Expected Value Analysis (Babe Ruth Effect)

It’s not the frequency of correctness that matters – but rather the magnitude of correctness that does…

Back in the late 1970’s, the famous behavioral economists – Daniel Kahneman and Amos Tversky – created Prospect Theory. The concept that humans value losses and gains very differently. Kahneman and Tvserky found that losses have about two-and-a-half times (2.5x) the impact that a similar gain does. This behavioral fact has dealt a blow to the conventional financial wisdom – especially the Efficient Market Hypothesis (EMH). Prospect Theory thus implies that humans naturally will feel a lot happier when they’re correct. So they try to be correct as often as they can (which leads to herd following).

When former-trader-turned-risk-philosopher Nassim Taleb wrote his book Fooled By Randomness – he described how he dealt with magnitude over frequency from his own experience. While Taleb was talking with fellow traders on the floor – a peer asked Taleb about his views on the market. Taleb responded – saying that he believed (like the rest of the market) there was a high probability that the market would rise over the next week. Another trader chimed in noting that Taleb’s positions were heavily short S&P 500 future. This was a sharp contradiction from his “high chance of a rising market” outlook. Although he (and the crowd) believed the most probable outcome was for the market to rise – the low chance the market declined created an asymmetric opportunity. Since the high-probable outcome (70%) was priced in already (because markets are relatively efficient) – there isn’t much more to gain. But in the off chance the market actually does decline (a 30% chance) – the effect is dramatic as the market re-prices the news. In Taleb’s mind he saw that betting on the high-probability outcome had a negative expected value compared to the greater risk/reward betting on the low chance the market declined.