In investing, thinking in probabilities is probably better than thinking in absolutes

“Risk means more things can happen than will happen.” Elroy Dimson

One of the most important lessons that I had early on in my investing experience is that it is more productive and profitable to think in probabilities, rather than absolutes. Unfortunately, it is a lesson that I sometimes need to re-learn. What I mean by that is thinking through the buying decision not as “is this stock definitely undervalued?” or “is this stock going to double?”, but rather as “is it more likely than not to be undervalued?” or “is the business more likely to be better in the future than it is now?” It is a subtle difference, but it re-focused my emphasis on not just the upside potential, but on the downside risk.

The silliness of my earlier approach can be likened to this situation: Imagine if you see your idol or celebrity dream across a busy road (for me: Warren Buffet, or for my girlfriend: Harry Styles). You get so excited to meet them and get a selfie that you proceed to cross the road without looking. The fact that you got to the other side and meet your idol without getting hit does not mean that it was a wise move. (Note: in my case I think it would be safe that Warren is a slower walker than Harry Styles and I probably can be a little more careful crossing the road)

Investing is a little more nuanced than that. For individual investors, the activity likely involves reading articles, annual reports, doing a bit of spreadsheet, testing out its products, maybe talking to management and perhaps going to hotcopper. These activities don’t really scream out “RISKY” as much as getting hit by a car, but the risk is very real and it involves your hard earned money.

Howard Marks explains it very well here (it is very worthwhile to read the entire memo and in fact all of Marks’ memo):

“Investment performance (like life in general) is a lot like choosing a lottery winner by pulling one ticket from a bowlful. The process through which the winning ticket is chosen can be influenced by physical processes, and also by randomness. But it never amounts to anything but one ticket picked from among many. Superior investors have a better sense for the tickets in the bowl, and thus for whether it’s worth buying a ticket in a lottery. Lesser investors have less of a sense for the probability distribution and for whether the likelihood of winning the prize compensates for the risk that the cost of the ticket will be lost.”

Using probability-adjustment tools

One of the changes that I’ve made is to use decision trees in my investment process. It is a blunt rudimentary tool but I find it guides me on a variety of scenarios that can happen in the future. It is definitely not exact, but I use it more as a guide. I also find that discounted cash flow analysis (DCF) is also helpful in understanding the key levers of the business and drivers of valuation. The trap of the DCF analysis of getting false sense of precision and security. I find that Keynes’ advice that “it is better to be roughly right than precisely wrong” invaluable here. The Kelly Formula can be used for the same purpose for portfolio allocation, however I haven’t understood it enough for multi-scenario outcomes. (If someone can help, please drop me a message!) My process is definitely a work in progress and I’m continually fine-tuning it.

Avoiding value traps

The visible outcome for me has been the reduced risk of picking value traps. I am normally a conservative person in terms of what I look for in a company and that leads me to look for beaten down stocks. However, those stocks sometimes have the greatest risk of further deterioration in their business. They are cheap for a reason. Thinking in probabilities opened me up to entertain and constructively analyse for worsening situations and avoid those stocks.

Howard Marks’ sums it nicely up with a piece of wisdom that sometimes gets forgotten, especially in periods where prices have been elevated for some time, “If riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.”

One thought on “In investing, thinking in probabilities is probably better than thinking in absolutes

  1. Pingback: weekly wrap 06/10/17 – hidden value.

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