Investing 101: Selection — Know Your Odds For Profit, Payoff Prospect, Commitment Time
Summary Illustration: Domino’s Pizza now: 91 of 100, +10.2%, 2 months; actual CAGR of +82% based on 194 prior days’ experiences when market professionals had outlooks like they have presently. Why know these dimensions? Answer: To make intelligent choice comparisons. Choices to buy, to sell, to hold. Comparison: Apple, Inc.: Odds — 82 of 100, Payoffs +13.8%, holdings 3 months, actual CAGR of +43%, based on 147 prior days’ outlooks in the last 5-years. Another Comparison: Exxon Mobil: 51 of 100, +9.3%, 3 months, actual CAGR of +3%, based on prior similar outlooks in 162 days’ of the last 5 years. Market professionals make these forecasts for their own use, not for publication. They typically get 7-figure annual compensations for making multiples of that pay in profits for their employers. I’m a long-term investor. Why such short-term commitments? Because every long term is made up of a succession of shorter terms. If you mentally lock yourself into a buy and hold, long term commitment, you will pay the price in terms of a lower score of accomplishment. That score is kept in terms of what your capital (including interim income) is worth when you need to start cashing it out for planned (even perhaps unplanned) uses. The proper yardstick is CAGR, compound annual growth rate, and the most important (powerful) element in that equation is time. The three stocks illustrated, Domino’s (NYSE: DPZ ), ExxonMobil (NYSE: XOM ) and Apple (NASDAQ: AAPL ), above are not bad stocks, but they each have had bad times to own them. A “till-death-do-we-part” strategy guarantees seeing the bad times eat up a lot of the good ones. All three have current outlooks of more than 9% gains in 3 months or less. That’s over +40% when compounded in a year. But XOM’s actual experiences have only been profitable 51% of the time, a coin-flip. The net result: a +3% CAGR from forecasts by knowledgeable, experienced folks. A whole community of them. Appearances can be deceiving. We are all human, subject to error, even the best of us. So what intelligent investors do is learn from the mistakes, keeping their costs as small as possible. But an even worse mistake is by being so fearful of not making mistakes that our learning curve is a flatline. Because it denies the investor of substantial net gains that courage could earn. The learning process What is essential in the process is being able to make comparisons between investment candidates. The place to start is with what is already being held. Every occasion a decision may be made to re-allocate capital (and time) to a different investment, what is being held now should be in the contest between candidates. To make it a fair (most productive) contest, there needs to be comparable scorecards for each one of the combatants. Some preliminary research needs to be done to generate the same elements of the comparable scorecards. Forget about pitting abstract notions of what technology will do for AAPL compared to DPZ, or what consumer attitudes will do for XOM compared to AAPL, or what world energy demands will do for or to DPZ. Like it or not, what will matter for each of these stocks, in terms that can be directly measured with the others, is their market prices, now and where they may be in the future. You or I may have earned through experience special hidden advantages of insight into one or another of the candidates. For the contest results to have their best chance of providing a desirable outcome, the knowledge base should be as equal as possible. But it is unlikely that, in the time remaining before when a decision needs to be made, similar comparable insights can be developed by us for the other-issue contestants. All that requires is to have, say 30,000 folks working for you (as Goldman Sachs does) on a 24-hour world-wide basis, relentlessly 7 days a week, gathering information about what the contest subjects – and their local & distant competitors – are doing, how it is being received by customers, what revenues and costs are involved, how technology is evolving, and how international political influences are likely to impact the interrelated scenes. Also importantly, how it is all being appraised by folks with the investment muscle of available capital to push prices up and down. Have you got that? Few do. The investing organizations that do have it engage in a continuing, very serious game, each doing their best to claim control over a larger share of the pie than they had before. The sly ones don’t get into a fight over the pie slices, but participate by waiting on table, helping to serve up, and by making side bets on the pie-fight’s outcomes, all for an immodest fee, charged to and paid by the other players in the game. That describes the role of market-makers [MMs], who facilitate the transacting of market-disrupting big-volume block trade orders necessary for $-Billion fund managers to make significant changes in their holdings. Some of the MMs provide temporary at-risk capital to allow trades to occur by balancing buyers with sellers. Others provide hedging and arbitrage skills to help the capital-providing MMs avoid the temporary risks taken. The side bets reveal what the players think can really happen to prices. They are set in different, highly-leveraged competitive markets of derivative contracts, where, equally well-informed, sophisticated speculative buyers and sellers fight it out. We just translate their bet actions into price range forecasts. See what has happened to our 3 current examples Figure 1 pictures how once-a-week examples of daily forecasts for AAPL have been implied by those bets during the past 2 years. Figure 1 (used with permission) Each of those vertical lines in Figure 1 are representations of the range of AAPL prices that was believed could occur in coming days. This is a picture of looking forward in time at what may be coming, not a “technical analysis” of past price history. These are forecasts made in “real time” as dated, before the subsequent events came to pass. Please note how so many of those range tops have subsequently been achieved by the heavy dot in each range that identifies the market quote at the time of the forecast. And note the progress of both upper and lower limits of the ranges. Declines in AAPL price often occur when the downside portion of the forecast range grows. That may be better seen in the picture of daily forecasts over the past 6 months in Figure 2. Figure 2 (used with permission) Beneath the picture in Figure 2 is a row of data spelling out the day’s forecast price range and the upside price change implied between the current price and the high of the forecast. That Range Index [RI] number tells what portion of the whole forecast price range is between the current market quote and the bottom of the forecast. Today’s is 20, meaning that about four times as much upside price change is in prospect as is downside. The RI tells how cheap or expensive today’s market quote is, compared to its expectations. The small blue picture shows how those daily RI measures have been distributed over the past 5 years. The other items in that data row are what happened subsequent to the forecast, had a buy of the stock occurred at the next day’s close, when the position was managed under a simple, standard strategy. These are the numbers cited for AAPL in the bullet point at the start of this article. Days held are market days, 21 a calendar month, 252 a year. The last item, the Credible Ratio matches the achieved historical payoffs of +7.4% with the forecast implication of +13.8%. The 43% CAGR is a calculation of the +7.4% accomplishments, not a forecast. What else goes on in the real investment world is a recognition that stock prices often go down on their way to an upside target. The -5.5% drawdown exposure is an average of the worst-case price experiences following the 147 prior instances of a 20 Range Index in the last 1261-day 5 years. They represent the point when an investor is most likely to become discouraged about his/her commitment in this stock decision. It is the real risk of mistakenly locking in a bad loss here, rather than choosing to tough it out to gain a profit averaging +7.4%. The Win Odds tell that not making the big loss decision was the right thing to do 82% of the time. This review of AAPL experiences from prior current-proportion (20 RI) forecasts lays out many qualitative aspects of an equity-choice decision that only the investor himself/herself has the right to make. To further illustrate those decision points, here are current-day pictures and associated historical data rows for DPZ (Figure 3) and XOM (Figure 4). Figure 3 (Used with permission) Figure 4 (used with permission) In all of these examples there is plenty of actual sample experience to measure. While there is no guarantee that future market outcomes will follow what has happened in the past, there is little likelihood that any of what is illustrated is a freak chance occurrence rarely to be repeated. And since repetition and habit are in human nature, having drawn these samples from multi-year periods on the basis of forecasts similar to the present, the chances ought to be better than average that they may be representative. Besides, in addition to your own judgment, do you have better evidences as a guide? So think about incorporating these notions into how you prefer making selections, ones to be comforting companions in your investing journey. DPZ makes a reasonable (0.9 cred ratio) +10% gain with 9 out of 10 chances of bringing it off, perhaps in some 7 weeks at a nearly +9% achievement. That would let you put the same (enlarged) capital to work again another 6 or more times in a year. Previously that has produced (including that tenth miscarriage) a rate of gain of over 80%, if a similar set of prospects can be found in other equities on a timely basis. Some 2500 stocks and ETFs are being appraised daily, and these kinds of gain prospects, profitability odds, and holding periods frequently appear. They offer a wide range of choices. In a different selection, AAPL offers nearly +14% upside instead of +9%, and what’s happening in technology may be lots more fun and interesting than what’s happening on the couch in front of a TV’d football game. Life is more than just making money. And what if, when XOM’s principal revenue stream was cut in half with crude prices going from over $100 down to $40, that has got everyone convinced that there’s not going to be a meaningful recovery above $50? But if it happens? The credibility of today’s forecast (maybe for opposite reasons) is quite low. Summer of 2014 saw market pros behaving as though XOM’s price could go above $110, and now they only see a recovery to less than $90 from $81. Wow, they think now the price could plummet all the $3 way from here to $78. Times change, so could expectations. These are just a few illustrations (not recommendations) of the selections constantly available to meet your objectives, your way. Conclusion You ought to compare the odds, the payoffs, the risks, the cost in time requirements and emotional involvement, in light of what has actually been achieved. It’s your capital. That makes it your call. But try to make the calls as satisfying to your desires as possible. To do that intelligently you need to have measures of what is likely to come about in the market, where the real score is kept. Measures that let you compare one choice against others. At times when it best suits you. Those comparisons can be made often and effectively, if you have the right kind of measures. And with good measures you can learn from your mistakes and minimize them. The advantage comes from being able to measure alternatives with standard scales common to all, re-measuring as frequently as makes sense in your circumstances. (For most of us, not daily or weekly.) Be an active investor, continually reappraising your future prospects, the ones you are creating by your choices. How they may be managed will be discussed in Investing 102 — portfolio management.