Monday, December 17, 2012

The Stock Market: Probability In Action

The stock market moves up and down every minute, day, and week. The movements appear to be random, and there have been books and academic studies proving this to be true. Now, I'm no academic but I am a professional investor. I have a vastly different explanation: divergent opinions on probabilities of outcomes.



"What?" I can hear most people saying. "Diver...proba..." Don't be scared by the lingo - I'm not really saying anything too complicated. Basically, a stock's price at any time represents the best guess for the weighted average of good and bad outcomes.

An example:
Stock ABC is trading at $100 today. After doing a lot of work, you estimate that with good times ahead the stock should be worth $150. Alternatively, with bad times ahead the stock is worth only $50. The market is saying that each outcome (good or bad) has an equal probability.

Tomorrow, the stock moves to $120 after the CEO discusses new orders. The value of the company didn't change, just the probability of the good outcome. The market is now saying that the good outcome has a 70% chance vs. the bad outcome's new 30% chance.

The formula here is: probability of good = (market price - bad price)/(good price - bad price).

The bet you would be making to buy ABC stock if the price is $120 is that the market still has the chance of a good outcome too low. Your personal target price would be the weighted average of your good and bad scenario prices. I think ABC has a 90% chance of the good outcome and a 10% chance of the bad outcome. So I'm willing to pay up to $140 for shares.

Summary:
The stock market is all about forecasts and probabilities. The value of businesses doesn't change with every tick and trade. Just investors with differing viewpoints on the likelihood of future success of a company. So next time you are thinking about investing in a stock, make sure your view on the good outcome's probability is greater than what the market is saying.

Best of luck in your investing.

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