normally I'd ask this in the investing/markets section but the question is mainly geared toward hedge fund professionals so please forgive the intrusion.

when you perform scenario based analysis and you compute the classic risk-to-reward ratio (3-1: 3 upside vs 1 downside), do you generally assign probabilities to this output?

that is,

if you think FB has 30% upside and 10% downside, do you also include the chances of it happening (50% / 50% for the ratio to make sense) ? that is, do you additionally say: FB has 30% upside with a 40% chance whereas the stock can go down 10% with a 60% chance?

and if so, do you have some general rule of thumb? I mean it's not like we can weigh all the different things that might happen that unlock value (or disrupt it). Also, I understand this analysis is best suited when evaluating binary-events such as FDA approvals and / or special situations rather than, say, industrial stocks which are more prone to a sensitivity analysis

BUT, I value your input very much and I would love to hear what your best practices are because I've always been curious about this and because, well, the buyside is where I'd like to end up.

thank you very much for your time

Comments (4)

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unfortunately that method is not viable when including this kind of analysis. the monte carlo methods, while doable, is not actionable upon and does not provide value added. most of the times is what happens and what doesn't that matters and in order to reassess your thesis as you go along you do not re rerun a monte carlo simulation, you revisit your hypothesis in the model and I was wondering wheter guys around here tweak those and ALSO weigh them by the probabilities.


To answer your question directly - no we don't assign a "probability" to our ranges. In my personal opinion - it would be nearly impossible to accurately project the probability of an outcome with any degree of quantifiable certainty. It is more difficult to accurately derive an investment probability than you might imagine...

I think the 2008/2009 crisis pretty much exposed the giant inherit risks associated with relying solely on simulations such as monte carlo, etc. In my opinion, these models should be used more as a supplement than an actual basis of investment. They would also be appropriate for options pricing scenarios, etc but again I think they overlook extreme bear and bull situations.

With that being said, I work a fundamentals-based HF and we aren't "quant" finance guys. I'm sure there are plenty of quant guys crushing it using only models and technical charts but we have no interest.


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