Every investor should think in terms of odds

Posted by TEBI on May 18, 2022

Every investor should think in terms of odds

 

 

By JOE WIGGINS

 

Last week I stumbled upon an old Grantland article by David Hill entitled Can’t Knock the Hustle. It is a fascinating examination of the two faces of competitive pool in the US. On one side was the traditional approach of conventional tournaments with prize money awarded to the winners (think the PGA Tour). On the other side were ‘action rooms’ where the purpose of the pool matches was gambling — spectators and players would bet on the outcomes of all manner of games with a variety of handicaps applied.

Although it is the same game being played, the objectives are entirely different — in one it is to find the best player, in the other to find the best odds. This distinction is important for investors. We spend much of our time trying to find the best investor, company, fund or story, and not enough time thinking about the odds.

The focus of the article was two characters. Earl ‘the Pearl’ Strickland — one of the most successful and controversial players in history (he has won more than 50 major titles) — and ‘Scooter’ Goodman, a player focused on gambling and action rooms.

Although Goodman was a pool player, this wasn’t his primary skill:

“Goodman has a knack for figuring out complex odds and probabilities”.

His main enjoyment from pool was not the game itself, but in attempting to secure an advantage in agreeing the terms of the game. His edge was not in shooting pool but setting the odds in his favour.

“That’s my favourite part, the negotiating… This is where you win.”

Critically, Goodman understood that he did not need to be a great player like Strickland, he wasn’t interested in winning tournaments or climbing rankings. He just had to understand how good he was relative to the competition.

“I can play the best in the world up here if you give me enough weight.”

By “weight”, Goodman means advantages or impediments that impact the odds. This might be one player giving up all the breaks (a major impairment) or the weaker player having to pot fewer balls to win the rack. There is all manner of adjustments that can be made to transform the probabilities of the game.

While Goodman thought about little but the odds of success, as investors we are prone to neglect them. This leaves us incredibly vulnerable to making decisions where the chance of a good outcome is vanishingly small.

 

Think about the odds

Why don’t investors like thinking in terms of odds and probabilities? There are two reasons — because its less exciting than the alternative, which is largely storytelling, and because it is perceived as too difficult.

Identifying a star fund manager, ten-bagger stock or the next great investment theme is far more captivating than trying to make a realistic assessment of the odds of success in that type of activity (particularly when the odds are usually terrible). When we have a compelling, narrative-led inside view, its salience means we grant it far more importance in our judgement than we should.

Calculating odds also feels like an inherently complex or even impossible task, but this is not the case. We don’t need to be spuriously accurate about the likelihood of a good outcome, just a general guide can be incredibly insightful.

When making an investment decision, we should think about the odds of positive outcomes in two ways:

1) What are the base rates for this type of decision? This means forgetting the specifics of a situation but looking at the outcomes of a reference class of similar instances.

Let’s take an example. In 2021, Jeffrey Ptak at Morningstar wrote a timely piece looking at the subsequent performance of funds after they had returned more than 100% in a calendar year. The results were bleak — of the 123 funds that had achieved this feat since 1990, 80% went on to register losses in the three years that followed.

This type of analysis is about creating a base rate to provide us with an outside view on a decision. When looking at a fund that has produced stratospheric returns it is very easy to be beguiled by the inevitably compelling stories that will be told about the theme and its manager. This can leave us entirely blind to the odds we are likely to be facing.

There is no right answer on base rates, no single metric that will provide precise and accurate odds but taking this type of outside view should be integral to any investment decision.

2) How difficult is the game we are playing?  We should also spend time reflecting on the difficulty of the task we are undertaking. Imagine we are trying to forecast where ten-year treasury yields will be at the end of the year. We can carry out forensic analysis of inflation dynamics and Fed policy, but before beginning this process we should be asking — how likely is it that we are going to get the answer to such a complex question right?

Overconfidence leads us to involve ourselves in investment activities where the sheer difficulty of the activity means that a successful result is very unlikely.

 

Key takeaway

Thinking about odds and probabilities is not intuitive and often uncomfortable, but it should be essential for all investors. It is far better to be an average investor with the odds on our side, than a good investor with the odds stacked against us.

 

JOE WIGGINS works in the UK asset management industry. This article was first published on Joe’s blog, Behavioural Investment, and is republished here with his permission.

 

ALSO BY JOE WIGGINS

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NEW TO INVESTING?

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You can either buy the book direct from the publisher or via Amazon:

For those in the UK, 

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