Investing Unplugged: Embracing the Art of Probabilities

June 12, 2023 By Dan Trosch, CFA
Puzzle Pieces - Investing Unplugged: Embracing the Art of Probabilities West Financial Services.

In the world of investing, uncertainties abound and, as investors, we are confronted with pivotal questions. “Have interest rates peaked? Will the U.S. have a recession this year? Will the U.S. default on its debt?” While it's valuable to have an informed opinion, making large portfolio decisions based solely on these macro events can be extremely challenging. For instance, a U.S. default on some of its debt does not necessarily translate into a credit rating downgrade that would push up Treasury bond yields (i.e., prices decline). Many investors face the pressure of making a big change to an already well-considered strategy. There is often a gravitational pull to make large “binary” decisions based on macro events, whether crises or during a boom. A few of these decision points are critical, but attempting too much of this type of decision-making can be somewhat unhealthy to portfolio performance. 

So, what’s the alternative? Savvy investors may be able to generate profits due to the uncertainty and indecision that many investors face, by reframing questions and thinking more in probability terms for multiple outcomes. Additionally, channeling efforts into multiple bite-sized decisions across various sectors and themes is a foundation for a robust investment process. 

Let's take an example: investing in regional banks after a significant decline in early 2023. Instead of trying to make a difficult binary decision, investors can assess the probability of the crisis worsening and the indicators that might drive a recovery in bank stocks. If we believe there's only a 25% chance of the crisis worsening due to a few smaller bankruptcies, with no further bankruptcies, then bank stocks could outperform the broader S&P 500 index over three years. In this case, the decision is a risk-conscious decision to increase bank stock exposure, perhaps via ETF to avoid single bank risk.

This approach can be applied to other investment sectors, such as consumer related stocks. For example, rather than trying to judge the growth or stability of consumer spending or wage trends, investors in retail stocks can examine competitive advantages across various companies and assess the probability of different companies gaining market share, and perhaps by examining physical vs. online sales trends. By examining several companies’ likelihood of performing well in strong and weak consumer environments, an investor can profit by adding to 1-2 retail stocks without dreading failure from a large, big picture portfolio decision.

Real-world examples encompass not only sectors and stocks but also choosing funds that align with specific styles or factors such as value, growth, and quality. By making a range of smaller, multi-faceted decisions, investors enhance the adaptability of portfolios and improve chances of success — not to mention, increased confidence! 

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This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product, security, or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. You should not treat these materials as advice in relation to legal, taxation, or investment matters. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisers.