Overview

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