Most of the math we learn in school trains the mind to think in linear terms. The repetition of one-answer equations like a + b = c reinforces us to expect rational, deterministic outcomes in thinking. But we all know the real world is a messy place where rational outcomes are the exception, not the rule. The best investors among us compensate for this by re-learning their highschool math. Instead of thinking linearly, they change their focus to another branch of mathematics: Probability.
The concept of probability was introduced in the 17th century by Blaise Pascal. Pascal, a favourite of the French aristocracy, came up with probability after studying his countrymen’s obsession with courtly gambling. He found that applying probabilistic thinking to salon card games like Faro bettered their winning outcomes. He even used this thinking to come up with the popular casino game Roulette. Later on he turned his life to the church after using probability to make a case for the existence of God. Pascal’s Wager, as it came to be known, went something like this: earthly life is finite, while the afterlife is either infinitely good (heaven) or infinitely bad (hell). So if God exists, then giving up some finite earthly luxuries is a fair trade for an infinitely happy afterlife. But if God doesn’t exist, then giving up earthly luxuries is a finite loss, with no risk of infinite harm. In other words, taking a known small loss today is favourable to taking a potentially big loss in the future. Sounds familiar?
For investors playing by more earthly stakes, the ideal outcome is thought to be finding a great company with positive growth prospects. However that’s not particularly hard to do (just find a list of the most popular companies on google). Where probability comes in handy is the next step of appropriately handicapping the company growth rates to determine value. Overpaying for even a great company could be a costly mistake, while underpaying for a great company ensures a positive outcome. Success is determined not just by the ability to identify a winner, but by getting the odds right so that the winner pays off appropriately for the risk.
In all, and possibly contrary to some readers’ philosophical views, the future does not necessarily have a fixed outcome, and is therefore not capable of being predicted. Assuming a range of possible outcomes and assigning probabilities to them is the preferred route towards a lifetime of sustainable investment success.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.