We had the privilege of hosting Pulak Prasad over a webinar with our clients upon the launch of his brilliant book “What I Learned About Investing from Darwin”. The book is rich with investing insight drawn from the world of evolutionary biology. One specific lesson was about Type 1 (picking a bad stock) and Type 2 (missing out on a good stock) errors in investing and how the former is far more important to avoid. In this blog, Jana Vembunarayanan builds on the concept and drives home the point mathematically and quite brilliantly at that.
“A star investor claims to be right 80% of the time in their investment decisions. When presented with a good investment opportunity, they will identify it correctly 80% of the time. Similarly, when faced with a bad investment, they will reject it 80% of the time. If this star investor makes an investment decision, what is the probability that it is a good investment?
The quick answer that comes to many is 80%. However, that is an incorrect answer. The right answer is 57%. Why is that the case? We cannot answer this question without knowing the base rates, which tells us what percentage of potential investments available to the investor are good business opportunities.”
The blog is worth the read in its entirety as the author uses the concept of base rates, sensitivity and specificity graphically to make the point:
“Avoiding bad investments is more important than identifying good investments….A dramatic improvement in investment performance occurs when the rate of Type 1 errors (false positives) is reduced. This happens when we minimize the error of making bad investments. Buffett is the best investor in the world because he is the best rejector in the world. A great investor is a great rejector.”
At this stage of the bull market, it is tempting to believe base rates are higher than they actually are.
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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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