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Money Wisdom – The Perils Of Blindsided Optimism: Neglect Of Probability

Suresh & Mahesh are planning a Goa trip this coming weekend. Besides the beaches, clubs and shacks, the big draw is the possibility to hit the jackpot on the Roulette table. (The probability of getting that one right number is ~2.7%, this too for every round they play !)^

The enthusiasm of winning blinds us to the chance of it happening. This is ignorance about the Neglect of Probability bias!

The story is an illustration of this bias. Let us understand more about the same in this edition of Money Wisdom.

Under the influence of this bias, we respond to the expected magnitude of an event, but not its likelihood. We lack an intuitive grasp of probability. Simplistically speaking, we focus on working towards or expecting what should happen but totally disregard the chance of that happening.

From the perspective of Investing and Financial markets, a few examples :

1). Many start-up investors are investing in young companies with an intent to back the next big Amazon, Microsoft or any billion dollar company. Many investors forget on how many companies have been able to achieve greatness and how there have been countless businesses which have not been able to survive beyond the first few months or years!

2). In terms of investments, we only focus on the expected or even desired returns, but we don’t look at the historical patterns of volatility to gauge what can be the range of expected returns, (especially in shorter time horizons), which can be quite high. Average returns can be misleading, but information on minimum-maximum range of returns can help you assess what can be the possible returns in the (especially) short to medium term. Using past patterns and current fundamental setup of markets we should be able to make right choices. Many-a-times, we wrongly assume that every bet of the future is grounded in absolute certainty of success.

So how can we avoid being a victim of this Bias, in financial markets or in life:

1). Focus on looking through the lens of return expectations and risk assessments

2). Be a student of stock market history and data patterns of market returns

3). Always build strategies using probabilistic thinking.

4). Build appropriate margin of safety to cushion from future uncertainty & possibility of ‘things not going as envisaged or planned’.

Nature has given us a pair of eyes. Poetically speaking, focus one eye to see a vision of ‘possibilities’ but ensure the other eye is keeping an eye on ‘probabilities’.

Let’s watch this video where Rolf Dobelli explains us about the Neglect of Probability bias and how not to be a victim of the same.

 

^38 numbers(0-36 & 00) in American roulette and 37 in others(0-36). Most people don’t count this so they wrongly assume a favourable ratio, the actual odds are 1/37=~2.7%

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.

Team IDFC
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