Refer to this recent tweet from Mr. Ashish Kila, head of investment management division at Perfect Group, one of the wisest and most humble souls I have had a chance to interact with at the Delhi Investors Meet held earlier this year:
“Think in terms of outcomes & not probabilities. Portfolio should be able to survive the tail events no matter how improbable they appear.”
What does he mean? Lets understand this with the help of an example. Say, your current age is 30 and you are told to assign a probability to you dying in the next 1 year. Don’t worry we are just discussing. You would definitely assign a very low probability to such an event assuming that you are in a relatively good health condition as on date. Say you mention 0.001% or 1 in 100,000. This is an arbitrary number but the point is that the probability that you will assign will be minuscule. Now think about this, with this probability in mind, would you wait for a number of years (so that this probability increases as you age) before you buy a life insurance policy? No. At least, I hope so!
What you did here is the correct thing: You thought in terms of outcomes not probabilities. The probability of you dying in the next 1 year or 3 years or even 5 years, howsoever small, can become an actuality and you are wisely guarding against this possible but improbable outcome by buying insurance.
In the context of investing, when you are exercising margin of safety via low price (vs intrinsic value), you are essentially insuring against things that can go wrong, howsoever low the probability. When you are diversifying across companies and industries, you are again doing the same thing. You are guarding against the “known unknowns” and the “unknown unknowns”.
At the risk of sounding paradoxical, I would say that it boils down to giving weightage to the low probability events in your decision making as such events may play out eventually. Some examples of such events are- a catastrophic fire in the main/ largest factory of a company, death of the key manager/ promoter, industry disruption, regulatory changes, wars etc.
The point Mr. Kila is making is that our portfolio should be robust enough to weather such storms. Too much concentration in a particular industry or in a particular company in the portfolio can be the cause of a disaster. Over confidence bias leads us to be too concentrated at times. I would like to end with a famous quote by Howard Marks (I love this one):
“There is a big difference between probability and outcome. Probable things fail to happen and improbable things happen all the time….the best thing that we can do is fashion a probability distribution that summarises the possibilities and describes their relative likelihood. We must think about the full range and not just about the ones most likely to materialise. Some of the greatest losses arise when investors ignore the improbable possibilities”