Probability and Proportionality
Judge each risk by both its likelihood and its potential impact on the investment.
- Difficulty
- Moderate
- Time to result
- ~weeks to results
- Steps
- 5
- Confidence
- 98%
Probability and Proportionality evaluates an adverse scenario on two dimensions: how likely it is and how much damage it would cause. Considering only probability can hide a rare but catastrophic loss, while considering only possible impact can make every investment appear unacceptable. The investor lists relevant scenarios, estimates credible likelihood ranges, measures their effect on the business or asset, and determines whether insurance, covenants, diversification, or other protections reduce the exposure. A remote event affecting a small portion of value may be acceptable; a recurring hazard capable of destroying the asset demands protection or rejection. Because both likelihood and consequence can change, the assessment is repeated rather than frozen at underwriting.
Origin
Brian Higgins presented probability and proportionality on Masters in Business as a recurring way King Street weighs scenarios without dismissing real hazards or inventing reasons to reject every investment.
Core principles
- 01Evaluate likelihood and impact together.
- 02Distinguish survivable losses from thesis-breaking losses.
- 03Do not reject investments merely because a bad scenario is imaginable.
- 04Do not ignore severe risks merely because they have not occurred recently.
- 05Match protection to the risk's expected and extreme consequences.
How to run it
- 1
Define the adverse scenarios
Identify concrete events that could impair cash flow, collateral, operations, or recovery value. Describe each scenario precisely enough to analyze.
Pro tip Include ordinary stresses and tail events rather than focusing exclusively on one class.
Watch out Vague labels such as market risk make probability and impact difficult to assess.
- 2
Estimate probability
Use history, location, industry evidence, and current conditions to assign a credible probability range rather than a falsely exact point estimate.
Pro tip Update base rates when structural conditions have changed.
Watch out A long period without an event does not prove that the event is impossible.
- 3
Measure proportional impact
Estimate the share of business value, cash flow, or collateral exposed if the event occurs. Determine whether the damage would be temporary, recoverable, or terminal.
Pro tip Test both expected damage and a severe but plausible case.
Watch out A low-probability event can still dominate the decision when its impact is catastrophic.
- 4
Evaluate mitigants
Check whether insurance, structural protections, covenants, redundancy, or diversification reduce either the probability or severity.
Pro tip Confirm that the protection remains available and enforceable under the adverse scenario.
Watch out Assumed insurance is not a mitigant if coverage is unavailable, excluded, or unaffordable.
- 5
Make the proportional decision
Compare residual risk with expected return and decide whether to invest, resize, protect, or pass. Revisit the decision as conditions evolve.
Pro tip Record why a residual risk was accepted so it can be reviewed later.
Watch out Creating increasingly remote scenarios can become an excuse never to invest.
In the wild
A property investor evaluates two sites. One faces a meaningful recurring flood risk capable of disabling the asset, while the other sits near a geological fault associated with an extremely remote event. The investor prices insurance and resilience measures for the flood-prone site but does not reject the second site solely because an extraordinary scenario can be imagined.
→ Protection and capital are concentrated on the risk with the more consequential combination of likelihood and impact.
Common mistakes
Looking only at likelihood
A small probability does not make a catastrophic, unmitigated loss acceptable. Impact must be evaluated alongside frequency.
Looking only at worst-case impact
Any asset can be paired with an imagined disaster. Rejecting investments without considering remoteness and proportional exposure creates paralysis.
Assuming protection exists
Insurance and other mitigants may be unavailable when risk rises. Verify terms, exclusions, capacity, and cost.
Is it for you?
Best for
It is best for underwriting investments exposed to operational, environmental, financial, or other uncertain events.
Not ideal for
It is not ideal when decision-makers require false precision from probabilities that cannot be credibly estimated.
From the transcript
“And then you look at probability and proportionality.”
“You can create a scenario with any investment where you'd never make the investment.”
“So that's the constant interplay that we feel is critical to arrive. You know, the best decision you can make”
From the episode
King Street's Brian Higgins On Navigating Distressed Markets
Brian Higgins