Every investment brings with it a range of potential outcomes. That range is wider or narrower depending on the investment. Somewhere in that range sits a most likely outcome. And knowing the most likely outcome helps with making investment decisions.
Of course, the most likely outcome isn’t guaranteed to happen. For example, if the most likely outcome has a 70% chance of success, it means there’s a 30% chance something else happens. So what if that something else happens?
As Peter Bernstein makes clear, in an old interview with Jason Zweig, knowing the consequences is the most important part of understanding risk:
Q: What are the important lessons about risk from your book Against the Gods?
A: Two things. First, in 1703 the mathematician Gottfried von Leibniz told the scientist Jacob Bernoulli that nature does work in patterns, but “only for the most part.” The other part — the unpredictable part — tends to be where things matter the most. That’s where the action often is.
Second, Pascal’s Wager. You begin with something that’s obvious. But because it’s hard to accept, you have to keep reminding yourself: We don’t know what’s going to happen with anything, ever, over any period. And so it’s inevitable that a certain percentage of our decisions will be wrong. There’s just no way we can always make the right decision. That doesn’t mean you’re an idiot. But it does mean you must focus on how serious the consequences could be if you turn out to be wrong: Suppose this doesn’t do what I expected it to do, not just because it goes bad but even if it just doesn’t go up enough. What’s gonna be the impact on me? If it goes wrong, how wrong could it go and how much will it matter?
Pascal’s Wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.
This isn’t just a paradigm for always coming out with conservative decisions. It’s really how you should make decisions, period.
There are two parts to Bernstein’s comment. The first is the reminder that nothing is guaranteed to happen with investing. You can make the correct decision and still not get the result you expect. So you have to expect unlikely outcomes sometimes.
But you also need to know the difference between making the right decision and making a mistake because mistakes can accidentally make you money and correct decisions can end in losses. Not confusing the two is important. If you understand probabilities, repeating the right decision should lead to positive results over time. Repeating the mistake is a recipe for disaster.
The second part is understanding the consequences of being wrong. Warren Buffett has a filter for catastrophe risk. He asks: what are the odds that this business could be subject to any type of catastrophic risk? Could it fail?
It doesn’t matter what type of return he might get. If the risk of failure exists, he passes. Because if he bets big and loses big, that’s hard to recover from. It cripples his ability to make money.
So Buffet’s priority is to limit his losses. He wants investments with a high chance of success but where the worst-case outcome is nowhere close to zero. Because if he’s wrong (or gets hit with an unlikely losing outcome), he doesn’t lose much. Buffett knows that if he finds enough of those, over a long period of time, compounding can overcome the small losses and work its magic.
Buffett relates a similar lesson from the collapse of LTCM:
But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.
Most investors dream about what could go right. Maybe at the end, they ask what could wrong? What are the consequences? Buffett starts at the end. Avoiding unnecessary risks keeps Buffett in this game called investing.
For most of us, investing is not about becoming a member of the billionaires club. It’s about being a member of the retirement club, the send-your-kids-to-college club, or the financial independence club. Taking unnecessary risks, just to have a little more money that you probably don’t need, puts those goals in jeopardy.
This post was originally published on June 30, 2017.
- Now You Get It – M. Housel
- Stock Market Got You Worried? Write a D-Day Note – J. Zweig
- Investment Mistakes to Avoid (pdf) – GMO
- Derivatives: Past, Present & Future – Investor Amnesia
- How Options Expiration Keeps Crushing the Stock Market – The Reformed Broker
- Due Diligence: Get On The Ground – MicroCapClub
- The Most Valuable Razors – Curiosity Chronicle
- New Study Disavows Marshmallow Test’s Predictive Powers – UCLA Review
- Taking a Fall: The 120-MPH, 35,000 Feet, 3-Minutes-To-Impact Survival Guide – Popular Mechanics