Although investing is far noisier and uncertain than most card games, it is also an activity where understanding the odds is critical. While investors may feel uncomfortable talking about their decision making in probabilistic terms, it is inherent in everything we do – whether we are explicit about it or not. Much like assessing our chances in a particular game of cards, active investors should be asking themselves three questions before making a decision:

1) What are the odds of the game?

2) Do I have skill?

3) What hand have I been dealt?

Let’s take each in turn:

What are the odds of the game?

This is simply judging the expected long run success rate of an activity – on the assumption that I am an average player. If my objective is to win at a game, I want to play the one where the odds are most in my favour.

For active investors this is about seeking to identify the structural inefficiencies in a market that might create advantages relative to an index tracking approach. Although these dynamics might change through time, they should move at a glacial pace.

To take a simple example of what this could mean – I might assume that the odds of success for an active equity fund manager are better investing in Chinese A shares than US large cap equities. This is because the former has more retail participation and may price new information less efficiently (amongst other things). This may not be true (there are certainly reasons why active investing could be harder in the Chinese domestic market), but such issues should be at the forefront of our thinking.  

This is clearly not an easy judgement to make and there will be no precise answer, but it makes no sense to invest actively without first at least attempting to consider the odds of achieving a positive outcome.

Do I have skill?

The structural odds of a game are our starting point, but they will be impacted by the presence of skill. A poker player with evident skill should win more over time. The problem for investing is that skill is difficult to judge and far, far more people think they have it than actually do.

Skill can be quite an emotive term, so it is probably better to frame it as an edge. If I am going to engage in an investment activity with average or underwhelming odds, then I need to have an edge to justify participating.

Investors have terrible difficulty talking about skill and edge, but it is essential to do so. It might be analytical, informational, behavioural or something different entirely, but it must be something. If my choices are consistent with me believing I have an edge, I need to be clear about what I think it is.

What hand have I been dealt?

Sometimes the structural odds of a game, or the influence of my skill in playing it, can be dominated by whether I am dealt a great or terrible hand.

As an investor I can think of these as cyclical or transitory factors that influence my chances of outperformance. This is nothing to do with the perennial promises of it being a “stock pickers’ market” or other such empty prophecies, but rather factors like observable extremes in performance, valuation or market concentration that arise at different points through time and may have a material impact on my fortunes.

The best recent example of such a scenario would be in 2020 when a select group of high growth, actively managed equity funds had delivered staggering outperformance against the wider market. They had generated astronomical returns and held stocks that traded on eye watering valuations. Investing in such funds at this time (which investors unfortunately desperately wanted to do) is the same as being dealt a terrible hand in a game of cards.  It overwhelms everything else – the overall odds of the game and our level of skill become irrelevant. The probability of achieving good outcomes from such starting points is inescapably low.

Of course, such a situation is even worse than being dealt a bad hand in a game of cards because investors – buying into the story and beguiled by past performance – will play it like it is a great hand.

The sad truth is investors are more likely to go ‘all in’ with an awful hand and fold a great one.

—-

Investors seem to dislike thinking in probabilities. In part this is because it can feel like we are applying spurious accuracy, but more because it can betray a profound uncertainty about the future, which jars with our general overconfidence. Despite this discomfort, we cannot escape the fact that we are playing a probabilistic game. We will never get to the right answer, but it would help our decision making greatly if we at least tried to carefully consider what our odds of success might be.

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).