When it comes to investing, you’ll always be forced to deal with incomplete information. There’s no way around it.
That’s why our team at Macro Ops frequently touts the importance of fallibility. Understanding the limits of your knowledge makes dealing with complex systems like the market much easier.
You face the same situation in poker. Poker players never have complete information. They can’t see the other players’ cards, and they have no idea what the flop will bring.
So how do poker player still win out even with this incomplete information?
They do so by understanding probabilities and only taking actions that put the numbers in their favor. It’s all about expectation.
Both poker and trading can be reduced down to negative and positive expectation.
Negative Expectation (-EV): Repeating actions “ABC” thousands of times in a particular set of circumstances produces a net unprofitable result.
Positive Expectation (+EV): Repeating actions “XYZ” thousands of times in a particular set of circumstances will return a net profitable result.
Here’s what expectation boils down to: If you take action X an infinite amount of times, would you make money on a cumulative basis? If yes, then the action is positive EV. If no, then it’s negative EV.
An example will help illustrate this concept.
Say you’re asked to play a game where you roll a six-sided die as many times as you want. If you roll 1 through 5, you have to pay $10. But if you roll a 6, you win $56.
Would you play this game?
Let’s figure out the expectation.
Since there are six sides to the die, you have a â…š chance of rolling a 1 through 5. This means that there’s an 83.3333% likelihood that you’ll have to pay $10 on each roll of the die.
On the other hand, you have a â…™ chance of rolling a 6. This means there’s a 16.6667% chance that you’ll win on each roll of the die and get paid 56 bucks.
So an 83.3333% chance of losing $10 on every role equals an expected loss of $8.33 ($10 x .833333). A 16.6667% chance of winning $56 equals an expected gain of $9.33 ($56 x .166667). Combine your expected loss with your expected win and you arrive at a positive EV of $1 per roll.
This is definitely a bet that you want to take because over the long haul, it’s a winning proposition.
Now, this positive EV doesn’t tell you anything about how your wins and losses will be distributed. You could be extremely unlucky and go 40 rolls without ever hitting a six, in which case you’d be down $400. But even then, the game is still positive EV and you’d want to keep playing. If you play it enough, your average return will equal $1 per roll.
The point of all this is that trading is game of expectation. Every trade you take should be viewed through the lens of whether it’s net accretive or net dilutive to your P&L if repeated over and over.
Understanding this concept makes it easier to deal with incomplete information in the markets. Instead of focusing on trying to predict future price movements, you’ll focus on gaming different scenarios, weighing probabilities and structuring your trade/investment in a way that makes it positive EV. This is exactly what we do at Macro Ops with our own investment strategy.
One way to increase your EV is by thinking in terms of Monte Carlo outcomes. Consider all actions and their outcomes as if endlessly repeated. Don’t worry about how the next trade works out, or the next 10 for that matter. You need to consider these actions on a much larger scale.
A profitable trade may still be -EV in the long run. Though it may make money now, it is not one you should keep repeating because eventually it will lead to disaster.
Another way to increase your EV is by getting good at scenario gaming. This is not the same as forecasting. Instead, it’s understanding possibilities and then using your analysis, judgement and process to assign probabilities to each scenario.
Here’s a a few of the questions that make up effective scenario gaming:
- What are the most probable outcomes?
- How much is the market mispricing this asset?
- How could I be wrong in my analysis?
- What would signal that I’m wrong?
- If I’m absolutely wrong, how much will I lose?
- What are potential tail risks to this scenario and how do I protect against them?
- How can I structure this trade to maximize my EV (build asymmetric opportunities)?
- How does this risk line up with other risk in my portfolio?
- If everything on my book went against me and stopped me out tomorrow, how much would I lose?
- Is this total risk within my limits (is this acceptable maximum risk)?
- Is this trade the best use of my capital right now (is it my highest EV opportunity)?
- Is this trade the best use of my capital right now (is it my highest EV opportunity)?
The key is to run through this process before making any trade. Evaluate whether each action is positive EV over time.
The goal here is to turn yourself in the house. You want to be the casino. You want to have the edge with positive EV on every trade to ensure you make money over time. The larger your edge, the more money you make.
Paul Saffo, a professor at Stanford who teaches forecasting, hit the nail on the head when he said the following (emphasis added by me):
The point of forecasting is not to attempt illusory certainty, but to identify the full range of possible outcomes. Try as one might, when one looks into the future, there is no such thing as “complete” information, much less a “complete” forecast. As a consequence, I have found that the fastest way to an effective forecast is often through a sequence of lousy forecasts. Instead of withholding judgment until an exhaustive search for data is complete, I will force myself to make a tentative forecast based on the information available, and then systematically tear it apart, using the insights gained to guide my search for further indicators and information. Iterate the process a few times, and it is surprising how quickly one can get to a useful forecast.
Since the mid-1980s, my mantra for this process is “strong opinions, weakly held.”Allow your intuition to guide you to a conclusion, no matter how imperfect — this is the “strong opinion” part. Then – and this is the “weakly held” part – prove yourself wrong. Engage in creative doubt. Look for information that doesn’t fit, or indicators that are pointing in an entirely different direction. Eventually your intuition will kick in and a new hypothesis will emerge out of the rubble, ready to be ruthlessly torn apart once again. You will be surprised by how quickly the sequence of faulty forecasts will deliver you to a useful result.
This process is equally useful for evaluating an already-final forecast in the face of new information. It sensitizes one to the weak signals of changes coming over the horizon and keeps the hapless forecaster from becoming so attached to their model that reality intrudes too late to make a difference.
More generally, “strong opinions weakly held” is often a useful default perspective to adopt in the face of any issue fraught with high levels of uncertainty, whether one is venturing a forecast or not. Try it at a cocktail party the next time a controversial topic comes up; it is an elegant way to discover new insights — and duck that tedious bore who loudly knows nothing but won’t change their mind!
So forget about trying to obtain complete information in the markets. Instead, view things through the lens of probability and expected value.
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