Overview:
Investing vs. Gambling
Have you ever thought about the difference between investing and gambling? A Morningstar options guide suggests that the difference is the expected return or expected value: a positive expected return is 'investing' while a negative expected return is 'gambling'.
Note: You are invited to follow any or all of the links below but it isn't necessary to do so nor to comprehend the explanations, some of which may be difficult to follow without some background in probability and statistics.
So how would we know whether an opportunity is an investment or a gamble? We would need to know the expected return, or what academics call the expected value. But in order to compute or estimate an expected value, we need to have a probability distribution. (Click here to see why.) In addition, by having a probability distribution we can compute or estimate risk as well.
Probability Distributions
There has been a great deal of research on how to quantify uncertainty
for 'random variables', such as the price of a stock. The classical
approach is to try to estimate the probability of each possible value of a
random variable, in our case, prices of a stock. Although much effort has
been expended, until now, techniques for estimating probability distributions
for stocks have not been very successful. See:
Deriving Probability
Distributions and
Probability Distributions for Stocks for more details.
The Big Short
In his book, The Big Short, Michael Lewis describes how two rather unsophisticated investors made huge profits by realizing that people and markets were not very good at estimating probabilities. Being able to derive probability distributions in a more scientific way should enable us to evaluate investment opportunities better than ever before.
Madness
of Crowds or Wisdom of Crowds
Many years ago, I sat in a course on investing given by one of my colleagues at
The George Washington University, Professor of Finance, Ted Barnhill. Ted
started the course advising the students that they should never invest without
first having read the book
Extraordinary Popular
Delusions and the Madness of Crowds, written by
Charles Mackay in 1841. Ted's advice has helped me personally avoid three
major economic bubbles that have occurred since the time I sat in on his course.
In 2004, a book by James Surowiecki called
The Wisdom of Crowds
-- subtitled Why the Many Are Smarter Than the Few and How Collective
Wisdom Shapes Business, Economies, Societies and Nations, tells just the
opposite story. Surowiecki presents numerous case studies to
illustrate that under suitable conditions, the combined judgment of individuals,
results in better decisions and predictions than most individuals and even
experts. The conditions are that the judgments be from a diverse,
independent, and decentralized population of individuals. The experiment
being undertaken here will collect judgments about the stock price of
one or more companies from of a diverse, independent and decentralized population of
individuals. The judgments will be in the form of pairwise comparisons as
is practiced in the Analytic Hierarchy Process.
The
Analytic Hierarchy Process
The Analytic
Hierarchy Process (AHP) is a process that has been used within tools
such as Expert Choice for a wide
variety of applications involving prioritization, including complex choice
decisions, forecasting, and resource allocation. (You will find many
citations if you Google AHP and almost any type of decision or business process,
such as six sigma, TQM, Business Process Engineering, Energy Policy, etc.)
In addition to relying on principles of aggregating judgments espoused on the
Wisdom of Crowds, we will employ several principles of the Analytic
Hierarchy Process, including structuring, making pairwise
relative comparisons, deriving priorities from these comparisons with what
is called the principle right hand
eigenvector (which gives new meaning to
GIGO) and
different ways of aggregating judgments and priorities.
Strategies
Not only is
knowing probability distributions necessary if we are to know if we are investing
or gambling, the probability distributions we will be deriving will enable us to
evaluate
a wide variety of investment strategies, ranging from individual stocks, to
portfolios of stocks, to derivatives such as covered calls, naked puts and options on futures.
Interested in Participating in the Experiment?
If you are interested in participating in the experiment to derive
probability distributions so you can determine if you are investing or gambling, please
click the following link:
I'd like to participate in
the experiment to derive probability
distributions for stocks
See also: http://ProfessorForman.com