I've delved into this topic a few times without further elaboration, so I thought I'd spend time today trying (and most likely failing) to make what may be a fairly esoteric point.
It is this: Not every investing decision with a positive outcome is good, and not every investing decision with a negative outcome is bad. It can be one of the most confusing elements of investing, and it bears some discussion.
Equities are, by tautology, risky assets. Risk is defined in a number of ways: Academics tend to view it as a function of volatility, while I prefer to see it as the potential for permanent loss. After all, if a company has a one-year problem and sees its normally staid stock price suddenly drop lower, if volatility is the measure, it has suddenly become both riskier and cheaper. Volatility is a fair measure of, well, how much a company moves vs. the market. To my mind, a company that has a stock price that is stable yet overvalued is significantly more risky than a stock that is priced too low yet volatile.
Besides, when risk is defined as volatility, it is quantified regardless of whether the equity falls or rises. How many investors would choose not to hold a stock "in case it goes up?"
Naturally, such an argument isn't the path to a tenured professorship at our most august business schools. That's fine. I'm not trying to be true to a theory. Making good investing decisions is hard enough.
What does interest me is the thought that investing is a probabilistic pursuit. Think about this: Not all investors are rational, yet the perfectly rational investor and the perfectly irrational investor might make the exact same decision at the exact same time. And they'll be rewarded exactly the same. You don't get style points from the market, nor do you get any bonus for knowing more about any single company than anyone else knows. My colleague Jeff Hwang notices whenever the Ameristar Casinos (NASDAQ:ASCA) change carpets at any one of their properties. Know how his results would differ from someone whose investment thesis is "I like gambling"? They wouldn't.
This is the single hardest thing for investors to understand about the stock market. It's also the single hardest thing for those of us who write about stocks to explain. The fact is, you can make a perfectly good investing decision and still lose, and you can make a decision based on absolutely nothing and still do great. The thing is that over the long term, those who make good, sound decisions ensure that they are taking advantage of "market discrepancies."
Market discrepancies happen because the market tends to make mistakes. Former Motley Fool writer Jim Surowiecki wrote a brilliant book this past year called The Wisdom of Crowds: How the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations. In it, he describes how a crowd of diffuse knowledge tends to be extremely efficient in making decisions, more so than the experts. But crowds also have dynamics that cause this incredible discounting ability to break down. To be efficient, they must have diversity and independence, and they must be decentralized. When a group -- in this case, the stock market -- loses its way it is invariably caused by one of these three elements coming out of equilibrium. It happens all the time, in any market. People think that B2B e-commerce is going to rule the world, or they believe that the chances of disruption of Middle Eastern oil supplies is imminent, or they think that some rinky-dink company whose CEO appears on television deserves a billion-dollar market capitalization.
It's an observable phenomenon. At the points when the stock market has sunk, people want to sell and run away. When a fund suddenly knocks the cover off the ball in a given year, people pile into it the next. The stock market may be the only place where people get excited by high prices and don't mind paying for something that has just gone up a bunch but invariably will have wish they'd sold when the music stops. Much of why this happens is explained in the research of Amos Tversky and Daniel Kahnemann, the latter making in a few words the point I'll likely fail to make in 1,000: "In a rising market, enough of your bad ideas will pay off so that you'll never learn that you should have fewer ideas." People tend to make similar mistakes, in exactly the same way, at the same time.
We're inclined to overestimate our own knowledge about what's going on at companies we hold. When WorldCom -- the predecessor to MCI (NASDAQ:MCIP) -- was coming unglued, ordinary shareholders stood up to defend the company from what they considered to be unwarranted attacks. But WorldCom didn't become a fraud in 2001; the game was in play several years before that. People who bought WorldCom stock in the mid-1990s had no idea that they had made an investment in which the probabilities were stacked against them, since the company was rotting from the inside out. Similarly, someone sold Enron shares at $70 apiece only a few months before the company collapsed. The evidence for this collapse was there in the company's financials. Obscured, but there. The probability for imminent collapse was extremely high. Yet the folks who sold Enron shares had at some point bought into a company that was a nearly total fraud.
If you were to plot potential outcomes on a graph, you'd end up with a distribution curve, non-normally distributed. From a probability perspective, the left tail for Enron (the one that includes market losses ranging from the moderate to the catastrophic) was very, very large. In effect, people who sold Enron just in time dodged the highest potential outcome of their investment. They made a bad decision and still got paid for it. It happens, but in the long run, the expected outcome is decidedly negative.
The really interesting (and when it happens, sickening) thing is when you've made a pretty good approximation of the probabilities of success or failure and the thing still goes against you. At present, for example, Krispy Kreme (NYSE:KKD) is scrambling for its life while it attempts to garner financing, and if it fails, it will probably end up in bankruptcy. In 2000, though, when the company was first on its way up, I commented that I thought its business didn't scale well and that it would have to invest massive amounts of money to grow at a rate that justified its valuation. For several years, Krispy Kreme did just that. My analysis looked foolish, to the point that I had to assume that the low-probability event had actually taken place. Fortunately, the company's stock always stayed so far ahead of where it should have been, even assuming healthy growth, that I was never, ever tempted to buy. But for too long a time, I was right, but wrong. The low-probability event was taking place. Had I shorted the stock, I likely would have found waiting for the collapse that might have never happened to be unbearable.
I believe that as you're investing, one of the worst mistakes you can possibly make is to assume that any time a stock goes up, it proves that your thesis was correct. It could be, as it was with the folks who got out of Enron just in time, that the market is giving you a pain-free way to rectify a mistake.
Contest update
In my Monday column about AIG (NYSE:AIG), I offered a beautiful Apolo Anton Ohno fanzine to the first person who could identify the source of this quote: "That which cannot go on forever, won't." About a thousand people gave the correct answer: economist Herb Stein. (My favorite incorrect answer was "Muammar Qaddafi.") The winner has been alerted by email. I had so much fun with it, I'd like to have a new contest, this time for a Wes Unseld bobblehead doll. Here's the question: There is only one word in the English language that is derived from Dhivehi, the national language of the Maldives. What is it?
Bill Mann owns none of the companies mentioned in this story. He picked Wisconsin-Milwaukee to make the Sweet 16, but beyond that, he sees little more than pain.
Bill is the guest analyst for this month's Hidden Gems newsletter. Come and see what the commotion is all about, and take afree trial today!
