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All Knowledge is Probabilistic: An Investor's Guide

Updated: Feb 13



In the realm of investing, uncertainty is the only constant. Amid the myriad of factors that influence the global financial markets, the dictum that "all knowledge is probabilistic" is crucial for every investor to grasp. This assertion suggests that all the information we have, even if it seems certain, is actually based on probabilities. In a world of rapidly changing financial markets, the acceptance that "all knowledge is probabilistic" equips investors with a tool to handle uncertainty more effectively. Going beyond the foundational understanding, it’s vital to see how this approach can be deeply integrated into investment strategies.



The Nature of Probabilistic Knowledge


The notion that "all knowledge is probabilistic" is rooted in the belief that absolute certainty is elusive. In simple terms, it means every piece of information, no matter how reliable, has an element of doubt or uncertainty. This can be due to incomplete data, changes in external factors, or the inherent variability in complex systems. Example: Consider a coin toss. Even though we understand the physics of a coin toss, predicting whether it will land heads or tails on any given throw is a 50-50 proposition, a pure probability.


Probabilistic Thinking in Investing


For investors, probabilistic thinking involves assessing the likelihood of various outcomes and making decisions based on these assessments. It's about understanding and quantifying uncertainties. Example: Imagine a pharmaceutical company is awaiting FDA approval for a groundbreaking drug. If the drug gets approved, the stock price might soar. If not, it could plummet. An investor might assess a 70% chance of approval based on available data. However, it's essential to recognize that even with a 70% probability, there's still a 30% chance of the drug not getting approved.


Why Probabilistic Knowledge is Essential for Investors


  • Risk Management: Recognizing that all decisions carry some degree of risk encourages investors to diversify their portfolio. If an investor puts all their money into one stock, believing it's a sure winner, they expose themselves to significant risk. Understanding probabilities helps investors hedge their bets.

  • Avoiding Overconfidence: Understanding that knowledge is probabilistic guards against overconfidence. Overconfident investors often overlook risks, which can lead to catastrophic losses.

  • Better Decision Making: By assessing the probabilities of different outcomes, investors can make more informed choices, weighing potential returns against associated risks.

  • Embracing Uncertainty: Accepting that all knowledge has an element of uncertainty can help investors remain calm during market volatility. Instead of panicking during downturns or becoming overly exuberant during booms, they can make decisions with a more level head.


Practical Application for Investors


  • Scenario Analysis: Investors can imagine a range of possible outcomes and assign probabilities to each scenario. For instance, considering best-case, worst-case, and most likely scenarios for a company's quarterly earnings.

  • Bayesian Thinking: This involves updating one’s beliefs as new information becomes available. If our hypothetical pharmaceutical company releases positive preliminary data, the investor might adjust the probability of FDA approval upwards.

  • Margin of Safety: Legendary investor Benjamin Graham preached about the importance of a "margin of safety". By purchasing stocks at prices far below their intrinsic value, investors give themselves a cushion against unforeseen negative events. Example: Suppose an investor believes there's an 80% chance a particular stock is undervalued. Buying that stock offers a margin of safety. If they're wrong, and the stock's true value is lower, they've minimized potential losses. If they're right, they stand to gain substantially.



In probabilistic thinking, it's not just about assigning a single percentage chance to an event. It’s also about understanding the entire distribution of possible outcomes. A probabilistic distribution provides a graphical representation of the likelihood of all possible results. Example: If you're evaluating a tech startup's potential return on investment (ROI) over the next five years, instead of just saying there's a 60% chance of a positive ROI, you might visualize a distribution. This could show a 10% chance of a -50% ROI, a 20% chance of a 0% ROI, a 50% chance of a 100% ROI, and a 20% chance of a 200% ROI.


The Role of Subjectivity


When considering probabilities in investing, it's crucial to remember that these aren't objective truths. Different analysts can look at the same data and come to different conclusions based on their subjective interpretations, past experiences, and biases. Example: Two investors analyzing a renewable energy company may assign different probabilities to its success. One investor, with a background in fossil fuels, might be skeptical and foresee a 40% success rate. In contrast, another, with a background in green technologies, might predict a 70% success rate.


The Benefits of Probabilistic Groups


Creating investment teams or committees where each member assesses probabilities independently can be beneficial. By aggregating these individual probabilities, one can arrive at a more nuanced and balanced overall assessment. Example: For a real estate investment, five members of an investment committee might assess the probability of profit at 60%, 70%, 65%, 75%, and 80%. The average, 70%, can be used as a consensus estimate, reducing individual biases.


Continuous Learning and Adjustment


Probabilistic thinking in investment isn't a one-time assessment. The market environment is dynamic. Thus, probabilities should be constantly adjusted as new information emerges. Example:

An investor might initially assess the likelihood of a retail company succeeding in a new overseas market at 75%. However, if news breaks out about political instability in that country or a major competitor entering the same market, the probability should be revised.



Coined by Nassim Nicholas Taleb, a "Black Swan" is an unpredictable event that has a massive impact. Probabilistic thinking should account for these rare but significant events, even if their precise prediction is challenging. Example: The global financial crisis of 2007-2008 and the COVID-19 pandemic are examples of Black Swan events. While their exact occurrence was hard to predict, portfolios that were designed considering such unforeseen events fared better than those that didn't.


The world of investing is a complex dance of numbers, trends, and human behaviors. Embracing the philosophy that "all knowledge is probabilistic" provides a sophisticated lens through which investors can interpret this dynamic landscape. Rather than seeking elusive certainties, investors are better served by understanding the myriad probabilities that underpin every decision. By continuously refining these probabilistic assessments in light of new data, considering diverse opinions, and preparing for both predictable and unforeseeable events, investors can achieve a strategic edge. This probabilistic approach promotes not just financial acumen but a broader appreciation for the intricacies and uncertainties inherent in both the market and life itself.

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