There are many skills that can help investors arrive at sound investment decisions. A good grasp of topics like strategy, finance, accounting and valuation is clearly high on the list, as is an ability to put together disparate pieces of information to form a cohesive picture of what is happening in an industry.
One skill that we think is highly relevant, but which doesn’t get quite as much attention, is an understanding of how probability and statistics affect investment calculations. We humans have highly developed instincts that have helped us survive countless generations of natural selection, but when it comes to probability, we sometimes get the wrong end of the stick. In some cases, the answer that feels right may be very wide of the mark.
Lies and statistics
Let’s look at an example. Suppose we have identified what we think is an excellent business, with an ability to raise prices year after year without impacting demand. What’s more, let’s suppose that we find this business trading in the market at a significant discount to our estimate of its intrinsic value. We think the company is worth $1.50 per share, but the share price is only $1.00.
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