Given how volatile and unpredictable financial markets are, thinking in probabilistic terms is an essential skill.  It allows us to acknowledge uncertainty, express our level of confidence clearly and gives us more freedom to change our mind. There is a problem, however. Expressing ourselves in probabilities doesn’t come naturally and is often actively disliked. At best it is regarded as spurious accuracy, at worst evidence of an absence of conviction. We value bold and singular predictions about the future, not caveats and caution. How do we encourage probabilistic thinking in a world that doesn’t want us to?

One idea I happened upon in Julia Galef’s excellent book “The Scout Mindset”, is the ‘equivalent bet test’, which is a decision-making tool described by Douglas Hubbard in “How to Measure Anything”. 

The concept is simple.

Let’s take a fairly generic claim that a professional investor might make. They think that the US ten-year treasury yield will rise above 5% before the end of the year. That’s great, but what does it actually mean? Are they certain that this will happen? (Given the historical accuracy of bond yield predictions, I hope not) Or are they only 51% sure? The difference matters a lot, but we have no idea. How do we find out? By creating an equivalent bet, where we are certain of the odds.

We say to our forecaster. There is now $100,000 at stake. We will give you this amount of money at the end of the year if your prediction on treasury yields is right. Alternatively, we will give you the same amount of money at the same time if you can pick a blue ball from a hat containing six blue balls and four red balls. You can only choose one of the bets – the treasury yield forecast or the drawing the balls from the hat.

If they decide to delve into the hat, then we know that their confidence in their bond yield forecast is less than 60%.

We can then adjust the ball selection bet to a point at which the forecaster is ambivalent about the two options. We then we have a reasonable guide to how confident they really are about their prognostications.

This is clearly an imperfect approach, a hypothetical $100,000 will almost certainly provide a different decision making response to a real sum of money, but it is likely to be broadly consistent and incredibly helpful.

Not only does the equivalent bet test encourage the forecaster to think about their judgment in probabilistic terms, it also provides a far greater level of clarity about both how confident an individual is and how well-calibrated (or not) they may be.

Whether we like it or not, we live in an uncertain, volatile and probabilistic world. Our decision-making approach should reflect this.

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Galef, J. (2021). The scout mindset: Why some people see things clearly and others don’t. Penguin.

Hubbard, D. W. (2014). How to measure anything: Finding the value of intangibles in business. John Wiley & Sons.

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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).