Especially in asset allocation, the general industry is trained toward thinking about “expected returns”. While mathematically expected returns are generally the average / mid-point of a range of likely outcomes, we tend to take the average as something that is almost certain to be achieved, rather than something that we have only a 50% chance of exceeding. Perhaps its because in our daily lives, we associate “expected” with “most likely” – for example, if we see the weather report stating that its expected to rain, that means there is a strong likelihood of it raining, i.e. an implied probability well north of 50%. However, in finance, if you asked an investment consultant what their “expected return” would be with say a greater than 70% likelihood, chances are it would differ from what is provided as their “expected return”, which is generally at the 50th percentile.

Human expectations of returns are not aligned with statistical expected returns

This highlights an important aspect of finance and investing – being forward looking, cash flows, returns and discount rates are probabilistic, and we need to get comfortable making decisions when there is uncertainty involved. Taking an inexact science and pretending it is exact can lead us to make mistakes.

Scientific disciplines (including weather) have used probability and statistics to help navigate uncertainty and make decisions that work over time, and adopting these techniques in investing may help.

Viewing an investment portfolio in terms of options that you own and have written can also help clarify your decision-making process. For example, you can view venture capital investing as owning a portfolio of deep out of the money call options. You can also express your traditional asset classes (e.g. credit) as being long or short options. This mindset can then help you decide how much to allocate to these exposures when a simplistic expected return framework may not suffice.

Disclaimer: All views expressed in this article are that of the author and do not necessarily reflect the views of his employer or any of its affiliates. The author may be associated as an investor or as an advisor with certain companies mentioned in this article.