Author Topic: The Difference Between Expectation and Probability  (Read 2974 times)

innerscorecard

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The Difference Between Expectation and Probability
« on: March 22, 2015, 10:00:59 PM »
One thing I often see new individual investors do is confuse expectation with a probable outcome. So many new investors think of stocks as something that should give them the returns here (http://www.bogleheads.org/wiki/Historical_and_expected_returns) basically as if they were a savings account with that interest rate.

That's why you get new naive investors asking whether they should put money they're going to use to pay for an identifiable discrete expense in even a few months into the stock market. They think they will get something approaching those annualized figures, within this period.

That's obviously not so, as most of you know.

Ben Carlson explains it pretty well in a recent blog post of his (http://awealthofcommonsense.com/whats-considered-long-term-in-the-stock-market/):

"Some investors mistakening believe that by holding stocks for the
“long run” they will be guaranteed a certain return on their investment. This is not true. Investors aren’t promised 8-10% annual returns just because they increase their holding period. Stocks are risky because even over longer holding periods there’s variation in the results. But history shows that you increase your probability for success by extending your holding period by decreasing your odds of experiencing loss."

I think there's an interesting mental conflict here. There's an inherent unpredictability in stocks. But as humans, especially people seeking FIRE, we have to try to plan for the future, and provide for our financial well-being. We can make estimates backed by data, but there will be surprises. Having a margin of safety which is actually already incorporated into the 4% SWR helps, but even then there will be surprises.

kvaruni

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Re: The Difference Between Expectation and Probability
« Reply #1 on: March 23, 2015, 02:35:54 AM »
Very fair point you make.

Of course, not everyone can come up with a Monte-Carlo simulation, and even fewer people can correctly analyse the results. For those reasons, I think people resort to statements such as "you will get 4% after inflation [when investing over a long horizon]". I don't even think it is too far off the truth. If stock markets would systematically underperform for the foreseeable future, then chances are very high that all other asset classes will also underperform (much like in Japan). If there is one catastrophic crash in the stock market, then all other asset classes will come tumbling down (see any crash). I'm just not a strong believer of the ever-winning portfolio where you can avert any and all catastrophes. I have been burned by things like gold and property, and I have learned my lesson. All we can do is be optimistic and hope for the best, being content in that we will only ever be slightly worse off than the markets themselves. The problem, of course, is that ''only sightly worse off than the markets", while more accurate, doesn't really have the same ring to it as "4% after inflation" :).

forummm

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Re: The Difference Between Expectation and Probability
« Reply #2 on: March 23, 2015, 09:51:18 AM »
Most people do not have the attentional capacity and mathematical skills to pay enough attention to the nuances and complexities of something as challenging as being a life-long investor and being able to count on the returns to sustain their needs and wants. This is one reason that people are paying obscene fees to businesses to manage their money. It really does take a lot of effort to understand this stuff to the point where you are willing to trust your future and your family's future with your judgement. Plus, then you add in all the uncertainties, and people really hate uncertainties.

As an aside, I think that in the US we've been pursuing very poor public/social policy in shifting people away from work-based pensions and into self-managed accounts. Why make everyone spend a ton of time trying (usually unsuccessfully) to become an expert at something they are not, and is taking time away from them making better use of whatever skills they are an expert at, and generally having poorer results, instead of just having some employer-portable, defined benefit strategy that people pay into through work and can smooth out jagged investment returns for a society? It doesn't make sense.

Retire-Canada

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Re: The Difference Between Expectation and Probability
« Reply #3 on: March 23, 2015, 01:22:19 PM »
As an aside, I think that in the US we've been pursuing very poor public/social policy in shifting people away from work-based pensions and into self-managed accounts. Why make everyone spend a ton of time trying (usually unsuccessfully) to become an expert at something they are not, and is taking time away from them making better use of whatever skills they are an expert at, and generally having poorer results, instead of just having some employer-portable, defined benefit strategy that people pay into through work and can smooth out jagged investment returns for a society? It doesn't make sense.

In Canada we have a reasonable start to that idea with the Canada Pension Plan. It's not enough to live off and is meant to top off savings or other pensions, but we could make it possible to contribute extra over the course of your working years to allow for a liveable pension benefit when you retire.

I agree that most people are not in a position to do anything more than throw their money at the nearest mutual fund without understanding the risks and the fees.

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ZiziPB

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Re: The Difference Between Expectation and Probability
« Reply #4 on: March 23, 2015, 03:03:35 PM »
innerscorecard, thank you for this post.  It's very scary to see new investors posting here and in other forums, intending to put all of their money into the stock market with a firm expectation of a steady return.  All of these 24 or 25 year olds confidently declaring their plans to be 100% in stocks...  All of the posters whose response to any investment advice request is "just put it all in VSTAX, that is what I do because I'm sure it will go up 10% annually and there is no reason to waste your money on any other investment"... It truly makes me shudder and wish for a good healthy correction in the markets sooner rather than later.  Until you have lived through one, you have no idea.

dragoncar

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Re: The Difference Between Expectation and Probability
« Reply #5 on: March 23, 2015, 05:52:05 PM »
The depressing reality is even "expected" returns are merely educated guesses.  Add to the list of things to understand:

The Difference Between Risk and Variance

Doulos

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Re: The Difference Between Expectation and Probability
« Reply #6 on: March 23, 2015, 07:31:07 PM »
This is that emotional fear problem with brains.
Expecting a long term recovery is reasonable.
Doom & Gloom is not going to get you anywhere.

If you are so worried about the future that you cannot accept low risks like index funds, then there are better guarantees, but the trick is none of them are really guarantees.
If the stock market crashed so bad such that you lose everything in an index fund that covers all of USA... and it does not bounce back... Then chances are...
- USA economy & government collapsed. 
- USD = hyper inflation.
- Your FDIC guarantee does not matter either. (banks also give you no money)
- Your 25% of international exposure probably went down with the USA.

But what is more reasonable is just accepting that life in general is just not certain.
You cannot put your faith in money.
If you want real guarantees, I suggest Jesus.

Then get back to investing, because the expectations that investing pays off are reasonable.