Probabilities and Odds in Investment

Every day, you are able to see investment analysts in the television and financial columnists in the newspaper predicting the direction where the markets are heading in the coming hours, days, weeks, months and/or years. They are trying to tell you whether the market is bullish (i.e. going higher) or bearish (i.e. going lower). However, you need to recognize that you should not make your investment decision based on this information.

In his thought provoking book Fooled by Randomness, Nassim Teleb quoted an interesting story that cleverly illustrates the concept of expected value and the uselessness in predicting market direction. In a meeting with his fellow traders, a colleague asked Taleb about his view of the market. He unwillingly responded that he thought there was a high probability that the market would go up slightly over the next week. Pressed further, he assigned a 70% probability to the up move. Someone in the meeting then noted that Teleb was short a large quantity of S&P 500 futures - a bet that the market would go down - seemingly in contrast to his bullish outlook.  Teleb then explained his position in expected value terms:

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Event                       Probability  Odd/Outcome     Expected Value
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Market goes up         70%          Up 1%                 Up 0.7%
Market goes down     30%          Down 10%           Down 3%

                                                   TOTAL              Down 2.3%
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In this case, the most probable outcome is that the market goes up.  But the expected value is negative, because the outcomes are asymmetric.

It is sad to note that people typically spend too much time and effort pursuing the higher probability events in making their investment decision, without even look at the odds.

Maybe there is a difference between gambling and investing afterall - most gamblers look at the odds before they put in their bets, while many investors do not even consider the odds when they invest their own savings (with much more money at risk) on a stock, bond, currency, and/or commodity. 

The Tote Board at the Hong Kong Jockey Club's Shatin Racecourse

References

Nassim Nicholas Teleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (New York: Texere, 2004).
Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006).