“What is important is to be aware of the possibility of a range of outcomes”
A very lazy way of analyzing an investment is, I am going to invest $1,000,000 and I should make $100,000. Therefore, my return is 100,000 / 1,000,000 = 10%.
A bit more sophisticated would be, I think I have an 80% likelihood of investing $1,000,000 and earning $100,000. Therefore, my return is (.80 * 100,000) / 1,000,000 = 8%.
Even better, would be to figure out what happens the 20% of the time you do not make $100,000. Perhaps you lose $10,000. The return would now look like this ((.20 * (-10,000)) + (.80 * 100,000)) / 1,000,000 = 7.8%
The ultimate would be to do this for every possible outcome. But that gets a bit tricky, doesn’t it? In the real world, there are infinite possibilities, each with a micro percent chance of occurring.
It reminds me of one of my favorite quotes:
“Better to be roughly right than precisely wrong.”
John Maynard Keynes
You do not need to be able to find the exact projection in order to make a good investment. I would argue it is impossible to even find an exact projection that has any accuracy.
What is important is to be aware of the possibility of a range of outcomes. Your first-level analysis will more than likely not happen, and a lot of different things could happen. Once you have internalized that, prepare for those eventualities. This will generally lead to:
• Taking on less debt
• Holding more cash
Going back to the specific analysis of the investment. It is important to think probabilistically, to not see things as black/white or success/failure. There are ranges of outcomes and likelihoods of occurrence. You should be able to get to a place where you can simply look at a deal and get a feel for the extremes. What is the downside? What is the upside? Are those extremes acceptable? Can I survive them?
These are the questions to ask yourself.