[This is an article from Value Investor Insight newsletter Fall 2009]

Most investors know that investing is an exercise in probability. But knowing it and actually living by it can be two separate things. 

"Games of chance must be distinguished from games in which skills makes a difference," writes Peter Bernstein in Against the Gods, his historic review of risk raking. "With on group the outcome is determined by fate, with the other group, choice comes into play. There are card players and racetrack bettors who are genuine professionals, but no one makes a successful profession out of shooting craps."

Like playing poker and betting on horses, investing is a game of skill similarly focused on assessing the odds of uncertain future events. "At the end of the day, investing is inherently a probability exercise" says Legg Mason strategist Michael Mauboussin. "Most investors acknowledge this point but very few live by it."

Why is it difficult for investors to think in terms of probabilities when assessing a company’s future performance and stock price? “It isn’t human nature to view the future in terms of a wide range of possibilities,” says Abingdon Capital’s Bryan Jacoboski, who was featured last summer in Value Investor Insight (August 29, 2005). “We naturally think in terms of what is most likely to occur and implicitly assess the probability of that scenario occurring at 100%. That may sound reckless, but it’s what most people do and isn’t a bad way to think as long as less likely, but still plausible, scenarios don’t have vastly different outcomes. In the investment world, however, they often do, so making decisions solely on the most likely outcome can cause severe damage.”

Anchoring on the most likely outcome is a natural attempt to reduce the complexity involved in making investment decisions, but also can reflect the dangerous overconfidence with which many investors ply their trade. Former Treasury Secretary and Goldman Sachs Co- Chairman Robert Rubin, who made his name on Wall Street as an arbitrage trader, warns against this “excessive certainty” in his book In an Uncertain World: “[It] seems to me to misunderstand the very nature of reality – its complexity and ambiguity – and thereby provides a rather poor basis for working through decisions in a way that is likely to lead to the best results.”

The first basic step in incorporating probabilities into investment decisions is to explicitly consider several potential

outcomes. Abingdon Capital’s Jacoboski looks at each of his holding’s business fundamentals under four to six distinct

scenarios, calculating an intrinsic value under each scenario and applying a subjective probability to each. The final estimate of intrinsic value is the intrinsic value of each scenario weighted by its probability of occurring. “A key is to capture low-probability but high-impact scenarios, primarily to see where the vulnerabilities are,” he says. He decided not to short Amazon.com a couple years ago, for example, after taking into consideration what he considered to be the unlikely event that Amazon’s scale would start translating into the profitability gains the market was expecting. In fact, that is the scenario that began to play out, and the stock rose 180% in the following year.

An added benefit to thinking in terms of probabilities is that it helps make explicit the actual risks under consideration. If given the choice between purchasing a $350 non-refundable plane ticket to attend a future event that could possibly be cancelled vs. waiting to buy a lastminute ticket for $1,200, many people would choose to wait. Nobody wants to blow $350. But in pure expected-value terms, it pays to buy the ticket now unless you believe the risk of cancellation is above 71%. Framing the question in this way may not change the decision, but can increase the chances that a more informed decision is made.

In studying the common traits of those most successful at games of skill – across disciplines – researchers have found a clear tendency to focus more on process than individual outcomes. Poker legend Amarillo Slim has described it this way: “The result of one particular game doesn’t mean a damn thing, and that’s why one of my mantras has always been ‘Decisions, not results.’ Do the right thing enough times and the results will take care of themselves in the long run.” Adds Legg Mason’s Mauboussin: “By definition, poor decisions will periodically result in good outcomes and good decisions will lead to poor outcomes. The best in their class focus on establishing a superior process, with the understanding that outcomes will follow over time.”

That’s not to say that process can’t be improved. Making explicit – and writing down – the probabilities used in making investment decisions can provide valuable learning. After all, if you judge an event to have had a 60% chance of occurring – and it doesn’t occur – you don’t know if you were right or wrong. The only true way to know is by tracking the same or similar events to see if they, over time, happen 60% of the time. Weather forecasters and bookmakers keep track of such things to refine their ability to judge probabilities. Investors should do the same – even if it’s with much less precision – to calibrate their probability-setting skills.

While necessary, skillfully assessing the probabilities of various outcomes for a company is not sufficient to making a sound investment. Stock prices have future expectations already built in – the trick is to find the gaps between those expectations and your own.

“Perhaps the single greatest error in the investment business is a failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the stock price,” says Mauboussin. Driving home this point is Steven Crist, chairman of the Daily Racing Form: “The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. There is no such

thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.”

Even with a framework to assess ambiguity, the right decision in the face of great uncertainty is often just to pass.

Warren Buffett refers to it as placing something in the “too-hard pile.” Writes Peter Bernstein: “Once we act, we forfeit the option of waiting until new information comes along. As a result, not acting has value. The more uncertain the outcome, the greater may be the value of procrastination.”