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# Portfolio Management and Wealth Planning【Reading 7】

Which of the following actions is most likely the result of applying Bayes’ theorem of conditional probability? A fundamental analyst revises a stock recommendation when:
 A) the firm issues an earnings report.
 B) she revises her inflation expectations.
 C) the firm experiences a major fire that destroys its production line.

A fundamental analyst bases recommendations on firm or market fundamentals such as expected earnings. The fire would signal an unexpected change in the firm’s fundamentals as would a revised earnings announcement. Revising a recommendation based on the probability of a given level of inflation is an example of applying a Bayesian framework to an expectation. That is, the firm’s performance is based conditionally on the probability of a given level of inflation.

What is the purpose of using Baye’s formula in the investment decision making process?
 A) Incorporate some quantitative aspects into the portfolio construction process.
 B) Incorporate new information into previous forecasts updating those forecasts which aids in the investment decision making process.
 C) Assign probabilities to various outcomes helping the investor gain insight into the range of those possible outcomes.

Baye’s formula measures the probability of an event occurring given the probability of some other event occurring. It is used in the forecasting process, for example new information about a stock would be incorporated into a revised forecast aiding in determining whether or not to buy or sell the stock. Using Baye’s formula should result in more accurate forecasts.
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