Calculate Probablities

 Probability Theory and the Market

Now, let us move away from the racetrack and pull all this together into the rality of the stock market. The chain of thinking is the same.

• Calculate probabilities. This is the probability you are concerned with: What are the chances that this stock I am considering will, over time, achieve an economic return greater than the market?
  
• Using frequency if it is available, and subjective interpretation if it is not, make your best estimate. Do the most thorough job you can of collecting and analyzing information about the company, and convert your analysis to a percentage number. That number represents how obvious it is to you that the company is a winner.
  

• Adjust for new information. Knowing that you are going to wait until the odds turn in your favor, pay scrupulous attention in the meantime to whatever the company does. Has management begun to act irresponsibly? Have the financial decisions begun to change? Has something happened to change the competitive landscape in which the business operates? If so, the probabilities will likely change.
  
• Decide how much to invest. Of all the money you have available for investing in the market, what proportion should go to this particular purchase? Start with the Kelly formula, then adjust it downward, perhaps by half.
  
• Wait for best odds. The odds of success tip in your favor when you have a margin of safety; the more uncertain the situation, the greater the margin you need. In the stock market, that safety margin is provided by a discounted price. When the company you like is selling at a price that is below its intrinsic value, that is your signal to act.
  

Thinking about probabilities may be new to you, but it is not impossible. If you are able to teach yourself to think about stocks in this way, you are well on your way to being able to profit from your own lessons. An opportunity such as Coca-Cola in the late 1980s (an outstanding business priced substantially below its intrinsic value) doesn't happen often. But when it does occur, those who understand probabilities will recognize it and know what to do. As Charlie Munger puts it, "The wise (investors) bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple."