Probability in Finance – Statistics For The Trading Floor – Quantitative Methods #Finance

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 CashNews.co we’ll be discussing probability and why it’s important for investors to have a good understanding

of how it works. 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 thought 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 deaths by the end of July what they should say is experts have a 95 confidence that the number of deaths 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 text-decoration: none;">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 none;">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 you