Interestingly, I came across a perfect explanation of this in an overheard conversation between two people who seemed to be discussing betting on the IPL. I think this was when the tournament had just begun. One of them asked the other who would he bet on to be the winner. The other one replied that he would definitely bet on Chennai. The first one was dismissive. He said that while Chennai have a good chance of winning, you would make a profit of maybe Rs 30,000 for every lakh that you bet. Something like Punjab would be better, he said. Capable of winning and yet the betting odds were such that the profit would be worthwhile.
Now, I'm obviously not condoning betting, nor am I suggesting that there is anything in common between such betting and investing. However, the fact is that this person had a good understanding of the concept of probability vis-a-vis payoffs, something which many investors do not understand or appreciate. Taleb, in one of his books, narrates how he was asked by a TV anchor what the probability of the markets rising were. He said that it was 99 percent. The anchor wanted to know so how would one trade that. Taleb replied that he wouldn't. Instead, he would trade for the one percent. The reason, he said that there was no way of making money off the obvious thing. On the minority side, he would almost certainly lose but if he won then he would win big.
Of course, all this business of trading and betting is not really what investing is all about. However, this idea does express itself in sober, fundamentally driven investing too, where a closely-related concept is that of the valuation of an equity stock. You can be certain that a company has a bright future, and you are right too, except that a lot of other people also know this. Inevitably, the the valuation of such an investment is high and thus the eventual returns high.
However, real investment is not a gamble. There is no either-or situation, at least not often. The criteria for winning is not something external, but whether you, as an individual, manage to achieve the financial goals that you set out for yourself. In reality, the first duty of any investor is to survive, that is, to not lose so much that they seriously damage their financial future. Everything else comes later.
The problem is an old one, and one I've written about earlier. There are two contradictory impulses that govern how people spend their money. One is to buy expensive things in order to signal their status, and the other is to get a good bargain, or, in investing terms, good value. Ideally, we would like to combine both. We would like status-symbol possessions that normally cost a lot, but we would like to have them to be a good bargain just for us. That sounds like an impossibly good deal but then, the fun of getting a deal is the maximum when it's good.
That means that although people instinctively look for bargains, they don't necessarily make correct judgements about the inherent value of things. Instead, they use price itself as an input for whether something is a good bargain. That sounds like circular logic, and it is. It's just that no matter what the other variables, the balance between probability and payoffs rules, or at least should rule, all other decisions.
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