Subjective Probability Vs. Objective Probability

Probability is the likelihood of an event to occur. It is impossible to guess some events whether will occur with 100% certainty and hence the use of the theory of probability is important. It tells us the certainty of an event to occur and how and why it will occur. Probability is an important theory in finance because most of the calculations in finance occur in the future for which probabilities of their occurrence are important to consider.

Depending on the nature of calculation or determination, there are two types of probabilities. The one that uses history and data is known as objective probability while the one that uses personal opinion is known as subjective probability. Here is more about the two.

The formula for calculating probability is,

$\mathrm{Probability\:of\:an\:event\:to\:happen,RateP(E)= \frac{Number\:of\:Favorable\:Outcomes}{Total\: Number\: of \: Outcomes}}$

Subjective Probability

Subjective probability is personal, and they are not data-driven.

  • A person may think a certain incident to occur at certain moments and hence form an opinion of their own. They may act depending on the opinion and such an idea of an occurrence of a certain event is known as subjective probability. Most subjective probabilities are not facts.

  • In most financial decisions, a quantitative measure is upheld to form an opinion. However, in the case of subjective probability, it is related more to subjective opinion than quantitative information.

  • For example, a person may think that the BSE will gain 65% value the next day, while another person may think it will gain 50%. Both are examples of subjective probabilities.

Objective Probability

Objective probability is the likelihood of occurrence of an event that is based on historical data.

  • Instead of using personal opinion, analysts use data and mathematical equations to derive the objective probability of an event. Since analysts use all kinds of measurements to predict the future, the objective probability is considered more accurate and sophisticated for making business decisions.

  • This kind of probability uses history and data to derive the likelihood of a future event that has not happened in the past. By comparing the historical data, the likelihood of an outcome is made. Quantitative analysis is the core of objective probability calculation.

  • Objective probability is more about independent events; the events that have a probability of occurring in the future but have not happened in the past.

The values of historical data impact objective probability, as it seeks information about the quantitative chance of an event to occur in the future.