Probabilities and Payoffs in Investing
Issue #10 Let's take a simple and practical approach to understanding how probabilities and payoffs can help us make better investment decisions.
Last week, I read an article by Morgan Stanley (dated 19th Feb 2025) that made me reflect on how we really make investment decisions. You can read it here:
Probabilities and Payoffs – Morgan Stanley
Around the same time, I finally picked up a book I had been putting off for a while — Thinking in Bets by Annie Duke. It talks about how we often have to make decisions without having all the facts. That’s something every investor deals with, every day.
You can follow my reading journey and see what I’m exploring on Goodreads.
Then, I came across an old interview of Mr. Rakesh Jhunjhunwala from December 25, 2008, on YouTube. Around the 4:40 mark, he talks about his approach to investing and trading in such a simple and honest way that it really stayed with me.
Watch the Interview
That’s when it clicked:
Investing is about probabilities, payoffs, and placing smart bets.
But there’s something even more powerful that ties it all together — compounding.
After watching two more short and powerful videos — Video 1 and Video 2 — I was reminded how compounding is often the real driver behind wealth. It works slowly at first, but over time, it creates massive results.
There’s a simple formula:
Wealth = Capital × (1 + r)^n
Let me break that down:
Capital is the money or assets you start with. This depends on how well you earn and how efficiently you save or invest.
Return (r) is the percentage gain you make each year. This comes from your knowledge, your asset choices, and your experience.
Time (n) is how long you let your money grow. This depends on your health, discipline, and ability to stay invested.
A perfect example is Warren Buffett. His big secret isn’t just getting good returns — it’s that he’s been doing it since he was 11 years old. At 94, he’s still compounding. That’s over 80 years of uninterrupted growth.
“The real power in compounding is not the rate — it’s the time.”
So if you want to build serious wealth, focus on three things:
Build your capital (earn + save wisely)
Improve your returns (keep learning + investing better)
Stay healthy and patient (give it time)
In short, good decisions made consistently over time, no matter how small, can lead to extraordinary results.
Whether you're just starting or already deep into your journey, remembering this simple idea — probabilities × payoffs × compounding — can make all the difference.
What Makes a Good Investment?
At its core, investing is about finding stocks that are priced lower than what they’re actually worth. If you believe a stock is undervalued and you have good reasons for it, that’s your edge over the market.
In India, we have a diverse stock market with different industries, government policies, and sometimes uneven information flow. That means if you do your homework well, you can find great opportunities where the market has got the price wrong.
Understanding Expected Value (EV): Your Investment Compass
Imagine you are considering investing in a mid-sized Indian manufacturing company that is expected to benefit from government infrastructure projects. Here’s how you can break it down:
High Growth Scenario (30% chance): The company executes projects well, demand rises, and your investment triples (3x).
Moderate Growth Scenario (50% chance): Things move at a steady pace, and your investment grows by 1.5x.
Stagnant Scenario (20% chance): Delays, competition, or economic slowdown cause a 20% loss (0.8x return).
Now, let’s calculate the expected value (EV):
(0.30 * 3) + (0.50 * 1.5) + (0.20 * 0.8) = 0.9 + 0.75 + 0.16 = 1.81x
Since the expected value is greater than 1, this investment could be a good bet! But remember, these probabilities are based on research, so the better your understanding, the more accurate your assessment.
Common Investing Mistakes & How to Avoid Them
1. Overconfidence in Hype
Example: During the bull run of 2021, retail investors rushed into Paytm’s IPO at ₹2,150 per share, assuming it would replicate the success of global fintech giants. However, the company struggled with profitability, and the stock tanked.
Solution: Always look at financials and industry trends before jumping in.
2. Fear of Missing Out (FOMO) on IPOs
Example: In 2023, the Tata Technologies IPO saw massive oversubscription. While the company had strong fundamentals, many investors blindly applied for listing gains without assessing its long-term potential.
Solution: Evaluate the company’s fundamentals before investing, not just the buzz.
3. Holding on to Losing Stocks for Too Long
Example: Many investors bought Yes Bank in 2019-2020 after it fell sharply, expecting a turnaround. However, bad loans and governance issues continued to plague the bank, keeping the stock under pressure.
Solution: Review your thesis. If the reasons you invested in the stock are no longer valid, move on.
Using Historical Data (Base Rates) to Make Smarter Decisions
If a company is struggling but claims a turnaround is coming, check similar cases in the past.
Example: Jet Airways was once a leading airline in India but went bankrupt. Despite new investors coming in, the airline’s past failures and the challenges of the aviation sector made many investors skeptical. Historical data showed that airline turnarounds are rare in India.
Looking for Asymmetric Payoffs: Small Risk, Big Reward
Some investments have limited downside but huge upside. Examples:
Early-stage sectors: Companies like KPIT Technologies (focused on automotive software) saw multibagger returns as the EV and autonomous vehicle theme gained traction.
Special situations: In 2021, Jio Platforms raised funding from global investors at a premium valuation due to its strong market position and digital ecosystem potential. Those who spotted this asymmetric opportunity early benefited massively.
Even if you lose on some bets, one big win can make up for many small losses (like in venture capital investing).
The Hidden Impact of Volatility on Long-Term Wealth
A stock that goes up 30% one year and down 20% the next doesn’t give you a 10% gain! Due to the way compounding works, volatility can drag down real returns.
Example: Many new-age internet companies like Zomato and Nykaa saw huge IPO pops but later faced high volatility. Investors who bought in at peaks experienced significant losses due to price swings.
That’s why steady growers like ICICI Bank among others often beat highly volatile stocks in the long run.
The Safety Net: Always Have a Margin of Safety
Benjamin Graham’s rule: Buy stocks at a price much lower than what they are truly worth. This protects you from errors in analysis and market downturns.
Example: During the COVID crash of 2020, companies like TCS and Infosys were available at attractive valuations. Those who bought with a margin of safety saw substantial gains as the market recovered.
The Ultimate Goal: Building Long-Term Wealth
Instead of chasing short-term gains, focus on steady compounding over years. Even a 15-20% annual return can make you wealthy over time, thanks to compounding.
Example: A ₹1 lakh investment in Shree Ganesh Remedies in 2018 is worth over ₹20 lakh today. The key was patience and holding a quality company through ups and downs.
Final Thoughts: Investing is a Game of Probabilities
There’s no certainty in investing, only probabilities. If you focus on:
Finding undervalued stocks with an edge,
Assessing expected payoffs carefully,
Avoiding psychological pitfalls, and
Prioritizing long-term wealth over short-term hype,
you can navigate the stock market with confidence.
What’s your experience with probabilities and payoffs in investing?
Let me know your thoughts! 📢
Much love,
Priyank
You can also follow me on X: https://x.com/priyank3195