by elmads

Probabilistic Thinking

“If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.”

-Charlie Munger

Everyone of us has been doing probabilistic thinking since we were young, and the extent which we do it differs from one another. There are people who do lay out a complete probability tree in their minds, while some does the superficial levels and make a quick assumption from it.

For instance:

• What’s the probability of you getting stellar results, or passing, or failing the exam without studying?
• How likely/unlikely that the person you like, also likes you, despite of you not exerting any effort to talk to that person?
• What’s the probability that you’ll win a the race you’ve prepared for several months?
• How likely/unlikely will you lose 10kg of your weight a year from now, with the current lifestyle that you have?
• What’s the probability for you to achieve your personal financial independence goal at exactly age 60 with your current savings rate, earnings power and investment returns?
• How likely/unlikely will you get a 15% investment rate of return for the next decade, when you purchase a piece of Amazon’s business at its current market capitalization?

Probabilistic thinking is not done to predict an outcome, because there is no one in this world who could accurately forecast what will unfold in the future. Instead it is for our own self-awareness, of how likely and unlikely will things happen, and if we’re comfortable to take or not take actions based from our own assumptions.

The percentage of an outcome happening based on several variables that can either happen at the same time, or not at all.

HOW I USE IT: If the probability is more likely tilted on the good side while having a low chance of the bad side, then that’s where we could swing hard on the opportunity presented to us.

Nonetheless, if ever the negative aspect pans out, rather than the positive side, then that’s a probability that I should also have accepted as a natural consequence of my decision. It’s the mindset of being responsible and accountable in all of my decisions, regardless of the outcome.

Basically, I ask myself, will I still be comfortable to own the business if my calculated and assumed worst case scenario happens? if yes, while the upside is within my target long term returns, then that’s a buy for me.

What are the odds that an investment will not go down substantially when the worse comes to worse (risk management), and how likely will it make you more money when good times start to roll?

Same as with personal finance, the core of it is based on the probability of cushioning each individual from financial risks such as losing a job, medical diseases, illnesses, disability, accidents, death, recession, pandemic, and wars. It’s unlikely that everyone in this world will experience all of this at the same time, but it is highly likely that you will eventually experience one of these risks during your lifetime. Even the pandemic was once in a generation event (no financial analysts or economists ever deduced such risk in their analysis because they think the probability is highly unlikely, but then there’s still a chance of it happening which actually did), yet we still experienced it in this lifetime. Always make decisions based on probability, and don’t forget to always be accountable on whatever outcome that may happen based from the decisions you make.

Personal Finance Core: Securing Cash Flow, Debt Management, Emergency Fund, Rainy-Day Fund, Life/Medical Insurance. 💪

Basic Financial Planning “Part 1”

The Downside of Probabilistic Thinking: This is not a perfect model in investing, because it is not purely objective, as it has a subjective aspect on it most especially when applied in our own lives. The more you know about something, the more you get to be a better assessor of risk, yet this is not without complete immunity from risks.

Just as like with the two great investors and businessmen of this generation Warren Buffett & Bernard Arnault. We don’t expect Warren Buffett to be as good, or even a better at assessing the risks and rewards of the luxury industry business as Bernard Arnault. Although the two are great businessmen and investors in their own rights, what differentiates them from one another is their “Circle of Competence”.

Circle of Competence

Circle of competence in a straightforward definition is the subject area which matches a person’s skills, expertise and innate abilities.

Successful people, not just in business, but also in different fields, emphasize the importance of circle of competence. It reduces the risk of us of trying to do things and dabble in areas that we don’t have complete understanding.

The moment we encounter a particular subject area that we don’t have any competence with, is an automatic disregard. Henceforth, safety from committing irreversible errors in the short-term and most especially the long-term horizon.

That being said, it doesn’t mean that our circle of competence cannot be expanded, because it certainly can be done, but it will take a lot of our time and effort to do so.

By continuously learning newer areas that feeds our curiosities, our circle of competence can slowly expand and grow. The more and earlier we do it, the wider our own circle of competence can grow.

HOW I USE IT: I have certain industries that I don’t understand, no matter how hard I try to study it, it just doesn’t connect with myself, my curiosities. I even tried to force myself to learn it, but I found myself repeating what I’ve done for my entire school life before, learning for the sake of just doing it because I need to pass exams to get a job, and not for the sake of learning itself.

Since then, I’ve always disregard to look into this certain industries, I’ve never dabbled with it because I just don’t completely understand it. Sure, there might be once in a lifetime opportunities there, but I can’t force myself to invest on things that I don’t grasp its fundamental system. If I tried to speculate and just put money on it, then things go south, I wouldn’t know if I’ll continue to buy, or hold, or just sell at a loss. And, if it’ll cause me distress, then that’s not a worthy asset to own at all.

“If an investment will take away my goodnight sleep, my peace of mind, then that’s not an asset I’ll ever take.” -Evan Madriñan

The Downside of Circle of Competence: It’s hard to expand our circle of competence. Average individuals like myself, would mostly only have one area where we can completely understand. I would say that having two CoC would be attainable, but having 3 or more would be tough. Then again, I might just be underestimating myself. What’s important is that we’re always willing to continue to learn.

Nonetheless, Circle of Competence in investing doesn’t automatically translate to certainty of our investments. There will always be times where, despite our enthusiasm and love about something, there are and will always be events that could invalidate our assumptions. To cushion such blow we must employ the mental model of “The Margin of Safety”.

Margin of Safety

“You don’t drive a truck that weights 9,000 pounds across the bridge that says ‘limit 10,000 pounds’, because you can’t be that sure about it.”

-Warren Buffett

The margin of safety is a cushion against any uncertainties in both investing and life. We cannot always be 100% sure of something, there will always be a margin of error with our calculations and assumptions. There is no such thing as complete certainty in our uncertain world, hence the mental model of margin of safety. It’s just like the quote above, which Warren Buffett said before.

There are no better persons to explain this mental model and how it applies in investing than Warren Buffett and Charlie Munger. The video below shows the 2007 Berkshire Hathaway Annual Meeting with the two investing legends of this generation, discussing about the Margin of Safety.

The Audio Transcription:

“We favour the business where we really think we know the answer and therefore, if a business gets to the point where we think the industry in which it operates the competitive advantage position, or anything is to chancy. That we can’t really come up with a figure, we don’t really try to compensate for that sort of thing by having an extra large margin of safety.

We really go on to try to go on to something that we understand better. So, if we buy something like See’s candy as a business or Coca-Cola as a stock, we don’t think we need a huge Margin of Safety because we don’t think we’re gonna be wrong about our assumptions in any material way. What we really want to do is buy a business, that’s a great business which means that business is going to earn high return on capital employed for a very long period of time or the management will treat us right. And, we don’t have to mark those down a lot, when we find those factors we’d love to find them when they’re selling at 40 cents on the dollar, but we’ll buy those that much closer to a dollar on a dollar, if they don’t like to pay a dollar on the dollar, but we’ll pay something close.

And, if we really get into something, you know when we see a great business it’s like if you see somebody walk in the door, you don’t know if they weigh 300 pounds or 325 pounds, but you still know they’re fat. So, if we find something that it is fat financially, we don’t worry about being precise, and if we can come in that particular example and if the equivalent is of 270 pounds and will feel good. But, if we find something where the competitive aspect are it’s just the nature of the business that you can’t really see out 5, 10 or 20 years, because that’s what investing is, a singing out.

You don’t get paid for what’s already happened, you only get paid for what’s going happen in the future, the past is only useful to you to the extent it gives you insights into the future, and sometimes the past doesn’t give you any insights into the future.

In another cases, like the stable businesses, it probably gonna give you a pretty guideline what’s gonna happen in the future and you don’t need a huge margin of safety. You should have something that you all should always feel you’re getting a little more than what it’s worth. There are times where when we’ve been able to buy wonderful businesses at a quarter of what they’re worth, but you don’t see those things very often. And does that mean you should sit around and hope they come back for 10 or 15 years? that’s not the way we do it. If we can buy businesses at a reasonable price valuation, we’re gonna keep doing it.”

Warren Buffet during the 2007 Berkshire Hathaway Annual Meeting

This has been the best explanation I’ve heard so far.

The Downside of Margin of Safety: It is a mental model that doesn’t work by itself. What do I mean by this? Margin of Safety should, as much as possible go hand-in-hand with Circle of Competence, and Probabilistic Thinking, because how would one know their personal corresponding Margin of Safety for an asset, if they don’t even know its intrinsic value, and what drives that value?

Going back to the bridge quote of Warren Buffett. How would you know not to drive any truck that weights equal or more than 10,000 pounds on the bridge, if you haven’t read or seen the cautionary sign board? and if you don’t know the total weight of the truck that you’re driving?

To Sum It Up

• Compound Interest
• Occam’s Razor
• Inversion Thinking
• Probabilistic Thinking
• Circle of Competence
• Margin of Safety

These six have been my core Mental Models for investing.

By the way, you don’t have to follow my own chosen core mental models, because there are 100s more out there. Try to read, find those models that will coincide with your personality, time, and own circumstances.

Mental Models are ideas from various fields that can guide us with some of our decisions in life.

I’ll continue to use my chosen mental models to guide myself to achieve my financial goals both in personal finance and investing.

Having my core mental models in my arsenal will not prevent me to do further stupid things in the future as I am well aware that I am a deeply flawed individual, yet these models would certainly aid me to lessen the risk for me to commit monumental amounts of stupidity moving forward.

I must continue to learn and transcend what I was yesterday in order to cull my greatest enemy, which is MYSELF: the lingering whispers of doubts, fears and negativity.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.