Probability Analysis, Game Theory and the Markets

Welcome to 2016! Last year was challenging for investors in the global financial markets. If you were fortunate enough to short commodities, energy stocks, Latin America and other emerging market stocks, you probably did well. In addition, if you were long Japanese stocks, U.S. health care stocks or technology stocks, you may have done all right. Beyond that, 2015 was a year with very little discernible trends. Will the financial markets be kinder to investors in 2016? Let’s discuss it. 

Because the future is unknowable, the notion that one can accurately forecast future financial market performance is imprudent. Moreover, this is true even if the forecast is delivered with great confidence. There are methods to determine if a given market or sector is over- or under-valued. However, this information lends itself to what investors might do, not to what they will do. In other words, because human behavior is highly unpredictable, even the best methods available cannot predict how investors will act. 

Probability Analysis

Two approaches that can help with investment decisions are probability analysis and game theory. The first is based on randomness while the second incorporates human behavior. We will begin with probability analysis, which is the more common of the two. To explain, assume XYZ Company stock is expected to return 8.0% over the following 12 months, based on its current valuation, expected earnings and other factors. In addition, assume that its risk (i.e. standard deviation) is expected to be 15.0% over the same period. Probability analysis suggests that returns will fall between negative 22.0% and positive 38% with a 95% level of confidence (i.e., two standard deviations). Moreover, the expected return is random and uncontrollable.

Game Theory

Game theory, on the other hand, models uncertainty by assuming investors make rational investment decisions. To clarify, if there is a large amount of short interest in XYZ and the stock has been rising lately, one might assume those holding short positions in the stock will cut their losses, which could push its price higher. Therefore, game theory uses specific information and assumes investors will act rationally. 

Going Forward

What lies ahead for the financial markets? Because the global economy is expected to remain slow throughout 2016, it makes sense that commodities will struggle. In addition, continued over-supply and weak demand for crude oil should keep its price in the low range (e.g. under $55 per barrel). Finally, if the U.S. economy strengthens, the Fed will likely continue raising interest rates. If all of this holds true, 2016 could look a lot like 2015, but with a slightly better result.

I’ve simplified how they work, but its also important to know that while probability analysis and game theory are intriguing, neither is foolproof and can lead to undesired results.

Until next time, thanks for reading and have a great week!

 

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