Thinking in Bets: Mastering Probabilistic Decision-Making for Investors

Many aspects of investing aren't black and white, but fall into gray areas. By learning to navigate this nuance and think more probabilistically, we can avoid feeling overly discouraged when things don't go our way or falling into the trap of hindsight bias.

Great investors understand that even sound decisions can sometimes lead to unfavorable outcomes. In fact, there are likely already several stocks in your portfolio that will turn out to be mistakes - you just don't know which ones yet. The influence of luck and uncertainty makes it impossible to predict exactly how each investment will turn out. Setting proper expectations allows us to maintain perspective when we inevitably end up holding some losing positions.

Key Lessons from Poker

Annie Duke's book "Thinking in Bets" draws valuable lessons from her 20-year career as a professional poker player. Poker provides an excellent arena for studying decision-making, as each hand involves multiple quick decisions with concrete results. However, the outcome of a hand isn't directly correlated to decision quality - even a weak starting hand can win through luck.

Framing poker decisions as bets about an uncertain future helped Duke avoid common decision traps. It allowed her to learn from results more rationally and keep emotions in check. This mindset applies well to investing and other areas of life where we must make choices with incomplete information.

Some key poker concepts that translate to investing include:

• Resulting: The tendency to equate the quality of a decision with the quality of its outcome. In poker and investing, good decisions can lead to bad results in the short-term due to luck.

• System 1 vs System 2 thinking: Fast, instinctive thinking (System 1) vs slower, more deliberate reasoning (System 2). Investors benefit from engaging System 2 thinking more often.

• Tilt: Becoming emotionally unhinged after bad results, leading to poor decisions. Investors must avoid reactive trading due to short-term losses.

Overcoming Cognitive Biases

Our brains aren't wired for perfect rationality. We have many cognitive biases that can lead us astray:

• Confirmation bias: Seeking out information that confirms our existing beliefs while ignoring contradictory evidence.

• Hindsight bias: Believing past events were more predictable than they actually were.

• Self-serving bias: Attributing successes to skill and failures to bad luck.

• Resulting: Judging decision quality solely based on outcomes.

To combat these biases, Duke recommends:

1. Actively seek out diverse viewpoints and information that challenges your beliefs.

2. Practice evaluating decisions independently from outcomes.

3. Consider multiple potential futures rather than assuming a single inevitable outcome.

4. Use tools like backcasting and premortems to gain new perspectives.

The Buddy System

Thinking objectively is difficult on our own. Duke advocates creating a "buddy system" of trusted peers who can help us view situations more impartially. Key traits to look for:

• Focus on accuracy over confirmation
• Willingness to disagree and challenge ideas
• Openness to diverse viewpoints

This group can help identify blind spots in our thinking and expose us to new information and perspectives. However, it's important to evaluate ideas based on their merit, not just their source.

Thinking Probabilistically

A core tenet of "thinking in bets" is embracing probabilistic thinking. The future is uncertain, so we must consider multiple potential outcomes and their relative likelihoods.

This applies directly to investing. Even with thorough research and sound reasoning, we can never be 100% certain how an investment will turn out. Instead of seeking certainty, we should:

1. Assign probabilities to different scenarios
2. Consider both upside potential and downside risks
3. Size positions based on conviction and potential outcomes
4. Be prepared to update our views as new information emerges

Thinking probabilistically helps avoid unproductive regret when things don't go as hoped. We recognize that even the best processes will produce some losers.

Backcasting and Premortems

Duke introduces two useful techniques for improving decision-making:

Backcasting: Working backwards from a desired future outcome to determine the best plan of action. For investing, this could mean starting with a target return and working out what would need to happen to achieve it.

Premortems: Imagining a negative future outcome has already occurred and analyzing why it happened. This helps identify potential pitfalls and failure modes in advance.

Both techniques leverage our mind's ability to "remember" imagined futures, helping us spot opportunities and risks we might otherwise miss.

The Quitting Equation

Knowing when to sell a stock is one of the most challenging aspects of investing. We face numerous biases that can cloud our judgment:

• Sunk cost fallacy
• Endowment effect
• Loss aversion
• Overconfidence

To combat these, Duke recommends developing a "kill criteria" framework - predefined conditions that trigger an automatic decision to exit a position. This could include:

• Fundamental deterioration beyond certain thresholds
• Management changes or strategic shifts
• Better opportunities arising elsewhere

The key is setting these criteria in advance, before emotions take over. However, the criteria should remain somewhat dynamic, allowing for updates as new information emerges.

Embracing Uncertainty

Ultimately, investing is about making decisions under uncertainty. Even the best investors are wrong close to half the time. By thinking in bets, we can:

1. Set more realistic expectations
2. Avoid overconfidence
3. Learn more effectively from both successes and failures
4. Make more rational decisions over time

Embracing probabilistic thinking won't eliminate uncertainty, but it can help us navigate it more skillfully. We'll never be able to predict the future with certainty, but we can work to steadily improve our decision-making process.

By applying lessons from poker and other domains of uncertainty, we can become more objective, mindful investors. This doesn't mean we'll win every hand, but it does mean we'll play the long game more effectively.

Article created from: https://www.youtube.com/watch?v=KYQAZxMEciY