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Probability Machine

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Step 8: Riskese

fascination with this phenomenon by stating, “I know of scarcely anything so apt to impress the imagination as the wonderful form of cosmic order expressed by the ‘Law of Frequency of Error.’ It reigns with serenity… amidst the Francis Galton wildest confusion. The huger the mob, and the greater the apparent anarchy, the more perfect is its sway. It is the supreme law of Unreason. Whenever a large sample of chaotic elements are taken in hand and marshalled in the order of their magnitude, an unsuspected and most beautiful form of regularity proves to have been latent all along.”86 I commissioned the creation of the Probability Machine to educate investors about the probability of outcomes that result from a series of random events. In the stock market, the random events are news stories about a company or about capitalism in general, and the resulting prices of securities. The random drop of the beads, starting with a central point of a fair price, simulates a series of fair prices, ultimately forming a normal distribution in the shape of a bell curve. The distribution of the beads bears a strong resemblance to the distribution of monthly returns shown in red bars behind the beads, also shown in Figure 8-2, reflecting 600 monthly returns (50 years) for an allequity index portfolio. Like the Probability Machine’s normal distribution, the portfolio carries a wide range of outcomes or a high standard deviation. It maintains an approximate normal distribution that accumulates to an average 1.14% monthly fair return over 600 months, but with a standard deviation of 4.67%, which is a high level of short-term volatility.

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