"risk" and playing the odds
June 27, 2009
– Comments (35)
I have often said that my strategy since coming to the market to buy into this big crash has been based around playing the odds. I'll explain
-Dreman's book describes the fact that buying stocks with low p/e, low p/b, low p/s etc valuations gives much better historical returns than buying expensive stocks even with no other considerations (bankruptcies, etc.). His stats ended in 1996 and began in 1971 i believe.
-Historically coming out of bear market crashes, small caps perform the best
-Historically coming out of bear market crashes the stocks that went downthe most come up the most
-Historically small caps beat big caps
-Historically buying into big crashes when markets have fallen dramatically has yielded good returns
-Historically money is made primarily by going against the trend. Everybody is bearish, be bullish. If Casino's are really in favor (2006 or 2007) they aren't likely to yield good returns over time, if they are really out of favor they are much more likely to. etc. Buying cyclics when they are on cycle has historically cost you money, buying them off cycle has made money.
One of my first blogs was titled something like "the boom or bust portfolio" and described how I thought the best return and lowest risk for the current market was to buy stocks that were so battered in share price that if they simply lived they'd at least double or triple. And diversify that across many stocks so that if even 1/2 of the companies you pick just live yo'd make money.
Along those lines, and along with the theme of playing the odds, lets take a look at a few scenarios and analyze them for risk and probable reward (remember, its all about playing the odds).
-A. your portfolio consists of 1000 stocks that are guaranteed by a higher power to go up 5%
-B. your portfolio consists of 1000 stocks that will have random returns from 0-10%
-C. your portfolio consists of 1000 stocks that will give random returns from -10% to +30%
-D. your portfolio consists of 1000 stocks that will give random returns of either -100% or +200%. boom or bust.
assuming that in the cases where there is a spread in the odds that the actual outcome is in the middle. So 1/2 of the companies hit the high mark and 1/2 hit the low markt.
the odds are that A. returns 5%
the odds are that B. returns 5%
the odds are that C returns 10%
the odds are that D returns 50%
The odds favor the most dramatically battered stocks in this example, and plain and simple I think the odds favor the most dramatically battered stocks in real life as well.
But nowhere that you read does anybody condone buying battered stocks, except maybe Dreman. No fund managers talk of buying them, you'd probably get a lecture if you posted on these blogs about buying them, and all of the stock picking guidelines you wille ver read will probably tell you to pick companies with criteria like
1. good growth
2. low debt
3. good profit margins
4. favorable fundamentals in their industry or business
Yet without a doubt, rarely, if ever, are stocks like those ever really cheap. Stocks like that may have been cheap eralier this year, but thats a rare event. And stocks not meeting those criteria were REALLY REALLY REALLY cheap earlier this year.
I don't submit this post as a guideline or recomendation, I submit it as a thought,one that I think would probably prove to give superior returns historically if you ran the calculations...
In essence I offer this thought: the market so badly misprices actual material risk, especially in bearish times, that the best odds are quite probably with the most risky stocks and not with the safest.
Or, alternately, if the market does mis-price risk to the high side in bullish times, I submit that big very safe stocks are the best things to own in bull markets when nobody wants them, and then transfer to battered beaten high risk stocks when things turn profoundly bearish.
Diversification or "being right" is clearly a key here...
I am of the opinion that a machine could invest better than 99% of minds, and I simply assume that my mind is one of the 99%, and as such I sould try to align myself not with hunches or thoughts or forsight, but with odds. And I submit that moving up the risk ladder in bearish times is quite possibly something thathas better odds than moving down it. The opposite may well be true in bullish times.
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