Value Investing

Forecasting – A matter of plausibility

By Alex Lanoie

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During my time at Columbia Business School in 2016, I took a course from Professor Paul Johnson which was a full-time week-long course named “Seminar in Value Investing” – I loved it. It was by far one of the best courses I have ever taken, undergrad and grad school considered. This seminar was a mix of life and investing advice based on materials from tens of authors and investors and Paul’s own life experience as a finance and investment professional.

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As we often do towards the end of the year, I was doing some cleaning and filing the other day, when I found a file full of handouts and articles from Paul’s class and I found some real gems. This is the only class ever which I’ve kept material from (I usually got rid of everything I could as soon as I knew I’d passed a particular subject).

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One of these handouts was a simple one pager titled “Scenarios” and the first sentence read “The key is to learn to think about plausibility rather than probability”. Now you might be thinking, right… what the hell are you talking about and what’s the difference anyway? Turns out there’s quite a big difference between the two and by changing the way we think about those two, it can be very helpful in making the right decisions (including, but not solely, in terms of investment decisions). Most decisions we make are linked to future events and this is exactly what these two terms deal with, the future. Johnson then continues by saying “Only requirement is to determine if an event is or series of events are possible. It is not necessary, and certainly not fruitful, to try to assign an arbitrary probability to the event(s).” This strongly resonates with me as I have always found it extremely challenging (and sometimes ridiculous) to allocate probabilities to future events. Everybody can come up with a different set of probabilities. However, the plausibility of something happening is usually easier to predict as the answer is a simple “yes” it’s plausible or “no” it’s not. Is it plausible (while staying reasonable) for Company A to go bankrupt within the next 24 months? No. Then, just forget about it. If the answer is “yes”, then let’s see how to deal with it.

Johnson suggests to follow the below steps when going through the process (which I have amended slightly):

  1. Is the scenario or event under review reasonably possible? If no, then no need to worry about it, if yes then go to step #2.
  2. Understand what would be the impact (risk) on me, my life, my family, my assets, my fund, my portfolio, etc.
  3. If I knew with certainty that an event or set of events was/were going to happen, what would I do to mitigate the potential risk? Those steps would then become your game plan. Rehearse them if needed. What you’re trying to accomplish here is to predict what could happen and prepare for it so that you’re not taken by surprise and react in an irrational manner. Johnson notes that if “fatal” is “possible”, under any set of events, then your risk exposure to that scenario is extremely high.
  4. This fourth step is very important and has actually helped me in the past avoiding serious investment mistakes before it is too late. Step 4 asks the following question: What milestones, outcomes, or events should I look for to tell that the scenario is unfolding? We often focus way too much on the ultimate outcome without paying attention to what will actually lead to it. We then set our sight on the final goal and don’t care about the process or don’t even bother to follow up and see if everything is on track. At the end, when we finally realize that the anticipated risky scenario has actually happened and we feel sorry for ourselves, it’s too late and with a bit of perspective we realize how easy it was to notice all the red flags throughout the process.
  5. Last but not least, at what point will I pull the trigger on the mitigation plan/process? At some point, following step #4, you might need to reassess the situation based on updated available information and decide what you should do next. You might have a plan B or you might want to cut your losses, depending on what you’re dealing with.

The sub-title of the second part of the handout is “Thought Process”, although I’d argue that “Mindset” would also be appropriate. In any case, Johnson describes it as follows.

The key to the planning process is to have thought through a number of scenarios so that:

A. You are sensitive to many different possible outcomes or future scenarios

B. You have thought through the early warning signs/markers to be on alert for change

C. You have different plans for the various possible scenarios and have thought through their implementation

D. You are prepared to act when the events dictate a change in plans.

Paul suggests to train your mind to think of alternative future scenarios and plan accordingly.

He argues that the above steps offer an alternative to trying to assess whether or not a “forecast” will be accurate. Instead, he suggests that when you read the paper, watch the news, or hear some pundit predict the future, run through the steps above to train your mind to be sensitive to change, rather than try to assign an arbitrary probability to the scenario. The process will become second nature over time.

Applying mathematical probabilities randomly without much support won’t make you progress and think much. However, thinking about future possible real life events will help you cope better with challenges (whatever it might be).

 

Next post, next week!

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