Teach yourself to THINK in PROBABILITIES and in MULTIPLE SCENARIOS.

Without question, Buffett's success is tied closely to number.

"One of the advantages of a fellow like Buffett is that he automatically thinks in terms of decision trees and the elementary maths of permutations and combinations."  (Charlie Munger)

Most people do not.

It doesn't appear that the majority of investors are psychologically predisposed to thinking in multiple scenarios.  

They have a tendency to make decisions categorically while ignoring the probabilities.

Thinking in probabilities

Thinking in probabilities is not impossible:  it simply requires attacking the problem in a different manner.

If your investing assumptions do not express statistical probabilities, it is likely your conclusions are emotionally biased.

Emotions have a way of leading us in the wrong direction, especially emotions about money.

But if you are able to teach yourself to think in probabilities, you are well on your way to being able to profit from your own lessons.

Not often will the market price an outstanding business or any other outstanding businesses substantially below their intrinsic value.

But when it does occur, you should be financially (have the CASH)  and psychologically prepared (have the COURAGE) to bet big. 

In the meantime, you should continue to study stocks as businesses with the idea that one day the market will give you compelling odds on a good investment.


"To the Inevitables in our portfolio, therefore, we add a few Highly Probables." (Buffett)

The Dale Carnegie Principle on worry.

Learn to apply the Dale Carnegie Principle on worry.

When we have to take decisions we worry about the consequences.

Before running away, ask yourself what is the worst that can happen if you take the decision.  

Analyse the facts and the situations; it may not be as bad as you think.

Be prepared for the worst, then go ahead and take the decision.

WHAT WARREN BUFFETT SAYS ABOUT DEBT

Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

‘Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.'

'It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.’

How much should you invest in a stock?

		Teh Hooi Ling Sat, Nov 24, 2007 The Business Times
How much should you invest in a stock?
THE science of numbers has developed quite a bit since June 1955, when a new quiz show called The $64,000 Question made its debut on American television. The show was a hit. It captured as much as 85 per cent of the viewing audience and spawned dozens of copycat shows. There was even betting on which contestants would win. But the problem was the show was produced in New York and aired live on the East Coast of the US. The telecast, however, was delayed by three hours on the West Coast. A gambler took advantage of the time difference by finding out by phone who the winners were, and then placing his bets before the West Coast airing. John Kelly, a physicist at Bell Labs, heard about the scam on the news. After some pondering, he was convinced that a gambler with "inside information" could use some of the equations developed by his colleague - Claude Shannon - to achieve the highest return on his capital. Mr Shannon, who created information theory after having realised that computers could express numbers, words, pictures, audio and video as strings of digital 0s and 1s, had developed formulas to deal with the signal noise of long-distance telephone transmission. Mr Kelly saw that the equations could be applied to the problem of a gambler who has inside information, say, about a horse race, and who is trying to determine his optimum bet size. A gamblr gets a tip on a race's outcome. He could bet everything he's got on the horse that's supposed to win. But if the gambler adopts this approach, he will lose everything should the information turn out to be wrong. Alternatively, he could play it safe and bet a minimal amount on each tip. This squanders the considerable advantage the inside tips supply. In Kelly's analysis, the smart gambler should be interested in "compound return" on capital. That is, to optimise the long-term growth rate of one's capital, the gambler - the theory also applies to investors - should vary the wager as a proportion to his overall capital depending on the probability of bet being a winning one, and on the payout of the winning bet. The Kelly formula or Kelly criterion has become a popular money-management formula for investors, hedge fund managers and economists. Uncertain events As the saying goes, the only certainties in life are death and taxes. For everything else, we form some kind of expectations of the outcome based on our experience, or what have been documented by others. In finance, the expected value is used to account for the uncertain outcome of, say, a project or an investment. Project A, has 30 per cent chance of making a profit of 20 per cent, 40 per cent of a profit of 12 per cent and 30 per cent of making a loss of 15 per cent. So the expected return is 6.3 per cent  (30%x20% + 40%x12% + 30% x -15%). If there are numerous investment opportunities with that kind of probabilistic outcome, then over a long period of time, the investor will earn an average of 6.3 per cent return per investment, as indicated by the expected return. However, some investments or gambles are such that there is a one in a million chance of getting a $2.5 million payoff for a $1 bet. But for the other 999,999 times, you lose 100 per cent of your wager. The expected return is a good 150 per cent. But if one were to bet a significant sum of one's wealth on this kind of gamble, it is almost a certainty that one would be bankrupted before the big payoff comes along. According to Kelly's formula, two numbers should decide how much capital one should allocate to bet on an uncertain event: the probability of the bet being a winning one, and the payout. The formula is this: (Probability of bet being a winning one x (expected rate of return +2) -1) / (expected rate of return + 1). So if you think that an investment has a 51 per cent chance of returning 20 per cent, then according to the formula, you should put 10 per cent of your capital in that investment. But if the probability of the investment yielding 20 per cent drops to 45 per cent or less, then you should not make any bet at all. Meanwhile, a stock with half a chance of returning 30 per cent, the wager size should be 11.5 per cent of your portfolio. This method forces an investor to seriously and thoroughly analyse the potential of a stock. And when he or she comes across a stock whose potential they think is severely unappreciated by the market, then they should have the conviction to commit a sizeable bet on it. The prerequisite for this kind of approach is that the investor must have deep understanding of a stock and the industry it operates in, and have knowledge of how companies are valued by the market. In a way, the world's most successful investor, Warren Buffett, also subscribes to this strategy. He advocates focus investing, and to bet big on high probability events. There have been studies done that, using Kelly's formula one can minimise the expected time to reach a fixed fortune. From the table, it appears that the probability of a favourable outcome carries a much bigger weight in determining how much one should put into an investment. Disadvantages The Kelly formula was developed to solve similar problems in gambling where the outcome is either win or lose. And it assumes a 100 per cent loss when the outcome is unfavourable. In the stock market, one rarely lose 100 per cent of one's investment in a single trade.  Also, a financial investor cannot completely rely on the number suggested by the Kelly formula as it does not take into consideration the possibility of a few available investment options. In gambling, using Kelly's formula can produce a rather volatile result. There is a one-third chance of halving the bankroll before it is doubled. According to some literature, a popular alternative is to bet only half the amount suggested, which gives three-quarters of the investment return with much less volatility. Where money accumulates at 9.06 per cent compound interest with full bets, it still accumulates at 7.5 per cent for half-bets. And as mentioned, this kind of strategy is applicable to those who know their ways around the stock market. But even for experts, putting 30 per cent of one's portfolio in a stock with a 60 per cent probability of a 35 per cent return seems rather big a bet. The numbers should at best be used as a rough guide. And for those who don't have the time or the inclination to carry out in-depth studies of stocks, a diversified  approach is perhaps safer. The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg

Consequences must dominate Probabilities

How to overcome your financial fears in investing?

These are the usual three basic fears one has to face in investing, namely:

Fear of loss
Fear of failure
Fear of unknown

Here are some suggested ways to overcome these:

Fear of loss:  Understand the probabilities and consequences of any potential loss(es) in your investing.  Always remember, in the face of uncertainties, your investing actions should be based on the consequences rather than the probabilities of these loss(es) occurring.

Fear of failure:  Nothing venture, nothing gain.  Without trying, you have already failed.  Seize the opportunity.  Be prepared for possible failures too, but take these as valuable lessons preparing you for a better future.

Fear of the unknown:  Research the topic well to become knowledgeable.


Also read:
I Will Tell You How to Become Rich: "Be fearful when others are greedy, and greedy when others are fearful."
http://myinvestingnotes.blogspot.com/2010/12/i-will-tell-you-how-to-become-rich-be.html

Investing mantra: Consequences dominate Probabilities

"Investing isn't just about probabilities. It's about consequences, and you've got to be prepared for them." - John Bogle 

Thinking in terms of Probabilities of Loss and Expected Returns

http://valuehuntr.com/2009/06/26/our-alternative-to-capm/

Risk and Uncertainty

Risk

What is risk?

In financial terms, risk is the probability of an investment's actual return being lower than expected.

Can we understand risk and take actions to lower it?

We now have the two elements necessary to start us on a path of business risk management.

How can we:

(1)  lower the potential downside of risk

and/or

(2)  lower the probability of occurrences?

Risk can be both

• intrinsic (within ourselves) and 
• extrinsic (from outside).  

If risk is the potential for a business loss, when may a business project be deemed a high risk?

A business project may be deemed a high risk because either:

(1)  there is a high likelihood of a loss of any size, 

or

(2)  there is even a very small likelihood of a large loss.  

Almost every business action carries some degree of risk.  High-risk actions require careful management because of their potential large negative consequences to the business.

Threat:  A threat is a potential event with a very low probability but a high negative impact.  

"Bet-your-company risk":  Avoid taking a "bet-your-company risk."  The potential negative consequences of such a risk are just too, too large.  For example, a bet-your-company risk would be spending all your available resources on developing a risky new product.  The company could fail if development were to be delayed or if sales were much lower than projected. 

However, entrepreneurial companies usually must face bet-your-company risks as they start up and grow.  Understanding and managing risk and uncertainty is especially important in these fledging enterprises.  Startups must be focused, innovative, responsive and also very lucky to survive.  Most often, they are not.

Uncertainty

"Uncertainty" is different from risk.  

Uncertainty is not knowing what the future will bring.  However, under the cloak of uncertainty, high risk can lurk.  Thus, lowering uncertainty can lower risks too.

Uncertainty can be more dangerous than risk.  Because we often know the elements of risks, we can plan for risk and take measures to mitigate the negative consequences of risk.  However, with uncertainty we are often flying blind.  It is hard to lower uncertainty if you do not know what it is and thus what to do to lower it.  

Quotes:  

"The consequences of our actions are so complicated, so diverse, that predicting the future is a very difficult business indeed."

"The best way to predict the future is to invent it."

"It's tough making predictions, especially about the future."

Related:
Risk and uncertainty in investing.  Investing is serious business.

Investing Money in Plain English (Video)

Buffett (1989): We've never succeeded in making a good deal with a bad person.

Warren Buffett mentioned about his investment mistakes of the preceding 25 years in his 1989 letter to shareholders. Let us round off that list of what he feels were his key investment mistakes.

"My most surprising discovery: the overwhelming importance in business of an unseen force that we might call 'the institutional imperative'. In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play."

How often have we seen merger between two companies not producing the desired outcome as was projected at the time of the merger? Or, how often have we seen management retain excess cash under the rationale that it will be used for future acquisitions? Further still, a lot of companies do things just because their peers are doing it even though it might bring no tangible benefits to them. The master has labeled these so called propensities to do things just for the sake of doing them 'the institutional imperatives' and has termed them as one of his most surprising discoveries. Further, he advises investors to steer clear of such companies and instead focus on companies, which appear alert to the problem of 'institutional imperative'.

Given the master's great predisposition towards choosing business owners with the highest levels of integrity and honesty, it comes as no surprise that one of his investment mistake concerns the quality of the management. This is what he has to say on the issue.

"After some other mistakes, I learned to go into business only with people whom I like, trust, and admire. As I noted before, this policy in itself will not ensure success: A second-class textile or department store company won't prosper simply because its managers are men that you would be pleased to see your daughter marry. However, an owner - or investor - can accomplish wonders if he manages to associate himself with such people in businesses that possess decent economic characteristics. Conversely, we do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We've never succeeded in making a good deal with a bad person."

Next on the list of investment mistakes is a confession that makes us realise that even the master is human and is prone to slip up occasionally. But what makes him a truly outstanding investor is the fact that he has had relatively fewer mistakes of commission rather than omission. In other words, while he may have let go of a couple of very attractive investments, he's hardly ever made an investment that cost him huge amounts of money.

This is what he has to say: "Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn't make. It's no sin to miss a great opportunity outside one's area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire's shareholders, myself included, the cost of this thumb-sucking has been huge."

The master rounds off the list with a masterpiece of a comment. It gives us an insight into his almost inhuman like risk aversion qualities and goes us to show that he will hardly ever make an investment unless he is 100% sure of the outcome. It comes out brilliantly in this, his last comment on his investment mistakes of the past twenty-five years: "Our consistently conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn't have liked those 99:1 odds - and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also."

http://www.equitymaster.com/detail.asp?date=10/25/2007&story=3

Be fearful of excessive leverage and debt

Property tycoon Simon Halabi bankrupt

Simon Halabi, the property tycoon who was estimated to be worth £3bn in 2007 and whose portfolio includes London HQs of JP Morgan, Aviva and Old Mutual, has been declared bankrupt.

By Graham Ruddick, City Reporter (Property)
Published: 12:13AM BST 02 Apr 2010

Simon Halabi and his wife Urte in 2006 Photo: Dominic O'Neill

The bankruptcy order was made in the High Court on Tuesday over a £56.3m loan he received from failed Icelandic bank Kaupthing Singer & Friedlander.

The nine offices make up a £1.15bn securitisation vehicle called White Tower 2006-3, and the fall in value caused a breach of loan to value covenants that prompted creditors to call in the debt.
Loan servicers were appointed to manage the portfolio and Ernst & Young were then called in as administrators on seven of the properties after HM Revenue & Customers issued a winding-up order over unpaid tax.

The financial health of Mr Halabi has so far been difficult to establish because his control of the properties was through a web of off-shore vehicles and family trusts.

He conducted most of his business through Buckingham Securities, his property advisory company, but this was put into liquidation last August following the collapse of commercial property values across the UK.
Mr Halabi first emerged on to the UK property scene in 2000 as a backer of Irvine Sellar's Shard development in London Bridge, but sold his stake in the project to Qatari investors two years ago.

The offices held by Mr Halabi's White Tower are being marketed for sale by property agents CBRE and Knight Frank. The agents hope an initial wave of eight sales will raise around £800m, with at least £200m then coming from the most valuable property in the portfolio, Aviva Tower.

http://www.telegraph.co.uk/finance/newsbysector/constructionandproperty/7546381/Property-tycoon-Simon-Halabi-bankrupt.html

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Consequences must dominate Probabilities

In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.


http://myinvestingnotes.blogspot.com/2008/10/consequences-must-dominate.html

Consequences must dominate Probabilities

In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.

The intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong - as even the best analyses will be at least some of the time.

The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong.

Many "investors" put essentially all of their money into dot-com stocks in 1999; an online survey of 1,338 Americans by Money Magazine in 1999 found that nearly one-tenth of them had at least 85% of their money in Internet stocks. By ignoring Graham's call for a margin of safety, these people took the wrong side of Pascal's wager. Certain that they knew the probabilities of being right, they did nothing to protect themselves against the consequences of being wrong.

Simply by keeping your holdings permanently diversified, and refusing to fling money at Mr. Market's latest, craziest fashions, you can ensure that the consequences of your mistakes will never be catastrophic. No matter what Mr. Market throws at you, you will always be able to say, with a quiet confidence, "This, too, shall pass away."

Ref:

The Intelligent Investor by Benjamin Graham

Pascal's Wager
http://www.infidels.org/library/modern/theism/wager.html