The Way of Investing

One of my favorite hobbies is investing. It's a little like gambling, but with an air of respectability. Besides the legitimacy of investing versus gambling, the other major difference is the outcome of your decisions. In gambling, the odds are fixed and known beforehand by both parties, that is, the player and the house. When you put money on, say, 12 in roulette, you and the house know that the probability of the ball landing on 12 is 1 in 38. Nothing you can do will change the probabilities. Investing, on the other hand, has unknown probabilities and unknown outcomes. This doesn't mean, though, that it's impossible to make money. What makes investing unique is that essentially you can stack the odds in your favor.

Suppose you wanted to invest $100 in a stock. If you did no research and simply bought a few shares of a randomly chosen stock, what is the likelihood that the stock will increase five years from now? If you have no knowledge of the company behind the stock and no knowledge of the economy that the company is a part of, it's probably fair to say that it is as likely that the stock will increase as it will decrease. But suppose you know that generally speaking, stocks go up over the long run. What are the chances that your randomly chosen stock will be higher five years from now? Perhaps the odds are now in your favor, say 75% of it going up versus 25% of it going down. Note that nothing actually changed; the only thing that changed was that you had some extra information about the stock. The more you move from a state of no information to a state of perfect information, the more the probabilities will move to 100% (and correspondingly, 0%). I described above the state of no information, where you knew nothing about the stock (or stocks in general) and simply picked one at random. At the other extreme, if you know for a fact that ABC Corp.'s first quarter earnings will be higher than the consensus forecast, then, all else being equal, there is a 100% chance that the stock will be higher. Assuming nobody else knows this (if they did, this information would already be priced in), you could make money on this news. At this extreme end, we call it insider information, and trading based on that news is illegal, and for good reason. After all, we believe in a level playing field for everyone, and insider trading goes against that idea.

But even when you use only publicly available information, it's still possible to make money beyond the market return. The key lies within the probabilities. Let's start with the micro level with individual stocks. Suppose the consensus is that there is a 50% chance that ABC Corp. will announce earnings of $1.00, a 25% chance that it will announce earnings below $1.00, and a 25% chance that it will announce earnings above $1.00. Accordingly, the market prices ABC stock at $10. You, on the other hand, believe that there is a 50-20-30 chance, respectively, meaning that you value the stock more than $10. Because you are a price taker (you're buying 100 shares when on average 10 million shares are traded a day, so your buying has virtually no effect on the price), you can enter the market without affecting the price. The next day, ABC Corp. announces earnings of $1.10. The market prices in this new information, and now ABC stock is worth $10.50. You've made money.

The issue, of course, is that you need to be consistently right, and for the individual investor, that's extremely difficult. After all, how did you know that the correct probabilities were 50-20-30, and not 50-25-25 like the market consensus? Was it pure luck? Fortune is fleeting. Was it a superior analysis? There are hundreds of stock analysts with Level 2 data, access to dozens of newsletters and commentaries, even fellow coworkers on the trading floor who spend hours every day following ABC Corp. The likelihood that you will be able to consistently outperform the market is extremely small. At the micro level, it's nearly impossible to make more than the market return without simultaneously increasing the amount of risk you're taking because markets are mostly efficient. (I'm not claiming the Efficient Market Hypothesis or EMH, however, which states that markets are totally efficient; there is a world of difference between "mostly efficient" and "totally efficient").

I should point out, however, that even if the EMH is true, that doesn't mean it's impossible to make money; it only says that it's highly improbable that you will make more than the market. If the market has a return of 30%, that's a pretty good return regardless.

As you start moving from the micro level to the macro level, though, you start gaining the upper hand. The Efficient Market Hypothesis does a good job of explaining why a stock might rise and fall, but it can't explain why there are bubbles in the stock market. At the macro level, there's more room for error, both in your judgment and in other people's judgment. Personally, I believe that even if on an individual level the Efficient Market Hypothesis applies, it doesn't necessarily follow that it should apply on an aggregate level. In other words, a stock might be priced so that it reflects all available information, but a stock market might be mispriced. I have to admit that this seems like a contradiction (a well-known example where the macro does not necessarily follow from the micro is Arrow's Impossibility Theorem; an example of its implications can be found here), and I haven't done any sort of research on it, but it is a compelling explanation, I think.

The other nice thing about working with markets is diversification. (I could write a whole post about how the word "diversification" is misused, but for now just think of it the way as we usually think of it: the more securities, the higher the risk-adjusted return.) Diversification allows us the ability to focus on the big picture rather than worrying about individual securities. If we take a hit on a particular stock, it won't affect our overall portfolio too much because it's such a small portion of it. But because overall the stocks will tend to move together, the movement of the overall market will outweigh the anomalous movements of individual stocks.

Working on the two ideas that markets as a whole can be mispriced and that diversification allows us to look at the overall picture, we can develop strategies that can take advantage of these mispricings. These strategies will require us to be able and willing to go long or short on a security. It's this ability and willingness to go short that separates the professional investor from the average investor. The typical investor is only long stocks. He buys an investment and hopes that it will go up. Because things go up and things go down, the amateur can make money only half the time. Not only is the professional investor is more knowledgeable than the average, amateur investor, but he also has more tools available. The professional investor buys an investment and knows that it will go up. But the professional investor also shorts an investment and knows that it will go down. He makes money regardless of the direction of the market because he knows the direction of the market. This applies no matter what particular strategy he's using, whether he's buying and selling individual stocks or buying and selling entire markets. I want to emphasize again that the difference between a professional investor and your neighbor who calls himself an "investor" is a mindset, a philosophy if you will.

I'll save further details on how to invest and what to invest in for a later post, and I'll end this post with my favorite investing quote:

"What's your advice for the average investor?"
"Don't be average."