Everything Not Zen: Finding Return Opportunities Amidst Renewed Market Volatility – Part III
A guy walks into a bar, orders a beer, and declares that the Yankees are going to win the 2019 Pennant. This is their year and there is no doubt.
Another guy walks into a bar, orders a beer, and declares that the Yankees are going to win the 2019 Pennant…with 48% probability.
The first situation is much more common than the second. If it isn’t the Yankees it is another team, or a political candidate, or a company that is poised to disrupt some industry, or a company that is poised to be disrupted. Pick a subject. People tend to take a position on the way the future will unfold and act as if no other outcome is possible. They have examined the facts as they have perceived them, and their mind is made up. Period.
Zen city
The second situation is rarer than the first. People don’t typically express their views in terms of probabilities. This is unfortunate–thinking probabilistically is the correct way to think about most situations in life. The future is inherently uncertain and adopting a decision-making framework that accounts for the many different outcomes that could unfold only seems logical. Investing is no exception.
Part II of this series (which you can find here)showed how probabilities surrounding cash flow scenarios are incorporated into security prices, and how changes in the market’s perception of these probabilities can lead to mispricing. This final part of the series will look at the belief updating process in more detail to understand how new information should be incorporated into security prices. We will also see how this process can go wrong. Identifying the mistakes of other investors is key to finding investment opportunities.