When I’ve discussed my personal investment philosophy with other retail investors, I've been told I have a very “negative approach”. This is not because I’m always bearish. In fact, I am quite often in a bullish minority. It is because I assume that my decisions will be wrong half the time.
This seems to be a reasonable, conservative assumption. If you buy a stock at random, the probability that the price will rise in any given time period is roughly 50 per cent. If you put a great deal of effort into research, those odds may improve a bit. But even the best investors don’t have 100 per cent strike rates (65 per cent is fantastic). So, assuming a 50 per cent strike rate leaves room for pleasant surprises.
Buying a stock is a little like betting on a coin-toss (if we ignore the possibility that the price will be static). If a coin is tossed 1000 times, heads or tails will register close to 500 times each. But those heads and tails won’t always alternate.
The coin may come up the same way up in succession for long runs of 15-20 times or more. You don’t need to toss a coin to prove this assertion. Multiple experiments have registered the results. If you’re a cricket fan, you can also look up toss winning records for various teams.
Similarly, investors often see periods when the majority of decisions are correct and periods when the majority of decisions are wrong. Again, you don’t have to take this on faith. Look up the public records of mutual funds and of great investors. Everybody has good years and bad years.
If you have to bet on a 50:50 occurrence and make money, the payoff when you win has to be higher than the amount you stand to lose. So the risk:reward equation must be skewed in your favour. This is obviously true whatever the betting process.
One key difference exists however. A coin has no “memory”. It doesn’t care whether it came up heads or tails the last time. Every toss is an independent event. This is not true for investments. Investors remember whether they made or lost money on the last investment. That influences the decision-making.
It is important for an investor to maintain calm, regardless of triumph and disaster. Behaviourally, this is a difficult attitude to maintain. When things go in your favour for an extended period, there is a tendency to get over-confident. Conversely, if have several losses in succession, there is a tendency to get unnecessarily risk-averse.
If the initial assumption of 1:1 odds was just a way of maintaining psychological equilibrium, it would be of some limited value. After all, there are many other ways to prevent blood pressure spikes. However, the assumption of 1:1 odds can also help the investor to develop rational target expectations when it’s tied to a basic axiom: buy risky assets only if they offer better return expectations than safe assets.
The obvious risk-free asset is debt. Let’s say it’s possible to generate a 7 per cent return from a fixed deposit. Hence, an investor wants a premium of let’s say, 10 per cent return from equity. If half the equity investments (the losers) generate negative returns, a much higher return is required from the rest (the winners). Let’s assume the investments are all of equal amounts. Any sensible investor will favour approximately equal investments anyhow, at least at the initial stages of entering a stock.
Now, there is one thing any investor can control. That is the extent of losses when a given investment goes wrong. The key is to use cut-offs. Before entering a position, decide how much you are prepared to lose and maintain the discipline to exit if the cut-off is hit. If a cut-off is set at let’s say, 15 per cent loss of the initial investment, there is also a basis for setting a minimum quantitative target for the winners.
To generate 10 per cent return overall, given conditions where 15 per cent will be lost on half the investment the remaining 50 per cent must generate at least 35 per cent return. This implies that an investor with the above numeric assumptions shouldn’t buy stocks with less than 35 per cent visible upsides.
This simple linear logic has to be modified a bit since considerations of time enter the picture. How long does the investor intend to hold? In part, that is itself dictated by the target expectations. It isn’t reasonable to expect 35 per cent return in a week without going into leverage.
If the investor is prepared to hold a stock for say, two or three years, he or she must think in terms of compounding. A return of 35 per cent compounded thrice is about 145 per cent absolute gain. Is the investor prepared to lose 10 per cent compounded (about 35 per cent)?
If the risk-free rate of return is different (it changes if interest rates vary), the numeric value of expectations will also change, of course. But the basic logic remains the same. This thought process gives me an additional tool for stock selection. If a given stock doesn’t meet target expectations, I stay out of the stock. If there are no stocks that meet my target expectations, I automatically cease to be an active investor.
Even in those circumstances, I continue systematic index investing. This is a compromise made because I believe that over the long run, equity offers better returns than other, less apparently risk-free assets. But I avoid trying to pick stocks and just buy the broad market instead.
There are many ways to calculate target expectations. Fundamentalists do it via various valuation formulae, using historical accounting ratios and forecasting future earnings growth. Technical analysts do it via price history analysis. Pragmatists will marry both approaches and perhaps, weight their expectations with degrees of confidence in the target-setting formulae.
There will always be large error values in all those calculations. Obviously you’ll lose sometimes, and sometimes you won’t make as much as you hoped for. But sometimes those errors will be in your favour, and the stock in question will far overshoot the target.
One important point is that you shouldn’t book profits while the price trend is running in your favour, even if it has already exceeded the target. So long as you cut off your losers at an acceptable limit, and continue holding your winners, this logic seems to work.
It’s an interesting behavioural situation. There’s no compulsion to set odds at 50:50. An investor, who is highly confident, could set odds at 70:30 in favour perhaps. One who lacks confidence may set them at 30:70 against. The higher the estimated odds in your favour, the lower the targeted return expectations will be. This fits with the whole matrix of risk:return assumptions - you demand a lower return for a less risky investment.
But very few people seem prepared to accept that they may be wrong at all! My conversations suggest most investors believe their next investment will always have positive returns, regardless of prior track records. Also, very few investors are prepared to cut off losses at preset limits.
I lack statistical evidence to prove it but the “I’m always right” approach may lead to more lumpy and volatile returns. Since most people seem to think this way, the consensus attitude could explain some of the chaotic nature of price movements.
This article was originally published on March 17, 2012.
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