Sahil’s Portfolio

Hi Sahil,
“This was extremely helpful”. I appreciate you clarity and analysis ability. I am not young like you. I have seen many bear and bull markets since Harshad Mehta time, and also faced 2008 subprime crisis. IMHO while making investing decisions, calculating an ‘expected value’ intuitively is an effective way to decide what choice to make – play the game or not.

“What is expected value?” you may wonder.

In the 1989 AGM of Berkshire Hathaway, Warren Buffett was asked about his approach to risk and investment decision making, and he replied –

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.
As an equation, it reads thus –

Success in investing = (Probability of gain X Amount of possible gain) – (Probability of loss X Amount of possible loss) = A positive number

Michael Mauboussin describes this concept as expected value. It is actually a very simple concept.

In essence, you don’t have to be right a lot, you just have to be right about your big bets at the right time. Here, while the probabilities matter a lot, so do the consequences i.e., amount of possible gain/loss.

It is important to get that equation right.

If you are willing to buy a stock, say, priced at 60-70x P/E or more, thinking the probability of it going higher is good, also remember the consequence of a period of weakness/slowdown in business. Such expensively priced stocks ride on high expectations, and the consequences of a small slip could be really bad.

Given that we often tell ourselves false stories to avoid the truth, with our minds clouded by denial, optimism and negative decision-making tendencies, the expected value idea can help us avoid the landmine of expensive, hot and bad stocks that cover a large ground in stock investing.

Buffett says –

In order to succeed you must first survive.
The stock market is not a casino. Unlike a casino, the longer you play here, the more are your chances to win (survive and thrive). But it’s important to –

• Play by a process and stick with it through the cycles.
• Think and act like owner of businesses and not renter of stocks.
• Use the expected value model to decide which businesses you want to own (where the expected value answer is positive) and which ones you must avoid (where the answer is negative).
  Regards