First a quick thought experiment: Let’s assume that this site offered a stock-trading recommendation email service titled “Bonanza System (BS)” or a similar catchy name. To counter your healthy skepticism, I offer free access for 6 weeks, with weekly email recommendations on stocks to buy and sell. Without committing any money, you monitor how the recommendations pan out…
It’s now six weeks later and lo and behold, all the recommendations from the “Bonanza System” have been spot on! You calculate you would’ve made a gain of 46% in just 6 weeks! Just then a new mail notification lights up and you click to see a reminder saying your free trial has ended.
Do you want to pay ₹24,000 for a year’s BS subscription based on the unlikely 6 week track record?
A regular weekday morning as you step out of the elevator and head to your car…
Part 1: You get into your car and strap yourself into the driver’s seat. You check that the gear shift is in neutral before turning the ignition. As the engine purrs to life, you check your rear-view mirror, press the brake, disengage the handbrake, shift into ‘R’. You park on an upward slope, so you only need to ease up on the brake and the car starts rolling backwards out of it’s parking space. You turn the wheel and go back to within inches of your neighbour’s parked car before you stop, shift into 1st and set off.
Part 2: You’ve decided to take an alternate route to office today, because the last few days you were stuck in traffic for well over an hour. You also left 15 mins before your usual time. You’re optimistic. You make good time for the first 20 mins and start to think you might even make it in under an hour. Then you turn onto one of the major toll roads and your heart sinks at the sight of two lanes with a long lines of vehicles, crawling along at walking speed. You curse under your breath but with no alternative, wade through the traffic. By the time you get to office, it’s an hour and 20 mins since you backed out of your parking space.
For a lot of folks, this might be a familiar and routine sequence of events. So what’s the relevance to getting better at equity investing?
Part 1 represents, what’s called a deterministic system.
Paraphrasing the scientific definition, it is a system in which, given a known initial state, applying a set of specific inputs will always produce the same output
Getting out of a tight but assigned parking spot with tricky angles is not an easy task, but with the right inputs (in the right sequence), you will get the same desired outcome. Judging whether the “right” things were done is easy, you’re at your exit gate ready to start your journey without damage to any cars or property.
Part 2, on the other hand, represents a probabilistic system,
a system in which, what has just occurred is not an accurate predictor for what will happen next
So even with the right “inputs”; the 15 min early start and the alternate (and logically better) route, the outcome isn’t necessarily what was intended i.e. reaching office within a certain time. But judging whether the right things were done isn’t as straightforward. We can intuitively say that leaving 15 mins early was a “right” step, but we can’t be as certain about the alternate route. Therefore, in probabilistic systems, a good process can sometimes lead to bad outcomes and vice versa.
Investing is a probabilistic system but many investors make the mistake of equating good results with a good process and bad results with a bad process. Ironically, long-term performers in probabilistic fields like sports-team management, pari-mutuel betting and also investing emphasize process over outcome.
The takeaway for investors is to focus on developing a sound investment process and let the results take care of themselves
A sound investment process focus
While there isn’t one silver bullet investment process, a sound investment process is nothing but one that gives you the best chance of identifying gaps between a company’s stock price and it’s expected value. Think of expected value as the weighted-average value for a distribution of probable outcomes.
As an illustrative, consider a company showing exemplary historic growth in earnings, who’s stock price has risen over 150% over the last 12 months and trades at over 85 times last twelve month earnings. The company might continue to surpass lofty expectations and therefore see continued stock price increase, or just about match expectations and see modest to flat price increase or miss expectations and see a price decline. Similarly, a company expected to deliver poor results, as reflected in it’s stock price, might with even a small probability of outperformance deliver significant returns.
Assign probabilities to each scenario and the price impact for each to provide an expected value that takes into account probable outcomes.
Therefore, a sound investment process considers the probability, payoffs and carefully considers where the consensus, as revealed by price, might be wrong. So, however enticing the coin-toss method (or similar arcane sure-win method) might look in the short-term, long-term investing success calls for developing a process grounded in favourable probabilistic outcomes.
More than you know: Finding financial wisdom in unconventional places – Michael Mauboussin
What are complex adaptive systems? – Trojan Mice
Complex Adaptive Systems – mit.edu