Mutual Funds Day 40: Probability Distribution
In the last chapter we learned about standard deviation, probability distribution has its roots in SD, if you have not read that article, please do so.
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Probability Distribution: If an event has a definite number of outcomes, and if we repeat the tests for a long duration, the outcomes will be spread in a unique bell-like pattern called the probability distribution. It may also be called a normal distribution, Gaussian, or Bell Curve.
Mathematically 68.2% of all outcomes will be between 1 standard deviations from the mean. 95.4% of all outcomes will be between 2 standard deviations from the mean and 99.6% of all outcomes will be between 3 standard deviations from the mean.
Even if you are from a mathematical background, you still might be thinking why these charts, data & jargon require so much explanation. I am here to reassure you that the probability theory and standard deviation have a huge role to play in making money in stock markets & mutual funds.
68% of all occurrences may be between +1 and -1 standard deviation of the mean value. So when you select your next mutual fund to invest in, you will have a higher confidence in predicting the returns trajectory if you know its standard deviation & mean.
Similarly, if you trade stocks or options, you will have a higher confidence in predicting the outcome if you know the SD and mean returns.
This bell curve fitting is used in many industries outside of the financial markets
- Year-end appraisals in corporations.
- Admission test results plotting.
- Satisfaction Survey
- Demography tests
The probability of something happening 68% of the time does not mean that it should happen as expected. When the results are other than ordinary, it is called an outlier. In financial markets, these outliers are called Black Swan.
When outliers happen, it has the firepower to ruin everything. The recent example of a black swan event was the COVID lockdown, it created ripple effects across the globe, many businesses closed, people were stranded and all of a sudden the sentiment was so bleak that people felt humanity would collapse.
This sentiment shift happened in a matter of days, the prior week everything was working so perfectly, people were cheerful and everyone had a positive outlook.
The broad point I am trying to make here is that — people expect the results of any event to be within the range they accept. If the results are way higher or lower, it can trigger panic.
The same is true in Investing, especially Mutual Funds. If the historic returns of an MF were say 12% and if the current period’s performance comes out to be 4%, it may create a huge redemption pressure. It may even have a snowballing effect and could spoil the fund’s credibility. There have been instances when AMCs have restricted redemptions due to liquidity pressures.
Similarly, if the same MF shows a return of 40%, it may again steal the news. More and more people would be flocking in to park their funds with this AMC. This sudden rush of inflows may even end up overwhelming the AMC’s operations.
When things go normal as expected, people do not notice. But the moment an outlier happens — it has the power to change the behavior of a group of people.
Next Chapter
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