This real-life story dates back to 2014, and it’s about my father.
During summer holidays, we were at our hometown in West Bengal where my father ran his business.
He was generally a healthy person, but for the previous few months he was having slight pain around his left shoulder. The pain was occasional and thus he did not bother to get it checked up. Ours was a very small town, and we were living at its outskirts. The nearest orthopedic doctor was around 20-km away, and so my father did not bother to visit him for a check up once.
One early morning, he woke up with an intense pain in that very shoulder. He took a pain killer, thinking the pain was due to him sleeping on his left side, with his arm pressed under his upper body. The pain reduced a bit, but stayed for a couple of more hours.
We decided to take him for a check up at a nearby hospital. He was not willing to go for two reasons – he hated hospitals, and his pain had reduced to almost negligible levels.
But something pressed us on and we convinced him for a couple of hours before taking him for a checkup.
It turned out that he had a minor heart attack a few hours back. Also, further investigations suggested that his arteries were almost 90% blocked.
A week later, my father was operated for heart bypass operation.
He survived, and lived for six more years.
Now, even when one considers my father’s otherwise good health then and the low probability of him having an heart ailment at that age (he was in his early 60s), the possible loss was so big (loss of life) that our decision to take him for a checkup, for what he was considering a shoulder pain for the previous few months, turned out to be a wise decision.
This story came back to light when I was reading notes from the 1989 AGM of Berkshire Hathaway, where Warren Buffett was asked about his approach to risk and investment decision making, and he replied –
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.
As an equation, it reads thus –
Success in investing = (Probability of gain X Amount of possible gain) – (Probability of loss X Amount of possible loss) = A positive number
Michael Mauboussin describes this concept as expected value. It’s actually a very simple concept.
In essence, you don’t have to be right a lot, you just have to be right about your big bets at the right time. Here, while the probabilities matter a lot, so do the consequences i.e., amount of possible gain/loss.
It’s important to get that equation right.
If you are willing to buy a stock, say, priced at 60-70x P/E or more, thinking the probability of it going higher is good, also remember the consequence of a period of weakness/slowdown in business. Such expensively priced stocks ride on high expectations, and the consequences of a small slip could be really bad.
Given that we often tell ourselves false stories to avoid the truth, with our minds clouded by denial, optimism and negative decision-making tendencies, the expected value idea can help us avoid the landmine of expensive, hot and bad stocks that cover a large ground in stock investing.
Buffett says, “In order to succeed you must first survive.”
So here’s the mantra.
In life, to live, simply avoid dying (till you can).
In investing, to succeed, simply avoid ruin (till you can).
Here are the best things I read and thought about today –
- The Math of Value and Growth (Michael Mauboussin)
- John Huber on the importance of running a concentrated portfolio, and letting your winners run (Acquirer’s Multiple)
- Peter Thiel’s Religion (David Perell)
- A Boxer Teaches You How to Get Better at Math (Ed Latimore)
- Thought for today – “Survival is the only road to riches. Let me say that again: Survival is the only road to riches.” ~ Peter Bernstein
That’s about it from me for today.
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Ignore probabilities and focus on consequences