an event can be extremely likely and
not happen or an event can be extremely
unlikely and still happen
this is an idea that many people find
confusing
in today's video we'll be discussing
probability
and why it's important for investors to
have a good understanding of how it
works
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probability is the study of events and
outcomes that involve an
element of uncertainty rolling a dice
for example
involves uncertainty as does investing
in the stock market
rolling two dice at the same time has an
uncertain outcome
but some outcomes are more likely than
others
and the likelihood of the different
outcomes can actually be quantified
while most people do understand
probability
in the real world few actually seem to
believe in it
people understand that certain outcomes
are rare
and that the best you can do is to make
decisions where the odds are generally
in your favor
they understand that you can make a wise
decision and end up being wrong
or make a badly thought out decision and
still end up right because that's just
how luck and risk work
but almost nobody actually uses
probability in the real world
when judging things in particular things
like
other people's successes what people
instead care about is
were you right or were you wrong
probability is about
nuance and gradation but in the real
world people see things as being more
black and white
if you said something will happen and it
happens you were right
if you said it will happen and it
doesn't you were wrong
that's how people think because it's
easier to analyze
outcomes than the talk process
underlying a prediction
a famous example can be drawn from the
2016 u.s
presidential election where american
statistician nate silver
calculated a 71 chance that hillary
clinton would win the election
that donald trump went on to win silver
had been named one of the world's 100
most influential people by time magazine
in 2009
after his election forecasting system
successfully predicted the outcomes in
49 out of the 50 states in the 2008 u.s
presidential election
in the 2012 u.s presidential election
his forecasting system correctly
predicted the winner of all
50 states and the district of columbia
nonetheless the main takeaway in 2016
was quite simply that nate silver was
wrong
great examples can be drawn from the
2020 coronavirus pandemic as well
news headlines say things like experts
predict 700 000 debts by the end of july
what they should say is experts have a
95
confidence that the number of debts by
the end of july will be between
550 and 850 000
or something like that it doesn't
necessarily make a snappy headline
but that's actually what a prediction
looks like
with the original headline if the number
of debts by the end of july turns out to
be say
650 000 people will declare the experts
wrong even though
it's pretty close if the number turns
out to be 900
000 they'll be called disastrously wrong
even though the forecasters knew there
was a reasonable chance of that
occurring
misunderstanding probability happens a
lot in investing too
predictions that come true bring
invitations to talk on cnbc
predictions that don't bring mockery
from those who end up being right
probability theory began in 17th century
france
when the two great french mathematicians
blaise pascal
and pierre de fermat corresponded over
problems from games of chance
these types of problems continued to
influence early researchers
in establishing a mathematical theory of
probability
today probability theory is a
well-established branch of mathematics
that's applicable in every area of
scholarly activity
from physics to weather prediction to
predicting the risks of new medical
treatments
knowing the probability of getting heads
when flipping a coin
is 50 percent the probability of
flipping heads on two coins flipped at
the same time
is then fifty percent times fifty
percent
or twenty five percent the four possible
outcomes are heads heads heads tails
tails heads and tails tails thus there
is a one in four chance of flipping
heads heads
or 25 percent that calculation of course
only works when the two events are
independent of each other
looking at events like weather forecasts
and questioning the likelihood of having
two rainy days in a row
recognizes that such events are
different to coin flips
rain yesterday might actually predict
rain today because storms can last more
than one day
and of course because weather is
seasonal probability turns up in
all areas of finance probability allows
financial professionals to calculate
expected value
the expected value of an investment is
simply the probabilities of the various
outcomes multiplied by the various
payoffs in the different scenarios
this is used everywhere from valuing a
simple equity investment
to pricing exotic derivatives the
insurance industry is almost entirely
built on probability calculations
and an important component of credit is
the probability a loan will be repaid in
my book statistics for the trading floor
which is linked to in the description
below
i work through all of the important
probability calculations and how they
can be applied to stock market analysis
as i mentioned earlier good ideas as
measured by probability
can turn out badly and bad ideas can
turn out well
at least in the short run in probability
theory
the law of large numbers is a theorem
that describes the result
of performing the same experiment a
large number of times
according to the law the average of the
results
obtained from a large number of trials
should be close to the expected value
and will tend to become closer as more
trials are performed
while every lottery does have a winner
if a person
buys thousands of tickets that have an
expected value of 70 cents
and they pay a dollar for each of these
tickets it becomes a mathematical
certainty that they will lose money
in her best-selling book thinking in
bets i'll put an
amazon link to it in the description
below professional poker player annie
duke
explains how in the long run the
cumulative effect
of being a little bit better at decision
making by taking probability into
account
can have a huge effect on how our lives
work out
things like jobs and relocation
decisions are bets
sales negotiations and contracts are
bets
buying a house is a bad all decisions
are bets on the future they shouldn't be
viewed as being right or wrong
based on how they turn out duke explains
in her book
how professional poker players try to
avoid the intellectual
foible of what she calls resulting which
means looking at a single
outcome as opposed to considering the
broader spectrum of possibilities
when poker players win they must
separate
luck from process if they can figure
that out they can improve their
game and their future outcomes and
understand
what was attributable to skill and what
was attributable to randomness
when a poker player or an investor
loses after placing a smart bet they
should not be upset
this is an outcome that has to happen
once in a while
understanding what would have been the
best move relative to the probabilities
is what actually matters probability is
central to almost all of the formulas
that are used in quantitative finance
possibly the most basic calculation that
we do in
finance involves projecting likely
or probable cash flows and then
discounting them at an appropriate
discount rate that takes risk into
account
this is the discounted cash flow model
modeling stock prices over time and
determining fair prices for financial
instruments
is once again heavily grounded in
probability theory
and this is how we price options the
insurance
industry is fairly obviously based
almost entirely on probability
so why does probability then get ignored
well a lot of what goes on in the
financial world
is an attempt to rid yourself of the
painful reality
of not knowing what's going to happen
next
someone who tells you that there's a
certain chance of recession happening
doesn't do much to get rid of that pain
and in fact they might just be adding to
it
but someone who says there is definitely
going to be a recession this year
offers something to grab onto with both
hands that feels like taking control of
your future
when you realize that making people feel
better is more appealing than giving
people useful figures
you start to see why financial
professionals often avoid using
probability at all in their discussions
but hopefully you can see here how
important probability is
and how important it is to improve your
way of thinking
and to think in a more scientific manner
and that using things like probability
and statistics
should improve your investing
performance and hopefully your life
outcomes in general
anyhow have a great day bye
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you