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)
I guess, the environmental factors count more for a probability in investments, unlike the classical mathematical approach.
ReplyDeleteAgree with your views!
Hi Ranjith, Welcome to Finsight. Yes, you are right, environmental factors are important. But what is more important is how an individual perceives the same.
ReplyDeleteFor example, the GDP growth rate of the last quarter is a number known to all. But when we ask at what rate the GDP would grow in the next quarter, you need an educated guess to answer the same. Investment decisions are not driven by historical rates of return, but the expected rates of return. The word "expected" brings in lot of subjectivity!
ReplyDeleteAwesome sir..Point taken..As you said, i need to look at financial things from subjective probability. I love the distinction between historical rate of return and expected rate of return..But this expected rate of return can be subjective or a derived variable from historical events..your thoughts sir?
ReplyDeleteOn a different note: while hiring a new team member, i am just confused whether to look at expected rate of return or historical rate of return:(
Murali...thank you for taking the discussion forward. My quick comment would be: what we are talking about is Bayesian Probabilities. Within this, subjective Bayesian Probabilities. I shall definitely publish a detailed blog on this shortly.
ReplyDelete