Stock markets: Knowing the odds
The biggest problem with Wall Street? Everyone is too busy assessing the rise without assessing the risk of failure. Read on as we dig into the numerical odds of an investment’s success… and how you might be better off just avoiding the losers.
In Iceland, there is a sign near one of its famous hot springs which reads: “You are here at your own risk. In large bold print, it lists seven warnings about the dangers of geysers and how you can burn yourself. Finally, in a stroke of genius at the eighth point, he simply said: “The nearest hospital is 62 km away.
Let’s think for a moment about the ruthless effectiveness of this – it actually means, “Look, if you haven’t dealt with a word of these caveats, just know that you’re going to be in agony for a long time if you try to.” become cute. Maybe the stock market should come up with a similar warning?
No one assesses the risk of failure
Words, by their very nature, carry connotations. When it comes to the sign in Iceland, that last line hits people from the opposite angle of the first seven for a very specific reason. The authors knew that the opening list describing the risks of geysers would resonate with most people. But, wisely, they also knew that a certain slice of the population would see the list only as a spoiler, harrassing harridan trying to spoil their fun. It was the connotation heard by their ears. So the need for a different approach that these people would actually appreciate.
In the investment world, connotations also play a very important role. Words like “aggressive” or “opportunistic” take on unexpected meanings, especially when compared to their traditional equivalents such as “conservative” or “stable value”. Blame it on Mountain Dew, Extreme Sports or the Hollywood generalization of people’s attitudes towards risk. For better or worse, reaching for the stars seems macho. In reality, however, these investment terms are just different names for numeric values and nothing more.
Yet such attitudes lead to another, more insidious, unintended consequence: a one-way assessment of risk. The first seven warnings on this sign deal with the situation before any potential injury occurs. That’s what a warning is, after all. But the eighth warning? This resolves the consequences of any incident. This is because investors only focus on the bullish side – the potential for outperformance – disregarding the potential for underperformance.
This is a human behavior bias at work and it causes investors to accept a risk that they have no idea they are taking. Maybe they should just avoid the losers?
Know the number
If one were to imagine a true risk assessment, a good example might be the signage at the top of a Black Diamond ski slope. Of course, the traditional sign should be enough warning. But what if they put a number of probabilities on the risk of catastrophic injury? Suddenly, that would force the intrepid skier to rethink his risk tolerance.
As an example, (although it is difficult to get well-studied data), anecdotal evidence points to an injury probability of 0.3% for most skiers. However, that number is almost certainly higher on the Black Diamond trails. Hearing such a number, the risk of failure suddenly approaches home. Is a 1% injury risk still worth a race? How about a 5% chance? Immediately the cost-benefit ratio is reversed and it is more important to quantify the possibility of loss than the potential enjoyment.
Going further, the follow-up question seems obvious: how would this apply to the investment world? What are the chances of failure of an average investment house? The truth is: no one knows! This is because outperforming the benchmark is the standard measuring stick. The theoretical risk-free rate of return assumes a certain level of return in the positive sphere no matter what. But, as has been shown time and time again in the market, what an investor thinks is going to happen… does not necessarily happen. Indeed, Wall Street evaluates only the rise, not the fall. No one assesses the risk of failure.
At Global and Local Asset Management, we believe investors deserve to know both. Unlike other managers who rely on a manager’s stock selection and a leap of faith, we use the system developed by New Age Alpha called Avoiding the Human Factor (H Factor). The human factor measures the likelihood that a company will fail to generate the growth implied by the stock price. This risk is caused by the fact that investors interpret vague and ambiguous information and integrate it into the price of a stock in a systematically incorrect manner.
The weaker the human factor, the more likely it is that vague and ambiguous information was NOT incorporated into the course of the action. The H-Factor System is a comprehensive, free portfolio tool that allows investors to apply our human factor metric to over 6,000 stocks, ETFs, global indices and their own portfolios.
In practice, we believe that the human factor and the H factor system allow investors to make much more informed choices about building their portfolio. In this way, we – and our investors – can manage risk like an actuary, not a portfolio manager. Rather than trying to pick winners, we just aim to avoid losers. It’s an approach seldom seen on Wall Street… an approach that allows investors to weigh both upside and downside.
Global & Local Investment Advisors (Pty) Ltd is a registered financial services provider under the Financial Advisers and Intermediary Services Act (FAIS). Global & Local Investment Advisors (Pty) Ltd holds license number FSP 43286.
Global & Local Asset Management (Pty) Ltd. Reg. Number: 2018/580284/07
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