Irrational tossers

By The Economist online

THERE are few sure things in investing. But the chance to bet on a rigged coin sounds like a good one. Alas, a paper by two fund managers, Victor Haghani of Elm Partners (and co-founder of the collapsed Long-Term Capital Management) and Rich Dewey of Pimco, shows that it is possible to get even that wrong.

The paper invited 61 people, a combination of college-age students in finance and economics and some young professionals at finance firms (including 14 who worked for fund managers), to take a test. They were each given a stake of $25 and then asked to bet on a coin that would land heads 60% of the time. The prizes were real, although capped at $250.

Remarkably, 28% of the participants went bust, and the average payout was just $91. Only 21% of the participants reached the maximum. 18 of the 61 participants bet everything on one toss, while two-thirds gambled on tails at some stage in the experiment. Neither approach is in the least bit optimal.

Apparently the right strategy is to use the Kelly criterion, named after a…

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Read more here: Irrational tossers

Category: Business and finance, Buttonwood’s notebook

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