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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.

Value is the hard part. This is because value is really “expected value,” which represents a range of potential payoffs with associated probabilities. Investing is an inherently probabilistic activity.

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Disclaimer of liability

The above has been prepared by Børsgade ApS for information purposes and cannot be regarded as a solicitation or recommendation to buy or sell any security. Nor can the information etc. be regarded as recommendations or advice of a legal, accounting or tax nature. Børsgade cannot be held liable for losses caused by customers’/users’ actions – or lack thereof – based on the information in the above. We have made every effort to ensure that the information in the above is complete and accurate, but cannot guarantee this and accept no liability for errors or omissions.

Readers are advised that investing may involve a risk of loss that cannot be determined in advance, and that past performance and price development cannot be used as a reliable indicator of future performance and price development. For further information please contact info@borsgade.dk

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