Predictions and Probability

Investing is as much art as science. The reason is that it involves the emotionally charged interaction of human beings, which science cannot model. Successfully investing is part good decision making and part not shooting yourself in the foot.

The Little Book that Beats the Market lays out a simple way to buy and sell stocks without letting irrational fear and greed undermine your success. Warren Buffet, every year in his letter to shareholders, points out the path to success and possible pitfalls for investors. But if you don’t feel like reading the works of either of those well-known and respected investors, you could read The Dhandho Investor: The Low- Risk Value Method to High Returns by Monish Pabrai.

The author quotes often from Warren Buffet, as well as referring to Benjamin Graham and Joel Greenblatt. The principles are sound and the examples are interesting. Investing really is simple, but it’s not easy. There are two very interesting points that he makes.

Buying low actually reduces risk and increases returns. This is the opposite of current academic thinking. The Efficient Market Theory (which has been debunked to my satisfaction) says that high reward cannot be separate from high risk, just as low risk leads to only low reward. In the case of entire asset classes (bonds, junk bonds, blue chip stock, penny stocks, real estate, etc.), the relationship may hold. But since markets aren’t always efficient, there are cases where businesses are underpriced. In that case, the chances of the share prices falling further are relatively lower compared to the chance of the share price recovering.

When investing, doing nothing is a very valid option. People seem to forget this, especially when they have cash in their investment account, “doing nothing.” It seems even harder for money managers, who are being paid to trade stocks. If they’re not trading, are they not earning their keep? When there are no good deals, it makes sense not to buy. And when you own the best companies available, there’s no need to sell or trade them away. Not to mention that trading incurs frictional costs. On the other hand, making one great investment, as long as enough capital is allocated to it, can boost your returns for a number of years.

The question is, how much money to commit to an opportunity. Ideally, you would commit more capital to the opportunities where you see the most potential and have the most confidence. Unfortunately, assigning probabilities is very problematic. For a thorough explanation, read The Black Swan. In this case, the Dhandho author can’t even predict all possible outcomes (he gives an example where he was pleasantly surprised), much less assign a probability. He solves the problem by just putting 10% of his money on each bet. But it doesn’t stop him from assigning probabilities to potential outcomes in his examples throughout the book.

If you don’t think that’s problematic, try guessing what the probability is of the second Thursday next month being rainy. Or the government losing the next election in a small European country. Or a helicopter falling out of the sky and landing on you as you step out of your house for a stroll. In fact, a helicopter did kill a pedestrian in a small town in B.C. last year, but that’s no reason to stay inside. We simply can’t calculate the odds on it, just like we can’t calculate the odds on stock market outcomes. All we can do is try to tip the expectations in our favour by investing in situations where the rewards of the positive outcome far outweigh the losses of the negative outcome.

The best strategy seems to be buying stock where the worst-case scenario is already discounted. In the worst case, you lose nothing, but in the best case, you stand to gain. This takes guts, not brains. It’s easy to find stocks that are trading lower than in the past. What’s difficult is gathering the courage to purchase the shares with your hard-earned money. The value of diversification, using this strategy, is that some will work out better than others and at different times.

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