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Last Updated : May 17, 2019 08:26 AM IST | Source: Moneycontrol.com

Viewpoint | Possibility vs probability & how your inability to distinguish between them affects your financial future

Unlike possibility, the ‘Probability’ is more data-driven and an intelligent way of assessing the chances of something happening. Probability can range from 0% to 100%.

Moneycontrol Contributor @moneycontrolcom

Dev Ashish

As an investment adviser, I frequently come across investors with an uncanny knack of running halfway to meet 'bad luck'! And when the so-called bad luck takes its toll, these people unsurprisingly blame it for all their losses.

So, what is this bad luck? Several times I have found that what many common people (investors) refer to as bad luck, is nothing but their inability to distinguish between the possibilities and probabilities.

Case in point: an investor observed that small-cap mutual funds had been delivering good returns for the past two years, and asked themselves if it is possible that these small-cap funds will continue to do very well next year as well? The answer they deducted is - yes, why not? As a result, he put all his money in small-cap funds.

Unfortunately, the small-cap space went downhill after their decision to go big on the space. As a result, they are sitting on losses, blaming bad luck.

So. What is the difference between possibility and probability in the context of the above example?

Is it possible that small-cap funds will continue to do very well next year too? Yes, it is possible; in fact, anything is possible.

But is it probable that small-cap funds will continue to do very well next year too? The answer to this is a lot more complex.

Since the last two years have been very good for this space, the valuations of small-caps, in general, has run up much beyond their historical averages. Also, standalone high valuations and a big disconnect from large-cap space’s valuation has never been sustainable for long -- at least that is what history tells us. So the party may not last very long and consequently, the probability of small-cap funds doing super well next year too is very low.

Hence, the difference in approach is to have considerations beyond the possibility of just yes and no, which alone is insufficient. We need more information to make the right decisions, which is when the probability comes in.

Unlike the possibility, ascertaining the probability, which can range from 0 percent to 100 percent, is a data-driven and intelligent method of assessing the chances of something happening.

Therefore, just because something is possible, the outcome should not be taken for granted. Rely instead on the probability of ‘that something’ before deciding to act. Think of it like this: anything probable is naturally possible, but not everything that is possible is probable.

Another example to drive home the point: Can mutual fund 'x' deliver 20 percent CAGR for 20 years? While the possibility is yes, what is the probability of this happening? Less than 5 percent, which is very low.

How? Suppose the following possibilities are there for a chosen mutual fund’s estimated returns in the next 20 years:

• Fund delivers 25 percent CAGR for 20 years - possible
• Fund delivers 20 percent CAGR for 20 years - possible
• Fund delivers 15 percent CAGR for 20 years - possible
• Fund delivers 12 percent CAGR for 20 years - possible
• Fund delivers 8 percent CAGR for 20 years - possible

• Fund delivers 4 percent CAGR for 20 years - possible

Now if you have a goal (let’s say) to save Rs 2 crore in 20 years, you will need to choose an estimated return percentage to find out how much you need to invest every month. Naturally, the higher the expected return, the lower will the required monthly investment.

As an investor, you would love to see the first option being realised. As that would mean putting in the least amount every month to reach your goal.

However, can you depend on your choice just because it’s your favourite possibility and works best for you? No. You need to find out how probable each of these possibilities is.

Have a look at the data below when we add some probability* data to the list:
• Fund delivers 25 percent CAGR for 20 years - (1 percent probability)
• Fund delivers 20 percent CAGR for 20 years - (5 percent probability)
• Fund delivers 15 percent CAGR for 20 years - (20 percent probability)
• Fund delivers 12 percent CAGR for 20 years - (60 percent probability)
• Fund delivers 8 percent CAGR for 20 years - (10 percent probability)
• Fund delivers 4 percent CAGR for 20 years - (4 percent probability)

* Hypothetically chosen figures but nevertheless based on general observations of available long-term aggregate data.

It’s clear now which is the most probable future.

Therefore, for your goal of saving Rs 2 crore in 20 years, it would be wise to stick with expectations of 12 percent return if you don’t want to be surprised negatively in future.

All said and done, you should always know the possibilities, but as investors, you are best served by sticking with what’s most probable.

Acknowledgement of this difference will help in your financial future and save you from many financial catastrophes.

When investing, there is a spectrum of possibilities with varying probabilities, which ones should never make the mistake of neglecting.

(The author is the founder of StableInvestor.com)
Not sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.
First Published on May 17, 2019 08:26 am
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