Tuesday, August 25, 2015

Betting On Longshots: An Investing Approach For The Prudent And Humble

     Everybody knows what a longshot investment is, right? A proposition with a poor probability of paying off, but which would pay off big if it were to pay off at all, right? So betting on longshots is the opposite of “playing the odds,” at least as traditionally understood, right? It’s just a way to go broke dreaming of riches you’ll never collect, right? Right?

     Wrong. At least, not always and everywhere right. And I shall tell you why.

     He who plays the odds – i.e, who places his bets on the most likely result of some process – is grist for the mill of the odds-makers. His bets are the stabilizing ballast for the field, for two reasons:

  1. There will always be more of his sort of bet than any other sort, and often more than all the others taken together.
  2. His bets are, on average, the largest ones made on the process.

     Thus, the play-the-odds bettors are the ones most important in determining the odds, and thus the payoffs, for all the possible outcomes. For any process with a strong element of chance involved, the total payoffs the process will offer will sum to no more than the total of all the bets.

     It is thus a natural consequence that the play-the-odds bettor will, on average, lose money.

     These observations are germane to many different betting scenarios, including the decision to commit money to the equities markets. In those markets, the odds-makers are the financial gurus, with emphasis on the popular ones. No one watches those commentators more closely than the short-term pseudo-investor we call the speculator.

     Speculation differs from investment in that it largely disregards the fundamentals of the equities involved. That is, it bears little or no relation to what the involved companies are doing while the speculators’ bets mature. It’s almost entirely based on the speculator’s anticipation of what other investors and speculators are likely to do, and the effect that aggregate behavior will have on the prices of the relevant equities. To be a successful speculator, therefore, requires more knowledge about the behavior of investors and speculators than about the activities of publicly traded corporations.

     Needless to say, a successful speculator is about as likely to share his knowledge of such matters as I am to convert to Scientology. His is that rare sort of knowledge whose value diminishes as it’s shared.

     Some years ago, when the markets were hot, hot, hot and seemingly everyone in America was eager to “get in on the action,” financial gurus were thick on the ground, vending their advice to anyone who’d listen. Many Americans learned the hard way that under such circumstances, becoming part of the herd that follows such advice is a great way to walk right off a cliff. The great speculators know it. They knew it then, too.

     Which is why respecting the value of longshots is so important to the man who can’t fly.

     In the investment market, a longshot is deemed such not because its odds of paying off are absolutely, objectively low, but because market behavior has a time-horizon associated with it: i.e., the time interval between one’s investment and an acceptable positive return. That horizon varies from investor to investor, but each of us has one. For example, I wouldn’t bet on an equity whose payoff date is likely to arrive fifty years in the future; given my age, such a payoff would have no value to me. I want a payoff within my usable lifespan: probably no more than ten years from the present day. But I’m a long-range investor; a speculator’s time-horizon will be much, much nearer: typically within two months or less.

     That difference in time-horizons distinguishes the “speculator’s longshot” from an equity for the investor with “staying power.” Many an equity is a “speculator’s longshot,” in that it has little chance of paying off acceptably within a speculator’s time-horizon – and speculators are uniquely sensitive to transaction and opportunity costs, which set a greatest lower bound beneath acceptable returns. But among such equities are some that will appeal to the long-range investor, who’s willing to wait longer than the speculator for a return.

     Therein lies the psychological difference between investors and speculators. It also hints at how to “bet the longshots” in a fashion that has a good chance of reaping strong positive gains.

     If you’re new to equities investment, two preparatory steps are mandatory:

  • Decide how much you can risk comfortably; i.e, without endangering your ability to meet your responsibilities acceptably. We’ll call this amount $P.
  • Decide on your personal time-horizon, which we’ll call T years. T should be no less than three, and probably no more than ten.

     Once those steps are behind you, you can think rationally about investing. The next steps are:

  1. Select a small group of publicly traded companies. Make them ones about which you have a reasonable prospect of learning a great deal.
  2. Study the hell out of each company – its fundamentals, its behavior over the past T years, and any announced plans. Disregard with prejudice any that speculators have targeted over that interval.
  3. Determine whether the popular financial gurus consider any of your selected stocks worthy of discussion: if they do, pass it by; if they don’t, it might be worthy of a bet.
  4. Decide for yourself whether any of those equities offer the prospect of adequate returns over the next T years.
  5. Do not share your knowledge or decisions with anyone, including your spouse or Significant Other. (No, don’t share it with me, either.)

     Once you’ve assembled a small – no more than ten – group of equities that you believe will pay off within T years, you’re ready to partition your $P among them. This is a matter of “feel” rather than analytical rigor. Some people will prefer to bet slightly more heavily on the stocks with potentially larger payoffs; others will simply divide $P by the number of stocks under discussion, allocating evenly to all. In either case, you can be assured that you’ve created a portfolio that short-termers and speculators would dismiss, which is the single most important consideration.

     Now comes the hardest part: Lock ‘em up. Keep your eyes on your selections, but your hands off them, until one or more stocks delivers the desired return. When one does, sell it and put the money in the bank. When T years have elapsed, liquidate everything you still hold. If you want to “play again,” that’s the time to do so.

     What I’ve outlined is similar to the “value” approach to investing, albeit more explicitly herd-averse. It’s how you bet on what others would consider longshots. It doesn’t guarantee success, but it limits your exposure and armors you against the anxiety that short-termers and speculators feel during significant market fluctuations. More, it exploits a bit of knowledge that short-termers don’t use:

     Time is the most powerful force in finance. Get it on your side.

     Of course, the most important element of the above investing strategy is the avoidance of a short-term mentality. It’s that mentality that leads to classifying many stocks as longshots.

     Douglas Casey, whose intelligence and expertise I respect, adopts a different approach in his Crisis Investing For the Rest of the ‘90s. Casey suggests picking ten stocks, each of which has at least a 1-in-10 chance of at least a tenfold return on investment over the course of a typical business cycle (2.5 to 5 years). While Casey’s approach has considerable merit, very few of us have enough access to knowledge about even one company to predict a tenfold increase in its value with 10% confidence. If you do, may God bless and keep you...and your stock selections, too.

     Note that Casey and others of sound judgment are equally adamant about not following the herd over the cliff. The herd is the speculator’s lunch. A speculator plays off the predictability of the herd, which flows from the popularity of the popular financial gurus. He times his moves to buy and sell before it gets fully into motion. Don’t be one of his appetizers.

     Finally, you might be asking “why this subject today?” Given the fluctuations in the market these past few days, what else would you think is on most people’s minds? The presidential campaign? Get serious!

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