Reflections from Michael Mauboussin’s latest report, “Probabilities and Payoffs,”
Sharing my favourite reflections from Michael Mauboussin’s latest report, “Probabilities and Payoffs,” which is similar to an article that we wrote recently, and is exactly how we invest at Vision Capital Fund .
1 | The Babe Ruth effect highlights that it is not only how often you are right that matters (probability) but how much you make when you are right versus how much you lose when you are wrong (payoffs).
2 | …smart investing is an exercise in optimization. The key to financial success when dealing with unknowns and ignorance, a good description of most investing, is assessing probabilities and payoffs. Decision theory becomes more important than optimization.
3 | Equity investors should focus on asymmetric upside payoffs, where the magnitude of payoffs on the downside is smaller than those on the upside. Because the upside payoffs for bonds are capped, bond selection is primarily a negative art. Whereas the upside payoffs for equities are uncapped, equity selection is primarily a positive art.
4 | Probabilities and payoffs are dynamic. Probabilities are subjective; they are only useful if set carefully and revised appropriately. New information should warrant revisiting and revising prior probabilities. How one can establish confidence in probability from fact and opinion is crucial. Think in relative ranges, not in precise absolutes. It is better to be directionally and approximately right than to be precisely wrong.
5 | Equity markets and investing are non-ergodic. When the time horizon increases, the cumulative impact of compounding leads to even more skewed results with fat right tails. The ensemble average and the time average are not the same. The best approach for non-ergodic systems is to find the opportunity with the highest geometric mean, not the highest arithmetic.
6 | Allocation and position sizing are then important in long-term geometric mean maximization. Edge is crucial. Betting too much is just as bad as betting too little. Make your best investments in your biggest positions, but never bet the farm. The position should be sized appropriately to optimize the probability and potential winnings in the long run.
7 | One should never let one's experience and age affect one's psychological perception of loss aversion. One should operate at the same neutral level regardless of age and wealth/fund size.
8 | Have sufficient humility because you can get it wrong, as we are constantly dealing with unknown unknowns. Many of the best investments over time are volatile and have large drawdowns. Many persistently focus on protecting the downside. One should choose instead to manage one’s own psychological mindset and expectations, be excited about significant price declines and see them as attractive buying opportunities, especially if the long-term thesis remains intact.
9 | Excess returns are a function of skill and opportunity set. Skill can be assessed through batting average, which measures how often you make money, and slugging ratio, which measures how much you make when you are right versus how much you lose when you are wrong.
10 | Skill shows up in the batting average and the slugging ratio (especially when it is high and keeps increasing). Portfolio construction and allocation are crucial. The pattern of returns for the underlying assets plays a substantial role in how a manager reveals their skill. A skillful manager produces excess returns by selecting the ones that go up and avoiding the ones that go down.
11 | Investing is an inherently probabilistic endeavor. When one can reduce the probability of losing and the magnitude of losses and increase the probability of winning and especially the gains from the winners, one can do very well over the long term.
Investor
5moPoint #3 closely aligns with Mohnish Pabrai’s philosophy: ‘Heads I win; tails I don’t lose much.’ The emphasis on asymmetric upside payoffs mirrors his approach to investing—minimizing downside risk while maximizing potential gains. A great parallel to Mauboussin’s insights on probabilities and payoffs.