Unknowingly all of us constantly use probabilities to make decisions in our day-to-day lives. We use such similar type of probabilistic thinking with investing.
We know that stock returns are hard to predict on a yearly basis. Over the course of several decades, however, we know stock returns tend to be positive.
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Unknowingly all of us constantly use probabilities to make decisions in our day-to-day lives.
Likewise, we know that owning bonds will likely reduce our long-term investment returns, but will provide a much smoother ride.
By looking at historical investment returns, we can make some reasonable guesses at how different asset classes will probably perform in the future.
For example, let’s say you had an stock investment portfolio worth Dh5,000. During the S&P500’s worst ever year when it recorded a loss of 37 per cent, you would have been hit with a Dh1,828 million loss.
Whereas if your portfolio size was Dh1 million, your loss would equate Dh365,500. Similarly, the same probability rule applies when the S&P 500 posted its biggest ever 53 per cent return.
You would then have pocketed a profit of Dh2,628 if you had invested Dh5,000 and a profit of Dh525,600 if you had Dh 1 million invested.
Probability, a lens for all things investment
In order to make consistently profitable investment decisions, we have to be able to assess and manage our expectations about risk and reward.
We do this by analyzing all relevant information, and then adjusting the probabilities and payouts that we assign to various outcomes.
Probabilities are the lens through which we must view all things investment related.
The framework through which we do this is known as probability theory, and a basic understanding of probabilities is important not just for investment purposes, but for routine finances in general.
Understanding probability theory, and its counterpart – expected value – will go a long way in helping you to become an excellent decision maker.
There are two properties that govern probability. The first is that a given probability must be between 0 (impossible) and 1 (certain).
Or in percentage terms, a probability must fall between 0 per cent and 100 per cent. The second is that all possible outcomes must have probabilities that add up to 1 (or 100 per cent).
Let’s use a basic coin flip as an example to highlight these two rules. When you flip a coin, the probability of landing heads-up is 50 per cent, and the probability of landing tails-up is 50 per cent.
Excluding the possibility of maybe the coin landing on its edge (as it’s an unlikely event), the only other two possible outcomes are heads and tails.
These outcomes must add to 100 per cent, which is why we assign them equal probabilities (50 per cent).
Heads – 49.5%, Tails – 49.5%, Edge – 1%. Here again, all possible outcomes add to 1 (or 100%).
Alright, now let’s get to the heart of probability theory. And while we’re at it, let’s explore a key element of probability theory: Expected Value.
Determining Expected Value
To help understand this concept better, here is the question worth discussing:
Would you rather have Dh2,000 right now, or a 70 per cent chance of winning Dh4,000?
Your answer to the above question will involve a number of factors, one of which should be probability theory. Also how you choose to go about it will show how risk averse you may or may not be.
We know how much Dh2,000 is worth, but how does that compare against a 60 per cent chance of winning Dh4,000? To find an answer, we turn to probability theory, or more specifically, a concept called expected value.
In probability theory, the value of a probability-based outcome is known as the expected value.
The expected value of a particular outcome is equal to the probability of receiving a value, multiplied by the value received. In short hand: Expected Value = Probability of Receiving Value x Value Received
The expected value of a particular outcome is equal to the probability of receiving a value, multiplied by the value received.
So, in our case, we can see that the expected value of a 70 per cent chance of winning Dh4,000 is Dh2,800. The formula: Expected Value = 0.70 x Dh4,000 = Dh2,800
In reality, for now the value to you would be either Dh4,000 (if you won) or Dh0 (if you lost).
Now that you have two values to compare for your decision ($2,000 and $2,800), how do you decide?
Your individual decision will be influenced by a number of psychological factors, one such being risk aversion.
Your individual decision will be influenced by a number of psychological factors, one such being risk aversion.
Either decision can be justified. It becomes more apparent if you were told that you we were going to run this scenario several number of times.
The key to allowing probability theory to work in your favor is having enough opportunities for probability theory to take effect.
If there is a 70 per cent chance of an event occurring, it may not happen on the first instance, or the second, but given enough opportunities, that outcome will occur close to 70 per cent of the time.
Let’s say this scenario was run some 200 times, and you chose the 70 per cent chance of winning Dh4,000 option each time.
Then there is a very high likelihood that you would end up with close to Dh280,000. This is calculated as follows: Expected Value = 0.70 x Dh2,000 x 200 = Dh280,000
The key to allowing probability theory to work in your favor is having enough opportunities for probability theory to take effect.
Probability theory never plays out over one event, or even a few. When this scenario is played only once, it is understandable for holding onto the Dh2,000 and not gambling it away as some cash is better than none.
But as an investor if you chose the guaranteed Dh2,000 each time, there is a much lower probability to achieving long-term financial success.
So, being a successful investor boils down to understanding the nature of decisions under uncertainty, and that is governed by basic probability theory.
Being a successful investor boils down to understanding the nature of decisions under uncertainty!
Real world probabilities not an exact science
Although we went through in detail the exact nature of how probabilities work with regard to investing, in the real world working with exact probabilities is unheard of. Instead, all we have to go on are subjective probabilities.
Subjective probabilities are unique to the person making them. This carries two implications. First, recognize that the probabilities you assign to various outcomes will be different than that of others.
Second, the accuracy of the probabilities you or anyone else assigns is based entirely on your knowledge and experience. The more you know, the more accurately you will be able to forecast the likelihood that certain outcomes will occur.
Real world illustration on how probability applies to business decisions
Let's say the executives of a food company must decide whether to launch a new packaged cereal and they need to then submit a paln to management.
They have come to a conclusion that five factors are the deciding variables: advertising and promotion expense, total cereal market, share of market for this product, operating costs, and new capital investment.
On the basis of the “most likely” estimate for each of these variables, the picture looks very bright-a healthy 30 per cent return.
On the basis of the “most likely” estimate for each of these variables, the picture looks very bright-a healthy 30 per cent return. This future, however, depends on whether each of these estimates actually comes true.
If each of these educated guesses has, for example, a 60 per cent chance of being correct, there is only a minimal chance that all five will be correct. So the “expected” return actually depends on a rather unlikely coincidence.
This simple example illustrates that the rate of return actually depends on a specific combination of values of a great many different variables.
Thus predicting a single most likely rate of return gives precise numbers that do not tell the whole story.
The expected rate of return represents only a few points of possible combinations of future happenings.
Predicting a single most likely rate of return gives precise numbers that do not tell the whole story.
It is a bit like trying to predict the outcome in a dice game by saying that the most likely outcome is a 7. The description is incomplete because it does not tell us about all the other things that could happen.
This is a situation more comparable to business investment, where the company’s market share might become any 1 of 100 different sizes and where there are factors such as pricing, promotion, and so on that can affect the outcome.
Key takeaways?
Investors should embrace probabilities to help improve decision making, especially when it comes to investments.
But remember investors can be irrational – such as the tendency to neglect probabilities when considering extreme scenarios, and our tendency to either give too much importance or ignore small probabilities.
This view, however, misses the value of applying probabilities. Its use is not as a precise figure but as a measure of confidence and a means to monitor how our views evolve through time.
The notion, however, that we should not talk about probability because we have limitations in this regard is entirely spurious.
