Probability Of Events

Suppose you live in a 100 year flood plain. Your chances of experiencing a flood are 1% every year. If you live in the house for 30 years, your chances of experiencing a flood are about 26% (1-(0.99^30)). It would definitely be prudent to take safeguards against possible flooding if you plan on living in a home for a long period of time in a 100 year flood plain. Suppose you buy a house in a 100 year flood plain that had experienced a recent flood. Has the probability of a future flood changed? Flooding events are statistically independent, therefore the probability of experiencing another flooding event is unchanged by the previous flood.

Investment returns of a diversified portfolio can also be treated as statistically independent events. The chances of experiencing any specific return this year are independent of the return in any previous year.

The ProFolio Return Probability Calculator can be used for calculating the probability of a specific return for any investment portfolio given the return and volatility data. For example, the figure below contains the return probabilities for a portfolio with an annual return of 5% and an annual volatility of 10%.

If your investment portfolio has the characteristics shown in the calculator, the chances of having an annual return greater than 20% is 7% or about once in every 15 years while the chances of having loss greater than 20% is less than 1% or about once in every 161 years. If you hold this portfolio for 30 years, the chances of experiencing a loss of 20% is about 17%.

 

Disclosure:

The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.

The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.

Performance data showing past performance results is no guarantee of future returns.

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