Probabilistic thinking: bayesian thinking, fat-tailed curves, and asymmetries for financial success
Wisdom
One piece of wisdom that motivates, encourages and empowers you to grow.
“Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong.”
—Benjamin Graham
Insight
One insight that helps you deeply understand a situation, idea, or concept.
Probabilistic Thinking
In the 17th century, Blaise Pascal and Pierre de Fermat used probabilities to solve the "problem of points," a gambling problem, which laid the foundation for probabilistic thinking.
Probabilistic thinking is a valuable tool that helps us make decisions by estimating the likelihood of specific outcomes. It enables us to navigate an unpredictable world by identifying the most likely results, so our decisions can be more precise and effective.
There are three fundamental elements of probabilistic thinking: bayesian thinking, fat-tailed curves, and asymmetries.
1. Bayesian Thinking
Bayesian thinking is based on the idea that we should consider what we already know when we learn something new.
This approach allows us to use all relevant prior information in making decisions, making our estimates more accurate.
For example, an investor is considering buying stocks of a particular company. They have prior knowledge that the company has been consistently profitable for the past five years.
Upon receiving new information that the company's latest product has been underperforming, the investor updates their beliefs by factoring in this new data and adjusts their probability of the company's future success accordingly.
2. Fat-Tailed Curves
Fat-tailed curves, on the other hand, describe situations where extreme events are more likely to occur.
In these cases, we cannot rely on the most common outcomes as representing the average, and the more extreme events that are possible, the higher the probability that one of them will occur.
For example, In the stock market, extreme events such as crashes or sudden surges in stock prices are more common than a normal distribution (bell curve) would predict.
These rare events, which lie in the "fat tails" of the distribution, can have a significant impact on an investor's portfolio, making it essential to plan for and consider the potential risks associated with them.
3. Asymmetrics
Asymmetries refer to the fact that our probability estimates are often skewed in one direction, usually towards over-optimism.
To improve our probabilistic thinking, we need to be aware of these asymmetries and adjust our estimates accordingly.
For example, an investor may overestimate their ability to predict the future performance of a stock, leading to overconfidence in their investment decisions.
This overconfidence can result in an asymmetric estimation error, where the investor consistently overestimates the potential gains and underestimates the potential losses, ultimately leading to poor investment outcomes.
Living Legend
One inspiring story of a famous person who is still living for doing something extremely well.
Eric Sprott
Eric Sprott is a Canadian billionaire who is widely recognized as one of the most successful investors in the precious metals and mining space. He has built his fortune by consistently making shrewd investment decisions, and probabilistic thinking has been a crucial part of his approach.
Sprott strongly advocates for Bayesian thinking, a mindset that entails revising one's convictions in light of new information.
Sprott is a strong proponent of Bayesian thinking, which involves updating one's beliefs based on new evidence. He has often stated that he tries to keep an open mind and is always willing to adjust his views based on the latest data. This flexibility has allowed him to identify lucrative investment opportunities that other investors may have overlooked.
One of Sprott's most notable successes came with Kirkland Lake Gold, a Canadian gold mining company. In 2015, Sprott became interested in the company and began to accumulate shares. At the time, Kirkland Lake was not widely known, and many investors were skeptical about its potential.
However, Sprott saw something that others did not. He believed that the company's management team was strong and that it had valuable assets that were not being fully appreciated by the market. He also recognized that the gold mining industry was entering a period of consolidation and that Kirkland Lake could be an attractive acquisition target.
Sprott's probabilistic thinking paid off. Over the next few years, Kirkland Lake's share price skyrocketed as the company made a series of smart acquisitions and expanded its operations. Sprott's early investment yielded massive returns, and he is now regarded as one of the company's most successful investors.
Sprott's success with Kirkland Lake is just one example of how probabilistic thinking can lead to profitable investment decisions. By carefully evaluating all available data, and being willing to adjust one's views as new information emerges, investors can identify opportunities that others may miss. Eric Sprott's career serves as an inspiration to those who seek to apply probabilistic thinking to their own investment strategies.
Final Thought
One question for you to ponder and think carefully about.
To achieve financial success as an investor, it is important to apply the mental model of probabilistic thinking. Developing a habit of asking questions like the following is essential:
“What is the probability that my investment will generate a positive return?”
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Cheers,
Ben Mumme
Founder and CEO of Living Your Greatness
P.S. This song will never get old.
P.P.S. What you probably don’t know about precious metals investor and billionaire, Eric Sprott.
Notes
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