Monday, May 11, 2009

Thoughts on Expected Value

I wanted to pass along a little info that got me thinking. I've been reading More Than You Know by Michael Mauboussin. He talks about process vs. outcome and expected value. Here are a couple of good quotes:

"But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field-such as investing, sports-team management, and pari-mutuel betting- all emphasize process over outcome."

The idea here is that a sound process, implemented over time, will likely lead to strong results. There may be times when the results are skewed, but they usually catch up. Take a look at a casino for example. Sure there are times when gamblers make lots of money, but in the long term, the house wins. This is due to their "process" or the odds being in their favor.

Now look at what he has to say about expected value:

"The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value. Expected value, in turn, is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes."

He quotes former Treasury Secretary Robert Rubin for an example:

"A focus on probability is sound when outcomes are symmetrical, but completely inappropriate when payoffs are skewed. Consider that roughly 90 percent of option positions lose money. Does that mean that owning options is a bad idea? The answer lies in how much money you make on the 10 percent of options positions that are profitable. If you buy ten options each for $1, and 9 of them expire worthless but the tenth rises to $25, you'd have an awful frequency of success buy a tidy profit."

" So some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis. Say there's a 75 percent probability that a stock priced for perfection makes its earnings number and, hence, rises, 1 percent, but there's a 25 percent likelihood that the company misses its forecast and plummets 10 percent. That stock offers a great probability but a negative expected value."

This is the type of thing when I look at where I want to invest, and if I want to buy a particular stock. Now take Ormat Technologies, for example. I've been following the stock for awhile. To me, it was priced nearly to perfection, and they were to report earnings during a pretty shaky time period in the economy. Expectations were fairly high, and they did deliver. Now the stock has responded, and those are gains that I missed by not being in the stock. But to me, the risk of an earnings miss (the stock would have dropped a lot likely) outweighed this gain to me. Maybe to you it is different. I'm trying to show examples of my reasoning, and where I find these ideas.

Its a great book by the way, and I'd recommend it.

1 comment:

Apostille said...

Hi. Those are some really nice tips. Stock market is really a sensitive area..