Investing and probability

Can probability help our investment decisions?

Chance.  Likelihood.  Possibility.  Odds.  Prospects. 

All are synonyms for Probability as far as Thesaurus.com is concerned.

People hearing the word probability may think sports betting or shudder at the memory of the college statistics class they passed – barely.  When they do, they may decide probability is best left alone.

However, probability is a tool we use without thinking about it.  For instance, I might look at the clouds in the sky and think there’s a good chance it will rain today.  You may see a new fishing rod or pair of shoes in the store and believe the odds are slim your significant other will approve of the purchase.  Our kids may peek at candy on the counter and believe the possibility of snagging it without mom or dad finding out is pretty good.  These are examples of probability assessments we use more often than we realize.  As a result, we should not consider probability a daunting math exercise but a subjective, beneficial tool to have on the road of life.

As useful hardware in our toolbox, probability can be employed in our investment decision making similar to the way in which Warren Buffett approaches it.  Probability, deployed within our investment screening and stock selection process, can make us better, more consistent investors by reducing risk.

It seems helpful to use simple probability within the framework of the Dividend Farming Scorecard to demonstrate how it can be put to work.  In this case, the general measures of probability (Low, Medium, High) are applied to each factor within the card.  Each item is also classified as negatively or positively influencing the business. 

Since financial success hinges more on avoiding investment potholes than scaling winners, I’m using probability to narrow the chance I’ll make a poor investment decision.

Reduce risk, increase reward.

For instance, if a company is a Dividend Champion, I believe the probability the firm’s history of dividend increases will continue is “High”.  The corollary assumption is that the chance of a poor outcome by investing in a Dividend Champion is low. 

Below is a general Dividend Scorecard with sample probability assessments and assumed business effects.

FACTOR	METRICS	Probability	Business Effect
CCC List	Champion	High	Positive
Current Yield	4.0%	High	Positive
Company Profile	Red Flags	Medium	Negative
Industry Leadership	Top 10	Medium	Positive
Market Cap	$10 B+	Medium	Positive
P/E	< 20	Medium	Positive
P/B	< 2	Medium	Positive
Debt / Equity	< 1	High	Positive
Dividend History (Years)	25	High	Positive
12 Month Price Range	Lower Half	Medium	Positive
Dividend Payout Ratio	< 75%	Medium	Positive
Portfolio Weight	Slightly Over	Low	Positive

These probabilities and assessments of their influence on the business represent my subjective view.  You might use different factors and probability measures or have alternative thoughts on how those factors can influence a firm’s prospects.

Be aware that firms under analysis rarely present uniformly positive factors.  Consequently, each of us needs to determine how many negative factors we may be willing to accept or to what degree we think any negative factor is acceptable when making the investment decision. 

Regardless of how they’re constructed, frameworks like the example above provide a repeatable method of analyzing investment opportunities.  Such practices help standardize our decision process and improve consistency.  Efforts grounded in facts and logic versus emotion and hyperbole improve our decision quality as well.

When our decisions become consistently better the risk associated with making repeated, poor decisions declines.  Minimizing poor decisions adversely affecting our financial performance leads to success.  In the end, isn’t that what we want? 

  

The thoughts expressed here are those of the author, who is not a financial professional.  Opinions should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.