Losing weight

Most stocks in the US and in the Philippines are taking a beating recently. The biggest drops (so far) were early this March. The past few days have mellowed but still there are some lingering erratic movements.

To wise investors, there's always a good opportunity even when the stock drops. For one, the stocks become cheap during this slide and so buying is better.

While at this, I thought of posting this problem 4.65 from page 305 of Introduction to the Practice of Statistics, 5^th edition, by David S. Moore and George P. McCabe. This is a simple problem on stocks using basic statistical probability. We have our final exam these days so this was also part of my review for Statistics.

4.65/305). You buy a hot stock for $1,000. The stock either gains 30% or loses 25% each day, each with probability 0.5. Its returns on consecutive days are independent of each other. You plan to sell the stock after two days.

a) What are the possible values of the stock after two days, and what is the probability for each value? What is the probability that the stock is worth more after two days than the $1,000 you paid for it?

b) What is the mean value of the stock after two days?

The problem can be solved starting with a tabular presentation below:

For a), the possible outcomes are:

There are 4 possible outcomes and so, each outcome has a probability of 1 of 4 or 25%. After day 2, note that there are two $975 coming from outcome 2 and 4. Hence, the probability of getting $975 after day 2 is the sum of the probability of outcome 2 and 3. This is 0.25 + 0.25 = 0.5 or 50%.

There is only one outcome of getting more than $1000 after two days. This is 1690 in outcome 1 which has probability 25%.

The mean value of the stock, say µX, is the summation of the all individual outcome with its specific probability. This is the same as the weighted value with probability serving as the weights.

There is a small gain on the average which is possible if one has several investments of this kind. However, if there is only one account, the law of large number is not at work. Given only one stock with an equal chance of losing 25% or gaining 30%, the chance of losing is actually greater. As shown in the table, there are three possible losing outcomes (out of four) that would shrink the stock below $1000.

In other words, this stock has a losing chance of 75%. Not a good one. In the stock market, there are several companies with better lose-gain attribute.

Historical daily performance can be checked from the company profile. This simple statistical analysis is only one of the tools that can be used as guide in investing. In particular, this gives an insight on what may happen should one redeem or sell the stock.

Statistics is a good exercise to keep our stocks and other investments in good shape.

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[written 03.14.2007]