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Why winners win and losers lose

Dear Friend,

Ask any successful investor how they make money, when so many of their brethren lose time after time and their secret is nearly always startlingly simple.

What they say is nothing to do with capital allocation, return on equity market timing or anything else — when you subtract all the mumbo-jumbo, the simple formula usually boils down to this — they only take on investments when the rewards on offer far outweigh the risks.

If they do this consistently for long enough, the law of averages brings them handsome returns.

If I could toss a pound coin for keeps and could win £2 every time I won, but only paid out a pound every time I lost, I should soon be a wealthy man.

In my imaginary coin-flipping scenario, the only necessity, other than persistent faith that the odds are right, is to have enough risk capital available to be able to suffer a run of bad luck. If calling heads or tails presents a 50/50 chance of success or failure, then losing 10 times in a row happens only one in over a thousand attempts.

So if I turned up to the coin-flipping match with ten pounds in my pocket I would have a 99.9% chance of being invincible. But we are men, not machines.

The trouble is that in the real world historical events influence our behaviour. The way the market works is that the price fluctuates according to our perception of risk, rather that the risk itself.

In the real world if a player wins the coin toss five times in a row, he will start to accept 50p for risking a pound — since his experience-rated logic says that he is bound to win every time.

Similarly if a player loses five times in a row, you’ll have to offer him at least £2 for a win to tempt him back in the game — and for some people no odds will convince them that they’re not going to lose their shirt.

Back to the reinsurance world — and right now in the Gulf of Mexico there are plenty of reinsurers who have had second thoughts about the game.

Never mind that the statistical evidence is that Hurricanes don’t actually go into the Gulf that often, but three losses in two years has convinced enough that they are on to a loser here.
That’s why prices are rising to levels that are tempting the true long-term winners come into the game.

This is not scientific but in blunt terms, on the best deals they are getting $2 reward for $1 of risk — for such prices, no wonder they are prepared to have a go.

In this industry we’re always beating ourselves up about how often we leave money on the table for others to pick up.

Well, right now there are plenty of people in our industry doing it all over again and reducing their writings either because they are running out of stake money or they are losing their nerve.

In the long run this is a losing strategy. In our business, risk selection is always over emphasised.

Successful reinsurance should always be about getting the price right — in the end, nothing else matters.

Let’s discuss this further down in Monte Carlo!

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