What are the chances of getting heads or tails when flipping a coin? Given that there are only two possible outcomes, even the average fifth grader could probably correctly answer is 50-50.
But what if the last 10 coin-tosses resulted in heads? What do you think the odds are of landing another heads on the next flip? While the answer is again 50-50—after all, there are still only two possible outcomes—many of us might feel like tails is likelier to come up after a long consecutive string of heads.
That feeling, known as the Gambler’s Fallacy, can lead us astray when it comes to assessing probability, or the odds of an event happening. Unfortunately, such misunderstandings about probability can affect investors, too, perhaps steering us toward poor decisions that don’t align with our risk tolerance and time horizons.
Indeed, I’d argue that a proper understanding of the probability of investment outcomes is the most important factor in determining your portfolio’s success. Otherwise, you are either guessing about its chances of performing well, or you’re abdicating that responsibility to an investment advisor, who may not have your best interests at heart.
While there are certainly no guarantees when it comes to investing, if you understand your timeline and your objectives, you can use probabilities to remove much of the uncertainty in the decision-making process and help you confidently manage your investment portfolio. Here’s how.
Consult historical data
While past performance of an investment asset is no guarantee of future returns, we have a large data set of historical evidence to help us understand how the markets have performed over the past 100-plus years. This provides a good proxy into the true nature of markets and how they are likely to behave in the future.
The following chart, courtesy of Ben Carlson’s A Wealth of Common Sense, speaks to the probability of outcomes by time frame if you are invested in large-cap North American equities (given that the S&P 500 is the single best gauge of that market).
Based on historical performance, the longer your investing time horizon, the higher your probability of seeing a positive return in the North American large-cap equities market. This does not mean that these returns are guaranteed. We know the future is uncertain. But when it comes to investing in anything—stocks, bonds, real estate—always think in terms of probabilities, not guarantees. If you have enough data, you can calculate the odds of a specific outcome.
Avoid rules of thumb
Many investment conventions are based on a one-size-fits-all approach that don’t make sense when you look at your specific circumstances.
Let’s assume, for example, you are 75 years old, you do not need to draw income from your investments, and you plan to leave most of your investment capital to your children. While the conventional investment wisdom is to move toward a portfolio with a greater proportion of fixed income assets as you age, this assumes that you have a lower risk tolerance during retirement, which is not the case here. Rather, because your investing horizon exceeds your life expectancy, your tolerance for equities remains high.