While making an investment decision or while accepting or rejecting any bet, the important question to ask always is – “What’s the alternative?”
Warren Buffett, in his 2014 letter to shareholders, wrote…
We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.
Russian roulette is a game where the player is given the option to take a revolver, having only one bullet, put it on his own head and pull the trigger. If he survives, he stands to win a huge sum, say US$ 10 million. What’s the expected payoff for such bet?
In this game, the probability of surviving is 5/6 (assuming 6 chambers in the revolver) and the upside is US$ 10 million. Whereas probability of encountering the bullet is 1/6 and outcome of this event is the loss of one’s life. You can’t really calculate the expected payoff in this case for how do you put a loss amount on death? I guess it’s infinite.
So even if the payoff were to be in billions and even if the revolver had not six but 1000 chambers with only a single bullet, you still can’t calculate the expected value since the downside is infinite. Buffett was implying that if the downside of a bet is unacceptable to you, no matter how low the probability, you shouldn’t accept the bet.
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