Time and Probability

Two of the hardest things to relate to in life are time and probability.

Time has a mysterious tendency to seem long or short depending on perspective, and probability has a surprising ability to be different than we think. In combination, the two phenomena can wreck havoc with our personal finances.

If we think in linear terms and focus too much on the immediate future, we are going to get things wrong. The temptation to do this is great, though. The immediate future is almost always pretty much identical to the immediate past. That gives us a very high probability of guessing the future right. However, what is often overlooked is that the gains achieved by getting things right based on this type of thinking are much smaller than the losses taken when we get things wrong.

Let us say that we discover a pattern that works 90% of the time.

Based on this fact alone, we would think we have discovered a sure fired way to make money from nothing. We simply place our bets with regular intervals, and reap the returns.

However, if the returns are 10%, while the losses are 90%, we gain nothing.

This is why day-traders very rarely last more than a few years.  Sooner or later, the pattern that was a sure winner, becomes the big loss.

The same is true for structured bets on probabilities. The XIV product, which was a bet on stocks neither going up nor down very much, was completely wiped out at a mere 10% correction.

The way to deal with our inherent tendency to think linearly is to look at things in very long perspectives. Recognizing where we are in a mega-trend makes it easy for us to put things in perspective, and make the investments that will weather the storms.

This is the strategy I recommend in my book on the subject. By studying mega-trends we can easily identify the things that are likely to do well over the long run.

For this to work, we have to be careful not to get ourselves into debt or in other ways become dependent on short term returns. Mega trends can take a long time to complete. If we are forced to sell before they become profitable, we are no better than the day-traders who find themselves caught by a sudden and unexpected down turn.