One of the investment risks in 2018 is the outcome of the 14th general election. Who will win? Unfortunately, nobody know what will happen with 100% certainty.
The objective of this article is to illustrate the use of decision tree analysis to guide us whether to be in the market or out of the market given the general election risk.
A decision tree is a graphical representation of sequential decision problem, incorporating logic, value and probability. Construction of the tree requires the compilation of relevant data and organisation of the problem into a logical sequence of information gathering and decision making.
TA Securities in its market outlook report, tables three scenarios and its outcomes had been identified as follow;
BN win and no major changes in seat tally. KLCI will gain three percent. The market will not surprise as the impact has been price in. Investor mostly expected BN will win and preserving status quo.
BN regain two-thirds majority in Parliament. Market will celebrate with 10% gain. Blue chip and GLCs could attract buying interest.
BN lose and no dominant power in the Parliament. Market will crash 20% immediately. The FBM KLCI could remain in the doldrums for the rest of the 2018.
Based on the TA Securities market outlook, the probability of each scenario was estimated. I assigned Scenario 1, Scenario 2 and Scenario 3 with probability of 0.7, 0.2 and 0.1 respectively.
Square node is a decision node. Circle node is a chances node. The decision tree commenced with the decision to invest or not to invest in the market. So A is a decision node and B is a chances node.
If the decision is not to invest, then nothing will happen. If the decision is to invest, then there are three possible scenarios and impacts as discussed above.
Expected Value is a probabilistic or weighted average. In other words, it is an estimate of the likely average return over a series o similar investment.
For example, Expected Value gambling in a casino is always negative to the gambler. Series of loses with occasional win added will give a negative monetary value. Gambler as a group is always a loser. Genting as a company all the time win.
The expected value of a scenario may be defined as the summation of product of its numerical outcome and its probability of occurrence.
The results show the Expected Value of positive 2.1. Hence the decision is to invest in the market.
Elias Abllah, Personal Finance