Room for Error

 



                                CHAPTER 13

                 Room for Error

 

The most important part of every plan is planning on your plan not going according to plan.


Some of the best examples of smart financial behavior can be found in an unlikely place: Las Vegas casinos.

Not among all players, of course. But a tiny group of blackjack players who practice card counting can teach ordinary people something extraordinarily important about managing money: the importance of room for error.

  

The fundamentals of blackjack card counting are simple:

 

 No one can know with certainty what card the dealer will draw next.

 

But by tracking what cards have already been dealt you can calculate what cards remain in the deck.

 Doing so can tell you the odds of a particular card being drawn by the dealer.

 

As a player, you bet more when the odds of getting a card you want are in your favor and less when they are against you.

The mechanics of how this is done don’t matter here. What matters is that a blackjack card counter knows they are playing a game of odds, not certainties. In any particular hand they think they have a good chance of being right, but know there’s a decent chance they’re wrong. It might sound strange given their profession, but their strategy relies entirely on humility—humility that they don’t know, and cannot know exactly what’s going to happen next, so play their hand accordingly. The card counting system works because it tilts the odds ever so slightly from the house to the player. But bet too heavily even when the odds seem in your favor and, if you’re wrong, you might lose so much that you don’t have enough money to keep playing.

There is never a moment when you’re so right that you can bet every chip in front of you. The world isn’t that kind to anyone—not consistently, anyways. You have to give yourself room for error. You have to plan on your plan not going according to plan.

Kevin Lewis, a successful card counter portrayed in the book Bringing Down the House, wrote more about this philosophy:

 

Although card counting is statistically proven to work, it does not guarantee you will win every hand—let alone every trip you make to the casino. We must make sure that we have enough money to withstand any swings of bad luck.

Let’s assume you have roughly a 2 percent edge over the casino. That still means the casino will win 49 percent of the time. Therefore, you need to have enough money to withstand any variant swings against you. A rule of thumb is that you should have at least a hundred basic units. Assuming you start with ten thousand dollars, you could comfortably play a hundred-dollar unit.

 

History is littered with good ideas taken too far, which are indistinguishable from bad ideas. The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance—“unknowns”—are an ever-present part of life. The only way to deal with them is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day.

 

Benjamin Graham is known for his concept of margin of safety. He wrote about it extensively and in mathematical detail. But my favorite summary of the theory came when he mentioned in an interview that “the purpose of the margin of safety is to render the forecast unnecessary.”

It’s hard to overstate how much power lies in that simple statement.

Margin of safety—you can also call it room for error or redundancy—is the only effective way to safely navigate a world that is governed by odds, not certainties. And almost everything related to money exists in that kind of world.

Forecasting with precision is hard. This is obvious to the card counter, because no one could possibly know where a particular card lies in a shuffled deck. It’s less obvious to someone asking, “What will the average annual return of the stock market be over the next 10 years?” or “On what date will I be able to retire?” But they are fundamentally the same. The best we can do is think about odds.

Graham’s margin of safety is a simple suggestion that we don’t need to view the world in front of us as black or white, predictable or a crapshoot. The grey area—pursuing things where a range of potential outcomes are acceptable—is the smart way to proceed.

But people underestimate the need for room for error in almost everything they do that involves money. Stock analysts give their clients price targets, not price ranges. Economic forecasters predict things with precise figures; rarely broad probabilities. The pundit who speaks in unshakable certainties will gain a larger following than the one who says “We can’t know for sure,” and speaks in probabilities.

We do this in all kinds of financial endeavors, especially those related to our own decisions. Harvard psychologist Max Bazerman once showed that when analyzing other people’s home renovation plans, most people estimate the project will run between 25% and 50% over budget.⁴³ But when it comes to their own projects, people estimate that renovations will be completed on time and at budget. Oh, the eventual disappointment.

Two things cause us to avoid room for error. One is the idea that somebody must know what the future holds, driven by the uncomfortable feeling that comes from admitting the opposite. The second is that you’re therefore doing yourself harm by not taking actions that fully exploit an accurate view of that future coming true.

But room for error is underappreciated and misunderstood. It’s often viewed as a conservative hedge, used by those who don’t want to take much risk or aren’t confident in their views. But when used appropriately, it’s quite the opposite.

Room for error lets you endure a range of potential outcomes, and endurance lets you stick around long enough to let the odds of benefiting from a low-probability outcome fall in your favor. The biggest gains occur infrequently, either because they don’t happen often or because they take time to compound. So the person with enough room for error in part of their strategy (cash) to let them endure hardship in another (stocks) has an edge over the person who gets wiped out, game over, insert more tokens, when they’re wrong.

Bill Gates understood this well. When Microsoft was a young company, he said he “came up with this incredibly conservative approach that I wanted to have enough money in the bank to pay a year’s worth of payroll even if we didn’t get any payments coming in.” Warren Buffett expressed a similar idea when he told Berkshire Hathaway shareholders in 2008: “I have pledged—to you, the rating agencies and myself—to always run Berkshire with more than ample cash ... When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

There are a few specific places for investors to think about room for error.

One is volatility. Can you survive your assets declining by 30%? On a spreadsheet, maybe yes—in terms of actually paying your bills and staying cash-flow positive. But what about mentally? It is easy to underestimate what a 30% decline does to your psyche. Your confidence may become shot at the very moment opportunity is at its highest. You—or your spouse—may decide it’s time for a new plan, or new career. I know several investors who quit after losses because they were exhausted. Physically exhausted. Spreadsheets are good at telling you when the numbers do or don’t add up. They’re not good at modeling how you’ll feel when you tuck your kids in at night wondering if the investment decisions you’ve made were a mistake that will hurt their future. Having a gap between what you can technically endure versus what’s emotionally possible is an overlooked version of room for error.

Another is saving for retirement. We can look at history and see, for example, that the U.S. stock market has returned an annual average of 6.8% after inflation since the 1870s. It’s a reasonable first approximation to use that as an estimate of what to expect on your own diversified portfolio when saving for retirement. You can use those return assumptions to back into the amount of money you’ll need to save each month to achieve your target nestegg.

But what if future returns are lower? Or what if long-term history is a good estimate of the long-term future, but your target retirement date ends up falling in the middle of a brutal bear market, like 2009? What if a future bear market scares you out of stocks and you end up missing a future bull market, so the returns you actually earn are less than the market average? What if you need to cash out your retirement accounts in your 30s to pay for a medical mishap?

The answer to those what ifs is, “You won’t be able to retire like you once predicted.” Which can be a disaster.

The solution is simple: Use room for error when estimating your future returns. This is more art than science. For my own investments, which I’ll describe more in chapter 20, I assume the future returns I’ll earn in my lifetime will be ⅓ lower than the historic average. So I save more than I would if I assumed the future will resemble the past. It’s my margin of safety. The future may be worse than ⅓ lower than the past, but no margin of safety offers a 100% guarantee. A one-third buffer is enough to allow me to sleep well at night. And if the future does resemble the past, I’ll be pleasantly surprised. “The best way to achieve felicity is to aim low,” says Charlie Munger. Wonderful.

 

An important cousin of room for error is what I call optimism bias in risk-taking, or “Russian roulette should statistically work” syndrome: An attachment to favorable odds when the downside is unacceptable in any circumstances.

Nassim Taleb says, “You can be risk loving and yet completely averse to ruin.” And indeed, you should.

The idea is that you have to take risk to get ahead, but no risk that can wipe you out is ever worth taking. The odds are in your favor when playing Russian roulette. But the downside is not worth the potential upside. There is no margin of safety that can compensate for the risk.

Same with money. The odds of many lucrative things are in your favor. Real estate prices go up most years, and during most years you’ll get a paycheck every other week. But if something has 95% odds of being right, the 5% odds of being wrong means you will almost certainly experience the downside at some point in your life. And if the cost of the downside is ruin, the upside the other 95% of the time likely isn’t worth the risk, no matter how appealing it looks.

Leverage is the devil here. Leverage—taking on debt to make your money go further—pushes routine risks into something capable of producing ruin. The danger is that rational optimism most of the time masks the odds of ruin some of the time. The result is we systematically underestimate risk. Housing prices fell 30% last decade. A few companies defaulted on their debt. That’s capitalism. It happens. But those with high leverage had a double wipeout: Not only were they left broke, but being wiped out erased every opportunity to get back in the game at the very moment opportunity was ripe. A homeowner wiped out in 2009 had no chance of taking advantage of cheap mortgage rates in 2010. Lehman Brothers had no chance of investing in cheap debt in 2009. They were done.

To get around this, I think of my own money as barbelled. I take risks with one portion and am terrified with the other. This is not inconsistent, but the psychology of money would lead you to believe that it is. I just want to ensure I can remain standing long enough for my risks to pay off. You have to survive to succeed. To repeat a point we’ve made a few times in this book: The ability to do what you want, when you want, for as long as you want, has an infinite ROI.

 

Room for error does more than just widen the target around what you think might happen. It also helps protect you from things you’d never imagine, which can be the most troublesome events we face.

The Battle of Stalingrad during World War II was the largest battle in history. With it came equally staggering stories of how people dealt with risk.

One came in late 1942, when a German tank unit sat in reserve on grasslands outside the city. When tanks were desperately needed on the front lines, something happened that surprised everyone: Almost none of them worked.

Out of 104 tanks in the unit, fewer than 20 were operable. Engineers quickly found the issue. Historian William Craig writes: “During the weeks of inactivity behind the front lines, field mice had nested inside the vehicles and eaten away insulation covering the electrical systems.”

The Germans had the most sophisticated equipment in the world. Yet there they were, defeated by mice.

You can imagine their disbelief. This almost certainly never crossed their minds. What kind of tank designer thinks about mouse protection? Not a reasonable one. And not one who studied tank history.

But these kinds of things happen all the time. You can plan for every risk except the things that are too crazy to cross your mind. And those crazy things can do the most harm, because they happen more often than you think and you have no plan for how to deal with them.

In 2006 Warren Buffett announced a search for his eventual replacement. He said he needed someone “genetically programmed to recognize and avoid serious risks, including those never before encountered.”

I have seen this skill at work with startups my firm, Collaborative Fund, has backed. Ask a founder to list the biggest risks they face, and the usual suspects are mentioned. But beyond the predictable struggles of running a startup, here are a few issues we’ve dealt with among our portfolio companies:

 

Water pipes broke, flooding and ruining a company’s office.

A company’s office was broken into three times.

A company was kicked out of its manufacturing plant.

A store was shut down after a customer called the health department because she didn’t like that another customer brought a dog inside.

A CEO’s email was spoofed in the middle of a fundraise that required all of his attention.

A founder had a mental breakdown.


Several of these events were existential to the company’s future. But none were foreseeable, because none had previously happened to the CEOs dealing with these problems—or anyone else they knew, for that matter. It was unchartered territory.

Avoiding these kinds of unknown risks is, almost by definition, impossible. You can’t prepare for what you can’t envision.

If there’s one way to guard against their damage, it’s avoiding single points of failure.

A good rule of thumb for a lot of things in life is that everything that can break will eventually break. So if many things rely on one thing working, and that thing breaks, you are counting the days to catastrophe. That’s a single point of failure.

Some people are remarkably good at avoiding single points of failure. Most critical systems on airplanes have backups, and the backups often have backups. Modern jets have four redundant electrical systems. You can fly with one engine and technically land with none, as every jet must be capable of stopping on a runway with its brakes alone, without thrust reverse from its engines. Suspension bridges can similarly lose many of their cables without falling.

The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.

The trick that often goes overlooked—even by the wealthiest—is what we saw in chapter 10: realizing that you don’t need a specific reason to save. It’s fine to save for a car, or a home, or for retirement. But it’s equally important to save for things you can’t possibly predict or even comprehend—the financial equivalent of field mice.

Predicting what you’ll use your savings for assumes you live in a world where you know exactly what your future expenses will be, which no one does. I save a lot, and I have no idea what I’ll use the savings for in the future. Few financial plans that only prepare for known risks have enough margin of safety to survive the real world.

In fact, the most important part of every plan is planning on your plan not going according to plan.

Now, let me show you how this applies to you.





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