Investing is a probabilities game. (I'm 97% certain.)

June 02, 2017

As I progressed through mathematics courses in college, I noticed a trend. There seemed to be an inverse ratio developing: the more Greek characters that dotted my equations, the lower my test scores were going. Once the numbers disappeared altogether from the math, I decided this conundrum was due not to the fact that I was bad numerically, but that I had never studied Greek.

I was more interested in a field where it was ok to be wrong every now and then, and computer engineering / computer science had that in spades relative to pure mathematics. Engineering is about probabilities: you aren't trying to get things perfect. Anyone who survived Windows 3.0 can attest to this. Anyone who drove a car in the 1970's can write a dissertation on it.

What you're trying to do in engineering is, given the constraints you have, design a solution that has the highest probability of success. The constraints might be time, money, materials, algorithms, people, a bad hair day, or other tangible and intangible barriers, but they always exist in an engineering problem.

In that sense engineering and investing are similar. They are both probability fields. What you are trying to maximize as an investor is your ultimate returns multiplied by your probability of achieving them. Except this equation isn't quite right, because it will give you a result that is too risky. Most humans whose first name does not resemble "Elon" with a last name of "Musk" want a relatively high probability of achieving a good outcome without taking too much risk. So you have to include a coefficient greater than one in front of the probability number to normalize what you are optimizing.

It is important to understand that in investing, everyone makes mistakes. It is not a certainties field. A fundamental problem is that as people, we don't think in probabilities. We like things that are concrete. (That's why we like predictions - they satisfy our hunger for concreteness, even if they are statistically meaningless.)

If we accept that investing is a probabilities game, what are we aiming for? Charlie Munger, the Vice Chairman of Berkshire Hathaway, recently said, "I think we have one big advantage. A lot of other people are trying to be brilliant, and we're just trying to stay rational."

At One Day In July, we recognize that a large number of managers in finance aim to be in the top tranche of performers every year. We also recognize that many of them are personally brilliant. Finally, we note that almost none of them are successful in this objective over the medium to long term.

Our objective is to be squarely in the next tranche down. We aim to be not the yearly star performer, but to do well against the benchmarks each year, and extremely well against active managers. There is a much higher probability of doing this repeatedly than going for the blue ribbon. Executed well, it is likely attainable.

Let's face it, it's not as glorious as the top spot each year: no one remembers the runner-up to Homecoming King or Queen. No coach starts off a tournament saying "Fire up kids, we're gunning for second place and if you achieve it there's Gatorade after the game in my car."

But the second tranche, year in and year out, puts you in *extremely* rarefied air over time. It's a probability I like. I'd probably even like it in Greek.

Dan Cunningham