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The Probabilistic Theory of Relativity

“A reasonable probability is the only certainty.” – Edgar Watson Howe

In Einstein’s Theory of Relativity, he postulates that space and time are relative to the person observing them. That a set of twins, one standing here on Earth and the other shot at the speed of light to the edge of the universe and back, will be significantly different in age when the twin returns to Earth, even though neither one of them noticed a difference in how time passed. In fact, if I take off on a cross country flight and my wife stays at home, I will be slightly younger than her when I arrive on the West Coast. In these examples, time and space are not continuums rather they are experiences. Careers are devoted to understanding Einstein’s theory, so we will not go into the science here, but understanding relativity is important for us as investors.

Knowledge itself is relative. I do not know if a company I’m invested in will beat earnings but the CFO surely does. In this case, uncertainty becomes relative and dependent on our differing levels of knowledge. If I, the investor, am assigning a probability of the company beating earnings, I will base it on my compiled knowledge of the company. As my knowledge changes, I will change my probability of success. The CFO will do the same thing, but his base of knowledge is different. This is described in statistical parlance as epistemic probability. Epistemic is the antagonist of aleatory probability (i.e. coin-flips) which is described by statisticians as an uncertainty due to randomness. No matter how much knowledge I gain, I will never know the outcome of a coin-flip, only the probability of its outcome.

Investing is not like coin-flips, blackjack, or poker in our ability to define aleatory probability. But that does not mean that we should give up on estimating an epistemic probability. In fact, it should be the foundation of our investment process. Gene Gigerenzer describes Degrees of Belief in his book “Calculated Risk”, “The point here is that investors can translate even onetime events into probabilities provided they satisfy the laws of probability – the exhaustive and exclusive set of alternatives adds up to one.  Also, investors can frequently update probabilities based on degrees of belief when new, relevant information becomes available.”

In investing, you are forced to invest with the knowledge you have today. There are no certainties and, as a result, we must accept that every investment thesis is based on a probability (degree of belief) of an outcome. For examples sake, let’s say that our degree of belief is 80%. This creates a vacuum that can only be filled by describing outcomes that make up the other 20%. In this vacuum, lies the elegance of probabilistic investing. It is an imperative calculation for every investment because it requires you to consider all the possibilities and it provides the flexibility to incorporate ever-changing research.

About Cameron Hight

Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and President of Alpha Theory™, a Portfolio Management Platform designed to give fundamental money managers the ability to create their own repeatable discipline to organize the complex process of portfolio management.
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