Investors express discomfort when things are uncertain. This is especially true when experiencing “heightened uncertainty,” such as with the current Eastern European conflict.
However, uncertainty is not just a circumstance of economic and investment markets, it is a fact of life. Our future, by definition, is uncertain. There are times when the future is less uncertain (the sun will rise tomorrow), but there are seldom, if ever, guarantees of future outcomes. In other words, life happens in probabilities. Learning to consider probabilities in our decision-making process will help us become more comfortable living with uncertainty.
The Probability Problem
The greatest challenge to thinking in probabilities is that it is just not natural. While gray matter fills our brains, they hate gray areas. They want to think in terms of certainty and will often convert a probabilistic scenario to either “will happen” or “will not happen.” An 85% chance of rain? The brain defaults to, “it’s certain to rain.”
When it comes to investing, we often hear terms such as “risk on” and “risk off” as if investing is just a switch. Investors similarly think in terms of “all in” or “all out.” This type of binary decision-making is natural, easy, and reinforced by the media. But it may lead to costly investment decisions.
Investing Probabilistically
Investing probabilistically is about adjusting your allocation, rather than making a significant move that amounts to a bet on which way the market will go. When the perception of the risk/reward balance is unfavorable, a small shift to safer assets is in order. And vice versa when the risk/reward balance is more favorable.
Because we cannot divine the future, the correctness of an investment decision should be based on strategy and probability, not the outcome. A good practice is to stop guessing what the market will do in the future. It cannot be known. Instead, consider making probabilistic adjustments proportionate with your risk tolerance. That will help you become more comfortable investing amid uncertainty.
©2022 The Behavioral Finance Network
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