When we think about betting, we may think about a blackjack table in a Vegas casino. In reality, however, we are in fact constantly making bets in our daily lives.
Every time we make a monetary investment, decide whether to try a new restaurant or stick to an old routine, and even when we meet someone new, we are consciously or subconsciously deciding whether to invest a resource – time, money, or our energy – into that person or thing.
Here are three keys to making better bets:
1. Judge the odds by incorporating the “outside view”
One smart way to improve your ability to judge odds is by looking at similar past outcomes of the situation you are assessing. Columbia Business School Professor Michael Mauboussin describes this as “the outside view” here. I highly encourage you to take a look at this article for a more in-depth discussion of this concept.
Here’s how the outside view works. Let’s say you come across an investment in a gold mine from a slick salesperson. That salesperson tells you about the merits of the investment, and you get pretty excited. You know it’s a risky bet, but you think the high reward could be worth it. Your first guess may be that the deal has a 50% chance of paying off.
Here is where you can bring in the outside view. Perhaps you do some research on the percentage of similar deals that have turned out well in the past and find 25 examples. If only 3 of those 25 similar deals returned their investors’ money (12% of the time), that might give you some pause. Maybe your initial guess of 50% wasn’t right.
However, you may think this specific proposal is an above-average deal (i.e. it has a better management team than average), so you tweak up the odds from these past “average” transactions, and you assume the odds of this deal working out are more like 25%.
The concept of the “outside view” has a lot of applications in daily life, such as whether or not you join a hot new tech startup. You may think the company is an exceptional opportunity, but by starting with the “outside view” of the percentage of high-flying tech startups that actually work out, then tweaking it for the idiosyncratic factors of the specific startup you are considering, you will probably make a more realistic appraisal of the situation. It still might be a great bet to join (especially if the payoff is huge if it works out), but by using the “outside view,” you are making a better judgment of the odds.
2. Bet seldom, but bet big when the odds are in your favor
I am a huge Charlie Munger fan, and he does a much better job than I can in summarizing this idea:
“The one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time.
But it is given to human beings who work hard at it—who look and sift the world for a misprized bet — that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple”.
3. Minimize the downside if the bet doesn’t work out
If you lose a significant portion of a resource such as money, it is very hard to make that back. That reasoning is why Warren Buffett says, “Rule number 1: never lose money. Rule number 2: never forget rule number 1”.
Obviously whenever we make any kind of bet, even if we made a good bet (betting when the odds are in our favor), there is always a chance it does not work out – otherwise, it would not be a bet. The key, however, is not to bet so big on any one thing that if it does not work out, we have suffered a permanent loss that is nearly impossible to recover from.
Buffett nicely summarizes this by saying, “Never risk what you have and need, for what you don’t have and don’t need”.