HOW WELL DO YOU INCORPORATE PROBABILITIES?

Most people are really bad at thinking clearly and rationally about (uncertain) future events.

‍

No surprise — our brains evolved to make snap judgements in very uncertain and potentially very deadly environments. Making carefully calibrated decisions based on large amounts of data isn’t easy, or natural for most people.

‍

Financial investing requires a calculated, probabilistic mindset that puts aside emotions and accurately sizes up dozens of variables to make smart buy vs. sell decisions.

‍

Weaknesses in probabilistic thinking is backed by social science. For example, studies show that most people significantly overweight low probability events. That helps explain why people buy lottery tickets or play low skill gambling games where the odds are very much against them. Our brains are wired to make us overrate the chances of a long shot.

‍

It’s clear why playing the lottery is a bad financial decision, but many people miss the flip-side of that mistake. Fear of the worst-case scenario (over-rating the likelihood of a catastrophic event) often scares investors away from good deals.

‍

Other studies show a similar cognitive bias toward seeing unknown probabilities as 50-50 propositions. When people don’t know how to evaluate an uncertain outcome, looking at it as a coin toss makes things a lot easier. In regular life, that might not cause any big problems, but when it comes to investing, it’s a big mistake.

‍

What is the default risk of a tenant, and how does that change when we see additional information on their finances? How hard would it be to replace a tenant quickly, and how does that change when we get new demographic information about a neighborhood? These kinds of risk and reward assessments are vital for investing success, and they require a true understanding of how to use probability and statistics.

‍

A bad investment research process might answer these questions like a checklist. Is there enough potential upside here? Or, is the risk of tenant default too high? The better process that Alliance uses instead combines carefully considered probabilities with risk mitigation strategies, like insurance. This process is both art and science, financial models and the intuition that comes from experience.

‍

While most people are bad at probabilistic thinking, all the best investors I know are great at it (or consciously know their blind spots). Investing demands this skill. We don’t bet on lightning strikes, we’re looking for high probability wins. And while bad things do happen, we don’t sit on the sidelines because of undue fear. As long as we can stay clear eyed about the risks we take, then over time, the rewards significantly outweigh the occasional losses.

‍