The outcome of any investment lands somewhere in the range of losing everything to making billions. One of those sounds great. The other…not so much.
Somewhere in that range, sits a most likely outcome. And knowing what the most likely outcome is, understanding the probability of success, helps with making investing decisions.
That, of course, doesn’t guarantee the most likely outcome will happen. Something with a 70% chance of success also has a 30% chance of failure. So what happens if that something actually fails?
As Peter Bernstein makes clear, in an old interview with Jason Zweig (highly recommend reading the entire interview), knowing the consequences is the most important part to 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 this. The first is the reminder nothing is guaranteed to happen with investing. You can do the right thing, make the correct decision, and still not get the result you expect.
So you have to expect to be wrong sometimes. But you also need to know the difference between making the right decision and making a mistake even though you get the wrong result. If you understand probabilities, repeating the right decision will get you 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, where he asks one simple question:
What are the odds that this business could be subject to any type of catastrophe risk – that could make it fail?
If the risk exists, he passes. It doesn’t matter what type of return he can get if there’s a chance he’ll lose everything. He wants high-probability, low-risk investments. Buffett knows that if he finds enough of those, over a long period of time, the returns will speak for themselves.
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 think about what could go right and maybe at the end they ask what could wrong? What are the consequences? Buffett starts at the end. Avoiding unnecessary risks is what 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 any other goals you set for yourself. Taking unnecessary risks, just to have a little more money that you probably don’t need, puts those goals in jeopardy.
- Stocks Don’t Really Become Less Risky the Longer You Hold Them – M. Statman
- In Long Run, There’s No Such Thing as an Einstein Investor – R. Shiller
- Soros, Dalio, and Munger on the One Trait You Need to Succeed – Quartz
- The Reasonable Formation of Unreasonable Things – M. Housel
- This Time Really Is Different – B. Carlson
- Inversion: The Crucial Thinking Skill Nobody Ever Taught You – J. Clear
- A Beginner’s Guide to Calling BS – Science of Us
- Mohnish Pabrai: Intensive Stock Research Can Be Injurious to Financial Health – Talks at Google
- The Amount of Work That Once Bought an Hour of Light Now Buys 51 Years of It – Washington Post
- Why “How Many Jobs Will be Killed by AI?” is the Wrong Question – A. McAfee