Investment Probability Theory Made Practical

by KenFaulkenberry

in Value

Investment Probability

Investment Probability

The words investment probability theory might initially cause your eyes to glaze over with boredom. But I believe I can make it practical for you and we can learn important lessons from a basic understanding of investment probability.

One of my favorite sayings is “Anyone who tells you they know what the stock market will do in the short term is either a fool or a liar”. The market cannot be predicted on a daily, weekly, monthly, or yearly basis. This is NOT true for longer periods of time; but we will talk about that later.

Probability Theory

So how do some people correctly predict short term movements with accuracy? Let’s look at probability theory illustrated in a simple example. If you flip a coin you have 50% probability of heads and a 50% probability of tails. If you ask 100 people to predict the outcome of a single coin flip the probability is 50% will predict correctly and 50% will get it wrong.

Flip the coin twice and odds are only 25% of predictors will guess both flips correctly. The accuracy will fall with each additional coin flip. At the end of 10 coin flips the odds are only 1 out of 1000 will have predicted every coin flip correctly. Is that person the best prognosticator? These are completely random events and the odds were 1 out of the 1000 would get ten correct guesses in a row.

Investment Probability

Although the stock market is much more complex, the same concept applies to investment probability. Studies have shown that short term returns in the stock market are random, although with a positive bias. The positive bias is the difference between the coin toss example and the stock market; meaning there will be more positive than negative outcomes over time.

If you have enough prognosticators (and we do!); there will be a few who are able to successfully predict the short term moves in the stock market over several or even many time periods. Unfortunately, people begin to believe the stock market prognosticators are infallible, and more and more people follow their advice.

The more successful the predictions the greater number of followers. In addition to more followers, investors become more confident in their abilities, and make larger and larger bets. After all, the predictor has been correct many times; they must know more than anyone else? Of course, this is incorrect.

Inevitably the odds eventually catch up with the prognosticator. They guess incorrectly, and many people are harmed. But more damage can be done with a few incorrect guesses that all the correct guesses combined. That is because few are following when the prognosticator first starts making predictions. But at the end many people are following, and many will most likely be taking much larger positions than they were in the beginning.

Investment Probability and Value

It is easy to become lazy and attempt to follow an investment guru instead of implementing value investing principles. But there are no short cuts in investing. Any investment philosophy that is going to make you rich quickly is a scheme that will end badly.

Fortunately, for those willing to develop patience and implement a long term investing plan, probability comes close to guaranteeing positive outcomes by focusing on valuation and investing for the long term.

A basic understanding of investment probability theory will cause an investor to ignore short term market prognosticators and focus on value. Examples of valuation tools I like to use are  Shiller PE10, the PEG Ratio, Earnings to Price yield, or Return on Enterprise Value (ROEV).

Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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