Margin of Safety: A Probabilistic Approach
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When Investing in Mavericks, I think about risk probabilistically. That is, I believe one way to achieve a margin of safety is by having a high expected value across your investments.
Expected Value Matters
When people talk about stocks, they tend to focus only on the merits of each individual investment idea. Unfortunately, that doesn’t capture the whole picture. What’s usually not discussed is how that investment prospect fits into one’s broader investment strategy, how they size their positions, how much they make when they’re right vs lose when they’re wrong etc.
Even if you have extremely high conviction about a potential investment strategy, the probability of being right is significantly smaller than we might think. For example, let’s say you have a highly concentrated 10-stock portfolio. Even if you’re 90% certain that each of your investments will make money, and if we assume that this 90% number indeed reflects reality, that gives you just a 35% chance that you will always be right! (90%^10 = 35%).
As Soros implies below, expected value matters.
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”
—George Soros
Batting Average & Win:Loss Ratios
To have a winning investment strategy, the expected value of our investments need to be positive, that is:
Probability(Winning Investment)*(Average Win) > Probability(Losing Investment)*(Average Loss)
A positive expected value therefore occurs when
The Win to Loss Ratio > (1 - Batting Average) / Batting Average
Where
Batting Average is the percent of times you successfully make a winning investment, and
The Win to Loss Ratio equals the average gain of your winning investments divided by average loss of your losing losing investments
Assuming equal sized investments, for a given batting average, the table below shows us the minimum Win to Loss ratios we require to break even.
Great investors tend to be right three-fifths to two-thirds of the time. From the table above, if one can be right 2 out of 3 times, then our average winners can about ~half the size of our average losers and we would still break-even! That’s where the margin of safety comes from, not from any one specific investment.
For example, if our losers are -20% on average, with a 67% batting average, our average winners can be just under 10% and we would still break-even!
Batting Average and the Win To Loss Ratio, of course, go hand in hand. Notice that in the table above, for an effective investment strategy, as our batting average goes down, the size of our average winners must go up. Therefore, by having bigger winners than losers on average, we afford ourselves the luxury (i.e. the buffer) to have a lower batting average.
The concentrated value investor focuses on high batting average investments (bottom half of the table above). Venture Capitalists on the other hand look for opportunities for outsized gains, given a low batting average (top half of the table above). By Investing in Mavericks, this is exactly what we are trying to mimic.
Where Does the Margin of Safety Come From?
It is this relationship between batting average and Win to Loss ratios where the margin of safety comes from.
Of course, when investing, the gain and loss amounts, and their respective probabilities must be based on valuation and subjective estimates, but a general rule of thumb is to aim for a 2:1 Win to Loss ratio. If we can achieve that, we could actually be wrong two out of every three times, and still make money.
That’s a pretty good margin of safety.
Of course, our empirical results will only follow after our investment theses play out, which typically have long feedback loops. Unfortunately, we must simply wait and see where we land. I suppose that’s one of the many paradox’s of investing.
The good news however is that when we buy a stock, the most we can lose is 100%, and that is also rather unlikely, but we can make multiples from a winning stock. So, the math is always working in our favor.
This is also why I believe investing is a Homerun Hitters Game.
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