Probabilities and Payoffs: Michael Mauboussin and Dan Callahan

**Maisam** (0:00)
Welcome back to The Deep Dive. Today, we're really getting to the heart of what active investment management is all about. And if you're an experienced investor, you know the mission, right? It's about generating those excess returns.

**SPEAKER_2** (0:11)
It is.

**Maisam** (0:12)
It's about finding that gap between price and value. Some people call it variant perception, others just call it edge. But it's this idea that the market prices something one way. And your view, your rigorous view, says the value is, well, meaningfully different.

**SPEAKER_2** (0:30)
And that idea sounds so simple, you know, price minus value. But it's probably one of the most difficult mental exercises in all of finance. Prices, well, for the most part, it's transparent. It's right there on the screen.

**Maisam** (0:41)
It's immediate.

**SPEAKER_2** (0:42)
Immediate, exactly. But assessing value, that's the hard part. That is what separates the successful long-term investor from everyone else. And we have to be really clear from the get-go. Value isn't some fixed number. It's inherently an expected value, or EV, which means it's a whole range of potential outcomes, of payoffs, and each one is weighted by its own probability. Investing is and always will be a probabilistic activity.

**Maisam** (1:07)
It's a game of odds. And to help us navigate that landscape, to move from just picking stocks to really designing a strategy that maximizes compounding over the long haul, we are doing a deep dive into some absolutely crucial analysis.

**SPEAKER_2** (1:22)
We are. Today, we're focusing on a paper called Probabilities and Payoffs. It's written by Michael J. Mauboussin and Dan Callahan, and it was published on February 19th, 2025

**Maisam** (1:32)
And our mission today is to get practical. We want to pull out the real world applications from this paper to help you optimize your strategy, and maybe even more importantly, your portfolio sizing.

**SPEAKER_2** (1:42)
It's all about mastering the math, especially the geometry of compounding and also the psychology you need to actually execute when you're under pressure.

**Maisam** (1:49)
Exactly. And right away, we're going to tackle one of the most counterintuitive ideas in investing. It's one that really defines modern strategy, the Babe Ruth effect.
It's this core concept that just challenges the whole idea of needing a high batting average, of needing to be right all the time. Instead, it says, you have to embrace failure for the sake of much, much bigger wins. Okay, let's unpack this.

**SPEAKER_2** (2:12)
So to start, let's just get a really solid definition of expected value, or EV. It's basically the quantification of all your potential payoffs, but each one is weighted by its probability.

**Maisam** (2:24)
Right, the odds of it happening.

**SPEAKER_2** (2:25)
The math itself is straightforward. You take the payoff of one scenario, multiply it by its probability, and then you just sum up the results for all possible scenarios. The key, though, is that all those probabilities have to add up to 100 percent.

**Maisam** (2:38)
Of course.

**SPEAKER_2** (2:39)
The final number, the EV, that's your weighted average outcome.

**Maisam** (2:43)
To make this really concrete, the paper uses a great simplified example. It's a hypothetical drug valuation for a biotech company. If you're an analyst, you might sketch out, say, five different possible outcomes for a new drug.

**SPEAKER_2** (2:56)
Let's call them dog, base case failure, base case success, moderate hit, and then the big one, breakthrough.

**Maisam** (3:03)
Okay.

**SPEAKER_2** (3:03)
If you look at the numbers they use, the worst case, the dog scenario, it has a 10 percent chance of happening, but the payoff is tiny, maybe $10,000. That outcome only contributes $1,000 to the total EV.

**Maisam** (3:15)
A tiny slice of the pie.

**SPEAKER_2** (3:17)
Exactly. Now compare that to the big one, the tail event, the breakthrough scenario. It also has a low probability, maybe just 10 percent, but the payoff is massive. We're talking $2.5 million.

**Maisam** (3:30)
So that single low probability event, what does that do to the total number?

**SPEAKER_2** (3:36)
It contributes $250,000 all by itself. So when you sum up the weighted values of all five outcomes, the total expected value comes out to $550,000.

**Maisam** (3:47)
So the lesson here is that it's not just about how often you're right. It's the product of the probability and the payoff. That's what matters.

**SPEAKER_2** (3:53)
That is the core lesson. Excess returns come from finding a big disconnect in one of those two things compared to what the market thinks. You might find high probability, low payoff events, like say a deep value stock that's statistically cheap, but doesn't have a ton of upside. Or, and this is happening more and more in growth areas, you focus on the low probability, high payoff events. You hunt in those fat tails.