Making decisions under uncertainty

Howard Marks is one of my favorite writers

His memos are filled with insights that are incredibly thought provoking. He just published his latest memo yesterday and it’s just plain brilliant. He draws parallels between gambling and investing

Here are some highlights:

You can’t tell the quality of a decision from the outcome

Because of these two factors, well-thought-out decisions may fail, and poor decisions may succeed. While it might seem counterintuitive, the best decision-maker isn’t necessarily the person with the most successes, but rather the one with the best process and judgment. The two can be far from the same, and especially over a small number of trials, it can be impossible to know who’s who.

By my stage in life – if not well before – one should have figured out his strengths and weaknesses and tilted his activities toward the former. I’ve concluded that my strengths include the ability to:

  • frame questions,
  • logically organize data and weigh pros and cons,
  • know what I don’t know,
  • accept that future outcomes aren’t predictable,
  • think about the future probabilistically, and
  • make decisions incorporating all of the above (although far from always correctly).

But let’s return to backgammon. In this game, two opponents – one moving clockwise and the other counter-clockwise – try to bring their pieces around the board while simultaneously preventing the other from doing so, and then be the first to take them off the board. Each player’s ability to move forward is determined by rolling a pair of dice. It’s a total disaster if you’re ignorant of the probabilities governing rolls of the dice and instead rely on luck, gut instinct or what you think is your innate skill. (In fact, the most important skill in backgammon consists of knowing these probabilities and thus what actions to take given your position.)

Over time, those world-class poker players taught me to understand what a bet really is: a decision about an uncertain future . . . .

Thinking in bets starts with recognizing that there are exactly two things that determine how our lives turn out: the quality of our decisions and luck . Learning to recognize the difference between the two is what thinking in bets is all about. . . .

The result of each hand provides immediate feedback on how your decisions are faring. But it’s a tricky kind of feedback because winning and losing are only loose signals of decision quality . You can win lucky hands and lose unlucky ones. . . .

What good poker players and good decision-makers have in common is their comfort with the world being an uncertain and unpredictable place. They understand that they can almost never know exactly how something will turn out. They embrace that uncertainty and, instead of focusing on being sure, they try to figure out how unsure they are, making their best guess at the chances that different outcomes will occur. . . .

How Is Investing Like Gambling?

Hidden information, luck and skill can play a part in investing. In active investing involving public companies, for example, all three are involved.

  • Clearly, no one knows all the relevant facts. The SEC tries to make sure all investors have equal access to information, but not necessarily complete access . For example, investors won’t know about first-quarter developments at a company until it reports earnings in May. And no one is supposed to know the results of drug trials and beta tests until they’re made public.
  • Luck – random, unpredictable, often-exogenous events – affects companies and their stocks all the time. Many aspects of corporate performance and profitability can be influenced by weather, for example. And the TV network carrying the World Series is likely to enjoy much greater ad revenue if the teams playing come from major markets rather than small ones.
  • Finally, the superior investor has the skill required to better assess revenue and profit potential, where we stand in the cycle, the fairness of an asset’s price and the margin of safety it affords. No one gets these things right all the time, but the superior investor does so more often than most.

I’d highly recommend reading the full letter

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