Probabilities do not matter, payoffs do. Careful readers of Nasseem Nicholas Talebwould recognise this phrase immediately. In this election season, investors seem to be constantly looking for ways to see the future. But how many understand the difference between probabilities and payoffs?
I came across a perfect explanation of this in an overheard conversation between two people who seemed to be discussing betting on the IPL. I think this was when the tournament had just begun. One asked the other who would he bet on to be the winner.
The other replied he would definitely bet on Chennai. The first one was dismissive. He said while Chennai had a good chance of winning, you would make a profit of maybe Rs 30,000 for every lakh you bet. Something like Punjab would be better, he said. Capable of winning and the betting odds were such that the profits would be worthwhile.
Now, I’m obviously not condoning betting, nor am I suggesting that there is anything in common between such betting and investing. However, the fact is that this person had a good understanding of the concept of probability visa-vis payoffs, something which many investors do not understand or appreciate.
Taleb, in one of his books, narrates how he was asked by a TV anchor what the probability of the markets rising were. He said it was 99%. The anchor wanted to know how one would trade on that. Taleb replied he wouldn’t. Instead, he would trade for the 1%. The reason, he said, was there was no way of making money off the obvious. On the minority side, he would almost certainly lose, but if he won, he would win big.
Of course, all this business of trading and betting is not what investing is about. However, this idea does express itself in sober, fundamentally driven investing too, where a closely related concept is that of the valuation of an equity stock. You can be certain a companyhas a bright future, and you are right too, except that a lot of other people also know this. Inevitably, the valuation of such an investment is high and thus the eventual returns are high.
However, real investment is not a gamble. There is no either-or situation, at least not often. The criteria for winning is not external, but whether you, as an individual, manage to achieve the financial goals you set for yourself. In reality, the first duty of any investor is to survive, to not lose so much that they seriously damage their financial future. Everything else comes later.
The problem is an old one, and one I’ve written about earlier. There are two contradictory impulses that govern how people spend their money. One is to buy expensive things in order to signal their status, and the other is to get a good bargain, or, in investing terms, good value. Ideally, we would like to combine both. We would like status symbol possessions that normally cost a lot, but we would like to have them at a good bargain. That sounds like an impossibly good deal but then, the fun of getting a deal is the maximum when it’s good.
That means that although people instinctively look for bargains, they don’t necessarily make correct judgements about the inherent value of things. Instead, they use price as an input for whether something is a good bargain or not. That sounds like circular logic, and it is. It’s just that no matter what the other variables, the balance between probability and payoffs rule, or should rule, all other decisions.