Wednesday, November 11, 2015

Time-Value Vs Expected-Value Or Likely Poverty Vs Average Riches

In his excellent book, A Mathematician Plays The Stock Market, John Allen Paulos outlines a potentially disastrous, trading strategy that clearly illustrates the difference between expected value and time value summary statistics or, in his case, mean (expected value = +10% -> average riches) and median (time value = –16.43% -> likely poverty) performance.

This extreme example points to the obvious advantage of knowing the most likely outcome of an investment and raises the interesting question of how to summarize a trading portfolio in time value terms?
By way of illustration, assume a trading portfolio (illustration only) that includes just two sports, baseball and horse-racing, with the following profiles:

It is now immediately apparent that, even though both profiles have positive expected values, they are losing propositions as reflected by their evens-equivalent, negative time values.
In summary, expected value summarizes the average performance across all traders and is of critical importance to the bookmaker whereas time value best reflects the most likely, individual outcome and is of paramount value to the individual sports trader!