Long-term risks in investing
A simple story explaining a fundamental concept.
2024-08-25 by Luca Dellanna
Imagine two fund managers, Alice and Bob. Alice takes more risks and therefore has both a higher growth rate and a higher rate of collapse. Conversely, Bob is more conservative.
Who gets wealthier?
For such a small sample, a lot depends of luck. So, let's imagine there are a hundred Alices and a hundred Bobs.
Who gets wealthier?
The answer is counterintuitive
On average, the wealthiest person will be an Alice, but Bobs will be wealthier on aggregate.
Let me explain.
In the short term, Alices will grow faster. Therefore, they will accummulate more wealth than Bobs.
However, as time passes by, more and more Alices will fail. Not all, obviously, and that's why at the top we will mostly see Alices. However, these Alices at the top, are a subset of all Alices. Many more will have collapsed.
As more and more time passes by, we see the following stratification: a small top made of extra-wealthy Alices, then a large group of wealthy Bobs, and finally, a largish group of poor Alices.
Survivorship bias
When we look at the top, we only see Alices, and that might give us the wrong impression that Alice's strategy is better than Bob's.
However, if we look at the aggregate of all fund managers over the long term, Bobs accumulate more wealth than Alices. Hence, Bob's strategy is better.
As I use to say, the croupier is the only person at the casino with a money-making strategy. However, every day, he sees at least one player getting wildly wealthier than him. But he must resist the temptation to switch from his good strategy to the player's worse one.
What fund managers can learn from this
The hard part of a good long-term investing strategy is to avoid the feeling of falling behind when colleagues with riskier strategies get temporarily ahead – and especially to avoid that your clients feel like they're falling behind.
I can help you with this.
I can both reason with you on whether a long-term strategy is truly better and, perhaps more importantly, I can give you emotional stories and effective methods to convince your clients.
If you are interested, do not hesitate to contact me.
Note: this example is an excerpt from my bestselling book Winning Long-Term Games
