Financial markets are more random than generally assumed. Consistency and recurring patterns in past performance may lead us to overlook this fact.
Investing is a prediction business. We buy a stock when our analysis predicts its market price will rise. We sell a stock when we predict its market price will decline. Every time we say something will happen in the future, we are making a prediction. And we don’t just predict that the stock’s market price will go up; we also predict that it will go up enough to provide us with a satisfactory return. Since a stock’s market price follows its earnings in the long run, we are basically predicting a stock’s earnings, and the underlying reasoning behind our predictions is largely an extrapolation of the prevailing conditions. If a stock’s earnings are increasing annually at 15%, we predict it to keep increasing at the same rate into the foreseeable future. Of course, we all know that the stock’s earnings will never exactly match our predictions. But we still predict, and there is nothing wrong in that – I mean the prediction business, not the underlying reasoning behind the predictions. As Dwight Eisenhower has said, “All plans are useless, but planning is important.” Likewise, when it comes to investing, “All predictions are wrong, but predicting is important.”
Our purpose in predicting where a stock’s price will be, three or five years from now, is not to get it right in exactitude, but rather to aid decision-making. However, most predictions fail miserably. The trouble is not in predicting, but in how we predict. We generally tend to underestimate the uncertainty and randomness inherent in most situations. If a stock’s earnings had increased by 10 – 15% over the past five to six years, a false sense of certainty about its prospects arises, causing investors to assign a higher market price for the stock. But the truth is that, despite a stable past, its earnings can still deviate significantly from recent levels, for better or worse. If our portfolios aren’t insured against such possible deviations, there will be consequences. Where a stock’s earnings will be next year, or three years from now, is a random event, but its stability in recent years may lead us to think they are more certain and thus predictable.
We all hold the belief that there is a formula underlying a stock’s success. We never doubt or question its existence. We endeavour to decipher this elusive formula, which will eventually enable us to predict future success stories. At times, we believe we have the formula, only for time to prove us wrong. Our method for deciphering the formula is to investigate successful stock ideas for common attributes and recurring patterns. Once we find one, we derive the formula from the attributes and patterns. However, had we expanded our investigation to mediocre or unsuccessful stock ideas, we might have found the same characteristics in them. We are unlikely to attempt that, because what we find might shatter our belief about a secret formula underlying every successful stock idea. The truth that there is no formula is unacceptable. The uncertainty and confusion that would follow such a revelation are too much for us to handle.
Employing our pattern recognition ability to identify stock trends is a handy skill. Patterns are more likely to continue than break. This means our predictions are more likely to be right than wrong in most situations. However, we aren’t in markets to prove our predictive accuracy but rather to consistently achieve superior returns. That’s where the problem is: any gains from following an established trend will be limited, as the market would have already incorporated it into the stock price. The greatest consequential market gains or losses occur when a pattern or expectation is broken, which, unfortunately, is a very random event and thus largely unpredictable. But we can position ourselves in the market such that we are not trying to profit from a pattern continuing, but from the rare, random event of the pattern breaking.
We deal with randomness with probability, which comes with its own challenges, as our minds are not designed to understand uncertainty and probability. When we toss a coin, the odds of heads or tails coming up are equal (1:1). However, if we toss a coin five times and get HHTHH, our mind is likely to assign a greater chance to heads coming up than to tails. It is a mistaken tendency because the odds remain the same, regardless of previous results. Coin tossing has symmetrical odds. But not all situations governed by probability have symmetrical odds.
Consider driving yourself to a town 50 kms away. The statement that ‘you will reach your destination safely’ is not certain; it is a probability. Perhaps you have driven to this town more than 100 times in your lifetime, and each time you reached the destination safely. However, that doesn’t make the event certain. It is still governed by chance. The 100 successful arrivals don’t eliminate the possibility of untoward incidents that could disrupt the next journey. But unlike coin tossing, the odds are not symmetric in this case. The odds are asymmetric, which means the chances of one possibility happening are greater than the other possibilities; this asymmetry has enabled you to achieve 100 successful arrivals.
The asymmetry was created by your actions and behaviours before and during the journey, such as driving during daytime, driving at moderate speed, strictly obeying traffic rules, having a good sleep before the drive day, staying sober before and throughout the journey, restraining mobile usage during the journey, avoiding heated arguments with co-passengers, and having the vehicle in good condition before the journey. These steps skewed the odds in your favour, say, like 1 to 5,000, which means you will have only one untoward incident in 5,000 trips; in other words, 4,999 successful arrivals in 5,000 trips. Importantly, the odds for each trip are determined not by the success or failure of previous trips, but by your precautions, behaviours, and actions during each trip.
Coin tossing is an activity whose outcome is purely determined by luck. There are only two possible outcomes, heads or tails, and each has equal odds. However, driving is an activity whose outcome is governed by a mix of skill, discipline, and luck. We achieved asymmetric odds through effective use of our skills and discipline. We can (or should) do the same with investing by seeking opportunities where the odds are asymmetric.
A stock’s market price reflects its market-perceived odds of success or failure, typically determined by its past price and earnings performance. The highest odds will most likely be for the trend or pattern continuing. If stock price or earnings are declining, the odds of further declines will be higher; if they are rising, the odds of further gains will be higher; if they are stagnating, the odds of stagnation will be higher. Since we aim to profit from the rare, low-probability event of a trend or pattern breaking, we look for situations where the odds are low, but the payoff is significant. Odds represent the likelihood of an event occurring; pattern-breaking events are rare; they have low odds. They are random events; we don’t know when they may happen. But when they do happen, the payoff is in multiples of the payoffs from events with high odds. In short, pattern-breaking events have very low odds, are random, but have very high payoffs.
Suppose you identify an opportunity with highly favourable odds: 9 to 10; the chances of gains are 9 out of 10; the chances of losses are 1 out of 10. But there is more to it. When the stock gains, which is more likely, you make an average profit of ₹1,000, while if the stock declines, which is very unlikely, you make an average loss of ₹12,000. There is asymmetry in payoff too; in the above case, unlike the odds, the payoff is unfavourable. That is, despite highly favourable odds, the expected return is a loss due to the extreme asymmetry in payoffs (Expected return = (9/10)*₹1,000 + (1/10)*(-₹12,000) = -₹3,000). It is not the likelihood of the event but the magnitude of the event’s payoffs that determines investment success. Investor George Soros has said, “It is not whether you are right or wrong that matters, but how much you gain when you are right and how much you lose when you are wrong that matters.” It is one of the wisest pieces of investment advice ever.
Multi-baggers are stocks that multiply your investment several times; they are extreme investment successes. They are rare and mostly unpredictable. However, extreme and unusual events are attention-grabbing and are more likely to be remembered. Investors, therefore, study such past cases to identify future multibaggers, under the false impression that the attributes and patterns of past multibaggers can predict future ones. Unfortunately, attributes and patterns from past success won’t deliver future successes. Financial markets are more random than generally assumed. Consistency and recurring patterns in past performance may lead us to overlook this fact.
I have had my share of multibaggers over the past 18 years, and they wouldn’t count for more than seven or eight. I would have made around 100 to 150 total investments during this period, and multibaggers account for less than 10% of them. There were a few extreme failures among this cohort of investments as well, those that lost 40% or more of the invested capital; they too constitute less than 10% of the total investments. However, an intriguing observation is that 70% of the gains I have made over these years have come from extreme successes (multibaggers). Similarly, more than half of the losses came from the extreme failures. In other words, our investment success depends significantly on a few rare, unpredictable events.
A significant share of market gains or losses comes from a very small number of rare events. They are random and unpredictable. Hence, it is imperative to stay invested through the ups and downs, because these rare events might occur within the short time you may have decided to stay out of the market. It is not about staying invested when earnings are rising and staying on the sidelines when earnings are falling. It is about the asymmetry in their consequences: how much you gain when earnings rise and how much you lose when earnings fall. You feel you are doing well if the stocks in your portfolio are rising because their earnings are increasing, and your portfolio is outperforming. Then, suddenly, an exogenous shock causes a rapid reversal of fortune. You fail to make sense of it. You didn’t see it coming. No one does. But they do happen… rarely… at the least expected time… with lasting consequences…
The trouble (and the opportunity) is when market-perceived odds, as reflected in the stock price, fail to account for the possibility of rare, random events. Our portfolio must be insured against the negative impacts of rare, random events. Likewise, it should also be positioned to benefit from the positive outcomes of rare, random events—the solution to both lies in identifying mispricing in market-perceived odds.
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