Math & Probability

If there's one thing that trips up most investors, it's math and probability. But it doesn't have to be a big obstacle. To excel at investing you don't have to have an advanced degree in math or statistics. You just need to grasp a few straightforward concepts that are important and relevant to investing.

Math

If you are fluent in grade school arithmetic and high school algebra, you have all the math training that you need as an investor. And you can even be terrible at algebra (like I am) and still be able to grasp the math of investing. 

Here's what you need to know:

Compound interest. Boiled down to its simplest form, compound interest is the idea that as time goes by, you are not just earning a return on the money you initially invested. You're earning a return on that money plus the interest you have collected along the way. Put another way, compound interest is earning interest on the interest you already made. Simple!

The Time Value of Money

Simply stated, a dollar in your pocket today is more valuable than a dollar you will get in the future. Why? Because of inflation. How does this relate to investing? Because the value of a company is determined by the growth of earnings and dividends that will come in the future. But those cash flows are not worth as much as they would be in today's dollars. There is a discount applied to the cash flows, and that is one of the key principles of investing math.

Probability

Investing is not a purely mathematical endeavor. There are emotions involved. When investors are happy and optimistic, they will pay more for a stock than they would if they were worried and pessimistic. That's where probability comes into play.

If you have ever participated in a game of chance, like cards or sports betting or horse racing or the state lottery, you have experience with probability. 

The worst odds of winning are found in the lottery. Very low probability of winning, and very high payout if you do happen to win.

In cards, if you are skilled you can tip the odds of winning in your favor, so that is a probability-rich environment for skilled players.

In the stock market, the odds are stacked against you, unfortunately. Unless you have some kind of an edge. Your edge can be something like an intimate familiarity with a certain company, and their prospects for future growth. Or it could be a superior strategy that is unique and profitable. 

Without an edge, the probability of beating the market consistently are slim to none.