Tuesday, April 29, 2014

Margin for Error: Be prepared when things DON'T go your way!

Many of us have experienced something along these lines: we take up a project and plan out all the details.  We'll do task A first, then B, then C, etc. all the way to task Z.  Somewhere in the middle of our execution, say task T, we screw up and the project is a complete failure despite all the effort we put in from tasks A to S.  Sometimes, we may fail at task T but we can still finish the project satisfactorily.  I think of this phenomenon as Margin for Error.

It's hard to define Margin for Error precisely but it's pretty easy to give a sense in plain English.  Picture any project or task you're doing that involves multiple steps or decision points.  If at any step you perform poorly and there's a good chance the project or task will fail, then there's a high margin for error.  Think of 5 pounds of a special bread: if the amount of any of your minor ingredients like salt, sugar, cinnamon, etc. are off by 1/16 of a teaspoon and the bread will not taste right, then there's a high Margin for Error.

In other words, any one mistake will derail all the effort you've put into a task implies a low margin for error.

Driving is an example of a task that doesn't have a high margin for error despite the possibility that a single bad move can end up killing you.  Assuming you've received the proper training to drive a car, you'd need to make a pretty drastic or utterly careless move to get yourself killed in most cases.  On the other hand, performing brain surgery has a high margin for error since it'll involve hundreds of steps and any slightly imperfect move in any of those steps may cause the surgery to fail.  Fortunately, most brain surgeons will receive years if not decades of training for this delicate procedure.

Day trading stocks is another activity with a high margin for error.  You're likely to risk a lot of capital making many trades each day.  Most traders know well enough to cut their losses on a bad trade but with so many trades happening, decision fatigue may set in on your 106,478th trade.  It only takes forgetting 1 stop loss  to incur a huge loss despite all the effort you put towards your last 106,477 trades.  This is a major reason why I stick with passive investing over active trading.

If you're unfamiliar with the financial markets, let's use an example with gambling.  Suppose you go to a casino and you play a game where you can bet double or nothing.  If you start by betting $1 and wager your entire winnings from one game to the next, you'll have $1 million after about 20 games.  Suppose you've devised a system that has a 90% chance of winning, what's the probability that you'll win 20 consecutive games?  About only 12%.  If your winning probability goes down to 80%, each game, you only have a 1% chance of winning 20 games in a row.  And I've never heard of anyone who consistently wins anywhere close to 80% of the time in a casino!

It's still important to work hard and plan ahead to minimize the possibility of failure in any important project or task you pursue.  But you're likely setting yourself up for disappointment if you do not have a realistic sense of the margin for failure accompanying the task.  (Chris Guillebeau used the metaphor of dominoes falling to describe this same concept which inspired my post.)

No comments:

Post a Comment