemplating the implications of the discussion, and the many other unknown (and maybe unknowable) aspects of the spectacularly high stakes gambling that we had witnessed.
What were Dave’s actual chances of falling on that climb? What was his pay-off for making the successful climb, and was it really a smart bet for Dave? How should all the other costs and benefits of the bet be incorporated into Dave’s decision? For example, how did he view the risk to us of his failure? How much value was Dave putting on the rest of his future life versus the immediate pleasure and benefit he would get by climbing up and down? To what extent were there benefits beyond the immediate pleasure he would get by “winning” his bet and getting up and down the cliff safely — e.g. might he also be seeking knowledge of the terrain, additional skills to use for the next climb, or maybe just some other kind of self-knowledge that is only accessible when you are standing on top of a high isolated cliff in the middle of Idaho?
Most importantly of all — Given that basic probability suggests that if you bet your life 100 times in a row, even if your chances of survival are 99/100 each time, you only have a 50–50 chance of surviving the experience, what kind of attitude allowed Dave to be so comfortable with the uncertain and potentially cataclysmic future that came with the decision to climb that cliff?
Free Climbing at the Supermarket
With the COVID-19 death toll still rising exponentially, the virus potentially on every surface we touch and in the exhalations of every person we meet on the street, we have suddenly found ourselves in Dave’s shoes. Put aside the disruption in the economy and the uncertainty in the investment markets that has made basic financial decisions feel perilous, even a simple trip to the supermarket can expose us to a fate every bit as lethal as Dave was facing in his recreational cliff climbing. And like Dave, we don’t know for certain the extent of the risks we are taking and, even if we did, most of us have neither the grounding in probability theory nor the psychological tools for intelligently making such high stakes bets.
Fortunately, there are people who can provide insights about how to manage our lives in such a risky world. Recently I had the opportunity to talk with one who is an expert at making good bets and who has learned, over many years, how to be comfortable when the stakes are high and the outcome highly uncertain.
In 1992 Annie Duke was at UPenn on her way to becoming a PhD in Cognitive Psychology when she discovered that her basic math aptitude, deep theoretical knowledge of human behavior, and a desire to “operationalize” her insights were the perfect pre-requisites for a much more lucrative career — that of a professional poker player. For the next 20 years, Annie played at the highest level of the game, placing first in the 2004 World Series of Poker Tournament of Champions and becoming the first and only woman to ever to win the National Heads Up Poker Championship. She has collected over $4 million in winnings during her career and has demonstrated, in a statistically significant way, that she knows how to make good bets.
In 2018 Annie decided to share her way of thinking with the world and published “Thinking in Bets” https://www.amazon.com/Thinking-Bets-Making-Smarter-Decisions/dp/0735216355 , a book that is, in my view, one of the best and most practical ever written on how to make decisions under uncertainty. While not specifically about financial decisions (my area of expertise), Annie’s insights about the nature of uncertainty and the mental mindset we should be adopting when facing the unknown (and unknowable) future are well worth considering, particularly now when our most important decisions are not just about money.
When I reached out to Annie a few months ago and told her that I was in the process of writing a book about financial decision making, she graciously agreed to share her perspective on the application of her expertise. Little did I know how relevant that conversation would be to figuring out how to manage basic life decisions in today’s “brave new world”.
In “Thinking in Bets” Annie says, “What good poker players and good decision makers have in common is their comfort with the world being an uncertain and unpredictable place”. Perhaps that is obvious, but what Annie says next is very important and potentially counter-intuitive, or at least unnatural, for most of us. She says that to make good decisions it is important for people to “figure out how unsure they are” and to “make their best guess at the chances that different outcomes will occur”.
Annie believes that all decisions are “bets” and the same thinking that leads to making smart bets will also lead to making good decisions.
It is the nature of uncertainty that unseen processes (deterministic, chaotic or random) transform the present into the future, but there is another aspect to uncertainty. All poker players like Annie and actuaries like me know that in making decisions under uncertainty it is important to try and determine the probabilities associated with the range of possible futures, making the choice that gives us the highest “expected value” given whatever our tolerance for risk is.
Some of the uncertainty comes from luck, a force that we can’t control. But Annie also focuses on how to make decisions when we have incomplete information about the current situation. In poker this arises because we don’t know the unseen cards that the other players hold and can only make educated guesses about what they might be based on other information (e.g. what bets they have made earlier in the hand, what facial expressions they may be wearing as well as the basic probability of specific card holdings and a host of other “indirect” clues).
One of the reasons Annie is so good at what she does is that she is able to quickly analyze these clues to make a better guess about the unknown information. While she won’t know until the hand is over whether or not her deductions were correct, evaluating and getting comfortable with this kind of uncertainty is just as important as learning to live with the randomness of what the future holds.
This is particularly true for many of the decisions that we are making every day to avoid becoming infected with COVID-19. Unlike Dave Bingham, who is intimately familiar with the peaks of Idaho and therefore was operating with almost complete information about his task, almost all the cards of the opponent we are currently facing are hidden from view. With COVID-19 testing still not available, we don’t know how many people around us are infected, we don’t know what the risk of getting infected is if we come in contact with someone with the virus, and we don’t even know yet what the fatality rate is. That means we don’t know just how much of a risk we are taking when we interact with people or frequent the places that they’ve been.
With respect to our investment decisions, there is also a huge amount of information that we may theoretically have access to but as a practical matter will never be able to ascertain. For example, even the best financial advisor around likely couldn’t tell you the precise degree of leverage, and therefore vulnerability, that exists within major Banks around the world, whose failures could cause another earthquake in the markets. Not only is that information changing on almost a daily basis, but none of the economic models I know of have been shown to be reliable enough to gauge the impact of such bank failures on the corporate bond market (where many of us have significant assets invested for retirement).
Therefore, in an environment with greater than usual incomplete information, forecasts will be wider and less certain. Guesses about the range of possibilities for the unseen cards based on indirect clues (as distinct from the a priori probability that an opponent holds a certain card) are more or less accurate depending on the internal processes we have developed to come to those guesses. What is most important to hone here is our forecasting ability, which includes an ability to understand and calculate probabilities based not just on luck but also on incomplete information.
While Dave Bingham’s confidence about free climbing up the cliffs of Idaho may have come from his ability to be comfortable with this latter kind of uncertainty neither my father nor I believed he could measure the probabilities associated with his climbing and act prudently as a result. Unlike Dave, Annie Duke does understand how to factor in probability theory, and more importantly, how to separate out the unpredictability of future outcomes from the incomplete information that can be an equal, if not greater, source of uncertainty in every decision we make — financial and otherwise. As a poker player she also didn’t just rely on her experience (or deep pattern recognition skills) to become a champion, but instead actively tried to get better at making guesses about the hidden information. Since almost none of us will make enough financial decisions in our lives to develop the “intuition” for the unseen cards that Annie undoubtedly has, it is those techniques for “educating” our guesses that has become vitally important for us to master.
Fundamentally, to get better at evaluating the unseen cards that are all around us, we need to not only be observant, but also to be aware that we are handicapped by the internal biases, fears and cognitive limitations that are built into our brains. By overcoming our inherent “irrationality” we can train ourselves to learn to make better guesses about the unseen aspects of the critical health and financial choices we face every day. A detailed understanding of how to do that, is beyond the scope of this essay, but if you go get Annie’s book and read it carefully you will pick up some valuable techniques. For now, however, let’s simply listen to what she says about the attitude one should have when dealing with incomplete information.
According to Annie one of the biggest hurdles we need to overcome when we face a decision where we have incomplete information is not that we don’t know everything we need to know, but rather it is the beliefs we hold get in the way of learning. When we do uncover information that was previously hidden, we will mold the newly uncovered information to fit our beliefs as opposed to adjusting our beliefs in light of the new evidence. As Annie says, “we don’t recognize how flimsy the foundation is for many of our beliefs”. This is as true when facing a decision about whether it is dangerous to take your kids to play in the local playground or whether the “low risk bond fund” your broker is recommending is a truly safe place to put your money. The truth is, we are all trying to figure out the cards that our opponents are holding in the high stakes game of poker that COVID-19 has forced us to play.
Making “all in” bets
Professional poker players like Annie make tens of thousands of bets every year and so long as she consistently makes good bets, at the end of the day (or year) Annie is very likely to come out ahead. The key is that players like her are focusing on winning in the long run since even good players sometimes lose all their chips in one hand. That is because one sometimes has to face a situation where an opponent makes a bet so large that in order to continue the hand, you have to put all your money into the pot. If you lose, you are out of the game. If you win, you get to keep playing. In Annie’s world this is known as an “all in” bet.
The best poker players understand that they need to only put an amount of money at risk in any given game that they can afford to lose without going broke. That allows them to have enough money on hand to come back to the table on another day to continue playing. That is how they reduce their risk of ruin.
In my business, ironically enough, we call this the “gambler’s ruin problem”, and actuaries stay up late into the night thinking about this issue as they help Insurance companies set underwriting and pricing standards (our form of betting) so that a series of unlucky claims, or one big event (e.g. a pandemic) that generates many claims at the same time, will not bankrupt their employer. In “Thinking in Bets”, Annie discusses “resulting” and how we should never judge the quality of our decisions by their results, but when everything is riding on the result of a single bet, knowing you made the right decision even though the result was catastrophic is of small comfort.
Unfortunately, that is the nature of this crisis. Ordinary activities of life, like going to the grocery store have become all-in bets like free-climbing an Idaho cliff. If you make too many of these all-in bets, eventually you will lose it all. And this kind of danger lurks also in our financial life, where our ability to sustain ourselves economically in the coming months may depend on putting our assets in a safe place, keeping a stream of income flowing so that we can pay our rent or mortgage and having a network of support available if we do get sick with COVID-19.
There is no easy answer to this problem, though both Annie and I have suggestions.
Annie advises doing all you can to minimize the number of times you will be faced with an “all in” bet. To go back to the cliffs in Idaho, this means just not taking those 1/100 chances more frequently than you absolutely have to. This is advice we have all heard before, “be careful when you shop for food and stock up when you go”, but Annie’s emphasis is on the frequency of the risks you take rather than the extent of the level of the risk itself, though clearly the risk of a single trip to buy food is important to assess, and gauging its importance vs the downside consequences is vital. So when you go by all means take the necessary precautions, but the reality is we don’t know enough about this virus to know how much we are reducing the probability of getting sick on any one trip to the supermarket. What we do know, however, is that whatever the risk is, by significantly cutting down on the number of your food shopping trips you will dramatically reduce your chances of getting sick. That is just the mathematics of probability at work.
Beyond that I think there is another strategy you can employ — this one more financial in nature. In a prior essay https://medium.com/@peteneuwirth/holistic-financial-wellness-barbells-and-the-wisdom-of-nassim-taleb-d8a788a5c828 I discussed how becoming “anti-fragile” is critical to maintaining financial health. In that essay I described “Barbell Strategies” designed not only to provide you with more upside potential than downside to thrive in the long term, but most importantly how to protect yourself from financial ruin if an aspect of your financial situation or the markets you are invested in suddenly collapse. The key aspect of that strategy is to make sure that a large percentage of your assets are absolutely safe, even if you are giving up some potential return in the process. As noted earlier, these days, it is important not to get too focused on the probabilities and “expected value” of the decision/bet you are about to make, but rather stay aware of the risk of a catastrophe in a market collapse or a sudden termination of a source of income (of course what constitutes a personal “economic catastrophe” will vary substantially from person to person).
This might seem like obvious advice when it comes to making financial decisions that could bankrupt you, but it is surprising how easily we are seduced by experts who tell us that “the market is about to recover” or that the recent drops in the stock market means that by investing now, you will enjoy a substantial upside with a seemingly modest downside. But before you accept that advice you need to consider the “worst case” scenario, and sometimes that worst case scenario includes more than just the investment you are considering.
For example, let’s say you have invested a lot of your assets in Municipal Bonds. You get a decent tax-free interest rate and the cities you invest in are all big ones. Not only that, but your broker tells you that the bonds are “absolutely safe” because they are “insured”. But what happens if the virus gets out of control and collapses the healthcare system in the city you have invested in? Isn’t it possible that the police, fire and government infrastructure all crack under the stress? Is the interest, or even the principle now guaranteed to be repaid? Cities have declared bankruptcy before, and many may again before this crisis runs its course. Is that a risk you want to take — particularly if you live in one of the cities you have invested in and may yourself be facing health and economic struggles as a result? It is not just the specific risk associated with the investment you need to evaluate but also all the correlated risks that could cause both the investment and other aspects of your financial life to collapse.
Annie Duke is not a financial advisor and I only give advice to individuals and organizations about specific risk assessment and overall financial wellness. Therefore, readers should take this essay as just the opinion of two people who happen to have some experience “making bets” and see the world of risk and uncertainty from a particular perspective.
That being said, Annie and I both believe that in the best of times, we make “all in” bets more often than we think, and until COVID-19 disappears from our lives we will be making these kinds of high stakes decisions all the time. At the end of the day, we also believe that what is most important is that you be aware of the bets you are making as you are making them, that you become aware of the emotional and cognitive biases that may lead you astray, that you avoid all-in bets when you can, and that you make your life as anti-fragile as you can. If you do all that, then all you are left to do is to simply accept that these are uncertain and dangerous times and that vigilance and a focus on risk have become necessary parts of our lives.
So take of yourselves, stay as safe as you can and keep your eyes wide open