Tuesday, March 18, 2014

The Value Of Being Able To Take Risks

One of the advantages of money that people fail to appreciate is the value of being able to take risks.  Because risk and reward are typically intertwined, the rich do get richer.

This year's March Madness tournament provides a particularly striking example.  Quicken Loans and Yahoo Sports are running a "billion dollar bracket": Pick the correct winner of every single NCAA Division 1 Men's Basketball tournament game, and win $1,000,000,000.00.

Now the odds of anyone winning are extremely remote, but it's still hard for either Quicken Loans or Yahoo to stomach handing over $1 billion to a lucky winner.  That's why they found someone to insure the prize: Warren Buffett.

Buffett's company, Berkshire Hathaway has a market capitalization of $300 billion.  It has nearly $50 billion in cash.  To Buffett, paying out a $1 billion prize is the equivalent of a person with $10,000 in the bank having to cough up $500.

Brad Null of BracketVoodoo.com has calculated the odds that someone out of the 15 million people expected to enter the contest actually picks a perfect bracket:

"Let’s assume at this point that 15 million people do enter. Leveraging the historical analysis that we have done on bracket picking behavior in the past, we estimate that the average bracket picked for such a contest would be about 20x less likely than the “all-favorites bracket” described above. And while there will be some duplicate entries, our analysis indicates that this would eliminate less than 10% of all brackets. Thus, there would be at least 13.5 million unique brackets among this set. Put that all together and you get about a 1 in 500,000 chance that Warren Buffett has to shell out that billion dollars. So the EV on that insurance policy he wrote is about $2000."

While we don't know how much Berkshire Hathaway got paid to write this policy, you can bet it was a pretty penny.  Let's imagine that Berkshire Hathaway charged $1 million for a policy that has an expected value payout of $2,000.  Not bad.  But only someone with that financial strength could A) afford to take on the risk, and B) be a credible counterparty.

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