Tuesday, September 11, 2007

Probabilistic Thinking and the 80/20 Rule

The human brain is inherently bad at dealing with probabilities. This is largely evident in the field of investing where investors try to handicap companies as potential investments, especially in the face of uncertainty. Investors should strive to improve their cognition of probabilities and operate with a frame of mind that helps to compensate for our wiring at birth. As well, investors need to avoid information overload, a few key variables is all one needs to handicap the odds of an investment’s success or failure.

Successful investors think in terms of probabilities, as Charles Munger noted in his 1994 lecture to the University of Southern California , “Buffett…automatically thinks in terms of decision trees and the elementary math of permutations and combinations…” Mr. Munger prescribes that everyone should understand elementary probabilities such as permutations and combinations, as well as decision trees, which are taught in middle school or earlier. For those who wish to learn more or refresh their memory there is a list of books on probabilistic thinking at the end of this article. As well, there is plenty of information available on the internet.

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