Getting Real: Investment Decisions Based on Probability
“Truthseeking, the desire to know the truth regardless of whether the truth aligns with the beliefs we currently hold, is not naturally supported by the way we process information. Instead of altering our beliefs to fit new information, we do the opposite, altering our interpretation of that information to fit our beliefs.” — Annie Duke, Thinking In Bets
Professional poker player Annie Duke has written a very insightful book that applies to investing: Thinking in Bets. Annie graduated from Columbia University with a double major in English and Philosophy. She then went on to pursue her Ph.D. in Cognitive Linguistics at University of Pennsylvania. However, she left school a month before defending her thesis and ultimately moved to Billings, Montana to be closer to family. At this time, she started her poker journey at a local bar called the Crystal Lounge. During her career as a professional poker player, she has won over $4 million in tournaments and earned a World Series of Poker bracelet.
Thinking in Bets intriguing for investors and others who want to improve their decision-making capabilities. In the book, Annie challenges the reader to attach probabilities to different types of outcomes. As she notes, “What makes a decision great is not that it has a great outcome. A great decision is the result of a good process, and that process must include an attempt to accurately represent our own state of knowledge. That state of knowledge, in turn, is some variation of’ ‘I’m not sure’…Improving decision quality is about increasing our chances of good outcomes, not guaranteeing them.”
For example, when someone says she is fairly certain that the Federal Reserve will lower interest rates later this year, you could respond “Would you bet $100 on it?” This immediately creates a gain/loss scenario requiring your colleague to think in terms of probability, perhaps along the lines of: “I think there’s a 75% chance the Fed will cut interest rates, so I’ll bet you $75.” This type of framing is much more precise and allows everyone, including investors, to better quantify and assess the possible negative outcomes.
At LNWM, the probability of outcomes is core to our decision-making process, and informs asset allocation, risk assessment and manager selection, based on quantitative and qualitative inputs. As Annie notes, probability based thinking doesn’t guarantee better results, but it does help us avoid avoid common decision traps, learn from results in a more rational way, and keep emotions out of the process as much as possible. Another way of saying this is that probability based thinking adds rigor and consistency to our investment process, making it more likely we will achieve our targets.