Where is the Wealth created?

Two days ago, while starting my course on Investments to the new batch, I was discussing a point that wealth is always created in the real market and not the financial market.  Let me explain the same.  We many times tend to believe that it is possible to create wealth in the financial market.  But financial market (and the entire financial system itself) is performing the function of mere intermediation.  It helps to bridge the gap between the suppliers of capital and the ones demanding the capital.  The capital has to ultimately flow towards production of goods and services.  Thus the income generated from such production of goods and services is distributed to the suppliers of capital through the financial system/market.  In the absence of demand for capital, the financial system/market looses its importance.

When an individual, who looks at creating wealth through various forms of investments in financial assets, may feel that the wealth creation happens in the financial market.  But, in reality he is participating in the real market (producing goods and services) indirectly and the wealth created in the real market is flowing back to him in the form of interest, dividend, capital gains etc. 

Probability Revisited

On my last post on Probability in Finance, Murali raised a question as to whether the subjective probabilities could be based on past occurrences (relative frequencies).  My answer would be yes, but in Finance the subjective probability can not be based only on relative frequencies.  One needs to combine his/her judgement with the relative frequencies.  Let me explain with the following examples.

A probability distribution of defective parts per 1,000 in a manufacturing process is developed based on repeated observations in the past.  Now if you want to predict the probability of 10 defectives per 1,000 during the next production run, you would immediately refer the distribution that is already developed.  Here your chances of being correct are relatively high.

Now, assume that you develop a probability distribution of rates of return per annum generated by a stock by observing sufficiently long period of time (say last 50 years).  If I ask you what is the probability that the same stock would generate 20-25% returns during the next year, I am sure, you wouldn't feel very comfortable to base your answer completely on the frequency distribution.  You would definitely use the distribution, but add to it your judgement on various other factors that you feel would influence the returns.  This is where the subjectivity creeps in.

Probability in Finance

Today morning I had an interesting discussion with Mr. Muralidhara, one of my close friends and a research scholar at SIT, on the concept of probability in Investments.  We learn/teach the concept of classical (a priori) probability as part of the course on Statistics.  Two important aspects of classical probability are all the outcomes are well-defined; their occurrences are equally-likely and the probability can be stated without conducting the experiment (a priori).  But when it comes to the concept of probability in Investments, if one thinks through the classical point of view, it leads to great misunderstanding as the above aspects are almost not present in most of the Investment/Finance related decisions.  In the world of Finance, what works is not the classical concept of probability, but Subjective Probability.  Richard Levin and David Rubin define subjective probability as “probability based on the beliefs of the person making the assessment.  It is based on whatever evidence is available…..may be in the form of relative frequency of past occurrences or an educated guess”.  This is the reason why we see different investment experts/analysts having different, and sometimes even divergent, views on investments in certain assets (even though the historical data available to all of them are the same).  It is very important for all students of Finance to view probability from this point of view to understand most of the theories and models in Finance.  Prof. Jayanth R Varma of IIMA explains this in detail in a recent working paper titled “Finance Teaching and Research after the Global Financial Crisis”. (available at the website of IIMA and at SSRN)