As often happens when I work through these big ‘Blog Series’ things, I tend to bash out a Draft and slowly over time I go over it and over it and refine and tweak and invariably they get longer rather than shorter. I am sure the idea of Proof-Reading and refining is to summarise and condense more but I am clearly pretty hopeless at that !!
I guess my logic is that I tend to need to clarify points so adding yet more text achieves this in the best way. As a result of this tweaking I have decided that it would be more appropriate to split what remains of the Blogs into two so we now have 6 Parts in total - but this one perhaps needs Readers to turn their Brains on and think about what I am scribbling, especially in the first section on Probability stuff, so maybe it is for the best that it is shorter. The Final Part will be in essence a Conclusion but there is actually quite a lot in it.
Probabilistic Decision Making
I mentioned back in Part 4 of this Blog Series what kinds of Drops in the Markets were typical and of course it is impossible to know precisely before an expected Market Sell-off just how heavy it is going to be. Having said that, it might be doable to come up with some simple Possibilities and then to assign Probabilities to these Possible Drops - it could work something like this - first off I will list the Possible Drops (for this example I have used the FTSE100 but you could put in any sensible Index such as the S&P500 - and of course you could use similar Probabilistic Methods for individual Stocks etc.):
We could then use our best judgement to assign Probabilities to these Possible Drops as follows (obviously the Probabilities must add up to 100%):
These Judgements could change according to the circumstances. For example, with a Major Event like Brexit coming along, you might decide that a Big Drop is likely so you would assign higher Probability Percentages to the Bigger Drops than if it was just a fairly ‘normal’ Pullback in a healthy Bull Market like we often get in the Autumn (and in such a case you might only go down to a Drop of 20% at the most or even less - you don‘t always need 6 Possible Outcomes - you can have the number you want but obviously it is best to not have too many and get too granular - or to have too few for that matter).
You can then do some clever Maths as follows and convert the % Probability into Numbers (I learnt this in a Book on Probabilities !! In essence a 100% Likelihood can be expressed as a Probability of 1.0):
We then get:
You then add all those Numbers together which gives 0.5 + 4 + 4.5 + 2 + 1.25 + 1.5 = 13.75
I might have totally cocked this up but I think it is right and it means that on the basis of the Possible Outcomes you have identified for a forthcoming Drop, and with the Probabilities you have assigned to them, you get an Expected Drop of 13.75% (in the terms you would see in a Probability Book this is called the ‘Expected Value’).
Doing some Probabilistic Modelling like this might enable you to take a view of the likely extent of a Drop that you expect to come along and this could help you decide how much of your Portfolio to Move into Cash and whether or not it is worth doing or whether you would be better off just Hedging in a particular case as I will talk about next. Of course there is no guarantee that the Drop will be 13.75% but you would be surprised how close this kind of mathematical modelling can get in reality.
As a general thing, whenever you have a List of several Possible Outcomes for something (not just Stockmarket stuff, but anything really) you can use this Method to assign Probabilities and come up with an Expected Value which represents the most likely Outcome. For example, I remember years ago when I was looking at a Mining Stock that was very likely to be a Takeover Target that I could use a similar kind of Modelling to work out what kind of Expected Price the Shares would be taken out at - in that case the most likely Takeover Price was for example 200p and I used Possible Outcomes of perhaps 160p, 180p, 200p, 220p, 240p, and then assigned a Probability % to each of those like I did above. That helped me make the decision whether to invest or not, depending on the Price at the time and my Expected Gain if the Takeover had gone ahead.
As I mentioned earlier in this Blog Series, my own preferred approach is to use Hedging to offset some of the Losses on my Long Portfolio of Stocks when there is trouble in the Markets. At the end of this Blog Series I will lob in a Link to stuff I have written about Hedging in the past - if you cannot wait, then go to the Educational Blogs Page and click on the ‘Category’ ‘Hedging’ and you should find a collection of related Blogs. Alternatively on the WD2 Website there is a beastie called the ‘Blog Index List’ which is a huge list of all the Blogs I have foisted on the Public and they are all fully Linked up now for the Educational ones.
In essence Hedging means using Spreadbets or CFDs (Contracts for Difference) or specialist ETFs (Exchange Traded Funds) to Short an Index so that when the Markets fall, you will gain on the Short Positions to offset some or all of the Losses on your Share Portfolio (you could use Options as well but I don‘t really understand anything about those). It is in effect just like moving into Cash but it is quicker and easier. In theory you could also Hedge using something like Gold although I am not convinced that works all that well in practice - it might do for Recession-related Sell-offs but for ‘normal’ Pullbacks in the Markets I don’t think it is all that great. The beauty of using Indexes is that although they are never a perfect match for your Long Portfolio of Stocks, there is usually a fairly high degree of ‘Inverse Correlation’ which is exactly what you need.
In theory you could use Short Positions on Individual Stocks to give you an element of Hedging - I suspect this could work well because there often seem to be Stocks that have really gotten ahead of themselves and are on bonkers Valuations etc. The trouble with this approach though is that it is much much Riskier and something you need to really be careful about is if there is a chance of a Takeover - getting ‘caught Short’ on a Stock that gets a Takeover bid is likely to be horrific and you might even be forced to buy the Stock back at higher than the Takeover Price - I have seen this happen so be warned (a Guaranteed Stoploss with your Broker might be wise on such Trades - as would brown trousers and incontinence pads).
A disadvantage of Shorting individual Stocks is that you can feel quite guilty doing it and you can easily upset people who are long on the same Stock - Shorting via Indexes dodges this problem.
Another Advantage of Hedging that I want to stress is how I think it can probably reduce some of the Timing Issues which I talked about earlier in this Blog Series. If you have to Sell and Buy many Lines of Stock from your Portfolio that takes time to do and it is highly unlikely that you will be Selling all that near to the Peak and likewise you will be most likely be Buying quite a while after the Trough. With Hedging it is very fast and chances are you can get Hedged after a small drop off the Top and once things Bottom out, you can quickly go Long on an Index if you want to.
Other Advantages of using Hedging are:
Disadvantages of Hedging:
That’s it for this Part - one more to go which should come out soon and I will put Links in that one to all the other Parts. If you want to read those again or if you have only just discovered my Blogs and Website, then you can find them on my Educational Blogs Page if you just scroll down a bit.
Here is a Link to the Blog Series I wrote on Hedging (be warned, it is extremely comprehensive but as you may guess from the paragraph at the start, I got bored when working on it !!):
There is also this one which you might like:
And try this one (please note the numbering of the Parts went a bit screwy and as a result it is a bit confusing - however, I think the Link below has Links to all the Parts at the bottom - there are 4 Parts):
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