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From Mark Ford, founder, Palm Beach Research Group: Here’s one thing every wealth builder should know: When the return on your investment depends on some expected future outcome, it is inherently risky. When it’s based on two expectations—a future event and a time frame—the risk is exponentially greater.
The application of a cautious intelligence can shorten those odds considerably.
But most investors don’t behave intelligently when it comes to speculative investments. They tend to overestimate the likelihood of a good outcome and underestimate the likelihood of disaster.
Elise Payzan-LeNestour of UNSW (Australia) Business School conducted a test tracking the decisions of investors given speculative opportunities. She then compared their behavior with the responses of lab monkeys.
The monkeys were presented with two levers—one that always dispensed a small amount of sugar and another that sometimes provided double the sugar and other times administered an electric shock.
Time and again, the monkeys took the gamble and ended up with less sugar and lots of shocks.
The same pattern was evident in the investors. When given the choice between speculations that offered high returns and guaranteed investments at lower returns, they favored the speculations.
In choosing safe versus speculative investments, Payzan-LeNestour concluded, investors are no better than monkeys.
So to make good investment decisions, we must put a leash on our monkey brains. That leash is a set of rational rules.
First (and most important): Don’t invest in what you don’t understand.
Second: When you do invest, limit your potential losses by applying the Palm Beach Three-Legged Stool of Safety: asset allocation, stop losses, and correct position sizing.
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