Did you know you can win more often than you lose, but still go broke?
This subject was explored in chapter three of Michael Mauboussin’s book, "More Than You Know: Finding Financial Wisdom in Unconventional Places." He noted that many investors believe that if they’re right in at least 51% of their investment decisions, they should come out ahead.
But he threw a bucket of cold water on that idea, saying it is wrong despite its intuitive appeal. To illustrate his point, he told an apparently true story about portfolio managers and a fund company. Because the firm was doing poorly, the treasurer decided to evaluate about 20 portfolio managers. He rated each of them by measuring what percentage of stocks in each manager’s portfolio beat the market.
To his great surprise, the treasurer discovered that the portfolio manager with the worst record was also one of the top performers. The treasurer asked the manager why he had such good results with such a bad batting average. In Mauboussin’s words, the manager responded this way:
“The portfolio manager’s answer is a great lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters. Say that you own four stocks, and that three of the stocks go down a bit but the fourth rises substantially. The portfolio will perform well even as the majority of the stocks decline.”
The author also called it the "Babe Ruth Effect," because while the baseball icon struck out quite often, he was still one of the greatest hitters in the sport’s history.
How do you get to be an effective investor, one who may not always make the right calls, but does end up with above-average returns? By using expected value analysis; as we noted previously, expected value analysis is “the weighted-average value for a distribution of possible outcomes.” To my mind, that evoked thoughts of the Bell Curve, which is made up of a series of probabilities; the highest probabilities are found at the top or center of the curve, and the lower probabilities occur in the tails on each side.
Mauboussin offered a second anecdote, this one from Nassim Taleb, in his book, “Fooled by Randomness.” In a meeting with fellow stock traders, one asked Taleb what he thought of the market. Taleb responded by saying he thought the market would go up slightly during the week, and when pushed to be more specific, said there was a 70% probability the market would go up.
At that point, someone else in the meeting pointed out Taleb had shorted heavily on S&P 500 futures. To that, he explained his position in terms of expected value. And Mauboussin provided this helpful table:
The table shows that why Taleb chose to short the market, even though he expected it to go up slightly. Notice under “Outcome” how he expects only a 1% gain if the market goes up, but a hefty 10% hit if the market turns down. The final column shows the expected values: a 0.7% gain if the market rises, a 3% loss if the market does down, leaving a net expected value of -2.3%. Since there is a negative expected value, the logical position is a short one.
What we’re seeing in this case are “asymmetric” outcomes. In other words, there is a discrepancy between the results for a positive market and a negative market. Mauboussin then cast the case in terms of individual stocks, writing:
“Stocks are sometimes priced for perfection. Even if the company makes or slightly exceeds its numbers the majority of the time (frequency), the price does not rise much. But if the company misses its numbers, the downside to the shares is dramatic. The satisfactory result has a high frequency, but the expected value is negative.”
On the other hand, there are “downtrodden” stocks. Most of the time they disappoint their owners and the share price edges lower. However, if there is good news, there can be a strong rebound in the price. The author described such a situation this way: “Here, the probability favors a poor result, but the expected value is favorable.”
The lesson is quite clear: Investors need to consider more than past frequencies; they must also consider expected value.
To bolster his case, he took lessons from practitioners in three probabilistic fields: investing, pari-mutuel betting and blackjack. In the investment case, he offered the example of Warren Buffett (Trades, Portfolio). Mauboussin quoted him as saying that you may start out with a 400-horsepower motor, but only get 100-horsepower of output. You would be better off with a 200-horsepower motor and get all its output.
Charlie Munger (Trades, Portfolio) once noted that Buffett had an advantage because he automatically thinks in terms of decision trees (a technique for listing potential outcomes, along with their probabilities). Mauboussin also showed examples from betting and blackjack, showing these probabilistic activities also benefited from the equivalent of expected value.
While expected value analysis may be the optimal approach to investing, our brains are hardwired to push us in the other direction. According to Mauboussin, Daniel Kahneman and Amos Tversky’s “prospect theory” helps explain this dilemma. They discovered that humans have a high aversion to losses when making choices, even over minor stakes. The emotional impact of a loss is about two and a half times the emotional impact of a win.
All of which means we are happier when we are frequently right, even if our portfolio is not outperforming its benchmark. As the author pointed out, “A few stocks going up or down dramatically will often have a much greater impact on portfolio performance than the batting average.”
Conclusion
Consider the size of the wins and losses when investing, not just the number of times you win. After all, you could win a lot but still lose money.
The antidote to this is the use of expected value, which refers to potential returns multiplied by their probabilities. Since multiple scenarios exist for every stock, both positive and negative, investors see a range of outcomes rather than just one.
Its use makes investment analysis more robust, and more likely to produce stock or portfolio gains.
Read more here:
- More Than You Know: Should Investing Be a Profession or a Business?
- More Than You Know: Be the Casino, Not the Gambler
- More Than You Know: Building on Charlie Munger’s Intellectual Legacy
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