Hi Guys,
During the early phases of World War II, the US Army Air Force suffered brutal losses on its bombing missions. The returning planes were damaged by numerous bullet holes. What to do to improve the survival odds of our brave pilots and crew members?
A statistician was asked to research this dire problem. He examined each surviving plane and carefully catalogued the damaged areas. He recommended increased armor plating.
He surprisingly concluded that the additional heavy armor only be placed on those sections of the plane that were not damaged by enemy fire. Why? His thinking was that all enemy fire impacted each plane in a random manner. The returning fleet had survived their impacts and the missing members did not.
The statistician reasoned that the fallen planes must have been hit in the areas not damaged by the survivors. He theorized that it was those areas that were critical to continued flying. This interpretation dictated where the bulk of the additional armor protection was needed. His recommendation was executed and the rate of downed aircraft substantially decreased. Thinking a little outside the box with a full toolbox increases the odds of success.
Integrating statistics into tough decisions can work miracles. That’s true in wartime, and it’s also true when investing. Throughout his lifetime, Warren Buffett counted on a little rudimentary statistical analysis and Probability Theory to inform his decisions. He practiced a force multiplier effect when he merged simple math with a commonsense approach.
As a young boy Buffett published a racetrack tip sheet (stable-boy selections. 25 cents per copy) that was data intensive. He still uses elementary Probability rules when making his multimillion dollar investment assessments today.
Buffett said: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That it what we're trying to do. It's imperfect, but that's what it is all about."
This is nothing more sophisticated than a standard estimate of expected net returns. Of course, the challenging part of this exercise is to assemble reasonable probability and gain/loss estimates.
Buffett and his partner Charlie Munger are somewhat unique. In making their judgments, this brilliant team continuously use and update their probability estimates. This is a working illustration of a Conditional Probability (Bayesian) approach. We all do the same when coming to an investment choice, sometimes consciously, sometimes subconsciously, and perhaps even sometimes unconsciously.
It seems like Munger has been more forceful in extolling the virtues of rudimentary Probability Theory than Buffett: “If you don’t get this……. elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest”. Munger has a way with words.
Munger advocates Probability Theory as just one tool in an extensive toolkit. He disclosed his investment thinking structure in a 1994 lecture at USC titled “A Lesson on Elementary Worldly Wisdom As It Relates To Investment Management & Business”. It is rather long, but delivers superior advice. Here is a Link to it:
http://www.trailblazercoaching.com/articles/worldly-wisdom-by-charlie-munger.pdfEnjoy. If it works for the Buffett-Munger team, it can be made to work for us too with just a little effort. A complete investment toolkit is always more useful then one missing critical parts.
Best Regards.
Comments
Thank you for responding to my post.
I really hope I motivated you to think about the general and specific market advice that Munger cobbled together in his outstanding lecture. That lecture might just be the very best that I’ve ever read. If it appears that I’m goading just a little, I think it is warranted given the overall quality of the proffered wisdom.
The Munger advice to extract and merge operational methods and rules from various hard disciplines (mostly scientific) is particularly useful. Familiarity, and not expertise, is all that is required. Anyone can do it.
The trick is to connect concept A from one scientific discipline with concept B from another area of expertise. That’s all Munger is proposing; he is not inventing anything new; he is simply integrating findings in several disciplines to investment decision-making. The lecture is terrific stuff.
Yes, I pulled the aircraft armament story from a book. I try to attract attention to somewhat dry scientific studies with practical stories. Stories are better at this goal than bland statistics. I’m not sure, but I believe I read the aircraft story in Peter Bevelin’s fine book “Seeking Wisdom, from Darwin to Munger”. I highly recommend the book.
It is perplexing that almost all investors, especially those who participate in the MFO discussions, deploy Conditional Probability methods without acknowledging that they do so. I suspect it is related to their shortfall in High School level math skills.
The typical US citizen exhibits both a math and a science skill deficiency. Based on comparable test scores, International institutions consistently place the US population in the lower one-third of the National groupings in math and science. That hurts investing decisions.
Physics professor John Allen Paulos said; “Innumeracy …… plagues far too many otherwise knowledgeable citizens”. I agree, therefore I post on this subject on the MFO Board.
There are many ways to introduce and explain Conditional Probability. I especially like MFOer Shostakovich’s unique way of expressing it. He said: “ Always update your prior. …….. And recognize that in many situations even a weakly informative prior can save you(r) bacon.” Indeed, small adjustments can integrate into an oversized positive impact over time.
The main theme of Nate Silver’s book “The Signal and the Noise” also emphasizes the huge influence that Conditional Probability plays in updating forecasts. Chapters in Silver’s book highlight both successes and failures in numerous applications. Weather predicting is a success story; earthquake predicting is a failure at this juncture. He details the issues with financial forecasting in a chapter titled “If You Can’t Beat’em”. The book deserves your focused notice too.
Once again, thanks for your kind attention.
Best Wishes.