What Investors Need to Know About the Probability Theory

What investors need to know about the probability theory

Probability theory is a branch of mathematics that enables us to comprehend the likelihood of random events occurring. It finds application in diverse areas such as finance, engineering, and computer science, allowing us to anticipate the probabilities of various outcomes.

Consider the act of flipping a fair coin as an example. Probability theory allows us to calculate the likelihood, or chance, of receiving either heads or tails. Because there are only two possible outcomes and the coin is fair, the probability of getting heads or tails is 1 out of 2, or 50%.

In more intricate scenarios, probability theory can become more involved. Utilizing mathematical formulas and techniques, it allows us to calculate the probabilities of different outcomes based on the available information. This proves invaluable when making decisions or analyzing data.

For instance, in the field of finance, probability theory aids in comprehending the risk and potential return of investments. By calculating the chances of various investment outcomes, it assists investors in making informed choices regarding where to allocate their funds.

Consequently, probability theory serves as a tool that facilitates our understanding and prediction of the likelihood of diverse events. Its practical applications span across numerous disciplines, enabling us to make well-informed decisions.

Probability distributions

Probability distributions are pretty awesome because they help us understand how likely different things are to happen in random events. It's like having a tool that tells us the chances of different outcomes.

There are two main types of probability distributions: Discrete and Continuous

Let's start with Discrete Distributions. They're all about situations where we count separate things. Think of rolling a die or flipping a coin. Each outcome is distinct and separate. It's like having a list that shows us the probabilities of each possible outcome. For example, if we flip a fair coin, we have a 50% chance of getting heads and a 50% chance of getting tails. Simple, right?

Now, let's talk about Continuous Distributions. These come into play when the outcomes form a smooth and unbroken range. Instead of specific values, we have a whole bunch of possibilities. Continuous distributions help us understand the probabilities of different values within that range. It's like getting an idea of how likely different numbers or measurements are within a certain range.

Okay, let's bring it to life with examples! The binomial distribution is a type of discrete distribution. It's handy when we want to find the probability of achieving a specific number of successes in a fixed number of tries. So, imagine we want to know the chances of getting two heads when flipping a coin five times. The binomial distribution helps us calculate that.

Now, let's move on to the normal distribution, which is a type of continuous distribution. This one is often used in finance. It helps us understand the probabilities associated with different values that a random variable can take. For instance, when people talk about stock market returns, they often assume they follow a normal distribution pattern.

So, probability distributions are like our trusty tools for understanding and measuring the likelihood of different outcomes in random events. They can be discrete like counting coin flips, or continuous, like measuring things along a range. By using these distributions, we can make predictions and analyze data in various fields.

Expected Value

The expected value of a random variable is the average value we expect to acquire from it. It is determined by considering all the possible outcomes and their corresponding probabilities.

Let's consider the scenario of rolling a fair six-sided die. To find the expected value, we examine the probabilities associated with each side. Since there are six sides, and each has an equal chance of landing face-up, the probability of obtaining any specific side is 1/6 (approximately 16.67%).

To determine the expected value, multiply each outcome by its likelihood and add the results. In this case, we multiply each side (1, 2, 3, 4, 5, and 6) by 1/6 and add them together. The expected value turns out to be approximately 3.5.

Therefore, the expected value of rolling the die is around 3.5. This implies that if we were to roll the die numerous times and calculate the average outcome, it would be close to 3.5.

We denote the expected value as E(X), where X represents the random variable of interest. It aids us in comprehending the "typical" or average value we can anticipate from a random event or variable based on its associated probabilities.


Is a measure that informs us about the extent to which the possible outcomes of a random event are dispersed. It quantifies the average difference between each outcome and the expected value.

To calculate variance, we employ the following formula: Var(X) = E [(X – E(X))^2]. Here, Var(X) represents the variance of the random variable X, while E(X) represents the expected value of X.

In simpler terms, variance provides insight into the extent of variation between the actual values of a random variable X and the expected average value. It offers a glimpse into the spread or concentration of these values.

When the variance is high, it indicates that the values of X are widely spread across a broad range. This suggests that the outcomes can deviate significantly from the expected value. Conversely, when the variance is low, it implies that the values of X are closer to the expected value, tightly clustered around it.

For instance, let's consider a random variable X that represents daily temperatures. If the variance of X is high, it means that the daily temperatures exhibit substantial variation from day to day, with some days being much hotter or colder than the average. However, if the variance is low, it indicates that the temperatures are more consistent, with most days aligning closely with the average temperature.

To summarize, variance aids in comprehending the degree to which the actual outcomes of a random variable deviate from the expected value. It provides insights into the spread or clustering of values and is denoted as Var(X).


Is a way to measure how two things are related to each other. In finance, it helps us understand the risk of investments. When we talk about covariance, we want to know if two investments move in the same direction. A high covariance means they tend to move together. For example, if one investment goes up, the other is likely to go up too. This means there is less diversification, and they may not protect against risk as well.

On the other hand, a negative covariance means the investments move in opposite directions. This is good because it shows that the portfolio is diversified. When some investments go up, others may go down, creating a balance. It helps reduce risk because not all investments move in the same direction at the same time.

If the covariance is zero, it means there is no strong relationship between the investments. The movement of one investment doesn't affect the movement of the other. They are independent of each other.

In simple terms, covariance tells us if two investments move together, move in opposite directions, or have no relationship. Understanding covariance helps investors evaluate the risk and diversification of their investments.

Conditional Probability

Imagine you have a coin, and you want to know the chance of getting tails when you know the coin is fair. Fair means it's not biased toward heads or tails, so both sides have an equal chance of showing up.

Conditional probability is like figuring out the chance of something happening when you already know something else. In this case, we want to know the chance of getting tails when the coin is fair.

To calculate it, we use a formula: P(A|B) = P(A and B) / P(B). It looks a little complicated, but let's break it down.

P(A|B) means the probability of event A given event B has happened. In our case, A is getting tails, and B is the coin being fair.

Now, let's imagine we have 100 coins, all fair. If we flip them all, about 50 of them would show tails, right? So the chance of getting tails (A) is 50 out of 100, or 50%.

Now, since we assume the coin is fair (B), that means all the coins are equal, and we have 100 out of 100 coins that are fair. So the probability of event B (the coin being fair) is 100 out of 100, which is 100%.

Now we can use the formula. P(A and B) means the chance of both A and B happening together. In our case, that's the chance of getting tails with a fair coin. Since the coin is fair, the probability is 50 out of 100, or 50%.

Finally, we put it all together: P(A|B) = P(A and B) / P(B). So we have 50% (A and B) divided by 100% (B), which equals 50%. That means the chance of getting tails when the coin is fair is 50%.

To make it simple, conditional probability helps us find the chance of one thing happening when we already know another thing has happened. It's like adjusting our probabilities based on the extra information we have.

Bayes’ Theorem

Bayes' theorem is a special formula that helps us change our guesses or predictions when we learn something new. It's named after a mathematician named Thomas Bayes who came up with it.

The formula looks like this: P(A|B) = P(B|A) * P(A) / P(B). Let's see what each part means:

P(A|B) is the chance of event A happening when we know event B has already occurred. It's like asking, "What's the chance of A happening now that we know B happened?"

P(B|A) is the chance of event B happening when we know event A has already occurred. It's the other way around, asking, "What's the chance of B happening now that we know A happened?"

P(A) is the chance of event A happening without considering any new information. It's like our original guess for how likely A was.

P(B) is the chance of event B happening without considering any new information. It's our original guess for how likely B was.

Bayes' theorem is used in many different areas like statistics, machine learning, and decision-making. It helps us update our guesses or probabilities based on new data or information we receive.

For example, let's say we have a spam filter for emails. When a new email comes in, the spam filter uses Bayes' theorem to update the probability of that email being spam based on certain things it knows about spam emails. By updating the probability, the filter can decide more accurately if the email is spam or not.

Bayes' theorem is also used in predictive modeling. It helps us update the probability of something happening in the future based on what we have observed in the past. This helps us make better predictions about what might happen.

Lastly, Bayes' theorem is used in risk assessment. Using new information, helps us update the probability of certain risks or events happening. This way, we can make smarter decisions based on the updated probabilities.

So, in simple terms, Bayes' theorem is a formula that helps us change our guesses or predictions based on new information. It's used in many areas to make better decisions and predictions.

In conclusion

Probability theory is very useful in different industries, including finance. In finance, it helps us understand and predict how financial markets behave. It also helps us determine the value of financial instruments like options and derivatives. With the increasing amount of data being generated and analyzed, probability theory is becoming even more important in these areas.