Here’s something to remember when it comes to risk management… an unlikely outcome is not the same as an impossible one.
For a good example, let’s look at some sports betting action from the NFL playoff game between the Los Angeles Chargers and Jacksonville Jaguars on January 14th. The pivotal moment came with just over 4 minutes left in the 2nd quarter. The Chargers had just kicked a field goal to take a 27-0 lead over the Jaguars. At that point in the game, the Chargers’ win probability was somewhere around 98%. A win by the Jaguars was very unlikely. But as we all know about sports, miracle comebacks can happen.
However, one Chargers fan decided that unlikely did in fact equal impossible. And this fan spotted an opportunity to harvest some easy money by placing a $1,400,000 bet that the Chargers would win the game. However, because the odds already favored the Chargers, the net payout or return on this investment was pretty paltry… $11,200.
Just let that sink in for a moment. This person put $1,400,000 at risk in order to earn $11,200! In percentage terms, they put 100% of their money at risk to earn a measly 0.80%. That’s pretty crazy!
Unfortunately, luck was not on the side of this individual. The Jaguars indeed completed a miraculous comeback and won the game 31-30. And the bettor lost the entire $1,400,000.
Repeat it with me this time… unlikely does not equal impossible.
Risk Management is crucial
Whether you are betting on sports or investing for retirement, risk management is crucial. Warren Buffett famously has two rules when it comes to investing:
1) Don’t lose money
2) Don’t forget Rule #1
Many people take these rules literally and say, “That’s impossible, how can you never lose money when the stock market goes up and down all the time?”
However, Buffett’s main point wasn’t to say that the value of your investments will never go down over the short-term, but rather that an investor should never put themselves in a position where the value of an investment will go down permanently. The individual who placed the bet on the Chargers violated Rule #1… they put their investment capital at risk of being lost forever, and that is exactly what happened.
Another error to point out is that the bettor also failed to consider other profit opportunities. For instance, the bettor could have earned $11,200 with very little risk by buying a short-term Treasury Bill and holding it for about 2 months. What’s more, depending on what state this individual lived in, they would have done even better on an after-tax basis as interest on US Treasuries is exempt from state taxes, but gambling winnings are not. Granted, buying a Treasury Bill doesn’t have the same excitement factor as betting on a football game.
The lesson here is that we ignore risk management at out peril. Seemingly small risks can explode into major issues if not addressed. I’m optimistic that this Chargers fan will be able to bounce back from losing $1,400,000. The rest of us, however, should stay laser focused on managing risk and making sound decisions.
