How Probability Can Improve Your Investing

dice probability chance gambleInvesting is never about hitting home runs with every investment that you made. There was once an interview with Charlie Munger, Warren Buffett’s partner in investment and Vice Chairman of Berkshire Hathaway, at which he reveal that Warren Buffett approaches all investments in terms of binomial probabilities.

The What Probabilities?

Don’t let the term scares you, we have all learned about binomial probabilities during our school days. It is basically asking ourselves how each possible scenario would actually occur in term of a percentage. This method can help us be more open-minded about our investments and allow us to take a different course of action if our investment has not turned the way we expected it to be.

For example, if we look at City Development (SGX: C09) today, there are a few things we need to consider using binomial probability.

1)      What is the probability of a sharp slowdown in the property market in Singapore?

2)      What is the probability that CDL is not able to grow its international business?

We can then make our analysis and valuation in term of each scenario with the help of our deductions. This allows our analysis to be more flexible and give us a chance to view a business from all angles. After all, there are many things that are beyond the control of us or even the management of the company. However, if we have an understanding of the risks involved, we can determine if the price we are going to pay for the stock is sufficient to compensate us for the uncertainty.

Going back to our example with City Development (and this is a very simplistic example), assuming we valued the company at S$ 15.00 per share under the assumption that it can successful grow its international business and we valued it at only S$ 6.00 per share if the company failed in its international expansion plan. We can then add the two estimated values together using binomial probability. Taking a simple 50/50 approach for this case, our estimated value of the company will then be:

Value per Share = (S$ 15.00 X 0.5) + (S$ 6.00 X 0.5) = S$ 10.50

In this assumption, buying the shares below this value will then be enough to cover the risk we are taking.

Foolish Bottomline

This is of course a simplified version of how to go about using binomial probabilities in our analysis. Nevertheless, all investing approaches are more guidelines than fixed law, it is important for us to create an approach that suits us personally.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.