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The Equitymaster Research Digest

Probabilities, Black Gold, and More...
Dec 1, 2015

Can you guess the most common type of question that fundamental research analysts put to each other?

It always starts with the same two words: 'What if...'

Our research tends to focus on long-term investments - far longer than most investors invest for. Therefore, it is important to keep different scenarios in mind before arriving at a view. The way to do it is with the help of what mathematicians call 'probabilities'.

If a stock is trading at 52-week lows, we ask if things could get worse. At 52-week highs, we check the probability of things getting any better. But most importantly, we use the 'What if' scenario to test the probability of losing money in the stock. Mitigating the risk for subscribers is always on top of our minds. Hence, the worst-case probabilities get our maximum attention.

Legendary value investors like Graham and Buffett have emphasised the importance of spreading one's risk. Graham, in fact, recognised the need to diversify one's portfolio so as to overcome probability of loss in uncorrelated events. This is what he wrote in Security Analysis, considered to be the Bible of stock investing.

  • The instability of individual companies may conceivably be offset by means of thoroughgoing diversification.

    There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor's favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss - not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.

    A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss. The individual probabilities may be turned into a reasonable approximation of certainty by the well-known practice of 'spreading the risk'. This is the cornerstone of the insurance business, and it should be a cornerstone of sound investment.
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