What are the chances of getting heads or tails when flipping a coin? Given that there are only two possible outcomes, even the average fifth grader could probably correctly answer is 50-50.
But what if the last 10 coin-tosses resulted in heads? What do you think the odds are of landing another heads on the next flip? While the answer is again 50-50—after all, there are still only two possible outcomes—many of us might feel like tails is likelier to come up after a long consecutive string of heads.
That feeling, known as the Gambler’s Fallacy, can lead us astray when it comes to assessing probability, or the odds of an event happening. Unfortunately, such misunderstandings about probability can affect investors, too, perhaps steering us toward poor decisions that don’t align with our risk tolerance and time horizons.
Indeed, I’d argue that a proper understanding of the probability of investment outcomes is the most important factor in determining your portfolio’s success. Otherwise, you are either guessing about its chances of performing well, or you’re abdicating that responsibility to an investment advisor, who may not have your best interests at heart.
While there are certainly no guarantees when it comes to investing, if you understand your timeline and your objectives, you can use probabilities to remove much of the uncertainty in the decision-making process and help you confidently manage your investment portfolio. Here’s how.
Consult historical data
While past performance of an investment asset is no guarantee of future returns, we have a large data set of historical evidence to help us understand how the markets have performed over the past 100-plus years. This provides a good proxy into the true nature of markets and how they are likely to behave in the future.
The following chart, courtesy of Ben Carlson’s A Wealth of Common Sense, speaks to the probability of outcomes by time frame if you are invested in large-cap North American equities (given that the S&P 500 is the single best gauge of that market).
Based on historical performance, the longer your investing time horizon, the higher your probability of seeing a positive return in the North American large-cap equities market. This does not mean that these returns are guaranteed. We know the future is uncertain. But when it comes to investing in anything—stocks, bonds, real estate—always think in terms of probabilities, not guarantees. If you have enough data, you can calculate the odds of a specific outcome.
Avoid rules of thumb
Many investment conventions are based on a one-size-fits-all approach that don’t make sense when you look at your specific circumstances.
Let’s assume, for example, you are 75 years old, you do not need to draw income from your investments, and you plan to leave most of your investment capital to your children. While the conventional investment wisdom is to move toward a portfolio with a greater proportion of fixed income assets as you age, this assumes that you have a lower risk tolerance during retirement, which is not the case here. Rather, because your investing horizon exceeds your life expectancy, your tolerance for equities remains high.
At the opposite of the spectrum is a retired couple in their mid-70s who need to draw most of their income from investments. Given the short-term volatility of equities, it makes little sense for them to be heavily invested in stocks. They need the safety of fixed-income securities to fund their retirement.
These are two contrasting examples that speak to using data and probabilities to guide your investment decisions. The mathematical reality is that while equities are more volatile in the short term, they are more likely to deliver superior returns over longer time horizons.
Don’t put stock in possibilities
When investing, it’s very tempting to think in terms of possibilities rather than probabilities. In the run up to the legalization of marijuana in Canada, for example, many investors were betting on the potential of this market to deliver positive returns. But because the industry was so new, there was simply not enough data to calculate any probability of outcome. Investing in this space was pure speculation, and those who did so are still waiting for their anticipated windfall.
Tying it all together
Investing is all about following a step-by-step process: define your objectives, establish your investment timeline, understand your tolerance for risk and volatility, and use probabilities of outcomes to guide your investment decisions.
Of course, as Warren Buffet says, investing is simple but not easy. While the process may be straightforward, it can be challenging to put into practice in the face of media noise and mixed messages. By learning to think in terms of numerical probabilities, you can mitigate your risk and make better investment decisions.
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