Thumbnail Image

Probabilistic approach to investment analysis

Johnson, Richard Tolley
Scope and Method of Study: This report has been undertaken to introduce probability considerations in evaluating prospective investments. The scope of the report is limited to the consideration of the type of investment made by a profit motivated firm. The method of study includes a survey of journals and books which present currently used methods of investment analysis and suggestions about future analytical approaches. The main emphasis of this report is placed on a presentation of a method of analysis which yields a complete probability distribution of the outcome from any given investment.
Findings and Conclusions: A firm is able to choose more wisely an investment that will increase its net worth if it knows the probability of realizing any given return from each investment it considers. By using the method of investment analysis presented in this report, management can derive estimates of the most likely rate of return and of the probability of realizing any other rate. The procedure requires three estimates for each revenue and cost expected during the life of the investment. It also requires the use of the beta distribution to approximate the actual distribution of each of these costs and revenues. The final result is a distribution of the expected rate of return approximated by the normal distribution. Such a solution, containing only two parameters, the mean and the variance, describes all possible outcomes and the probability of their occurrence.