Why we are not as right as we think we are

The types of errors we make in investing with the analogy of a deer and a lion

"Reject first, select after."

This should serve as the guiding principle for making any significant life decision, and it yields particularly valuable outcomes in the realm of investing.

In fact, in my job where I work for a fund that invests in the public markets, our interactions with clients often involve explaining why we choose not to invest in certain themes or sectors within our fund. Many times, clients are surprised by our decision not to invest in specific sectors.

As an amateur in the game, my views become even more solidified when I read from successful fund managers who have been following these principles for decades and also following my colleagues at work who have been doing the same.

The book I recently finished discusses precisely this topic: "What I Learned About Investing From Darwin" by Pulak Prasad. 

Disclaimer: This is a dense book that may require a significant amount of time to read. It certainly did for me, as I aimed to fully absorb all the insights and knowledge it had to offer. The book draws parallels between the theory of evolution and long-term investing.

Pulak Prasad is the founder and fund manager of an exceptionally successful fund that has been investing in Indian companies since 2007.

In this blog, I will concentrate on the principles I have learned from one of the chapters in his book. Specifically, I will delve into the concept of what not to do and the underlying rationale behind the notion that rejecting potential investments initially proves to be a more successful strategy compared to simply moving forward with selections.

In case you haven't had the opportunity to read my previous blog post, where I discussed the concepts of Type 1, Type 1.5, and Type 2 errors, I will try to explain what these terms mean as they are explained in Prasad's book.

There are two types of errors, CFA charter holders and students will be aware of the theoretical explanations:

Type 1 Error: This occurs when I make a poor investment decision, thinking it's a sound one. It's also referred to as a false positive or an error of commission. This essentially means accepting the null hypothesis when, in reality, it's false.

Type 2 Error: On the other hand, this involves rejecting a potentially good investment because I believe it's a bad one. It's termed a false negative or an error of omission. This corresponds to rejecting the null hypothesis even though it's actually true.

It's important to note that reducing the risk of a Type 1 error often leads to an increase in the risk of a Type 2 error, and vice versa. In other words, when you take steps to minimize the chance of making a Type 1 error, you may inadvertently raise the risk of making a Type 2 error, and vice versa.

Please pause and re-read this sentence while taking a few slow, deep breaths to fully grasp the information before moving forward.

Investors must be attuned to the type of error they prioritize while considering the implications of potentially making more errors of the opposite kind.

Pulak Prasad gives examples of reducing these two types of errors through the process of evolution: 

1. The Error of commission or Type 1 Error:

Speaking about Type 1 errors- thinking we made a good decision when in fact it was a poor one, he uses the analogy of a deer drinking water from a watering hole.

If the deer chooses to drink water from the watering hole, it exposes itself to the risk of being attacked by a crocodile or lion in hiding.

The deer has learned through years of evolution and ancestral lineages that if it remains overly cautious, hydration will become an issue, but if it becomes too careless, instant death becomes a problem.

Unlike us, who are only risking our money, the deer is risking its life at a watering hole every single time. Over millions of years, they have learned how to navigate this risk, lest they become extinct.

2. The Error of Omission or Type 2 Error:

Now, in the process of minimizing Type 1 errors, the deer exposes itself to the risk of encountering a Type 2 error.

The thirsty deer might not be able to run fast enough to evade a lion in the jungle if it is not adequately hydrated. This situation arises when the deer chooses to forgo visiting the watering hole due to its fear of the lion.

The deer has to navigate between these two types of errors to ensure survival.

This simple analogy of the deer and the lion can be further applied to identify similarities with errors made while engaging in the investment process, specifically in the context of filtering stocks.

Now, which error would you prefer to minimize in order to enhance your likelihood of success?

Pulak presents an example illustrating why prioritizing rejection should come before selection and supports this with straightforward mathematical calculations.

He illustrates this concept by using data from the year 2018, gathered from the pool of 4,000 listed companies in the United States.

A competent investor would assume that about 25% (roughly 1 out of 4) of these investment opportunities qualify as "good investments." Consequently, we can estimate that there are approximately 1,000 good investments, leaving the remaining 3,000 categorized as poor investments.

Let's consider a scenario where you encounter a star investor who claims that she has a method to accurately identify these "good investments."

She claims that she is accurate 80% of the time. This implies that when encountering a bad investment, she will reject it correctly 80% of the time, and when encountering a good investment, she will choose it accurately 80% of the time.

However, contrary to what one might assume, this investor's accuracy rate is not 80%.

In fact, this star investor's correct prediction rate is possibly only 57%.

1. Here is the first example explaining why this is so:

Considering that there are 1,000 good investments, and given that this investor makes Type 2 errors 20% of the time, she will correctly identify and select 800 companies from this list of good investments.

Likewise, in the market, there exist 3,000 bad investments. Due to Type 1 errors occurring 20% of the time, she will incorrectly classify 600 companies from this list as good investments.

Consequently, her total count of investments she considers good becomes 1,400 (800 + 600).

But only 800 out of these 1,400 investments are actually good, therefore her probability drops down to 800/1400= 57% 

1. Now let's analyze the situation where the investor reduces her Type 2 errors from 20% to 10% while maintaining her Type 1 error rate at 20%.

Out of the 1,000 good investments, she correctly selects 900, and out of the 3,000 bad investments, she wrongly considers 600 as good.

As a result, the calculation becomes 900 / (900 + 600) = 60%. This represents a mere enhancement of 3 percentage points.

3. Let’s see the third and final example.

Suppose the investor becomes more adept at rejecting investments and decreases her Type 1 error rate from 20% to 10%. Consequently, she would only choose 300 bad investments from the pool of 3,000.

While her Type 2 error rate remains unchanged, 80% of the good investments are accurately identified, resulting in the selection of 800 investments.

Hence results in a total of 1,100 investments selected, out of which 800 are actually good, therefore 800/(800+300)= 73%! A substantial increase in the success rate.

This example underscores the significance of prioritizing the reduction of Type 1 errors, as it leads to a more substantial improvement in the accuracy of identifying good investments.

Hence, by grasping the concept of Type 1 and Type 2 errors, we realize that the number of investments an investor perceives as good will likely be higher according to their expectations compared to what aligns with reality.

This table encapsulates the relative impact of each error on investing: 

For both the deer and the investor, evaluating the types of errors they are committing holds pivotal importance in their decision-making processes.

In an extreme scenario where both Type 1 and Type 2 errors are reduced to 10%, her success rate improves to merely 75% an increase of 2 percentage points. Without explaining in detail, here is the math: 900/(900+300)= 75%

This underscores the argument that while investment literature and education emphasize selecting good investments, individuals would benefit more from understanding how to avoid poor investments.

I also addressed Type 1, Type 2, and even Type 1.5 Errors in another one of my blog posts titled 'Quitters are Winners.' There, I discussed how making timely decisions to quit, both in investing and life, serves as a key factor in making progress.

So, what's the solution? I can think of a few things here:

1. You can either embrace this reality and empower yourself with the tools to filter out stocks, or you can invest in a fund that potentially adheres to this philosophy if you believe this is an appropriate process
2. If you are a DIY investor it is better to understand which sectors you specifically wish to avoid due to the operating metrics of that sector so as to reduce your probability of risk
3. Risk is always prevalent, over time you learn where not to invest to reduce the probability of risk. The game of investing should involve the mitigation of risk as much as humanly possible to increase the probability of winning by adhering to set processes
4. Regardless of your level of experience, you will make Type 1 and 2 errors so it is better to understand why you went wrong so as to prevent the probability of you making that same mistake again
5. Buying a great business at a fair valuation is crucial because even buying an excellent business at an absurd valuation will lead to the erosion of your capital