Michael Mauboussin: Put Expected Value In Your Valuation Toolkit

In this article, Michael Mauboussin explores how investors can generate excess returns by focusing on the gap between price and value, emphasizing the practicalities and psychology of expected value in investment decisions. He explains that while price is observable, value is inherently probabilistic, requiring careful estimation of possible payoffs and their probabilities.

The paper covers the challenges of modeling uncertainty, the importance of considering both probabilities and payoffs, the psychological hurdles investors face (like loss aversion), and best practices for applying these concepts across asset classes.

Here are the key takeaways:

• Expected value is central to investment decision-making, requiring a thoughtful assessment of both the range of possible payoffs and the probabilities attached to each.

• The frequency of being right (batting average) matters less than the magnitude of gains when right versus losses when wrong (slugging ratio)—a concept Michael calls the “Babe Ruth effect.”

• Investors often struggle with uncertainty, overconfidence, and loss aversion, which can distort decision-making and lead to suboptimal outcomes.

• Using base rates, scenario analysis, and simulation helps reduce bias and improve the quality of forecasts, while maintaining a margin of safety is essential to manage risk.

• Different asset classes (public equities, buyouts, venture capital) have distinct profiles of probabilities and payoffs, affecting the dispersion of returns and the importance of access and skill in generating excess returns.