Ten investing lessons from a master of probabilities

Investing isn’t about knowing the future—it is about thriving when you don’t. Clearly, this is easier said than done: Making big decisions in the face of uncertainty is a high‑pressure situation. And it certainly doesn’t help that humans are subject to cognitive biases and behavioral traps that affect our ability to make clear decisions at such moments. Fortunately, as I learned recently, there are steps we can all take to mitigate the impact of these psychological pitfalls on our performance.

As part of the T. Rowe Price Investment Institute’s Expert Speaker series, I recently welcomed Annie Duke to our Baltimore office to record a podcast and speak to our investors. Annie is a former professional poker player and now a renowned author specializing in behavioral science and decision‑making.

Being comfortable with discomfort

Annie explained that there are two main types of uncertainty: incomplete information (epistemic uncertainty) and luck (aleatoric uncertainty). We almost never have all the information we need when making a decision, and even with perfect information, the world is probabilistic. In investment, as in poker, results are a function of both prowess in decision‑making and luck. We are dealing in probabilities: Understanding and articulating those probabilities can improve our process and investment outcomes by calibrating risk and reward and destigmatizing being “wrong.”

"...the best investment decisions are made amid discomfort, not overconfidence."

The most successful investors—and poker players—are those who are comfortable with uncertainty, Annie told us. She cited the influence of her friend (and one of my investment heroes) Howard Marks and highlighted his belief that the best investment decisions are made amid discomfort, not overconfidence. Being comfortable with being uncomfortable and thinking in probabilities of outcome are key traits in superior decision‑makers.

In her book Thinking in Bets, Annie Duke defines “resulting” as the tendency to judge the quality of a decision based on the quality of its outcome. Given there is a component of luck in investment outcomes, this leads to conflating luck with skill and prevents accurate assessment of decision‑making processes. There is information in every trade, good or bad, and there is value in conducting a postmortem. Annie Duke’s approach was to describe a poker hand to her mentor step by step without revealing the outcome so that the reviewers’ judgment was not colored by knowledge of the result. She believes investors should do the same: Focus on the quality of the process, not just the outcome.

Avoid falling into the same old traps

We all have cognitive biases, and we need to be aware of the traps that our own minds lay for us. Resulting is a form of self‑serving bias, where people attribute their successes to their own skill and their failures to bad luck or the actions of others. This bias serves as a comfort blanket for fragile egos but inhibits self‑assessment, leading to overconfidence and a failure to improve.

Another common bias is loss aversion—the tendency for individuals to feel the pain of losses more intensely than the pleasure of equivalent gains. Research shows that this pain/gain ratio is 1 to 0.7. In practice, this means that when winning, people tend to minimize risk by locking in gains prematurely; when losing, they become risk‑seeking by escalating their commitment as they try to recoup perceived losses—the investment equivalent of “playing on tilt” in poker. In investment speak, loss aversion manifests in the risk‑seeking tendency to defend your losers, or average down, and the risk‑minimizing tendency to trim your winners.

Quitting as a strategy, not a tactic

One of Annie’s key ideas, which she outlined in her book Quit, is the importance of quitting as a strategic, not a tactical, choice. She regards the old aphorism “quitters never win” as a damaging myth. On the contrary, she says, winners do quit often and early, cutting losses and reallocating resources to better opportunities. Or put another way, sell low to buy low.

"...winners do quit often and early...."

To illustrate this, she told a story about American rock climber Alex Honnold, who was the first person to free solo a full route of the notoriously difficult El Capitan rock formation in Yosemite National Park. On a previous attempt to climb El Capitan, Honnold, who was accompanied by various friends and was being followed by a documentary crew, abandoned the climb because the conditions didn’t feel right. He just said, “This sucks,” and quit. Despite the weight of expectation from all these people pinned to the rock face to support him, he made the decision to quit because the risks seemed too great.

It might be tempting to simply attribute Honnold’s decision to the fact that he understood the risks, but there are plenty of examples of expert climbers not turning around when they should have. In the 1996 Mount Everest disaster, depicted in Into Thin Air, for example, eight climbers caught in a blizzard died while attempting to descend from the summit after several members of the group ignored the “turnaround time”—a predetermined time at which climbers are supposed to stop ascending and begin descending. The lesson here is that sometimes when we’re focused on a goal, the forces driving us to keep going are so powerful that we carry on even when it is evident we should quit.

Why “kill criteria” are a lifesaver

Annie’s own version of a turnaround time when playing poker was a strict stop‑loss limit. Even expert investors don’t get their quitting decisions right every time. The ability to sell well differentiates average investors from great ones.

Annie believes that investors should hone their sell skills by defining their own “kill criteria”—explicit, ex ante conditions that, if met, trigger an exit. These criteria should be based on the fundamentals of your thesis, not arbitrary price points. It is important to be mindful of common pitfalls such as “thesis creep”—e.g., “I bought this stock as a diversifier, but it persistently correlates with other risk assets or has serially missed earnings, yet it’s too cheap to sell.” The key is to set kill criteria as you initiate a position, or a rating, when you are less emotionally invested and can think more objectively.

"Like going to the gym or yoga, benefiting from learning new skills requires continuous application...."

Organizational culture is vital here. Leaders often reward good outcomes and punish bad ones, regardless of process, which can incentivise risk aversion. Like going to the gym or yoga, benefiting from learning new skills requires continuous application—in this case, applying these principles to every investment decision.

Poker does not map perfectly to the investment world—in poker, the feedback loops are almost instantaneous. Players at a poker table do not exactly replicate market conditions, and markets are not a zero‑sum game. As Annie illustrated, however, poker does offer some invaluable lessons that can be applied in the investment world (see box).