Rule 4: Probability
When I was writing equity research for a living the use of the word “bet” (as in, e.g. “the shares represent a good bet at this price”) was banned. I assume that it was feared that the appearance of this word in a document offering investment advice would trigger reckless behaviour among our readership, potentially exposing us to ruinous litigation.
I thought this both ridiculous and wrong. Investment is betting. I would go as far as saying that if you don’t understand this, you cannot expect to invest successfully.
There is a probability applicable to all possible future events. Investment is not about predicting the future because no one can do that consistently. Investment is about finding and buying under-priced probability and avoiding or selling over-priced probability. The investment manager Kyle Bass talks of finding an “asymmetric hedge” meaning that he decided that the probability of the sub-prime crisis blowing up was materially under-priced.
This interview with him is well worth watching despite repeated hostile and uninformed interruption from Sarah Montague who has learned her technique on the Radio 4 Today programme.
Backing an outcome regardless of the price or odds is gambling. In a horse race, if you don’t back the nag that comes first, you don’t win. If you manage to back a 10-1 horse at 20-1 that may look like a “good bet” but if it doesn’t win, you have still lost your money. Whatever gambling is, it is not investment.
Investment is betting on probabilities, not on outcomes. How can we judge if the probability of an event is over-priced or under-priced? Do not try to guess the probability of an outcome with a view to pricing it. Do ask when the price is telling you about the probability – then ask yourself if this is reasonable.