Yes or No? – The Wrong Question.
Market Meditations | July 7, 2021
Does alien life exist? Will my business succeed? Will Ethereum hit all time highs again this year? These are all questions that don’t have clear answers. Answering yes or no simply would not be appropriate given our lack of information. So how can we approach these questions in a more suitable way? The key is not to think in such a binary manner but instead, to think about probabilities. This way of thinking is often referred to as probabilistic thinking.
To leverage an example, should you prepare for an alien invasion?
- There either will be an invasion, or there won’t and we will not know whether it will happen in our lifetimes until it does or we reach the end of our lives.
- However, even if we believe in aliens, how many alien invasions have there been to date? None.
- So whilst we do not know whether aliens will invade, it simply doesn’t make sense to prepare for it.
The importance of this is stressed when we examine some of our biases. First is our systematic overconfidence that we actually know the truth which can lead to over-precision in our judgements1. When we view these biases in the context of the Illusion of Control2 – that we believe we have far greater impact on final outcomes than we actually do – we see that humans are prone to making overly precise, binary decisions that we think will result in a specific outcome with utter confidence! In reality this is rarely the case.
Developing a probabilistic mindset is not easy. Firstly we must understand basic concepts of probability. If you aren’t familiar with these, check out Khan Academy’s introduction. Then we must consciously ask ourselves not will this event occur but instead, how likely is this event to occur3. We can use prior data, such as how many times has this event occurred before, in an attempt to help inform the probability; however sometimes this information is not available and we have to use our subjective nature to guide the process. After establishing our initial framework we can then use bayesian updating to update our probabilities when receiving new information.
To improve our ability to make decisions even further we are then able to attach outcomes to our probabilities to calculate what is known as expected value. As Warren Buffet summarised: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about”. If you want a more detailed explanation, check out Sam Trabbuco of Alameda Research’s breakdown.
Whether it’s trading, running a business or deciding whether we should prepare for an alien invasion, probabilistic thinking is an essential part of making good decisions in an uncertain world. Get to grips with the basic principles of probability, ask yourself how likely an outcome actually is and stop answering simply yes or no.