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What are the probabilities?


JBird
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Inspired by a lecture from Charlie Munger, http://ycombinator.com/munger.html, I thought it may be useful to have a discussion on probabilities. Specifically, attempting to quantify the probabilities of some future events, as well as explaining the thinking process behind the estimation. I'd like to stick to events that are both important and knowable. Consider first the questions Warren asked of Charlie during the Berkshire meeting this year:

 

What is the probability that inflation runs at 5% or higher in the next 10 years?

 

What is the probability that the US dollar is the world reserve currency in 20 years?

 

Of course, answering these questions cannot be done with precision.

 

 

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Inspired by a lecture from Charlie Munger, http://ycombinator.com/munger.html, I thought it may be useful to have a discussion on probabilities. Specifically, attempting to quantify the probabilities of some future events, as well as explaining the thinking process behind the estimation. I'd like to stick to events that are both important and knowable. Consider first the questions Warren asked of Charlie during the Berkshire meeting this year:

 

What is the probability that inflation runs at 5% or higher in the next 10 years?

 

What is the probability that the US dollar is the world reserve currency in 20 years?

 

Of course, answering these questions cannot be done with precision.

 

Bird,I don t know if these things are knowable. I don t think anyone knows, so it is probably not that important.

 

This concept of expected valuation/probability is new to me.

 

Obviously putting a probability on an outcome is more of an art + guess. Other outcomes may be a lot easier -example; probability that coke will continue to grow earning by x % and will be a great business in 10 years (because everybody knows this,it may not be very important either for the sake of making money, but to realize this)

 

For the sake of (me) learning and discussion:

 

 

  In the case of inflation being >5% 

    my possible out comes would be i >5%  or ii <5%

 

  Seeing that I have no idea and have no insight I would use (what was recommended in book Thinking, Fast and Slow) the base rate as the most likely.

 

http://4.bp.blogspot.com/-NQAuKUEl4Y0/T3EjXaTS-2I/AAAAAAAABUQ/k21b2SrBnZQ/s1600/U.S.+Yearly+Inflation+Since+1900.jpg

 

it appears that inflation was >5% twelve times over last 100 years

 

So I think that a probability of inflation <5% of 88% is as good as any

 

Therefore probability of inflation >5% is ~ 12% is as good as any, possible but not likely.

 

The second question re US dollar being a world currency:

 

Possible outcomes- yes or No

 

The base rate in my mind would be continuing the status quo especially seeing I have no special insight. If I had special insight or fact then I would adjust my guess accordingly.

 

Intuitively I think it is likely and probable that US dollar will still be the reserve currency.

 

I think its possible but unlikely that some other currency or basket of currency/commodities will be the reserve currency

 

When I think that something is probable, I think that it is at least 51% probable. In this case  I would guess that there would be more  certainty and while it is probably not 100%, over short period of time like 20 years I will guestimate it at 95-99%.

 

Bird, it may be more instructive to look at how we could use probability, mathematical/expected valuation in some stocks that have recently been discussed and are popular here- say BAC or MBIA or SHLD.

 

 

 

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What is the probability that inflation runs at 5% or higher in the next 10 years?

 

Greater than 0%, less than 100%.

 

What is the probability that the US dollar is the world reserve currency in 20 years?

 

Greater than 0%, less than 100%.

 

I await my Nobel prize.

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You said yourself that these things can't be answered with precision and I agree.  Any answer is nothing but fortune telling and/or opinionated guess work.  But I will make my guess.

 

What is the probability that inflation runs at 5% or higher in the next 10 years?

 

85%:  This isn't a high-hyper-inflation scenario and with all the money printing going on I think it is safe to assume that 5% is likely to be reached in at least one year out of the next 20.

 

What is the probability that the US dollar is the world reserve currency in 20 years?

 

50%:  20 years is a long time and the rate of change is picking up.  I think we are likely to see more change in the next 20 years to our society and our way of life than we've had in the last 60.  I'd say it is as likely as not that the position of the US, in general, and the US dollar, specifically, in the world will be one of those major changes.

 

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Let me throw my hat in the ring.

 

1. Regarding inflation of >5% in the next 10yrs.

    I have no idea but the taking history as a guide. I think US might not see inflation at the level. Japan on the other hand may see high inflation. So i say 49% chance for US to see >5% inflation. Japan may be 70% chance.

 

2. USD as reserve currency for next 20yrs. For some reason I am pretty confident that USD will be reserve currency for next 20yrs.

Here are necessary conditions for reserve currency:

      1. Wide acceptance. or Trust in currency.

      2. Rule of Law for business and personal freedom.

      3. Need to be transparent.

      4. No hindrance on capital movements.

      5. A deep and liquid Bond market.

      6. military/economic strength.

 

Just looking at the size of the economic bloc, i would say the following are possible candidates for reserve currency status:

1. US dollar.

2. Euro.

3. Chinese Yuan.

 

 

Of the 3, Chinese currency will pass the least of the Qs. Even though there are Creditor nation and will be the biggest Economy past 2016 as per IMF projections.

 

Euro has good chance if they get their act together. But again, they dont have a Euro bond market just a single currency.

 

In my opinion USD will be Reserve currency for next 20yrs so i put the probability at 95%. There is always an outside chance of good Bond market developing in Eurozone or China. But China has to do more than just have a bond market. Those are all low probability events.

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Keep in mind that probability is just a % estimate of the specified event occurring, at a future point in time, +/- an allowance for uncertainty. P(ground breaking event, t=1): 85%, +/- 5% means there is an estimated 80-90% chance of the 'ground breaking event' occurring within 1 year. High enough to warrant a potential investment in the ground breaking event actually occurring. 

 

The longer the time period the more uncertain the estimate, & the less powerful the prediction. P(ground breaking event, t=7): 85%, +/- 35% means there is an estimated 50-120% chance of the 'ground breaking event' occurring within 7 years. Essentially a coin toss. Low enough to warrant changing the strategy to shorting, or selling calls on, the company to capture the misplaced enthusiasm. 

 

Probability is also a 'relative' measure, that assumes all else 'constant'. i.e the company business plan will remain as profitable as it currently is throughout the whole 7 years, there will be no interim financing to support development, etc. All unrealistic.

 

Most folks restrict their use of probability to short horizons, & the limitations are recognized intuitively.

Actuaries & underwriters excluded. 

 

 

 

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Keep in mind that probability is just a % estimate of the specified event occurring, at a future point in time, +/- an allowance for uncertainty. P(ground breaking event, t=1): 85%, +/- 5% means there is an estimated 80-90% chance of the 'ground breaking event' occurring within 1 year. High enough to warrant a potential investment in the ground breaking event actually occurring. 

 

The longer the time period the more uncertain the estimate, & the less powerful the prediction. P(ground breaking event, t=7): 85%, +/- 35% means there is an estimated 50-120% chance of the 'ground breaking event' occurring within 7 years. Essentially a coin toss. Low enough to warrant changing the strategy to shorting, or selling calls on, the company to capture the misplaced enthusiasm. 

 

 

 

Probability is also a 'relative' measure, that assumes all else 'constant'. i.e the company business plan will remain as profitable as it currently is throughout the whole 7 years, there will be no interim financing to support development, etc. All unrealistic.

 

Most folks restrict their use of probability to short horizons, & the limitations are recognized intuitively.

Actuaries & underwriters excluded. 

 

 

 

 

Not to quibble... But what does it mean 120% probabilistically speaking in real life sense? :)

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Yes. Definitely... like what Nate Silver mentioned in the book the Signal and the Noise, computers can do weather forecast relatively well within 2 or 3 days. It's a coin-toss around 7 days due to the Chaos theory. An example of the theory is that a butterfly flapping its wing in Brazil can cause a tornado in Texas that sort of thing. Various airflows can interact with each other in unpredictable ways.

 

It's a great book, by the way!

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