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How understanding statistics can make you a better investor

Today’s post is inspired by a recent conversation with my two teenage kids.   They were humouring me one day, listening to my fatherly advice about which high school mathematics courses to take during the next few years.   My top recommendation?  Basic statistics.

After they finished rolling their eyes at me, I explained.  Basic statistics comes in handy your entire life, equipping you with the tools and the mindset to realistically assess your odds for success or failure in any given venture.   You may still take a long shot anyway.  (Isn’t that what youthful energy is for?)  But at least you can proceed with your eyes wide open.

Will they follow the advice?  I place the odds at 82%.   To ensure my thought process doesn’t go to waste, let’s explore the vital role that statistics play in investing.

Possible versus Probable

It happens all the time:  Investors disregard or misinterpret the statistics and probabilities that should be guiding their financial decision-making.   Columnist and advisor Barry Ritholtz addressed this issue in a still-relevant 2013 post, “Possible versus Probable.”  In investing, he observes, “so many people seem to confuse facts with forecasts.”

Basically,  just because an investment outcome is possible doesn’t mean it’s probable.   For example, it’s possible that an isolated, high-risk venture could triple your money overnight.  But what is the probability it will?   About on par with me becoming Canada’s next Prime Minister.   Sure, it’s possible.   But the probability?   Close to zero.  (For starters, I take lousy selfies.)

By accurately assessing your investment odds, you may rightfully think twice about dumping your life savings into highly improbable “opportunities,” no matter how wonderful the outcome might be if you “win.”   On the other hand, based on the same statistical assessment, you might reasonably conclude that a small stake may still be worth it to you.   This is known in classic finance as “the lottery effect,” where investors are willing to “take large chances of a small loss for a small chance of a large gain.”

That’s an extreme example.  Statistics and probabilities can also help you appreciate why you usually want to offset your riskier stock holdings with a fixed income safety net.   As financial author Larry Swedroe likes to point out:  “I consider it a rule of prudent investing to never treat the unlikely as impossible or the likely as certain.”  Thus we follow the probabilities and opt for broad global diversification over extreme concentration … to prudently hedge our bets.

The problem is, instead of objectively assessing these sorts of odds and proceeding advisedly from there, investors too often are overcome by a host of behavioural biases ranging from overconfidence to confirmation bias.

In other words, they wing it – and they may not even know they’re doing so.   There’s something in psychological circles known as the Dunning-Kruger Effect,  wherein “the least competent people often believe they are the most competent because ‘they lack the very expertise needed to recognize how badly they’re doing.’”

This is where basic statistics again comes to the rescue.   Knowing we’re otherwise prone to skew our objective views, statistics may help you keep your financial cool next time you’re tempted to rush into a financial foray in which the odds are stacked against you.

As Ritholtz suggests,  “Who should focus on the Possible?  Writers, dreamers, artists, futurists, designers, technologists, entrepreneurs — the people who imagine the future. … For investors, however, you are best served by sticking with the Probable.   Understanding the difference will save you a lot of capital over the long run.”

Now, where my kids are concerned, I wish them a blend of both:  bountiful possibilities, as well as a solid understanding of the probabilities involved as they make their way in life.