How to Use Conviction Levels in Investing

Marcus Padley breaks down why risk is unavoidable, how to use conviction levels, and why indecision is the enemy of good investing.

Seven. Risk is unavoidable. Make decisions using a balance of probabilities. One of the worst things about individual investors is indecision. People won’t do things because they don’t know; they’re uncertain. And the classic example is that by the time something becomes obvious, it’s too late. It’s already in the price. That’s why some people always buy at the top and always sell at the bottom. By the time something becomes obvious and they finally make a decision, the whole market knows. And in that case, it’s going to be wrong.

Why You Must Make Decisions With Probabilities

That brings us to one of our principles. Principle number seven: risk is unavoidable. Make decisions on the balance of probabilities.

Here’s a trick to doing that. We ask the team here – because you never really know, and it’s not terribly empirical – should we? For example: should we cash out of the market? Or if you’re making a decision yourself, should I buy BHP (ASX: BHP)? Should I sell BHP?

Just ask yourself: if you would say “yes, let’s buy it”, what’s your conviction level out of ten?

Just make up a number. It’s not empirical. What matters is that you have a conviction level. You can’t do maths on this. When we cashed out of the market recently, I had a conviction level of about seven and a half to eight and a half. Not entirely convinced, but confident enough.

One of the things we work with internally is that once we get over six to seven, it’s twice as likely we’ve got twice the conviction of the opposite. So if we get to a seven on “should we buy BHP?”, we think it’s twice as likely that BHP is going to go up.

You can canvas other people, but you’ve also got to canvas yourself. When you make a decision, what’s my level of conviction?

100% Conviction Means You’re Probably Late

You have to accept that you’re not going to know. And if it is 100% certain, you’re probably too late. There has to be a level of risk for any worthwhile investment decision.

What happens with us is we do enough work and pay enough attention to the market to work out that something is genuinely a seven to eight – seven and a half to eight and a half. Meanwhile, the rest of the herd is sitting at 50/50, because they haven’t even thought about it. They haven’t done the research.

Why Research Moves Your Conviction Higher

For example, a lot of people haven’t worked out that AI companies are hiding the cost of data centres by putting them into special purpose vehicles and issuing debt on the back of those vehicles. All they do is take a lease charge and the earnings. So the debt risk is hidden on their balance sheets.

That makes you realise: what if one of these data centres goes wrong and the bonds attached to it collapse? Who’s holding the bonds? What happens to all the other data centres? The big hyperscalers building data centres have a risk there that could be hidden. There have been a few articles about this.

We’ve done enough work to go: hang on – Big Tech is a bit of a risk. Riskier than most people think. And that gets us to a conviction of maybe seven and a half to eight and a half on “should we cash out?” Instead of sitting there without doing any work and hoping it goes up – basically 50/50.

The Point: Know Your Conviction Level

For every decision, ask yourself: what’s my level of conviction? And if you’re doing it as a team, as we do, ask everyone’s conviction level. Argue it, pull it together, decide. And we tend to get to the point that if we’re over six or seven, it’s twice as likely as the alternative.

So to get over indecision, accept principle number seven: risk is unavoidable. Make decisions using a balance of probabilities.