Thursday, June 18, 2009

What’s it to Ya’?

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Let’s return to Bill, our would-be investor from yesterday? We figured out that his expectation was a gain of two bucks a share if he buys stock in that mining company. However in that greatly simplified example, he will not gain two dollars a share. Either he will lose $10 per share or he will gain $20 per share. Should he buy the stock and if so, how much? Obviously that depends on his situation. In fact it depends on both his financial status and his emotional make-up. Beyond the calculation of expectation he should ask himself two questions:

First, “Can I afford to lose that money if the stock goes down?”

Second, “How much will I worry about losing money?”

Now if his last name is Gates (assuming of course that he is the Bill Gates), he could buy thousands of shares and not lose sleep over it. If he loses, it will hardly dent his resources. However most of us don’t have such deep pockets and the loss of a few thousand dollars would take a major bite out of our budgets. That is one reason such investments may be wise or unwise, depending on the person. While such things as gains or losses can be calculated in isolation, that simple math doesn’t tell the whole story. The effect those gains or losses is very personal. This brings us to another technical term, “Utility.”

In the technical definition, utility is what something means to a particular person or company. For Bill Gates, the utility of $30,000, or even $300,000 is minimal, probably not even measurable. If he loses that much it will not affect the food he eats, the clothes he wears, or his lifestyle. Of course that also means that a gain of that much likewise has minimal utility to him. It would make no difference in his life. Not so for most of us. A loss of $30,000 would force us to modify our way of living while a gain of that much would allow a change of lifestyle. A gain or loss of $300,000 would have an even greater effect. That money has a much greater utility to us than it would to Bill Gates, even though the dollar amount is the same.

Utility, how much a gain or loss really means, depends on the individual at least much as it depends on what is actually gained or lost.

The other side of the utility coin is the emotional part. We tend to remain aware that we could lose, and that can be worrisome. A friend once said to J.P. Morgan, “Worry about my stocks is keeping me awake nights. What should I do?”

Morgan’s reply was simple and profound. “Sell down to the sleeping point.”

That was good advice, and Morgan didn’t even need to know how much his friend had invested. He just knew that it was more than that particular person was comfortable with.

How able are we to tolerate risk and uncertainty? This varies from person to person. Some of us are able to sleep soundly while a major part of our resources are at risk. Others are greatly bothered by much lower risks. Many stockbrokers have tests to help them evaluate how risk-adverse a client is. However we don’t necessarily need “official” confirmation of our own tolerance. If an investment or other action makes us uncomfortable and disturbs our sleep, we are beyond our risk tolerance level. If feasible, we should reduce our exposure to whatever is bothering us. The utility to us of what we’re doing does not justify the emotional price we are paying.

Another important aspect of this is that utility of a gain tends to be less than the utility of an equivalent loss. Part of this is the psychological effect I mentioned before that emotionally we feel a loss more than a gain. However there is also a very real non-psychological effect.

Suppose you have retirement savings of $500,000. You invest some of it and it pays off, big-time. You gain $250,000. You’re delighted, you now have $750,000 and that gain represents one third of your savings. You may retire a bit earlier than you planned or decide on a different retirement lifestyle.

Now suppose that several investments went terribly wrong. Instead of gaining you lose that $250,000 leaving you with only $250,000 for retirement. Now what you lost represents 100% of what you have left! You will have to make a big change in your expectations, maybe delay your retirement and not be able to do what you planned after you finally do retire. The utility of that loss is greater than the utility of the equivalent gain. The amount you can reasonably improve your lifestyle with an extra $250,000 is less than the amount of cutting back you will have to do if you lose that much. In addition, it is psychologically more difficult to adjust to a lower standard of living that to move up the economic scale.

Utility is one more thing we should think about when deciding on anything risky. We may or may not do some mathematical calculations, but we should think about it. We can think of how likely a loss is and what it will mean to us if we do lose (or gain). With a sound understanding of that, we are more likely to make good decisions.

Of course there are ways to help reduce risk while still getting many of the benefits from the “Nothing ventured, nothing gained” approach. I plan to discuss some soon. However there is another aspect of utility I want to talk about first so I’ll do that next.

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