Monday, May 19, 2008

Decision Tree - Buffett's Secret Weapon, Part I

Charlie Munger, Buffett's alter ego and partner, spoke to a bunch of university students in 1994. He said you need a lattice model - multi-models to be a successful investor. Please master elementary in mathematics, accounting, psychology, biology, economics and etc, said he.

I am particularly interested to highlight his speech on decision tree. This is one of his secret weapons that's rarely published in books or written extensively in anywhere - perhaps is too technical for most people. Don't worry, it's only a Form V mathematics, remember?

So you have to learn in a very usable way this very elementary math and use it routinely in life -just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.

If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.

You're giving a huge advantage to everybody else. One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations....

Many educational institutions - although not nearly enough - have realized this. At Harvard Business School, the great quantitative thing that bonds the first - year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life....

An example of a decision tree. Let's say you have two choices of developing a new product.

Product A, Decision I: A smoke and fire detector. It can detect flames as well as smoke. It will cost $100,000 to develop. Potential $1,000,000 in revenue.

Product B, Decision II: The motion detector,which uses conventional household lighting, will cost only $10,000 to develop. Potential $400,000 in revenue.

Click for larger image

In decision I, you have an expected value of $ 400,000 and decision II gives us expected value of $ 310,000.

A natural instinct for most people will go for decision I due to higher expected value, even though they've a 50% chance of losing $ 100,000. Most will argues that a 50% chance for $ 900,000 pay-off is a worthwhile risk.

In decision II, though the payoff is lower, $ 310,000, we have a 80% certainty to generate a payoff of $ 390,000. You have only 20% chance of losing $ 10,000. With this, I will go for decision II.

I will show you in my future write up on how Buffett has been optimizing his portfolio based on decision tree principle. He always says: in high probability event, put down a big bet - a very powerful decision making principle indeed.

1 comment:

John Frazier said...

I am guessing the probabilities were given? Also can you link me to the follow up on your "future write up" on the subject?