Decision 1: Choose between:
A. A sure gain of $240
B. 25% chance to gain $1000
Decision 2: Choose between:
C. A sure loss of $750
D. 75% chance to lose %1000
I'll talk about it later in the posting, but make sure you chose it now :)
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Reading through this book now.
It's called clueless in banking and finance.
It's a brief overview of the entire banking and finance industry, ranging from the purpose of banking to the different types of debts or equities instrument to raise capital. Learnt SOoo much from this book alone that it's even to kickstart more reading if I'm interested in certain aspects of it. Now I now what's tranche, what's underwriting and footsie :) haha
There's this interesting survey talking about how behavioural finance show us why investors do not behave rationally, therefore making markets not as efficient as what we learn.
The survey earlier on was conducted with a sample of 150 people. The majority of respondents chose A (84%) and D (87%), meaning that they prefer to have a sure gain and avoid the sure loss. Is that your choice? haha :)
The rational choice is not A and D. You can actually calculate the expected returns based on the different choices.
If you choose A and C,
1st case: 240 + (-750) = -510 (100%)
2nd case: 240 - 750 = -510 (100%)
Expected gain = - $510
If you choose A and D,
1st case: 240 + (0) = 240 (25% chance)
2nd case: 240 - 1000 = -760 (75% chance)
Expected gain = 240x0.25 + -760x0.75 = - $510
If you choose B and C,
1st case: 1000 + (-750) = 250 (25% chance)
2nd case: 0 - 750 = -750 (75% chance)
Expected gain = 250x0.25 + -750x0.75 = - $500
If you choose B and D,
1st case: 1000 + (-1000) = 0 (18.75% chance)
2nd case: 1000 + 0 = 1000 (6.25% chance)
3rd case: 0 + -1000 = -1000 (56.25% chance)
4th case: 0 + 0 = 0 (18.75% chance)
Expected gain = 0x0.1875 + 1000x0.0625 + -1000x0.5625 + 0x0.1875 = -$500
I'll just spare you the maths and just showed you the essential working to derive the expected gain/loss from choosing different scenarios.
The rational choice here would be either to choose B and C or to choose B and D, as it would result in the likelihood of losing less. If all the 150 participants chose randomly, the chances of getting A and D individually would be close to 50%. The high percentage of respondents choosing A and D means something.
Market efficiency can only work if investors are rational, which they are not. If they can't even make rational choices, how can we assume that they would react rationally and price in all the news and information available to them? I'm not even going to talk about information and news that are not available to them.
Interestingly, the book mentioned that the rational economic choice would have been B and C. They did not even go through the calculation themselves to find out the other rational choice. Hahhaa, says more about rationality in human behaviour.
Want to know my choice? I chose B and C. I did not work out the probabilities before coming up with my decisions. I chose it because in technical analysis, I've trained myself to cut losses and maximise profit. B would maximise my profit while D would minimise my losses, hence my decision. I always prefer sure and smaller losses compared to huge but probable losses.
China raised the interest rate the 4th time this year, in its attempt to curb the overheated economy. I wonder what sort of impact we'll see in HK and Shanghai bourses tomorrow. From past experience, it might even rally further, because it has been priced in.
We'll see tmr.
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