Investing, like most things in this world, is a probability game. The reason is simple, it involves making decisions in an environment of uncertainty, where outcomes cannot be predicted with absolute certainty. A wide range of factors, such as economic conditions, political events, market sentiment, and company-specific developments, all contribute to this uncertainty. Since, to our best knowledge, there is no one who can consistently predict these variables with absolute accuracy, investment decisions should be based on the likelihood of different outcomes and their payoffs. We must have the intellectual humility to admit that we don’t have the ability to predict and understand the specific outcomes precisely and definitively, instead the best we can do is work with the probabilities. When considering probabilities in investing, it's not just about the simple likelihood of different outcomes but also the expected payout if those outcomes occur. Optimally you would look for high probability events with high payouts, but they can be hard to find. At times, lower probability events with higher payouts may be a more worthwhile investment than higher probability events with lower payouts. This is captured by the concept of expected value, which combines the probability of each outcome with the potential return or loss associated with it. Essentially, expected value helps investors evaluate whether an investment is worth pursuing based on the average result they can expect over time. However, expected value relies on the assumption of repeated trials or a large sample size. In other words, the law of large numbers suggests that the more often you engage in similar investments, the closer your actual results will match the expected value. This means that while individual investments may have uncertain outcomes, consistently investing with positive expected values should lead to favourable long-term results. This is where the concept of survival becomes crucial in investing. Because expected value hinges on the long-term, an investor must remain in the market long enough for the probabilities to play out in their favour. Capital preservation and managing risk are key to ensuring that short-term losses or fluctuations don’t lead to financial ruin. If an investor takes on excessive risk and suffers a major loss, they may be forced out of the game, unable to benefit from future positive outcomes, even if their overall strategy has a good expected value.
As a consequence of the probabilistic world of investing, focusing on process over results is essential because it can be difficult to judge investment performance and skill based solely on outcomes. In investing, where each decision involves uncertainty and a range of possible outcomes, good decisions don't always lead to favourable results, and conversely, bad decisions can sometimes produce positive returns due to randomness or lucky circumstances. This inherent variability makes short-term results a poor indicator of true skill and effectiveness. To maximise skillful returns, investors should emphasize long-term performance, as a larger sample size provides a clearer picture of probabilities and reduces the impact of chance. By analysing the investment process—such as decision-making strategies, risk management, and adherence to a well-defined plan—investors can better understand and refine their approach. In this probabilistic framework, evaluating the process rather than just the results offers a more reliable measure of an investor’s ability, helping to discern skill from luck and leading to more consistent and sustainable success over time.
As part of understanding probabilities, one must have an understanding of the role of risk, or the downside, in any investment. Although much of modern finance seeks to quantify risk through volatility, we believe this to be a misleading definition, we instead believe risk should be defined as the chance of permanent capital loss. Non-linear returns are not of concern to us in the long term. The use of volatility as a measure is natural for it is comforting to be able to quantify risk, but in reality, there has been no perfect numerical indicator for the risk of financial loss in any investment so far. Analysing risk instead requires an analysis of qualitative and quantitative factors regarding the underlying asset, and while there will be general frameworks you can use to estimate risk in a given estimate, there will be no clear way to produce standardised and precise percentages of chances of permanent capital loss.
One important thing to note is the role of leverage in risk. Leverage has been a major factor in many investment failures and financial wipeouts. While it can significantly enhance returns by amplifying gains, it also magnifies losses, which can lead to severe financial setbacks, including complete loss of capital. This risk is particularly pronounced in situations where leverage is used excessively, such has been the case for many long-gone but once thought invincible financial institutions. Survival is a critical aspect of successful investing. The ability to endure through market fluctuations and unpredictable events is essential for long-term success. Overleveraging increases the risk of being wiped out by unforeseen events, even if an investment has strong long-term potential. Plenty of investments have had long-term solvency and return potential but have been cut short due to sudden moments of market panic leading to leverage wiping out investors even though the underlying investments would have recovered and prospered in the long term. Therefore, we recommend minimising the use of leverage or avoiding it entirely. Prioritising financial stability and conservative use of leverage helps ensure that you remain in the game long enough to achieve good results and navigate through market challenges. As Warren Buffett famously said: “The first rule of investment is don't lose. The second rule of investment is don't forget the first rule.”
With all this in mind, one of the core ideas in applying probability to investing is to focus on finding asymmetrical bets where the potential upside outweighs the downside risk. If an investment offers equal chances of reward and risk, whether it be high, low, or medium, the expected value will balance out to zero, meaning that while you might experience some short-term gains due to luck, the long-term outcome will likely revert to where you started or worse. Furthermore, high risk does not always bring high reward, as markets can experience mispricing. In these cases, inflated prices may offer low return potential while simultaneously carrying a significant risk of future decline. This is particularly true when investor sentiment drives prices beyond the intrinsic value of an asset, creating an imbalance between risk and reward. In such scenarios, taking on high risk does not necessarily guarantee a corresponding high reward; instead, it exposes the investor to the possibility of substantial losses as the market corrects. To achieve asymmetric returns over the long term, it is essential to ensure that for every unit of risk you take on, there is a proportionately greater potential reward. This approach helps in identifying opportunities where the potential gains significantly exceed the potential losses, increasing the likelihood of favourable long-term results. The ideal investment is one that is low-risk and high-return, this is an obvious concept, and thus they can be hard to find, but it is best to not settle for much less than this.