Success is an accumulation of LITTLE successes in life…
Probability And Investment!
Posted On September 23, 2010
Probability And Investment!
If I want to be good as an investor, then I need to be good at arithmetic to analyze the odds of an investment. Also, I need to be able to read and write. There is where scholastic education plays an important role. Scholastic education teaches me how to read, write and do arithmetic. It is one of the three vital educations as highlighted by the Rich Dad’s series by Robert Kiyosaki. The other two vital educations are professional education and financial education.
How does arithmetic play a part in investment? To answer this question, I need to explain a little on the probability using the example of a coin.
What happen when I throw a coin and let it lands onto the table? It is obvious that the coin is either going to show head or tail. What if I throw 2 times, what are the chances of the coin showing head?
I cannot really be sure what are the chances. I may get 2 heads in a row. I may get 1 head and 1 tail. I may get 2 tails.
What if I throw a 100 times? How many times is the coin showing head? I will find that the number will be somewhere near 50. In other words, I will find that there is a 50 percent chance of getting a head if the number of throws is large enough. The probability of getting a head is the chances of the coin showing head out of a large number of throws. That is the probability of getting a head is 0.5.
Similarly, if I have thrown a six-sided dice, the probability of getting a six in a 100 throws is about 1/6. But I can do something to increase my odds of getting a six. I can use a modified six-sided dice that has a higher probability of showing a six compared to a normal six-sided dice. In this way, the probability of getting a six is increased.
And this is what a professional investor does to make money from an investment. He increases the probability of winning by identifying and managing the risks involved. He does not invest for the sake of investment. He has a plan for investment that includes risk management. Yes, investment is a plan based on what I have understood from the Rich Dad’s series by Robert Kiyosaki.
A good example will be looking at how a professional trader makes use of probability to his advantage.
In a stock market, the price of a share can go up, go down or remain the same. That is the probability of the share price going up is 1/3. Remember, the probability only holds if there is a sufficient large amount of trades. Like in the case of throwing a coin, the probability of 0.5 is true only if there is a large number of throws.
Let imagine that I have an initial capital of ,000 to invest in shares. If I invest ,000 in a single trade, what is the probability of the share price going up? There is no way to predict or tell. This is like throwing a coin once and try to guess whether it will show head or tail upon landing.
If I invest 0 in each trade, then I can make at least 100 trades. That is the number of times that the share prices will go up in a 100 trades is near 33. This is like throwing a coin a hundred times and the number of times that I will get a head in a 100 throws is near to 50.
A professional trader understands the fact that probability is only true if there are a sufficient large number of trades. Thus, he only risks a small amount of this capital in each trade.
Another way to apply this probability is to limit the loss of each trade to 0. That is, I can invest all my capital in the share of a single company. If the share price goes down and my loss hit 0, I will sell off my position and exit the stock market. Of course if the share price drops too suddenly, I will end up losing much more money than I am willing to loss. Thus, this approach is not that advisable.
In addition, the professional trader makes use of technical analysis to increase the odds of winning. He analyses the chart for indication of to buy and sell. Also, he uses a few other techniques to increase his chance of winning. All these are included as part of his investment plan.
The above description is based on my understanding by reading a book. I have gathered from the Rich Dad series by Robert Kiyosaki that investment plan is different for each individual. If I read more books, I will definitely find more approaches and methods for trading. Different professional traders have different investment plans and thus they will do things differently.
* DISCLAIMER *
The author only provides the material and information as a layperson’s views about an important subject. The materials and information are from sources believed to be reliable and from his own personal experience, but he neither implies nor intends any guarantee of accuracy.
All the materials, information and procedure in this book are only the author’s personal opinion. You must consult your own professional advisor and other reputable sources on any matter that concerns you or others.
The author, publishers and distributors are not competent and do not profess to give legal, accounting, medical or any other type of professional advice. The reader must always seek those services from competent professionals who can review your own particular circumstances.
The author, publisher and distributors particularly disclaim any liability, loss, or risk taken by individuals who directly or indirectly act on the information contained herein. All readers must accept full responsibility for their use of this material.