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It was only a few months ago when all of the news headlines were completely absorbed with the triumvirate of political threats for 2013; the "fiscal cliff", sequestration, and the debt ceiling. Knowing the recent track record of our political parties in jointly crafting a solution, I was concerned, to say the least. So concerned in fact, that I headed to the sidelines. I decided that the risk of political gridlock and resulting damage was greater than any short-term gains that I may make in the few months leading up to the looming deadline. As of today (April 12, 2013), the S&P 500 is up 11% so far this year.

My brother, who's a financial advisor for UBS (UBS), helped me to look at the market objectively through the lens of probability theory and expected value. In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on. Let's remove the thick spectacles and apply this to a financial market example using the SPDR S&P 500 (SPY):

The economy has essentially three basic variables - expansion, contraction, and stagnation. Obviously there are varying degrees of expansion and contraction, but we're going to keep this example simple. Next, we assign a value and probability of occurrence to these three variables for SPY.

Assumptions:

  • SPY value if economy expands = 180 (90% probability of expansion)

  • SPY value if economy contracts = 110 (5% probability of contraction)

  • SPY value if economy stagnates = 130 (5% probability of stagnation)

To arrive at the expected value, we'd simply calculate the value of each variable and sum. 180*90% + 110*5% + 130*5% = 174

With SPY closing just shy of 159, based on these assumptions, we could objectively decide to overcome our fears and hang in the market. Conversely, based on different assumptions, our expected value could be below the current market price. In that case, we may objectively decide to short.

Obviously, the assumptions that derive your expected value are critical. I'd suggest utilizing economic forecasts from your most respected economist or more objectively, an average of several economists forecasts to pin down the probabilities of occurrence. Determining the value of the variables is more difficult, but you could look at recent contractions and expansions as a guide.

Expected value calculations are far from perfect, but they can be extremely useful by keeping you in the game instead of watching from the sidelines and squandering opportunities.

Source: Stop Sitting On The Sidelines