If you have glanced at, or perhaps even read, my epic Blog around Hedging, you will know that I wasn’t really happy with the Final Version which went live but I had just got to the point where I could not stand working on it any longer.
Part of this was because it bored me rigid and I had my thoughts on another Blog idea which I was much keener to write and this is the coming together of those musings. I like my ‘Educational’ type Blogs to be very different to the stuff Readers can find elsewhere and to actually be of use to Long Term Investors in the Real World - after all, if I am just repeating the usual Finance Industry BS then why should Readers bother with it and why should I waste my time writing it?
I am pretty sure this Blog falls into the ‘thought provoking’ receptacle and it is something that I expect to find challenging to write and I am sure it will be insightful for Readers and has the potential to really make you think about how you go about your Investing and/or Trading. Needless to say, after the previous sentence, I will boldly make the claim that the ideas and thoughts within this Blog could really make a big difference to your Returns - with luck they will help mine as I could really do with it this year !!
The Roots of the Idea
As I have hinted at in the above text and I have mentioned on some recent Tweeting, this Idea has been forming in my mind over many weeks (if not months !!). The crux is that I have several close mates who Buy and Sell pretty much the same Stocks that I do - in fact, one friend Buys almost exactly the same Stocks that I do and in the same proportions.
This is where it gets really weird - last year my Trading ISA closed up 28% but her SIPP (which is in theory pretty much a mirror) was only up about 18% - which makes not a lot of sense as they should be very similar.
This disparity in Returns was very noticeable among my other Friends as well although they do not have such a close match to my Portfolio - but still the Returns were wildly different.
I can take this further - when I think about the Returns people across Twitter etc. achieved for 2015, there was a huge variation but I think it fair to say that the People who Invest in a very similar way to me and who seem to be on the whole very experienced, tended to produce the better Results. I have not done a scientific survey, so this might just be anecdotal nonsense, but to a large extent the Returns probably clustered around 8% to maybe 30% ish and with a large number around 15% ish.
Now this deepens my conundrum - how is it that a group of People with very different Stocks can get surprisingly similar Returns? I suspect that I could compare my Portfolio with those of most of the People on my Twitter Feed and there would be very little overlap - maybe a handful of Stocks would be common to my Portfolio and any I compare it with.
Following on from the bit above, when I think about it there are utterly thousands of Stocks to choose from and to a large extent Returns on any Stock you buy are unpredictable - so how is it possible that we can pick a relatively small Subset of these Stocks and make money? Is it not just as likely that we could buy such a Subset and lose money? Although of course if the general Trend of the overall Markets is up, then probably it is likely that we could randomly select a Basket of Stocks that would rise.
All the above thoughts have been enhanced by the work I have been doing on another Blog Draft which is about ‘Red Herrings’ (irrelevant Information around our Stocks - the Blog on this actually went live some weeks back - I have included a link at the bottom of this spiel) and Noise. Part of my conclusions from that particular Blog are that many Investors strive for ‘Perfect Information’ around a Stock whereas in reality that is an impossible goal - we have to make do with not knowing everything - it is very much the Pareto 80/20 Rule - 80% of the Information in 20% of the Time/Effort. We then need to take ‘Risk Management’ approaches such as having a Diverse Portfolio to ensure that the 20% of Information we can never get does not destroy our Capital in a terminal way.
Factors of a Trade
This led me to the idea that whenever we Buy a Stock, our Stockpicking Skills (i.e. the choice of Stock) might only be perhaps 20% or at the most maybe 50% of whether or not we have a successful Outcome of the ‘Trade’ (Profit, Flat, or Loss are the possible Outcomes). The other elements of a successful Outcome to a Trade might be the way in which we ‘Manage’ the Trade and other factors such as our Psychology and the Costs involved and as @Wellard57 on Twitter suggested, a large chunk of it could be Luck.
If my guess at the Stock Selection being as low as 20% of a Successful Outcome is right, then the implication is that how we Manage a Trade could be as much as maybe 30% and the Costs might be 3% (to be honest, I am not sure that Costs are really all that relevant here - maybe it is miniscule and immaterial) and our Psychology might be 25% and Luck might be 20%. Of course all these figures are utterly subjective and pure guesswork by me but you can muck around with the proportions how you see fit - it’s the concept that is more important here.
To add more colour to this, I wrote the following Text in the ‘Red Herrings’ Blogs - but it is worth repeating I feel:
“Our task as Investors is to accept that we can never have Perfect Information and we must manage the Unknown and Unknowable to ensure we are successful. We must weight the Investment Odds in our Favour. One way of thinking about this is to consider that the success of any Investment we make probably depends on the following elements:
Stock selection - 20%
Timing - 15%
Valuation - 20%
Trading Techniques (add to Winners etc.) - 20%
Discipline and Psychology - 20%
Luck - 10%
PS, who noticed that the Percentages in the table don’t add up? Clearly observation and attention to detail are not your key skills so maybe there is no point you bothering to seek out Perfect Information !!”
It strikes me that I should add a bit on the Luck element. Of course, there are 2 sorts of Luck - Good and Bad. One we want, the other we really don’t want !!
In many ways these 2 forms of Luck are asymmetrical - I might be wrong here, but I get the feeling that Bad Luck can really wham you hard whereas Good Luck is a lot slower. Bad Luck could be a Profit Warning out of nowhere and we all know these regularly hit Small Cap Stocks by as much as perhaps 30% to 50% in one Day, and the Stock tends to continue falling for some time afterwards (I got whacked by Vislink VLK 55% today just to show exactly that). On the flipside, Good Luck might just be a decent Trading Update and the Stock might rise perhaps 5% to 15% or so - much smaller than the impact of Bad Luck.
Of course you could have some exceptional Good Luck and get a Takeover Bid for your Stock which results in a jump of maybe 30% or 50% or something - but I suspect these are much rarer than the Bad Luck of a Profit Warning (and I wonder if this might be even more likely if you tend to hunt around for low P/E and high Divvy Yield ‘Value Stocks’.)
It also seems like we get streaks of Bad Luck - and we probably do on Good Luck as well but my selective memory seems to note the Bad Luck streaks more than the Good Luck streaks - or maybe that is because when things go well I think it is my Skill whereas when things go poorly it must be my Bad Luck !!
I’m thinking the solution to the Luck problem is to undertake Actions that can add to our Good Luck but also undertake similar or other Actions that can reduce the frequency and the impact of our Bad Luck. For example, ‘Adding to Winners’ means weighting up on Good Luck when a Trade is off to a good start and letting Losers wither on the vine or using a Stoploss will reduce the impact of Bad Luck (please note, I will explore in more detail what ‘Adding to Winners….’ actually means in practice in the next Part of this Blog Series.)
Randomness and Mean Reversion
Building on the ‘Luck’ theme, could it be that a large proportion of our Returns (good or bad) are down to ‘Randomness’ and ‘Mean reversion’? Academic types would argue that Stocks move in a Random manner and are entirely unpredictable - I see the theory here but in reality I am not sure this is true - and if it is true, why on earth do we all bother mucking around with our ‘Investment’ activities?
I sort of subscribe a bit to the idea that in the very Short Term the moves a certain Stock (or Asset) makes are pretty much unpredictable and random but as the time horizon extends, I feel that there is some predictability - even if it simply means that over a period of Months the Share Price of a Good Business will do well whereas a Poor Business will fall in price. It’s the classic Ben Graham, “In the Short Term the Stockmarket is a Voting Machine, in the Long Term it is a Weighing Machine” (obviously I have simplified things here because Valuation must come into it as well).
The other thing that makes me question the ‘Randomness’ idea is that Share Prices clearly are not Random in that they follow very clear and defined Trend Channels most of the time. OK, to many people these Channels are a mystery and they cannot see them but to people who have been mucking around with Simple Technical Analysis for any period of time will realise that Share Prices can be in an Uptrend and then they can go Sideways and then they can go into a Downtrend or variations around this - but it is clearly not correct to say they are Random. Maybe it is fair to say they are short term Random moves within some larger confines of a Trend Channel.
Anyway, irrespective of whether or not Share Prices are Random, simply using some ‘Rules’ (like adding to Winners etc.) may mean that you can turn these Random moves into Profit - I will explore this more in a later Part to this Blog.
Mean Reversion sort of ties in more with the ideas I just mentioned about Share Prices moving in Trend Channels. The idea of Mean Reversion is that everything in life tends to move around an ‘Average’ Value and Share Prices do exactly the same - so they can move Up and Down to large extremes, but over time they move back towards the Average - i.e. they ‘Mean Revert’.
This is probably a much more useful concept for us as Share Investors - it in effect means that if we Buy or Sell at the Extremes, then it is most likely that the Price will move back towards the ‘Average’ Value - this is something we are relying on when we ‘Bottom Fish’ a Stock and when we Sell out of a Stock that “Looks really toppy and over-extended to the Upside”.
Anyway, however, we cut it, Randomness and Mean Reversion could easily be responsible for some part of our Good or Bad overall Portfolio Returns.
Right, that’s it for Part 1 - don’t worry, the Monkey will show his Stinky Banana Arse at some point in Part 2.
Link to the ‘Red Herrings’ all 3 parts:
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