Understanding probability and statistics can be an aid in making better decisions. Unfortunately, we use familiar probability ideas that we learned in elementary school. The ideas in that knowledge make sense and are accurate only if there are few variables and clearly defined rules about what can happen.
In the real world, things that happen are not limited in the same way. For example, a tossed coin can only appear as heads or tails. The probability of heads is 50%, but when the weather service says the likelihood of rain tomorrow is 50%, it means something different.
With complex systems like weather, the stock market, geopolitics, and who will win the Stanley cup a year from now, there is no confined data set. With coins, there are only two variables. With the stock market, there are millions; and worse, their relative importance changes from hour to hour.
The real-world probabilities are not clearly defined like the coin tossing. These probabilities are found by observing what has happened and creating probabilities from those occurrences. That’s how statistics work. You study a large population of events and infer probabilities. These probabilities are always shown with a “confidence level.” Ideally, the level should be pretty high. 95% or more. Even then, you could expect one in twenty examples to show a different result. The results are persuasive but not conclusive.
The absence of a defined data set and the relative importance of each data point at any point in time means you cannot make easy predictions. The variables in the stock market might follow a predictable path, but not always, and we don’t know why and certainly not when.
There is always something you haven’t considered. There is no practical way to trade against information known in the stock market. Knowing that and knowing that there are investors with long successful investment records, you should look for a way to avoid playing the game by the observations in the stock market.
Do Warren Buffett, Seth Klarmann, Benjamin Graham, and Charlie Munger use market statistics and theories like Modern Portfolio Theory to guide their investment decisions? They do not. They buy an interest in a business and hold those investments for a long time.
That does two things for them:
No decision you make in the real world is certain to turn out as you expect. You have to learn to deal with imperfect and incomplete information to succeed.
The first step is to simplify the range of information, like buying an interest in a business instead of buying a stock. That is not child’s play because you must understand how businesses work and how to value them.
If the first step is beyond your skills, then buying an index is the next best step. No variable affects every business the same way, so if you own all of them, the variations tend to offset each other. You are investing in the business share of the economy instead of particular businesses.
Learn more. As Mike Baker, businessman and former CIA operative, says in his new book, Company Rules, “Whoever has the best intelligence…wins.” Having better information is not an accident. You will have to work to get it.
Reactive decisions are seldom good decisions. When investing, the best you can hope for is to identify tendencies. Knowing that stock prices are volatile doesn’t help you to know the price tomorrow, but it might help you understand better what is happening and give you insight into the longer term.
When you act on deeper information, knowing its limitations, you make fewer and smaller mistakes.
As Buffett has said, “Risk is what happens when you don’t know what you are doing.”
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