The most remarkable and useful observation from Michael Mauboussin' Credit Suisse report is to "think probabilistically."
Michael Mauboussin, managing director and head of global financial strategies at Credit Suisse, wrote Decision Making for Investors during his tenure with U.S. asset management firm Legg Mason, and it remains my choice as the best single short paper ever written for investors. Mr. Mauboussin's most recent Credit Suisse report, Thirty Years: Reflections on the Ten Attributes of Great Investors, is a summary of all he's learned in 30 years in finance and offers a similar treasure trove of valuable investment information.
I'll list all 10 of the investing characteristics Mr. Mauboussin uses to define the world's best investors then discuss what was for me the most remarkable and useful observation.
Mr. Mauboussin's 10 attributes of great investors are: be numerate (and understand accounting); understand value – the present value of free cash flow; properly assess how a business makes money; compare effectively (expectations versus fundamentals); think probabilistically; update your views effectively; beware of behavioural biases; know the difference between information and influence; how to size investment positions; and read – keep an open mind.
My pick for best sentence in this all-around brilliant and useful report is in the section under "think probabilistically."
"Great investors recognize another uncomfortable reality about probability: the frequency of correctness does not really matter, what matters is how much money you make when you are right versus how much money you lose when you are wrong."
The concept is relatively simple – a portfolio with one big winner, one small winner and three small losers will likely outperform a portfolio where all positions rise a small amount – but there are layers of complexity beneath the simplicity.
Applying this lesson means that investors need to develop the skill of coldly, objectively, estimating potential dollar-amount gains and losses for any investment. Consider a hypothetical hedge fund manager with $500,000 to put to work in the markets. The manager believes there's a 60-per-chance that the oil price will rise to a higher target and buys a futures contract that will triple in value – a profit of $1-million – if this is the case. To calculate probability-adjusted expected return, the 0.6 probability is multiplied by the potential $1-million profit, so it's $600,000.
This manager also sees a 40-per-cent probability they are wrong, that the oil price will head lower, and the loss on the value of the futures contract would be 50 per cent, $250,000, before they could sell it. The expected loss in this case would be 0.5 times $250,000 or $125,000. In the case of this (entirely made-up) trade idea, the expected gains of $600,000 exceed potential losses of $125,000 and the manager is justified in acting on it.
Referring to Mr. Mauboussin's rule of "what matters is how much you make when you win, and lose when you're wrong" concept, it's not difficult to see how a series of five trades like this would lead to strong overall portfolio performance, even if only two were successful.
The most adept money managers are those able to find investments with a high probability of big returns and, having already estimated potential losses when the investment was made, limit downside by selling quickly if things don't go their way. As Mr. Mauboussin writes, "there are few sure things" and one important way to win in the markets is for investors to stow their egos, admit when they're wrong and jettison failing invest ideas.
The skill and knowledge necessary to fully implement this investing lesson take years to develop. Our hypothetical managers' thought process, for instance, is only as useful as their ability to successfully predict the crude price. But the decision making framework involved, if used frequently over time, would help all investors gain an edge and a heightened ability to uncover bigger winners while limiting downside.