Morgan Stanley IM: Probabilities and Payoffs – The Practicalities and Psychology of Expected Value

We discuss some of the issues with the calculation of expected value, what the payoff picture means for investing, the implications of volatility drag, the psychology of dealing with probabilities and payoffs, and how these ideas can be helpful for investing in various asset classes.

• The prime task of an investor is to find opportunities with gaps between price and value, with price being fairly straightforward and value more of a challenge to assess.
• A common approach to estimate value is to consider expected value, the sum of the products of various payoffs and their associated probabilities.
• Some markets have seen a shift in appetite from high probability, low payoff opportunities to low probability, high payoff ones, including the trading of short-dated options in equity options markets.
• In this report, we discuss some of the issues with the calculation of expected value, what the payoff picture means for investing, the implications of volatility drag, the psychology of dealing with probabilities and payoffs, and how these ideas can be helpful for investing in various asset classes.

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