Trading on Expectations.

Firstly, an Expectation is the Average Payoff after taking into consideration the likelihood of a desirable outcome, payoff and the cost of invesment. You would do something if an expectation is positive. (i.e. a positive bet.)

E(x) = p(x). payoff - cost of investment.

Found this insightful synopsis on the various types of expectations traders (investors?) form when they buy and sell commodities in Moosa, "International Finance: An Analytical Approach", 2nd Ed. Ch. 4 pp. 107

Moosa quotes Pilbeam's[1] research concerning expectation formation mechanisms:

Extrapolative expectations mean that the exchange rate is expected to rise if it rises in the current period, and vice versa. (If ER rise now, it will continue to rise in future.)

Adaptive expectations mean that if exchange rate rises in at least 2 of the last 3 periods, then it should be expected to rise in the coming period. (If ER rising for past 2 out of 3 periods, then it will continue to rise in future.)

Regressive expectations mean that the exchange rate is expected to rise if it falls in the current period, and vice versa. (If ER is falling now, then it will rise in future.)

Rational expectations mean that expectations is formed on the basis of all available information. If this information is reflected in the forward (i.e. type of derivative) spread, then a currency that sells at a premium should be expected to rise, and vice versa. (If Forward Spread indicates rise, then a currency that sells at a premium should rise in future.)

Heterogenous expectations occur when the trader follows the majority signal. (Monkey see, monkey do.)

Contrarian expectations occur when the trader follows the opposite of the majority signal. (Monkey see, monkey do opposite.)

So as an investor with an element of speculation in you, how do u form your expectations?

[1] K. Pilbeam, 'The Profitability of Trading in the Foreign Exchange Market: Chartists, Fundamentalists and Simpletons', Oxford Economic Papers, 47, 1995, pp. 437 - 52.

Books to read for Financial Statement Analysis

This may sound obvious but if you would like to learn how to perform Fundamental Analysis on a stock the best place to start would be to get your hands on a university approved textbook for any module teaching Financial Statement Analysis.

I am using Stephen H. Penman's "Financial Statement Analysis and Security Valuation".

The textbook I am using is clear and succint and the maths isn't too complex. Just a series of Present Value calculations. (Remember Arithmetic progressions and Geometric progressions in A. Maths? Yup. its along those lines!)

Forget about spending $20 - 30 on those skimpy 300 page paperbacks that tells you how to read and analyse financial stocks. They don't have the exercises and supplementary notes and in my opinion the detail necessary to help you gain any insight into what's going on in the financial statements.

You can get cheap copies of these textbooks on University noticeboards, especially towards the end of semester. I got mine for $50. Best value for money ever.