I believe "Probability" is one of the most sensible mathematical techniques after "Compound Interest" formula. If one has a good command over these two, and simultaneously apply them while investing, once can do wonders and is bound to become wealthy in long term. To support my views, I have examples of some great investors who are applying both the principles while investing and they are not only rich but extremely wealthy. List of such investing extraordinaire includes WARREN BUFFET, Mohnish Parbai etc.
Charlie Munger, in one of his speech highlighted the way Warren buffet thinks. He mentioned that Warren buffet is so much rational in thinking that he uses Decision tree Analysis in almost every decision making. Similarly, Mohnish parbai too in his book "Dhandho investor" has mentioned about probability as one of the effective tool and suggested "Kelly Criterion" for portfolio construction.
Why Probability Works ??
In my sense, Probability is such a powerful tool, coz it reduces the effect of uncertain event on the decison's outcome. The reason for it might be, that it incorporates the possibility of unfavourable events before hand and hence normalise the decision, making it future proof to a great extent.
In investing paralance,we can take it as "margin of safety" of decision making. If we see the underlying effect of "margin of safety", it is meant to reduce the effect of uncertain event of future that can have effect on stock price. As, one cannot ascertain the future unfavaourable event correctly, incorporating "Margin of safety" in an investing decision is suggested over and over again by each and every Value investor ranging from Father of Value investing "Ben Graham" to Warren buffet, Charlie Munger to Walter Schloss, Seth Klarman (Even wrote a whole book on the topic) to Mohnish Parbai.
Probability and Investing : Application of thoughts
We usually start our investing through our hard earned money and after finding a next possible mulitbagger, we are inclined to bet on it heavily. But, a scrip will be multibagger in future and we as investor, can't and never will be able to ascertain future correctly. So, making an investing decision based on the optimism that everything will turn out as presumed, will be nothing short of utter foolishness.
So, this is where we can plug in probability and take its advantage in portfolio construction. One such method is "Kelly Criterion" as highlighted by Mr. Mohinsh Parbai in "Dhandho Investor". The Kelly Criterion formula is simple :
Capital to be committed : Probability of winning – (Probability of losing / Edge)
(where, Edge = Win ratio i.e. Winning Amount/ losing amount)
The other probability method to be deployed is "Margin of Safety".
Example :
Suppose you analysed the stock with CMP of Rs.120 and its near its 52 Week Low (Rs. 118/-). Now as per your analysis, the stock price may go upto 130/- on account of some triggers (say some value accretive product launch, some buy back indications from management etc.).
As per kelly criterion, the weightage of this scrip in your portfolio should be ascertained as under :
Probability of Winning : Say 60 %
Hence, Probability of Losing : 1- 60% = 40%
Expected Win Amount = Rs. 10/- (130 -120)
Expected Loss Amount = Rs. 5/- (120-115)
Hence Edge = 2
Kelly Criterion = .6 – (0.4/2) = 0.4 i.e. 40 %
Hence as per Kelly's Criterion, one can bet upto 40% of its capital on this particular investing bet.
Conclusion:
As rightly mentioned by Prof. Sanjay Bakshi "A chain is as strong as its weakest link", one should apply the mathematical models with due caution and only after acquiring proper knowledge. As half knowledge is extremely dangerous,especially for investing decisions,
So, wish u a happy new year and all the luck for your future investing decisions.
--
Tony Stark
CEO- Stark Capital
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