Positive Mathematical Expectancy: Why long-term investing works.

Posted in Blog
02/03/2021 Mduduzi Luthuli

An iron rule of investing is that almost nothing is certain and the best we can do is put the odds of success in our favour.

Since we’re working with odds – not certainties – it’s possible to make good decisions that don’t work, bad decisions that work beautifully, and random decisions that may go either way.

Few industries are like that, so it’s easy to ignore. But it’s a central feature of investing in the stock market. What most people fail to, or refuse to, comprehend is that risk and volatility are normal characteristics of investing.

Investing is similar to white-water rafting. You’re going to get wet and tossed around, with a decent chance of minor injury. It’s kind of the point. Many investing blunders occur when people expect “normal” to be a period when nothing goes wrong when in fact it’s normal for things to constantly be breaking and falling apart.

Many investors – especially new investors – have no clue how much risk they can endure, and when they think about a future when they might lose money, they underestimate the psychological torment of the uncertainty that arises when the world faces a situation like we saw in March 2020, that can push the stock market down 30% in a month.

We all overestimate our ability to predict what is going to happen. This is largely because humans underestimate the role of chance. We look for patterns – even when they do not exist.

Random factors affect every event in our lives. Nevertheless, after the fact, we often believe that we should have expected the event, and we invent causes. People are not very good at recalling the way an uncertain situation appeared to them before they knew the results.

Nobody likes to think they are not in control of their life. More especially with the financial decisions that may mean retiring with more than enough or with nothing at all.

Professional investors, no matter how much they may think or say otherwise, are no better at near term forecasting than the average man on the street. They know nothing about the future and the exact events that will most likely impact how the financial market will perform.

A distressing number of them enjoy speculating on macroeconomic matters such as foreign exchange rates, commodity prices and future interest rates. However, numerous studies have shown that short term forecasts in these areas are no better than would be achieved by chimps throwing darts.

Likewise, we are bombarded with predictions of the short-term direction of the stock and bond markets. Yet, study after study has shown that the timing of near-term market increases, and decreases, is entirely unpredictable.

These pundits are not as seers but are entertainers. Paid to make a calculated guess at best, that most times turns out to be wrong. A fascinating study published by Fernando Chague, Rodrigo De-Losso, and Bruno Giovannetti from the Sao Paulo School of Economics and the University of Sao Paolo bears this out.

The authors wanted to answer the question whether it was possible to day trade for a living. What they found is that among those who traded for only one day, about 30% made a profit after fees. For those who traded for more than 300 days, 97% lost money.

The probability of an individual exhibiting a positive profit monotonically decreases with the number of days he or she trades,” the authors wrote. “This peculiar pattern is contrary to what ‘self-selection’ — individuals who persist in an activity are generally those with better performance – and ‘learning by doing’ would suggest.

In turn, patterns like this are usually found in gambling activities, such as the casino roulette, where the proportion of successful players also monotonically decreases with the number of rounds played.”

To put that in plain English, absolutely nobody on earth can accurately predict and time the market with enough accuracy to justify trying to do so for profit. Short- and medium-term market movements are driven by so many variables that neither you nor I can predict them with any accuracy or consistency.

Both of which are necessary for such predictions to be useful to an investor. To state otherwise is to be ignorant, a liar or a criminal participating in insider trading.

In fact, it is an important step for the sophisticated investor to recognise their own limitations and to understand that the odds are stacked against them if they wish to get ahead of the markets in this way.

The good news though is that long term markets, that is, the behaviour of share prices over 10-20 years+, are far easier to speculate upon. Therefore, they are the best place for investors and traders to start making consistent returns.

Successfully run companies that achieve great profits and invest in their own growth generally increase investor demand for their shares. The fundamental laws of economics tell us that the higher the demand and lower the supply (because people are buying them) the higher the price will go.

There is rarely a sustained and significant rush for the shares of a company that are shrinking and losing money each year. Supply becomes abundant as investors wish to offload what they have in these companies, and there is less demand, driving prices lower.

However, those companies that are growing and achieving great numbers, and continue to do so over the next 10 years can almost certainly expect to see greater demand for their shares over a 10-year period. Those are the fundamentals of stock market investing.

History tells us this has been so for hundreds of years. It is very rare that a great company that does most of the right things see their share price fall over such length of time.

Instead of focusing our efforts on matters we cannot control, like attempting to understand the behaviour of share prices over the next hour, day or week, we prefer to focus on matters we can control.

Such as researching and trying to understand which of the countless listed companies globally are achieving great results, why they are achieving those results, and is it sustainable for long enough to allow them to practice the correct behaviours that encourage further company growth.

Instead of pure speculation on process over a very short space a of time, where the odds of our success are low, it makes more sense for any investor to make decisions over the long term based on facts and evidence, where success rates can be very high.

The only way to do so is to invest in what you know and understand why you own it. If you were sitting with cash today and was given the chance to buy your current investment portfolio, would you do so and why? Without a fact-based response to such a question, you have no reason to be invested besides speculation, luck and hope.

This is also the reason why so many people lose money during a market crash. They have no conviction on what they own, why they own it and for how long they should own it. This leads to emotion-driven decisions resulting in permanent capital loss.

Successful investing comes down to the insights of behavioural finance. We know that investors tend to put money into the market at tops, when everyone is optimistic, and take the money out at bottoms, when panic is widespread.

The key then to investment success is to do the opposite and keep one’s emotions—aggressiveness and defensiveness—in balance. Perhaps the smartest thing an ordinary investor can do is to engage in periodic rebalancing of a diversified portfolio.

If one asset becomes so highly valued that it comes to represent a disproportionately large share of the portfolio, then reduce its weighting and place the proceeds in underweighted assets. Such rebalancing may not be “mastery” in the fullest sense, but it will generally reduce risk and often enhance a portfolio’s return.

But again, in order to do so repeatedly and in such a manner that will yield long-term investment success, you need a fact-based assessment of what you own and why you own it. Then you need to understand that the market can remain irrational (random) longer than you can remain solvent.

Since we’re working with odds – not certainties – it’s possible to make good decisions that don’t work, bad decisions that work beautifully, and random decisions that may go either way.

For assistance with your investment management needs, contact us on info@luthulicapital.com

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Any fool can know. The point is to understand - Albert Einstein