Investing Myths and Disjunction Fallacy

Here are the results from a twitter poll I ran yesterday.

gain loss quiz

It was a small sample size. Only 30 people. I assume most were financially literate.

I wonder what people thought when they saw the results, after answering the poll. Did they feel more or less sure of their answer? Did they feel validated or perhaps confident in their contrary position?

It seems most people believe that a 50 percent loss takes a 100 percent to make it whole again. That a 90 percent loss takes a massive 900 percent to offset it.

That my friends is bullshit. It is one of the most widely perpetuated myths in investing.

Investing is a parallel pursuit. A 50 percent loss in one investment is offset by a 50 percent gain in another investment of the same size. A 90% loss is made whole by a 90% gain.

the real gain loss picture

Yes if you loose 80% of your total portfolio you’ll need to make 400% to get back to scratch. While that concept is important, I consider focusing on outcomes for individual investments more crucial. I’ve always liked the saying, look after your pennies and the pounds will look after themselves.

There is no need to be terrified of losses. The upside is infinite the maximum downside is only 100 percent (ignoring leverage). I don’t wish to encourage you to be a bag holder and take big losses. My aim is simply to make you wonder why almost everyone is hell bent on convincing you that deepening losses require exponentially higher returns to offset.

Now for anyone thinking, but you didn’t say an investment I thought you were talking about a portfolio, let’s talk about disjunction fallacy.

In short disjunction fallacy is thinking that a member is more likely to be part of a subset rather than a member of the set which contains the subset. In the above poll, both 50% and 100% are subsets of it depends.

This is similar to the better known Linda effect or conjunction fallacy, when people guess that the odds of two events co-occurring is greater than either one occurring alone.

The return required to make you whole depends on whether you’re considering a portfolio or an investment and the position size of each investment.

What’s a Fundamental Setup

Most investors know about technical setups, even if they dismiss them. But fewer investors know about fundamental setups.

I trade fundamental setups. While there are many tools on my investing tool-belt, fundamental setups are definitely the hammer.

But before we can get to fundamental setups we must discuss forecasting.

Forecasting gets a bad rap. However, done well forecasting clears that crystal ball which you’re always bitching is cloudy.

The reason forecasting is so maligned is due to singular forecasts. 32 Celsius and sunny next Tuesday, 12 month price targets, the list is endless. It’s not the forecasters fault, as they provide what the majority want, the highest probability outcome.

Forecasting done well recognises multiple outcomes with probabilities assigned to each. At it’s simplest a weighted range.

Here’s an example using Prana Biotechnology ($PBT, $PRAN).

Within 8 weeks Prana should announce results for 2 pivotal trails, one is a company making event the second is even bigger, a major pharma pipe-line ass-saving blockbuster.

The first trial will be reported any day now. Let’s say it has a 50 percent chance of good results, while the second $10 billion plus blockbuster trial has an 80 percent chance of success. Prana’s share price is up a whopping 500 percent in the last eight months on anticipation. Yes I’ve enjoyed the ride!

If the results of the first trial are so-so or worse, the share price could easily halve.

In the unlikely (10 percent) event the results are bad then you’d loose three quarters of your investment. In case 3/4 doesn’t sound too bad, invert it. While a 50 percent loss only takes a double to make you whole again a 75 percent loss take a home-run — a 400 percent gain — to make you whole.   

If the results are good then the share price should quickly double. Good results would also provide a substantive floor under the share price in case the blockbuster results are disappointing, while simultaneously increasing probability of success for the blockbuster to 90 percent.

If the second trial results are excellent then Prana should be a ten bagger, a 1000 percent gainer, over the next couple of years.

Should you buy?

Prana Biotechnology $PRAN $PBT

The current risk reward profile based on the above simplified forecast is a risk of 55 percent of capital to make a double, that is roughly 2:1 reward to risk — 10% chance of a 75 percent loss, 40% odds of losing 50 percent and a 50% likelihood of doubling your money with an accompanying higher likelihood of further large returns. We could quantify those potential future returns, but we’ll keep this simple.

A 2:1 reward to risk is not great when dealing with speculative opportunities so I would not be a buyer now.

The fundamental setup I’d now look to buy is a failure at the first hurdle, so long as it is a stumble and not a glue factory fall. The share price will get hammered, yet the probability of success in second trial should only fall slightly.

Let’s say the share price falls the forecast 50 percent and at the same time the probability of good results from the second trial fall to 70%.

The risk reward then becomes a 10% chance losing 75%, 20% chance of losing 50%, 30% chance of 200 percent and 40% chance of 500%. That’s a risk of 58% for a possible 370% gain or over 6:1 reward to risk profile. That’s a much better fundamental setup than the current opportunity provides.

Alternatively a buy on thirds approach makes a lot of sense in this type of situation. That is, buy a third now, a third more after the HD results and then a final third only if the AD results are good. Your gains will be less, but importantly your risk will also be considerably less.

A third approach is to explore options as a means to play Prana.

Other fundamental setup examples

Here’s an example of a fundamental setup for pSividia last year.

A Peter Lynch favourite setup was the out of favour stalwart. A good example of the stalwart setup was QBE in 2012. I recommended QBE to TMF Share Advisor because there was very high probability of a getting a quick 30-40% gain out of QBE. That’s the type of return to expect from a stalwart setup, staying longer simply ensures your returns will quickly approach market averages.

One of my favourite setups is the fallen market darling. A great example here is CROX — remember Crocs? I recommended CROX as a turnaround play back in 2009. Another is when Netflix was taken out to the woodshed in late 2011 and 2012. If you forecast these events as having a probability of occurring then you’re prepared to buy if and when they do.

In summary, forecasting is good, nay essential, in fundamental investing. Forecasting clears my crystal ball helping me think more clearly about the future and thus assists me in finding the type of fundamental setups I like to invest in.

Disclosure: Long Prana – but have been a seller recently.

Step beyond margin of safety

Margin of safety is the much vaunted investment tool of value investors, and by value investors I mean all sensible long-term investors. Margin of safety is a great concept, but is it the best tool for investment selection, risk management and portfolio optimisation?

Michael Mauboussin argues it is in this excellent 2001 paper.

Investors should base the magnitude of their investments on the size of the margin of safety.

Mauboussin’s Ruminations on Risk is a brilliant paper. I mostly agree with him, but want to share an even better investment tool we can easily use.  But before we get to that, let’s play a game.

Game on

Imagine you have two investment options. Investment A has a margin of safety of 12 percent, while Investment B has a MoS of 8 percent. Which would you invest in?

Probably neither, right? So for the sake of the game imagine you must invest in either A or B.

I’m going to hazard a guess you opted for A. Its MoS is 50 percent greater than B and for some of you that return may even be above your hurdle rate.  Investment A is the logical choice if you use MoS as you primary investment selection tool.

Let’s keep exactly the same investments, but throw my preferred investment selection, risk management and portfolio optimisation tool into the mix. Let’s look at the return/risk profile of these investments.

risk/return ratio

The current price of both A and B is $5. Investment A has an 80 percent chance of being profitable, that is a 60 percent chance of 20 percent upside and a 20 percent probability of a juicy 60 percent profit. Conversely Investment B has a mere 20 percent of being 20% profitable.

Remember, I haven’t changed the game, the respective margins of safety for A & B are still 12 percent and 8 percent.

Are you still happy with your investment decision? As a reminder, A has a 12 percent MoS and an 80 percent chance of being profitable, whereas B has an 8 percent MoS and a mere 20 percent chance of profitability.

Think risk

If you’re still opting for A, then perhaps the following sentence which encapsulates my investment philosophy will help change your focus slightly. Focus on the downside, and the upside will take care of itself. (Hat tip to Mark Sellers.)

The downside for A is 60 percent, whereas B has a comparatively modest 20 percent potential loss. Hopefully, that changes your investment decision. For me, focusing on the risk rather than the return has led to better investment decisions, and I’m confident it will for you too.

Investment B is the better investment choice, despite having both a lower margin of safety and lower probability of profit. I know some of you won’t be convinced and may even believe the higher probability weighted MoS for A means that over time successive investments in A will result in higher overall returns.

The pain of asymmetry

We’ll you’d be right, except for the asymmetry of returns. For those not familiar with the asymmetry of returns, all it means is that identical percent gains and losses are not the same, e.g. it takes a 100 percent gain to make up for a 50 percent loss. Losses hurt more and not just psychologically.

This asymmetry results in B having the higher probable return after a number of iterations. For example if we start with $5 then after ten iterations B will have grown to $8.20 while A will only have grown to $6.10.

If you’re using a probability weighted margin of safety you’re already way ahead of most dart throwing investors, but it may be time to take another step on your investing journey. Adding the return/risk ratio to your tool kit helps you focus on the downside and will improve your risk management.

My hurdle rate is not a percent return, it’s a return/risk ratio of three. For every dollar risked I want a potential payoff of three dollars. Investment B meets that criterion, whereas A has return/risk ratio of 1:1. See what a huge difference the return/risk ratio makes? It’s like pulling back a veil to see the real picture.

As I said in this post, using a risk return framework forces me to consider multiple outcomes and to look forward. It provides a rationale mechanism to overcome the noise of fear and greed. Most importantly, it forces me to consider what could go wrong.

The return/risk ratio is also my portfolio optimisation tool of choice. The higher the ratio the larger my investment.   As I said 3:1 is my hurdle, I may invest a small portion of funds in companies meeting that hurdle, I start getting excited with ratios over five. I invest a lot when the ratio is over seven, as I did when I was pounding the table on Telstra in early 2011 – back when everyone else was calling Telstra a dog. Currently Telstra does not meet my hurdle rate, but as I’ve sold most of our holding and admit to being slightly addicted to its dividend, I continue to hold a small weighting.

Part Two – Putting the return/risk ratio into practice

Once you start regularly using the return/risk ratio it makes investment decisions easier.

What’s the probability and size of the downside? What’s the probability and size of the upside?

This same frame work should be used for both prospective and perhaps more importantly to current positions.  After all it’s only what you own that can hurt you. Saying that, I admit to not rigorously applying it existing holding, although I really should.

Imagine you’re a reasonably smart investor and followed my recommendations of investing in Integrated Research (ASX: IRI) at around $0.45. Hold on, I think I’ve written about this before. Yes here you go.

When I sold, Integrated Research was up 265 percent since my recommendation in the first edition of Motley Fool Share Advisor. IR was also up a market obliterating 300 percent since I’d recommended it as one of TMF Australia’s radar stocks.

Like me, you may have found IR was close to 3 times larger a position in your portfolio than originally intended. That’s a nice problem to have, but it is still an issue that requires thought. For example if you bought a 5 percent position, IR was now over 13 percent of your portfolio.

Above $1.30 IR was significantly overvalued. So why hold 3 times your normal position in an overvalued company? That would be stupid right? But hey if you see it differently please let me know in the comments below.

Here’s how someone summarised IR on Hot Copper:

However, it tells the story: 1st article when IRI had earnings of 4.5c, share price under 40 cents, dividend 4 cents, and cash. Relatively low risk.

Now, 2012 earning 5.4 cents, SP $1.20+, dividend 5 cents, still has cash.

Company obviously in a sound position, however value … ? One would have to say the “easy” money has been made.

I like that thinking. It’s simple, value focused and based on tangible information.

At the current price of $1.24 my analysis suggests a possible downside of $0.40. Yes, you should always work out the risk fist, remember focus on the risk and the return will take care of itself. So I only need to answer one question, is a $1.20 upside probable?

Can IR double in price from here? I see virtually no chance of that.

IR has grown revenues at 3.5 percent a year over the last five years, while earnings per share have grown at a miserly rate of 1 percent. The growth rate has been slightly higher over the shorter time-frames, but still nothing to get excited about.

While I respect the excellent management team and think Mark Brayan justly deserved the IT Executive of the year award for his excellent strategy and execution, there simply is no sound investment case that can be made for IR at the current price.

Mr Brayan sensibly diversified IR’s revenue stream due to the sword of Damocles hanging over the company – the huge risk in HP Non-stop infrastructure revenue collapsing. He has added a few more hairs to the sword, but make no mistake, software is a cyclical business and if, or more likely when, those infrastructure revenues go into terminal decline the slowing growth of unified communications and payments are unlikely to stop investors being cut.

Back to the point

Anyway, I’m getting away from the point of this article, which is that a return/risk framework is a superior investing tool than margin of safety. It conveys more information and focuses on both the risk and return, whereas margin of safety tends to focus the mind on returns. My returns have improved since adopting the return/risk ratio and my losses have shrunk. For me it is the ultimate risk management and portfolio optimisation tool.

Ahead of the Buffett Curve

I like to review my share sales after three months. No particular reason for three months, it’s a quarter, it’s both long enough and not too long.  Today I’m going to make a tiny exception and review my Moody’s sales four days early. Back in April I sold MCO at $28+, today it closed at $26.52, 7.5% lower than when I sold. Meanwhile the S&P 500 is up 11.3%. Wait a second while I pat myself on the back… What I feel even more chuffed about is Warren Buffett now selling down Berkshire’s stake in MCO. Talk about confirmation bias overload. As John Hempton at Bronte Capital points out Buffet is a fantastic seller of stocks.

I normally focus on absolute performance first and relative performance second, but when it comes to my share sale reviews I reverse that. The relative performance is what counts. I find this often saves me from both unwarranted self flagellation and praise.

Take Netflix as an example. I sold Netflix back in February only to see it move ever higher for the next two months and despite a pull back it was 10% higher at my three month review. Fortunately the S&P and Nasdaq were up respectively 17% and 20% so I was able to leave my cat-o-nine-tails in the draw that day. For people who’ve been reading for a couple months I’m still not ready to talk about Leucadia, but I assure you my back has almost healed.

On a less self congratulatory note I was ahead of the Macquarie (MQG) curve today. Selling 40% of our holding in MQG an hour or so before the trading halt. The price movement before the halt indicates that some people had more than an suspicion that there’s good news afoot. After opening at $39.89 MQG had moved up to $41.10 by 2.26pm, a healthy 3% gain for the day. Then five minutes later $41.66, two minutes later $42.04. MQG requested a trading halt at 2.37pm with the price at $41.80.  Still as MQG force fed me the shares for $26.60 six weeks ago I won’t be complaining.

I’m currently eyeing up a couple companies which appear to have a better risk/reward profile than MQG and which I can actually understand. There’s also yet another SPP that I may be taking up. These Australian companies are sucking me dry, still you won’t hear me complaining about it like so many other commentators seem to be. Suck it up guys, if you portfolio is so large that $15k bites are too small for you bother with then you’ve really got nothing to complain about have you. Take the lambo out for a spin, have a cry into your Crystal and suck it up.

How to Size Individual Positions Using Kellyesk Formula

How to size individual stock positionsIt’s over a year since I read any of the articles I linked in yesterday piece on the Kelly formula and portfolio management. After reading the brilliant article by Michael Mauboussin Size Matters – The Kelly Criterion and the Importance of Money Management I realised that both he and I did not explain how to actually use the Kelly formula in sizing individual positions. So let’s try to fix that glearing omission.

I’ve now copied a few more columns from my portfolio spreadsheet to yesterday’s Kelly Spreadsheet. As I stupidly never documented my reasons for using these formulas, the following is my best guess and why I choose them.

Geometric Mean:  As I am in the market for the long term, have no intention of withdrawing funds and will compound my investment I choose geometric mean instead of the average (also known as mean or arithmetic mean). For a discussion on this read the Mauboussin article.

Percent of Portfolio: This calculates what percent of my portfolio I should invest in one position. Based on dividing the geometric mean by the sum of the geomeans.

Actual Percent of Portfolio: Let me stress again all the figures in my example are made up. However, I do hold positions in all of the stocks except Microsoft. This column is exactly what it says on the can. The actual percent of my portfolio that I have invested in that stock.

Adjust Actual: This is the amount I need to change my investment to align my actual with my calculated amount.

Hopefully that makes it clearer how I use a Kellyesk Formula to determine my individual position sizing in my portfolio. If not please feel free to ask questions. Also, please note that I do not solely rely on the expected return, reward/risk, geomean or percent of portfolio to determine my actual investment. I consider them all and then use my gut for a final decision. Perhaps as time goes on I’ll get more comfortable relying solely on one or a combination of those calculations, but I’m not there yet. However, I have found these calcuations incredibly helpful for both my buying and selling of indivudal stocks. I hope you also do.

Kelly Formula Meet Portfolio Management

KellyThe Kelly formula or criterion is best known as a bet optimisation tool. Popularised by Ed Thorpe, the formula which is named after its creator, John Kelly, is used by gamblers to determine the optimal bet based on given odds. A year ago I mentioned that I use Kelly criterion in my portfolio management and I promised to expand on that. While I have thought in terms of probabilities for a long time it was only a couple years ago that Mohnish Pabrai, in in his book The Dhando Investor, introduced me to the Kelly Criterion. Let’s get stuck into how I use a betting tool for money and portfolio management and then I cover some Kelly background. If you’re a Kelly novice you may want to read the second part first.

Using the Kelly Formula for Portfolio Management

I have two main uses for the Kelly formula, neither of which are the intended purpose. My third and less important use is the intended purpose of Kelly, an aid in determining my individual investment size. I use Kelly as a comparative tool and as and aid to focusing on probabilities, risk and returns. Before we dive into each of those I should explain how I use a method that is designed to be used with binary outcomes with known odds for investing, where there are multiple possible outcomes with unknown odds. I mentioned yesterday how I was struggling to articulate my use of the Kelly Criterion. The reason for this lies in my own confusion. I could not reconcile how my simplistic spreadsheet calculations mapped to the Kelly Formula. I have spent countless minutes trying to reconcile my spreadsheet to this site which computes the Kelly Criterion for multiple outcomes. If only I’d annotated my spreadsheet with my reasoning I’d have saved myself those minutes. I took a different tact this morning and looked at my spreadsheet and thought “what the hell was I thinking and what are those figures telling me.” I then recalled I had dismissed the use of Kelly and settled on a much simpler approach of expected average return. I’ll call it Kelly for dummies. Here are the steps in my process and (hopefully) an embedded spreadsheet to illustrate.

  1. For each current and possible investment determine three target prices. I unimaginatively call the targets, low, medium and high. You may wish to call them forkit, it’lldo and yeforkingha, I’ll leave that detail up to you. The idea is you conservatively determine the worst, best and most probable outcomes (low, high, medium). In investing the worst outcome is always zero, i.e. a 100% loss. You can decide what to use for worst, but I suggest continuously using 100% would not be very useful in the calculation or you analysis of probable downside. Think of worst as worst probable outcome.
  2. Then give each outcome a probability. My default is 30%, 40%, 30% for worst, probable and best respectively. I alter those defaults when I have a strong conviction.
  3. Then based on the current asset price your spreadsheet calculates the average expected return.

Example Spreadsheet.

If missing try this link.

I use the average expected return for an investment to compare  all my actual and possible investments. The relatively higher the expected return the more likely I am to invest and the larger my investment will be. Steps one and two are by far the most important. They are the focusing steps. Determining targets and especially the downside worst case focuses my efforts on a key aspect in investing, managing risk and reward. Ascribing percentages to those targets is a double check. In general I find a lot of investors spend too much time focusing on intrinsic value to the detriment of risk and reward analysis. Investing is an exercise in probability not in mathematics. The expected returns is also part of my selling criteria. It quickly highlights any stocks I should be considering selling. That’s a topic I’ll cover another day. Another benefit of this approach is avoiding delusion. You don’t have to be delusional for you mind to fool you into distorting history. We all like to think we’re better than we are and our mind is happy to oblige with lashings of hindsight bias. Recording your targets and other observations up front and then revisiting them is an excellent way to keep hindsight bias at bay.

Putting it all together

Here is an example from my investment in Biota. I starting investing in Biota in October 2008, with the price around $0.40. I calculated the worst probable outcome as $0.30 with a probability of 40%, the probable outcome of $0.75 and the high of $2.00 both with 30% probabilities. [Note: I did publish those figures, though I actually presented four outcomes.] The average expected return from that was a high 136% or an average target price of $0.95. For me that is a very high average return and combined with other factors led me to make a large investment in what many people would have considered a speculative stock. So what were some of those other factors?

  1. Return to risk. With the exception of my dividend producing core stocks, I don’t get out of bed for a return to risk of less than three. That is I’m looking for a return of three times my risk, 3:1. For Biota I commentedLike beauty valuations are also subjective, a combination of art and science. My range of values for Biota range from $53M – $215M, with per share $0.70 – $1.20 looking like fair value and $0.30 as downside value.”  So return was $0.30 to $0.80 with risk $0.10 for a return to risk ratio between 3:1 and 8:1. Not only do I get out of bed for that I leap out and sprint naked to my computer to place a buy order. I apologise for that mental image 😉
  2. Buffett’s Rule Number Two: Don’t forget rule number one, never loss money. I admit to playing fast and loose with those rules. As my teachers often commented “could try harder”. Despite not being great at implementing rule number two, I do get excited when I find an opportunity that has very little downside and plenty of upside. The investing world is full of opportunities with considerable upside, but they are predominately accompanied by plenty of risk of loss of capital. Opportunities like Biota are beautifully illustrate what Mohnish Pabrai meant when he coined the phrase “Heads you win a lot, Tails you lose a little“. Low risk opportunities with possible high returns. In general I consider myself a value growth investor. I buy growth when it is on sale.
  3. Confirmation bias is considered a cognitive bias and as such is tainted. Heck who wants a cognitive bias! While I don’t want a bias I am happy to utilise them. The only cognitive bias I am terrified of is bias blind spot — the tendency not to compensate for one’s own cognitive biases. While I am a smart guy, I recognise the investing world if full of smart people and that being the case I am unlikely to be the first person to “discover” a wonderful opportunity. I like to look at a share register to see if any investors I respect are on the register. When I looked at Biota I discovered not only was management buying shares back at almost twice the current price, but Hunter Hall International (HHL.AX, who I mentioned yesterday) had also been buying shares at considerably higher prices and then held 12% of shares. As nothing had fundamentally changed since their recent purchases I took a big hit on the confirmation bias bong.
  4. Circle of confidence. Tick, I know and like biotech investing.
  5. Possible catalysts. Tick, tick, tick. While the swine flu outbreak was not predictable a large one quarter uptick in Relenza sales certainly was probable and Biota had a pipeline which could deliver good news.
  6. There’s more, but I am now so far off topic that I must stop and get back to Kelly.

Here is an example spreadsheet which you can copy to Excel. I did this in Zoho sheet so you can play around with a few examples and easily copy it to Excel. Unfortunately Zoho sheet has a few limitations so if you’re entering new shares you need to copy down the formulas and change the current formula to your ticker (unlike Google Docs, zoho does not let you reference other cells for stocks updates). Also note, I plugged in the first numbers that sprung to mind, these are not intended to be actual target for any of the stocks.

[UPDATE: I have now updated the above spreadsheet. Check out how I use Kellyesk calculations in my sizing of individual stock positions for an explanation of the new columns.]

Kelly Background and some Notes I’ve copied over the years.

I think Munger’s recent book recommendation, Fortune’s Formula, and many of the papers referenced in the bibliography are pertinent to this discussion. The book is about Kelly‘s criterion, which is a formula for sizing bets to maximize long-term compound return from a series of bets where the winnings are reinvested. Kelly‘s criterion has two components: edge and odds. Edge is the amount of profit that YOU BELIEVE that you will make if you could repeat this bet many times with the same probability. Odds are the market place or tote board odds. Your odds must be different from the market place odds or you don’t have an edge.The optimal return is obtained by betting a fraction of your portfolio equal to the edge/odds. Overbetting and underbetting result in sub-optimal results. However, overbetting is more serious because it leads to a large variation in returns and to eventual blowups (LTC and Eifuyu were examples of overbetting). Underbetting reduces returns and variance. The book presented Ed Thorpe’s (one of the best Kelly criterion investors) hedge fund results which were spectacular for the degree of over-performance and the small variance over a 20 year period. Ed Thorpe always underbet – specifically made bets of half the Kelly criterion because he was worried about being too confident about his assumptions in investing and unconsciously overbetting. Long story short, the book and especially the papers show that if you really good at finding investments with large edges, you could get decent returns without a lot risk holding only four or five positions. If you can only find investments with smaller edges, you will get less return and need more positions to reduce risk. From reading the book and the papers, I found that I was intuitively doing the right thing. However, I am planning to now track the edge and odds on investments to see if I can improve. via TMF : Liquid Lounge

Risk and Uncertainty: A Fallacy of Large Numbers

Basically the idea is that if a single play is not acceptable, then no sequence should be acceptable, when the goal is to maximize the expected utility. The theory is basically that people, when thinking about the law of large numbers, tend to forget that even if you play 50 million or more you still don’t have full certainty that you will win, but at the same time your potential losses grow accordingly (you could sequentially play 100 million times and still not win, losing a lot of money if the idea was to be risk averse). Mathematically the expected value of return is the same no matter how many times you would play, it’s a simple multiplication; but psychological humans behave very different. I don’t remember the source off the top of my head, but there have been some experiments asking what people were willing to pay for the probability of winning something (i.e. how much they would pay to increase a single percentage point in their chance of winning). The increase from 0% to 1% (lottery) or from 99% to 100% (insurance, the assurance of winning) will always command much higher prices than, for example, paying from 34% to 35%; even though the expected return is the same in all cases. also via TMF: Liquid Lounge

But wait, there’s more, how about a set of steak knives.. Each of the following articles and sites are excellent resources well worth taking a look at.

[KELLY PART TWO: Check out how I use Kellyesk calculations in my sizing of individual stock positions.]

Shorting now? You’ve got to be kidding

Someone is always left holding the bag. This is the same concept as the oft quoted patsy at the poker table.
If you invest late into trends then you have a higher probability of being that patsy.

People investing late in trends should examine if they suffer from herd mentality, confirmation bias etc. While numerous studies show momentum strategies are successful, all those strategies attempt to identify major trends early on. One of the most basis the death cross of the 50dMA crossing below the 200day shows when getting on board this trend was appropriate, back in January.

yttire’s initial post in this thread on TMF spelt out a good case for not going short right now. This was my response to the idea of using an ultra short now.

Stepping into a trade as yttire outlines is a great trading strategy. Most traders I have read recommend a similar strategy and even long term investors express similar sentiment in phrases like water the flowers and pull the weeds.

The only tools that I know which are any use at giving you an edge over the short term are sentiment and chart based. If you use those tools then you may also want to layer on some historical fundamental analysis. From that it seems likely we’re at fair value now. While markets often overshoot and hence lower prices are a possibility, the probability of lower markets are reducing.

There is no need to swing at every trade. Is this a time you’re likely to have a high probability of success with an ultra short?

Edge – The Way of the Turtle

Most Friday’s I drop my daughter at dance class, head to one of Melbourne’s best cafés and have a latte while I wait for Borders to open at 10. I then have around 20 minutes to choose and scan an investment book. While I am normally a slow reader I can skim a book in 20 minutes and pick out a few lessons which resonate with me.

Way of the TurtleToday my book of choose was Way of the Turtle, by one of the original turtles, Curtis Faith.

Almost every page I scanned contained a gem. From the introduction where Faith said he has learnt something from almost everyone he has every interacted with to his thoughts on edge and his simple clear rules.

Before I buy this book I thought I should re-read the Turtle Rules, a copy of which is linked at the bottom of this blog post on investment tips.

Faith’s Dos and Don’ts for Thinking Like a Turtle, are a great example why even strict fundamental investors can learn a lot from trading books like this or Tharp’s Trade your way to Financial Freedom.

  1. “Trade in the present. Do not dwell in the past or try to predict the future. The former is counterproductive and the latter is impossible.
  2. Think in terms of probabilities not predictions. Instead of trying to be right by predicting the market, focus on methods in which the probabilities are in your favor for a successful outcome over the long run.
  3. Take responsibility for your trades. Don’t blame your mistakes and failures on others, the markets, your broker, and so forth. Take responsibility for your mistakes and learn from then.”

Jim (BMW) has provided the framework to easily implement number two. The BMW method provides a framework rooted in probabilities for a successful outcome over the long run.

But Dean, what does this all have to do with EDGE? I hope to wrap up the loose ends at and tie it back to many conversations held on the BMW board. First indulge me with one final quote from Faith, this quote spoke to me so strongly that other shoppers looked up as I exclaimed “Fork yeah!”

the best edges come from the market behaviors caused by cognitive biases.

I realise the market is made up of different opinions and communities such as this are a reflection of those opinions. However, I all too often see cognitive biases in TMF posters and no doubt some of mine ooze on to these digital pages.

People talk about price way to much. The worst examples of this can be found in TMF subscriptions publications. Many issues contain phrase like “XYZ is now a bargain at 30% off its high” or “we’re getting to buy XYZ at a 30% discount form recent prices”. While XYZ may be a bargain, I find this constant reference to price insidious in publications which aim to educate investors.

Many people fail to recognise that companies are on sale for a reason and those reasons are obvious to all market participants. Once a reason is priced is, you need to invert your thinking and see if a reversal of that reason is an opportunity for a catalyst. Making predictions based on known priced in reasons or worse predicting based on your own views is unlikely to outperform a focus on the probabilities. This mental momentum, make us believe that as everything is going wrong for XYZ it will keep going wrong. While that can occur the BMW method highlights that it probably won’t keep going wrong. The most probable outcome for companies with proven track records is that they will bounce back.

Consider your biases and formulate strategies to overcome then. If you are not buying more now than you were over the last couple years then perhaps you are predicting and letting your cognitive biases rule the day.

FWIW – in personal and/or model portfolios

  • I continue to hold SSD and sell calls on it.
  • I recently sold my trading position in Amgen. While the news flow has changed from negative to positive recent investors are likely to be nervous and have little conviction. Pocketing 50% in short order was a no brainer and more than compensated for my only ever loss on Amgen (2008 Leaps vertical spread which due to inexperience with spreads I let slip from profitable to a loss)
  • I’ve bought PFE, FDX and GE.
  • Taken large losses on a number of companies.
  • Started buying Australian banks (not recommended for US investors due to Fx rate).
  • Passed on BARE.
  • Safely profiting with SAFT.
  • Continue to hold way to many companies.
  • Trying to make time to look at AKAM and STP, which from a cursory look both appear to offer good value and excellent prospects.
  • Been very distracted trying to get a couple businesses off the ground when I should probably simply be focusing on My Family Inc. Despite having overcome monetary desires I still fail to contain my egotistically desires. While I should be the most contented I have ever been, my ego pushes me to achieve more, denying me the enjoyment of here and now. I must find a solution for that! Oh the pain, the pain of being an A type 😉

You Probably Should Be Using Probabilities

Investing is all about probabilities, the probability of reward versus risk. It doesn’t mater whether you’re a value, growth, fundamental or technical trader or investor you should be using probabilities to help you be a better investor. I use the Kelly Formula for comparative analysis of my portfolio and new opportunities and will discuss that in depth another day. Today I’d like to focus on short term probabilities. If you sit firmly and unflinchingly in the long term buy to hold camp then move along there is nothing for you to see here. For everyone else I hope to illustrate how using probabilities helps me answer the question of whether to buy or sell prior to an earnings release.

There are two main reasons why we should even consider the question of buying or selling prior to earnings. Behaviourally investors experience heightened emotional turmoil prior to earnings. This is because earnings act like steroids for the competing emotions of Fear and Greed. This is especially true for volatile companies, for smaller companies or any company that you are considering selling or buying.

Before we go on I’d like to instill some faith in you that probability is one of keys to investing. Charlie Munger, Warren Buffett, Mohnish Pabrai and countless other superstar investors have talked and written extensively on the probability. It is one of the essential tools in their belts and they even pursue probability in their leisure activities. Buffett is drawn to Bridge as it is a game of probabilities.

I’d like to use this quarters reporting season as an example of my use of probability. I’m currently trying to trim down my bloated personal portfolio and get back to my concentrated ways. Concentrated for me means 10-20 companies, while for various reasons I found myself holding 49 companies late in 2007. My diet is going OK, I’m now down to 44 companies with 21 of those being meaningful positions. Anyway, back to the point.

Prior to earnings my thinking went like this. I want to sell at least a few companies. I want to do it prior to earnings as a significant portion of price movements occur around earnings time. In general the prices of stocks are static for 70% of the time with real movements occurring 30% of the time. I want to sell companies with uncertain long term futures.

My initial list was eResearchTechnology (ERES), Netflix (NFLX), CryptoLogic (CRYP), American Reprographics (ARP), Take-Two Interactive (TTWO), Harmonic (HLIT), Alvarion (ALVR), American Eagle Outfitters (AEO), II-VI Inc (II-VI) and Nuance Communications (NUAN).

I posted on a number of those companies and this post on ARP illustrates my thinking. ARP had good earnings and as it was so beaten down and investors had low expectations the price gained significantly for just good earnings.

I didn’t post the following as by writing my question I answered it. (If you don’t already write down yhour investing thoughts, then start an investing journal today.)

So tell me, what would you do with the following? No this is not a trick question it is a real life question and I am interested in your opinion, naturally everyone should feel free to reply.
Netflix hit my final sell point of $40 last Thursday [April 17] so I stayed up Friday night to sell it. I was selling a part positions in a couple other companies as well, II-VI and NUAN, so when I turned to NFLX to enter my limit order I was happy to see it trading at $40.85 bid and so entered my sell limit at $40.85. The bid then started falling away quickly, very quickly. I decided, like me, there would be a lot of people who had $40 as their price target and that the selling would quickly abate and my order still had a good chance of being filled later that day. I went to bed content with the dual thought that I always use limits orders and due to intra-day volatility they are hit 90% of the time, plus I always liked the saying that amateurs open the market and professionals close it.
I awoke the next morning to see NFLX down at $38.56, my order had not filled. Both of my other orders had been filled and they were entered at prices higher than the stock was trading at.

NFLX earnings are out today, 21st April. I expect good earnings as Netflix has beaten all competition into a pulp. While NFLX isn’t quite priced for perfection it is certainly priced with good things in mind, so excellent earnings and guidance will be required to push NFLX higher.
Long term I like the Netflix strategy, but it has been a volatile company and I am confident it will continue to be volatile as competitors will continue to assault the NFLX castle. Hence I sell NFLX when it approaches my valuation targets, this has worked well before and I’d wager it will again. I sold half of my large position at around $33, my cost basis is around $20 from June last year. It is not in a tax deferred account, so capital gains will bite a little.”

By the time I had finished typing that and ran some quick numbers I decided to sell NFLX and placed an order for $39.95. Like most investors I am plagued by fear and greed. I use numbers to stop the pathetic, debilitating, irrational arguments. The probabilities supplemented with an understanding of investor behaviour drummed in me to David Dreman led me to sell.

This is already getting to long and I’m gagging for a cuppa so here is how my decisions this earnings season turned out.
NFLX – Sold. Excellent, I feel good about selling, but as I like the long term potential of NFLX I am now faced with a decision on when to get back in. I consider the current price good, but not a slam dunk.

ARP – Held. Excellent, but I am still concerned about their lack of organic growth and the probability of a commercial building slowdown. I need to look closer, but my gut says sell.

ERES – Sold. This didn’t work out so well as ERES is now around 30% higher than where I sold. What went wrong, what can I learn. I invested in ERES as a turnaround opportunity. They sell cardio monitoring for clinical trials and the FDA had mandated heart monitoring. Their previous management were clowns and investors had no faith. I set firm targets for the new management and tracked what they said and delivered very closely. The new management proved to be excellent, my thesis was validated I profited. I sold based on a high valuation. If they had of delivered OK or worse earnings the price was going to tank. I should fell OK about my decision as based on the probabilities of investing it was the smart thing to do and ERES could easily trip in a coming quarter and present another opportunity for me. However, I don’t feel good, as I believe I didn’t rank the chances of this earnings being good as high as I should. I had grown to admire the new management, but was blinded by my valuations. I believe my valuations affected my probabilities. This is a mistake I make over and over again and one day hope to counter it. Here are my pre-earnings thoughts.

CRYP – Sold. Lucky. I had been looking to sell CRYP as it was never a company I was happy holding. It is the only company I’ve ever held that I would never mention to my partner or friends. I think less of myself for holding it and am glad to rid myself of it. As I dislike it so much I ignored it. A couple days prior to spreadsheet highlighted the upcoming earnings and coincidentally they announced a deal. The price shot up I sold. I didn’t run numbers, but my gut told me to grab the opportunity.

This is getting way to long, my mouth is so fury that I’m coughing up fur balls.
TTWO – Held, they’re worth more. Though my probabilities tell me to sell if I find a better opportunity.
HLIT – Added to, good earnings, market stupidly focused on guidance and price is now a bit lower.
ALVR – Added to, good earnings and guidance, market loved it.
AEO – Held
II-VI – Sold half
NUAN – Sold half

I am not advocating short term trading here. I’ve never calculated my average holding period, but it is probably around two or three years. Quickly checking my current portfolio I see the average purchase date is August 2006. I don’t run the probabilities for each my company every quarter, though I do try to update my Kelly targets after each earnings release. I find both my pre and post earnings probability calculations help me:
• contain fear and greed
• to have a rational basis to my decisions which I can check and hopefully improve on
• and force me to think about the company and its prospects at least once a quarter.

For anyone wanting to read more here are a couple articles to get you started
http://www.wallstraits.com/main/viewarticle.php?id=1397
http://en.wikipedia.org/wiki/Probability

Cheers
Dean