I'm previewing a book, soon to be published, What I Learned About Investing from Darwin by Pulak Prasad. In the first chapter, he reviews Warren Buffet's strategy: don't lose money. He relates this to prey and predators not risking an error in judgment that a situation is good when it's bad. For example, don't risk thinking the watering hole is safe when you know a lion is nearby. Or don't risk chasing a heavyweight prey like a wildebeest if you're just a lightweight cheetah. In statistics, this is a type I error. The counterpart to this is passing on good opportunities; this is a type II error. According to the author, almost all, if not all, investment literature teaches you how to reduce the error of missing out on good opportunities.
The author's, mimicking Buffet, key insight so far in my reading is improving your systems to reduce taking risks on investments that appear good but aren't. You're overall performance in decision-making results, investments, etc. will improve dramatically.
The author uses this example: Suppose there are 4000 investment opportunities. Since most early businesses fail, the likelihood of good opportunities in that pool could be 25%. Suppose you have an 80% track record of being right--far above most sports statistics success rates, by the way.
A lot of advice goes along the path of "you can't win if you don't play." "Need to buy a lottery ticket if you want to win." "Better to shoot a thousand times and hit 300 then shoot 10 times and only hit 3." As Taleb points out in Black Swan, it's impossible to precisely pick the winners so it's better to spread the bets knowing a few are going to win while most won't.
Prasad counters this by saying, "It's better to miss out on some good opportunities rather than waste time not improving the ability to avoid bad investments."
Take the 4000 opportunities. A thousand are good. You'll pick 800 of them with an 80% success rate; you'll miss out on 20% of the good opportunities. But you'll also pick 600 of the 3000 bad options (20%). Your overall success rate is 57%, slightly better than 50/50 or throwing darts at the list and picking that way (800/1400).
If you could reduce your risk in one of the areas, which risk would you select? Missing out on good opportunities or investing in bad companies?
Starting position: 20% type I, 20% type II = 57% success rate
Not missing good opportunities: 20% type I, 10% type II = 60% success rate [whoops, not much improvement since we'll get 900/1500 success ratio]
Not investing in bad opportunities: 10% type 1, 20% type II = 73% success rate [wow, a big jump since we'll get 800/1100 success ratio]
Also, if the ROI on the good opportunities equals the loss of the bad investments than, with a 73% success rate, your overall profits will soar compared to the other strategy of not missing out on some good opportunities.
Doesn't this just make sense? How come so many of us don't do this? Probably because we think if we spiral this logic to a reduced conclusion, we'll only be investing in savings accounts earning tenths of one percent on our assets. But I'm looking forward to Prasad teaching us how to spot those money-losing opportunities.
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| From the "Charge of the Light Brigade" |
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