Probability-based Investing

Whether we explicitly realize it or not, every investment decision is probability based. For example

• I love Company X’s products. I believe it has a good chance of doing very well. I buy the stock

• I see Stock X has fallen 50% in one year, while the business has actually grown its profits. I think the stock has a great chance of rising in price in the future

Both “good” and “great” are probabiilties, not explicitly called out, in my head. Maybe good means 60 %, great means 80%, or some other value.

A good exercise before investing is to quantify a range of value for the probability of gains. The answer, say “60-70%” may not be fully accurate, but it will force you to think through the factors that get to that probability. Your investing decisions will only improve if you regularly do this exercise.

A slightly-advanced version of this is weighted-probability investing. Let me illustrate with an example

• I see a company stock and believe it has 30% chance of becoming 10X in 5 years. It also has a 70% chance of going to half. So if we invest $100, The expected value of the return will be = (30% X 10 X100) - ( 70% X 0.5 X 100 ) = 300 - 35 - 265. (Note: To learn more about expected value & probability theory, check this website)

  • This means that I expect the stock to go up to $265 from $100

Seems easy right ? Put a probability on the outcome and voila, you have a certain answer ! Not so fast. The formula above depends completely on the probabilites you assign to each outcome. And that is the difference between a great investor and a losing one. Good investors, over time, get better at evaluating business prospects, and hence assigning probabilities. The others make random guesses, if they even get so far as to thinking like this.

Moral of the story: Learn, learn, learn. Look at your results (real or play-money) and evaluate your own ability to forecast. Based on that, choose the investment path that works best for you

• Invest yourself in individual company stocks

• Invest in market average indexes like S&P 500, BSE Sensex, FTSE 100…etc.

• Invest in active mutual funds if you can evaluate the managers

• Find good investors and follow their picks, no harm in copying what works.

Happy Investing !

Note: To learn more about basic probability theory, check this website