I recently read War and Chance by Jeffrey A. Friedman, which considers how foreign policy specialists deal with the uncertainty that surrounds their high stakes decisions. Friedman focuses on an historic reticence to explicitly discuss either probabilities or confidence levels when making subjective judgements. Whilst the impact of decisions made around the whereabouts of Osama bin Laden or the presence of WMD in Iraq have consequences that are far more profound, it struck me that the challenges and concerns highlighted by Friedman are also relevant to how we make investment decisions. In particular, the struggle we have in articulating how much conviction we hold in a position or opinion.
The conviction that we express in any investment view reflects our expectations around the likelihood of certain outcomes. We are constantly making judgements that are founded on our subjective belief about probabilities and our confidence in the available evidence. Despite this we seem unwilling to talk in these terms. Instead, there is a tendency to frame investment positions in a definitive fashion – I believe X will happen because of Y. The absence of nuance entirely belies both our own fallibility and the sheer uncertainty of the environment in which we operate. Ignoring these factors not only impacts the type and size of risks we take, but materially inhibits our ability to change our mind and learn from past decisions.
Why don’t we talk about probabilities?
In a similar fashion to foreign policy, the reluctance to address uncertainty and be specific around our probability judgements is driven by several factors. Many people recoil at the spurious accuracy that appears to exist when numeric probabilities are expressed – how can you be 67% sure of something? But this misses the point. We are making this judgement whether we are transparent about it or not. It is better to offer some level of clarity rather than not mention it at all or cloak it in vague language that will be interpreted differently by everyone who sees it.
The even greater impediment to being clear about probabilities when expressing an investment view is the value that the investment industry places on confidence. The conclusion we reach will either be right or wrong, and therefore there is a desire for our rationale to be consistent with that. It is all or nothing. This is a meaningful decision and therefore we want it to appear as if it is an objective one (even though we know that this is an impossibility).
When we discuss uncertainty and probability, we are admitting how much we do not and cannot know. This jars with the fact that we are being paid for our investment acumen, and it is rarely a prudent marketing strategy to highlight your limitations. Particularly as everyone else seems more certain than we do.
The value placed on (illusory) certainty and (over) confidence is vividly apparent in the categorical fashion in which we discuss our investment views. For example, if I take the position that the dominant, large tech / consumer stocks in the US are overvalued and will underperform over the next five years, most of my time will be spent justifying why this perspective is correct and other theories are false. If presented with a counter argument – such as certain names in this space becoming virtual monopolies that will not see their excess returns competed away as quickly as in ‘traditional’ industries – my instinct is to debunk this point to validate my own position. Yet if I accept uncertainty and a range of potential outcomes, I should not be discrediting all other scenarios, but rather acknowledging that there are other plausible paths. Albeit ones I ascribe a lower probability to than my central view.
Disentangling confidence and probability
A crucial distinction that Friedman makes is between probability and confidence, which are often conflated. Probability is based on the likelihood that something is true, whilst confidence is based on our belief in the robustness of the evidence supporting that view. I believe that the chances of a single fair coin flip coming up tails is 50%; I also consider the chances of value stocks outperforming growth over the next 12 months to be 50%. The probability I have ascribed to both outcomes is identical, but my confidence in my coin flip view is far greater than in the value versus growth call. In the first case my 50% forecast is based on what I do know, the second case is based on what I do not know. Expressing conviction is about both probabilities and confidence.
Friedman states that the confidence we hold in our own analysis has three distinct components: i) The reliability of the evidence, ii) the breadth of reasonable views around a judgement, and iii) the extent to which fresh information could alter our perspective.
Overtly utilising such a framework is crucial for a robust decision-making process and for understanding the level of conviction we should hold. A cynic might suggest that financial markets are too noisy to distil confidence in this fashion, but if that is the case then it simply means we do not have sufficient confidence to take a view – which is perfectly reasonable. Also, when making an investment decision these three aspects are always implicit in the conviction we possess; it is far better to be open about these assumptions, particularly if we want to encourage consistency in our decision making and have the ability to learn from mistakes.
The benefits of probabilistic thinking
Being clear about the probabilities we ascribe to potential outcomes and our own confidence in our views can be incredibly important to our investment decision making; especially when informing our level of conviction. There are at least five clear benefits:
1) Clarity of view: Investment views tend to be either absolute or obscured (sometimes deliberately) by vague and ambiguous language. This means that they are either negligent of uncertainty or useless. Addressing this by being more specific – by using numeric probabilities, for example – provides far more transparency around what we believe.
2) Realism: All investment decisions are made amidst uncertainty, although most of us behave as if that is not the case. As soon as we employ probabilities in a consistent manner, we open ourselves to alternate scenarios. It is crucial to concede the uncertainty both of an event and our own ability to foresee it.
3) Ability to change our mind: Moving away from categorical views makes it far easier to change our mind and update our thinking. If we predict something will happen, we invariably become committed to that position, and often defined by it. Utilising a more nuanced approach that acknowledges other possible outcomes affords us the freedom to adapt and update as we receive new information.
4) Ability to learn: All investors will be wrong and wrong frequently. We cannot hope to improve our decision making unless we are consistent in how we record and convey our views. If we are clear about probabilities and our level confidence at the point a decision is made; it becomes possible to review this in the future and understand the flaws in our judgements when we err. It allows us to become better calibrated.
5) Consistency and comparability: Given that investors will be expressing numerous views at any given point in time (and through time) the ability to treat them consistently and compare them equitably is paramount to effective decision making. If our conviction differs between views, what is causing that? Why are we happy to take more risk in position A than position B? We can only answer such questions if we have a clear framework to understand probabilities and confidence levels.
Don’t forget the magnitude
Whilst our conviction should be driven by probabilities and confidence, that is not all that is required. We must always consider the magnitude of potential outcomes. The most significant example being situations where there is something unpleasant lurking in the tail of the distribution. A bet with a 99% chance of a favourable outcome, may be unappealing if there is a 1% risk of ruin. In such a scenario we might have an incredibly high conviction in our view, but still decline the ‘bet’ or at least size it in a manner that seems optically inconsistent with the strength of our beliefs. Being more open to considering probabilities offers some protection against being ignorant of such tail risks because we are explicitly incorporating other possible scenarios in our thinking.
Uncertainty is uncomfortable and unappealing, but it is also the reality of financial markets. The unequivocal investment opinions that we so often hear, and offer, feel bold and informed but are incongruous with the environment in which we make decisions.
Whether we acknowledge it or not, the conviction or strength of belief we hold in our investment views must be based on assumptions around probabilities and confidence. Yet we rarely discuss our investments in this manner. This is a problem not simply because it is hard to understand how much weight to give to other peoples’ opinions, but it also impairs our own decision making. If we are to formulate, compare, scale and adjust our investment views appropriately we need to be clear not only about what we believe and why, but how much we believe it.
Friedman, J. A. (2019). War and chance: Assessing uncertainty in international politics. Oxford University Press.