probabilities

Probabilities, Truth And Consequences

Why we are bad at probabilities and worse at understanding consequences?

Q1 hedge fund letters, conference, scoops etc

probabilities

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A client came to me recently with a net worth well over $10 million. He had enough money to support his family’s desired lifestyle for the rest of their lives, but not so much that he could withstand a large loss without cutting back substantially. Yet this client owned more than 130% in risky assets, meaning he had far more debt than fixed income. Much of the debt was in a variable rate margin loan against his brokerage account.

More on this client at the end of this piece, but first let’s look at the subjects of probabilities and consequences.

Forecasts and probabilities – the odds are you don’t know the odds

Have you ever turned on an investing show and heard the expert make predictions as ranges? That is to say, something like, “my forecast for U.S. stocks over the next year is a mid-point of 7% with a 95% probability that returns will be between a loss of 21% and a gain of 35%.”

I suspect not.

We all want to know precisely how markets will perform because we hate uncertainty. Precision gives us a sense of comfort. Unfortunately, that sense of comfort is completely false, dangerous, and makes us ignore consequences.

I’ve been teaching behavioral finance for about 15 years and go through some exercises with my students to demonstrate how bad we are at estimating probabilities. One such exercise involves asking the following question, which you may want to try to answer before reading on:

In college basketball, what percent of the time does the team behind at half-time come back to win the game?

If you are like most people to whom I’ve asked this question, you probably guessed somewhere between 30% and 50%, though I’ve had answers as high as 90%. I actually once counted a whole NCAA season and the answer was just a tad under 20%. It turns out that the team behind at halftime is typically the inferior team and that same team shows up in the second half.

Why then do we guess so much higher? Consider the following games. Which is more likely to make the news?

Game 1: Team A is behind by 15 points at halftime and loses the game by 25 points.

Game 2: Team B is behind by 15 points at halftime and comes back to win in triple overtime.

The obvious answer is the second game. A thrilling comeback is more memorable. Rarely has a movie been made where the horrible sports team in the beginning of the movie finishes in last place at the end of the movie. We want to hear about winners!

The same dynamic is present in investing. I bet you see advertisements for investment funds that have outperformed. These would be Morningstar four- and five-star funds. We think they are easy to find and the odds of picking one in advance are high. And you’ll see those managers on television touting about their own brilliance. Yet there are just as many one and two-star funds that you don’t see advertised. Admittedly, sometime you’ll see the managers of these funds bragging on television as well, but only because no one bothers to check their performance.

Much like the blowout game that didn’t make the TV highlights, here is a mutual fund advertisement you’ll never see in the financial media.

Read the full article here by Allan Roth, Advisor Perspectives


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