Probability

Probability is the language we use to talk about the future when we can't be certain what it holds. In investing, it’s the art and science of assigning a numerical likelihood—from 0% (impossible) to 100% (a sure thing)—to a potential outcome. For a value investing practitioner, probability isn't about gazing into a crystal ball; it's a disciplined tool for weighing risk and reward. Instead of asking, “Will this stock go up?” the probabilistic thinker asks, “What are the different paths this company could take, what is the likelihood of each, and what would the stock be worth in each case?” This framework transforms investing from a game of blind prediction into a calculated process of identifying situations where the odds are overwhelmingly stacked in your favor. It’s about making bets not on certainties, but on favorable probabilities, which is the cornerstone of intelligent investing.

Many people equate investing with gambling, but a savvy investor uses probability to do the exact opposite. A gambler at a roulette table faces fixed, unfavorable odds. An investor, however, can analyze a business and a market to find situations where the odds are not 50/50, but are tilted significantly in their favor. The goal is to calculate the expected value of an investment. This powerful concept combines the potential outcomes with their probabilities. If you can buy an asset for far less than its probability-weighted value, you have found a good bet. It’s like being offered 3-to-1 odds on a coin flip that you know is fair. You’d take that bet every single time, because over the long run, probability ensures you’ll come out way ahead.

In the world of investing, we deal with two distinct types of probability, and understanding the difference is crucial.

Objective probability is based on hard, repeatable data from a large number of trials. Think of rolling a die; we know with mathematical certainty that the probability of rolling a '4' is 1/6, or about 16.7%. We don't have to guess. In investing, we can use this by looking at historical data:

• How often have companies in the steel industry experienced a downturn over the last 50 years?
• What percentage of the time has the S&P 500 returned more than 10% in a year following a recession?

This data provides a useful baseline. However, the famous disclaimer, “Past performance is not indicative of future results,” exists for a reason. The world changes, so while historical data is a guide, it’s rarely the whole story.

This is where the real work—and the real opportunity for an edge—lies. Subjective probability is your best educated guess about a unique, one-time event. It’s not based on thousands of identical past events but on your own analysis, experience, and qualitative analysis. Examples of questions requiring subjective probability:

• What is the probability that this pharmaceutical company's new drug will get FDA approval?
• What are the chances a new competitor disrupts this company's market-leading position?
• What's the likelihood that a new management team can successfully turn the company around?

Assigning a number here isn't a wild guess. It’s the result of deep research: reading clinical trial results, analyzing the competitive landscape, and judging the track record of the CEO. This is the art of investing.

Let's imagine you're analyzing a stock, InnovateCorp, currently trading at $70 per share. After extensive research, you map out three likely future scenarios.

1. Scenario A: Bull Case. InnovateCorp’s new software is a massive hit.
   • Probability: 30% (0.30)
   • Estimated Stock Value: $150
2. Scenario B: Base Case. The software does okay, but it's not a game-changer.
   • Probability: 50% (0.50)
   • Estimated Stock Value: $90
3. Scenario C: Bear Case. The software launch fails, and they lose market share.
   • Probability: 20% (0.20)
   • Estimated Stock Value: $40

Now, you can calculate the probability-weighted average value of the stock:

• (0.30 x $150) + (0.50 x $90) + (0.20 x $40) = $45 + $45 + $8 = $98

Your analysis suggests the stock’s expected value is $98. Since it's currently trading at $70, you have a significant margin of safety. This doesn't guarantee the stock will hit $98, but it shows that based on a rational assessment of the probabilities, the investment offers an attractive risk/reward profile.

Thinking in probabilities is a superpower for investors. It helps you stay rational, avoid emotional decisions, and focus on what truly matters: getting the odds on your side. As the legendary Warren Buffett advises, “it is better to be approximately right than precisely wrong.” The goal isn't to predict the future with 100% accuracy. The goal is to build a portfolio of investments where the potential gains, weighted by their probabilities, far outweigh the potential losses. This is the essence of investing with an asymmetric risk profile—a situation where your upside is many times larger than your downside. By consistently making bets with favorable probabilities, you are putting the mathematical laws of the universe to work for you.