Mauboussin Gives Us Confidence

Alpha Theory is in the business of getting people to think probabilistically. In doing so, distinguishing between probability and confidence, probability can be confusing. Michael Mauboussin’s new piece, “Confidence: Methods to Assess Confidence Under Uncertainty,” discusses the distinction and helps investors understand some approaches to estimating confidence.

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"Investing is an activity that is inherently probabilistic. Nearly all investment opportunities present a range of possible outcomes with some chance of occurring. The goal is to invest in situations where the expected value, the sum of the potential outcomes times the probability that they happen, is different than the price.  

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Coming up with thoughtful probabilities can be hard. Academics who study the intelligence community find it useful to distinguish between probability and confidence. Probability is an “estimate of the chances that a statement is true” and confidence is “the degree to which an analyst believes that he or she possesses a sound basis for assessing uncertainty.” The important point is that these are distinct concepts that often get combined. We believe that it is useful for investors to separate them."

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We wrote on this topic in 2009, sharing Cameron Hight's experience of comparing the probability of placing bets to the investment process with risk-adjusted return. In the experiment, Cameron is offered two bets. In bet number one, he is paid $150 for every head and $100 for every tail of a coin flip. In bet number two, he is presented with a bag of poker chips that are only black or white. He receives $150 for every white chip he pulls out and must pay $100 for every black chip he pulls out. Which bet would he prefer? Likely, the coin-flip bet because he is more certain about the distribution of probabilities.

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What we found is that this same logic also applies to investing. You may have high certainty in your probabilities for one investment and low certainty in another. They both may have the same risk-adjusted return, but you are not willing to invest in them equally.

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Give Michael’s new article a read. And, while you’re at it, see here for our 2009 blog entitled “The Probability Problem” for a riff on the Ellsberg Paradox in explaining the difference between probability and confidence.