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August 4, 2010

Probably is not a Probability

If I tell you that I believe something is likely to happen, what probability would you give my usage of "likely"? How do you know it is the same as my estimate of "likely"? We all use probability expressions in our conversations to express differentiated levels of uncertainty. The problem is that my expression may not match your interpretation. The further the gap between the two, the more flawed the decisions that come from the conversation will be.

I've often been asked by portfolio managers, why I think it is important to force analysts to come up with a discrete probability. Closing the gap between my meaning of "likely", "probably", "possibly", "almost certainly", "maybe", "slim chance", etc. and your interpretation is a critical reason.

There are numerous studies that find that one person's intentions generally (look, another probability expression) don't match their interpretation. These studies show that many times the gaps are so vast to make the words meaningless.

As a portfolio manager, the most important goal is to accurately capture the economic impact of an asset in your portfolio and size the position based on that impact. Without an accurate assessment of probability, that task is rendered ineffective.

There is a considerable amount of literature on the subject and I've chosen a few that prove my point. There are studies that show that certain probability expressions on average have similar meaning. However, the variance between individuals was great and we are talking about interpersonal relationships where the expression of probability can have a huge impact.

Check out the studies for proof that Probably is not a Probability.

"How probable is probable? A numerical translation of verbal probability expressions", Ruth Beyth-Marom, March 1982

"Adolescents' and adults' understanding of probability expressions", Michael Biehl, May 2000

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