October 2022 Commentary

We all tend toward innumeracy generally, and we’re
especially bad at probability.

If a weather forecaster says that there is an 80 percent
chance of rain today and it remains sunny, instead of
waiting to see if it rains 80 out of 100 times when his or her
forecast called for an 80 percent chance of rain (or even
eight in ten), we race to conclude — perhaps based upon
that single instance — that the forecaster isn’t any good.
To do math, neither maturity nor knowledge of human
nature and experience are required. All that is needed is the
ability to perceive patterns, logical rules, and linkages. But
because of the enormity of random variables involved in
real life, patterns, logical rules, and linkages alone do not
solve many actual puzzles. Correlation does not imply
causation. Information may be cheap, but meaning is
expensive and elusive. Insight is priceless.

If one reads an investment disclosure – yes, that would be
the small print at the page bottom – odds are the
information will incorporate some quantitative description
pertaining to “risk”. That measure will ascribe its meaning
to one of the buzzwords (Sharpe ratio, R-squared, standard
deviation, correlation, etc.) derived from the bell curve,
that symmetrical graph representing probability
distribution.

Such measures of future uncertainty satisfy our human’s
ingrained desire to “simplify” by squeezing into one single
number matters that are too rich to be described by it. In
addition, they cater to psychological biases and our
tendency to understate uncertainty in order to provide an
illusion of understanding the world.

Daniel Kahneman offers an interesting explanation for why
it is so difficult for people generally to compute and deal
with probabilities. He said, “to compute probabilities you
need to keep several possibilities in your mind at once. It’s
difficult for most people. Typically, we have a single story
with a theme. People have a sense of propensity, that the
system is more likely to do one thing than the other, but it’s
quite different from the probabilities where you have to
think of two possibilities and weigh their relative chances of
happening.”

Accordingly, when assessing the effectiveness of a given
financial, economic or social strategy, the observation
window needs to be large enough to include substantial
deviations. Therefore, one must base strategies on a longtime frame but,
in some situations, you will never see all the
components. And so, to extrapolate the Russia/Ukraine
crisis, or rising interest rates, or geopolitical interference
into predictions of long-term market or business/economic
weakness are, at best, fraught with probability bias. Or
described another way, Mandelbrot and Taleb would refer
to this as “wild randomness.”

Weight, height, and calorie consumption are “Gaussian” –
they can be described by normal distribution. Market
returns, distribution of incomes, casualties in terrorist
attacks or wars – these are all man-made variables of wild
uncertainty. The normal bell curve has thin tails, where
large events can be considered but are far too rare to be
consequential. Wild randomness describes distributions
that have fat tails – a higher probability of extreme values
that can have a dramatic impact on the outcome.

Which is why we at Laurus do not try to fathom
unpredictable macro factors such as consumer or political
actions, long-term inflation, or the reaction of business
growth to inflation, or the reaction of markets to the
reaction of business growth to inflation. There are too many
variables to solve these equations.

Successful long-term investing is ultimately the outcome of
very specific selections, and this is where we will continue
to devote our efforts. Laurus’s investment process is
entirely geared to identifying those unique business models
that separate the top achievers from the rest of the pack.
While market and exogenous valuation influences will
guarantee that performance will fluctuate in the short term,
experience has shown that, while our formula may not work
during particular months or even quarters, it does tend to
work over several years. Great businesses, like great
athletes, will always triumph.