Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [32]
Most hedge fund managers happily load up on risk to stay in the game. Hedge fund wisdom is “heads I win, tails you lose, and I still win—just not as big.”There is one other possibility:The coin can stand on edge—the hedge fund manager gets bailed out, and you give back your winnings, but we will get to that later. For now, winning means that a hedge fund’s returns are up, managers collect hefty fees while attracting new money, and investors get a reasonable return on their money. Losing means that hedge fund managers still make hefty fees and investors have a negative return or perhaps even lose all of their money.The hedge fund manager hates to lose, since he will not be able to attract new money and the money, upon which he gorges, will shrink, thus decreasing his payday.
Nobel Prize-winner Daniel Kahneman and Amos Tversky, a Stanford psychology professor, studied the financial psychology of judgment and decision making. They found that people feel more strongly about the pain that comes with loss than they do about the pleasure that comes with an equal gain. In fact, most people feel about twice as strongly about the pain of loss according to their study. If you really hate to lose, you may feel even more strongly about it than that. Surprisingly, people will take much more risk to avoid a loss than they will to earn a gain, even when the economic results are the same.
If you don’t believe it, try the following game. Imagine that I have given you $100,000, and I have also given you two choices. I will either guarantee you an additional $50,000 or I will allow you to flip a coin. If it’s heads you get another $100,000; if it’s tails you get nothing additional. If you choose to take my guarantee, you are certain to walk away with $150,000. If you choose to flip the coin, you get either $100,000 or $200,000. Which option do you choose? Most people choose to take my guarantee and walk away with the certain $150,000.
Now suppose instead I have given you $200,000, and I have given you the following two choices. I will either take away—guarantee you lose—$50,000, or you can flip a coin and try for a different outcome. If the coin comes up heads, you lose $100,000; if it’s tails you lose nothing. Now which option do you choose? Most people will choose to flip the coin to try to avoid the certain loss of $50,000 even if it means they might lose $100,000.
In both situations, you wind up with $150,000 if you choose my guarantee. In both cases if you choose the coin flip, you have a 50-50 chance of ending up with either $200,000 or $100,000. Most people choose the sure $150,000 when they stand to gain. It is a very different story when they stand to lose. Most people will choose to flip the coin because they will take more risk to avoid losing money, even if that means they will potentially be worse off than if they just took their loss. The feeling seems to be that they should at least try to avoid the loss.They shouldn’t stand by, do nothing and just let it happen to them.
I prefer Warren’s conditional probabilities to any of these choices. The odds of a favorable outcome appear much higher to me.
Now imagine you were running a hedge fund earning 2 percent on all of the funds you have under management and earning 20 percent of the upside. Better yet, if you can get away with it, take 5 percent as a fee on the assets under management, and take 44 percent of any potential upside. If your bet loses, your investors will withdraw all of their lovely money and you will get no fees at all. How much will you hate losing now? Enough to risk doubling your investors’ losses?
If you were the hedge fund manager,