SHARES

How playing darts is like investing in shares

Darts is a game of precision that seems easy at first but becomes very, very hard by the end, just like active stock management.

This article was first published on New Age Alpha.

Anyone who has played a casual game of darts, say, at a bar or in the basement, knows an overarching rule of the game: it gets harder as it progresses. While rule systems vary, most games start with a wide-open board full of possibilities. But then, by the end, you’re aiming for the Double 18 and only the Double 18 to win. In short, it’s a game of precision that seems easy at first but becomes very, very hard by the end.

Just like active stock management.

Wait, you mean active management is difficult?

No one can predict the future. If people could, there’d be no such thing as ‘risk’. The word would lose meaning because, seeing the future, people would simply avoid hazardous situations. In investment decision-making, however, the word becomes especially nuanced since investors view hazardous situations differently.

We know we may make money or lose money, and this means an investment is risky. But that’s true of any investment, big or small. Thus, the trick is to find investments that are more likely to result in greater payoffs than losses. Like tossing a dart at a wide-open board, it seems like a very straightforward situation. But, in reality, it’s easier said than done.

You see, the additional challenge when investing involves the uncertainty regarding both the probability of success and the potential payoff of said success. There’s potential to actually nail that Double 18 only to see it turn into a Triple 4 because the market decided it was worthless. Therein lies the challenge…and the need to reappraise investment risk entirely. One way is to flip the script and start with what investors can know for certain.

Skewed results

One truism is that stock returns are, on average, positively skewed. (See the seminal publication of Beedles and Simkowitz (1979)) This means that, if you were to look at the history of a stock’s daily returns, you would generally find that there are more big positive returns than there are big negative returns. The reason for this is clear; the most a stock can go down is 100%, but the most it can go up is unlimited.

Another way to describe this observation is to say that a cross-section of stock returns is asymmetrically distributed. This means that, if we took the entire S&P 500® and looked at the one-year returns of all those stocks, there would be a few huge winners, but most stocks have more mediocre returns.

The mere fact that a collection of stocks’ average return is positive (or even very attractive) does not imply that the risk of loss does not exist. In fact, because returns are positively skewed, that attractive average return might be a bit deceptive. The outcome could be a lot more unattractive returns, but the few positive outliers pull the average up.

Below are two charts, one with a symmetrical normal distribution and one that is skewed positively. Note that in the symmetrical chart on the left, there is an equal number of above-average and below-average observations. But in the chart on the right, even though the average (or mean) is the same, there are more below-average observations than above-average observations.

Notice the area under each curve. This is the cumulative probability of any particular return occurring. In a normal distribution, the areas above and below the average are the same. But because there is so much more area under the curve to the left of the average of the skewed distribution, investors are at a disadvantage when trying to beat the average. Investors, practically without fail, always try to pick the best stocks on the right side of the curve. And the question becomes: why are they making it so hard on themselves?

It may come as no surprise that investors display what researchers such as Bali, Cakici and Whitelaw (2011) have called “a preference for lottery-like returns.” Why do so many pour capital into microcap or venture capital firms? Perhaps because they are attracted to the potential (yet somewhat unlikely) enormous gains that some such investments typically are perceived to generate – the investments far to the right in this skewed distribution.

This is a behavioural phenomenon created by certain investors that nonetheless impacts everyone’s portfolios. The temptation to get rich quick is a strong one, no doubt. But that is not responsible investing and, in many respects, is more akin to gambling. Put simply, in an asymmetrical investing environment, high risk-reward stocks have more to lose than low risk-reward stocks. Therefore, we believe that investors are better served by not attempting to pick the winning stocks when they can simply avoid the losers.

In 2021 the average S&P 500® Index stock returned 29%. However, of the stocks in the index, 274 returned less than this average, and only 231 returned more. This result was driven by a handful of outliers skewing the distribution to the right. Note the most extreme outlier, Devon Energy Corp, which returned 196% in 2021. (Source: S&P Dow Jones Indices) How many managers would have successfully chosen Devon Energy when the year began? Maybe the manager that did, posted impressive performance and attracted a great deal of attention. But anyone trying merely to beat 29% would have been better served avoiding the 274 stocks pulling the average down than swinging for the fences on Devon Energy. You see, picking winners requires knowledge of the future, which of course is unknown and unknowable. The more the manager attempts to predict the future the more risk they are exposed to.

The truth is that selecting the precise stock in the cramped right side of this skewed distribution is just not likely to happen. There just aren’t that many of them. And worse, with fewer options to choose from, you’re more likely to overpay. In fact, some may say the whole activity is more akin to throwing darts. If one is serious about investment, it’s more mathematically sound to simply remove the underperforming stocks on the left – the losers.

The New Age Alpha Human Factor Methodology is specifically designed to identify and avoid those stocks we believe are likely to be losers and make the odds work for the investor rather than against. The methodology may not always pick the Double 18 (the next Amazon or Facebook) but it may still outperform because it avoids the Triple 4s – (the more common stocks on the left side of the distribution).

About us

At Global and Local Asset Management we firmly believe in stripping out all vague and ambiguous information from the investment process. This is why we use New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). The H-Factor measures the probability a company will fail to deliver the growth implied by the stock price. This risk is caused by investors interpreting vague and ambiguous information and impounding it into a stock’s price in a systematically incorrect way. The lower the Human Factor, the more likely vague and ambiguous information has NOT been priced into the stock. The H-Factor System is a free comprehensive portfolio tool that enables investors to apply our Human Factor metric to over 6 000 stocks, ETFs, global indexes, and their own portfolios.

New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to protect investor portfolios against this idiosyncratic risk caused by human behaviour. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behaviour. Through New Age Alpha’s research, they have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation of their investment approach, they have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behaviour.

If you would like to know more about how the Human-Factor score tool works and how we “Avoid the Losers”, then please contact us at Global & Local Asset Management.

Disclosures

Global & Local Investment Advisors (Pty) Ltd is a registered financial services provider in terms of the Financial Advisors and Intermediary Services Act (FAIS). Global & Local Investment Advisors (Pty) Ltd holds FSP license number 43286.

Global & Local Asset Management (Pty) Ltd. Reg. Number: 2018/580284/07

Global & Local Asset Management is an authorised juristic representative of Global & Local Investment Advisors (PTY) Ltd FSCA License Number: 43286

Any investment performance figures quoted herein are for illustrative purposes only and should not be construed as investment advice.

Investment advice can be provided by Global & local Investment Advisors (Pty) Ltd but only after an analysis has been conducted of the investor’s current financial circumstances and investment portfolio, only then will a recommendation be provided based on that investor’s own circumstances by Global & Local Investment Advisors (Pty) Ltd.

New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC, New Age Alpha Advisors, LLC (“New Age Alpha Advisors”) and New Age Tau, LLC.

Investment advice is offered through New Age Alpha Advisors, LLC a wholly-owned subsidiary of New Age Alpha LLC.

New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements.

Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or strategy made reference to directly or indirectly in this firm overview, will be profitable or equal to corresponding indicated performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Returns for one year or less are not annualised but calculated as cumulative returns.

No client or prospective client should assume that any information presented in this firm overview serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. Any charts, graphs or tables used in this firm overview are for illustrative purposes only and should not be construed as providing investment advice. Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented has been calculated by applying each Index strategy backwards in time and is not a contemporaneous record of actual assets managed by New Age Alpha.

All New Age Alpha trademarks are owned by New Age Alpha LLC. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (SPFS). All other company or product names mentioned herein, including S&P®, are the property of their respective owners and should not be deemed to be an endorsement of any New Age Alpha product or strategy. This firm overview is limited to providing general information about New Age Alpha and its investment advisory services. It is for informational purposes only and should not be construed by a client or a prospective client as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice. New Age Alpha’s specific advice is given only within the context of its contractual agreements with each client. Investment advice may only be rendered after the delivery of Form ADV Part 2 (an investment advisor’s disclosure document) and the execution of an investment agreement by the client and New Age Alpha. New Age Alpha’s Form ADV Part 2 and descriptions and summary annual reports or its composites are available upon request.

Was this article by Mauro helpful?
2  

ADVISOR PROFILE

Mauro Forlin

Global & Local Asset Management

COMMENTS   1

You must be signed in and an Insider Gold subscriber to comment.

SUBSCRIBE NOW SIGN IN

Many truths in the analysis but the part that is left out is the negative impact of typical diversification. An active manager that has whatever chosen selection criteria and only invests in ten shares will over time beat the pants off a manager that invests in a hundred shares.

End of comments.

LATEST CURRENCIES  

USD / ZAR
GBP / ZAR
EUR / ZAR
BTC / USD

Instrument Details  

You do not have any portfolios, please create one here.
You do not have an alert portfolio, please create one here.
INSIDER SUBSCRIPTION APP VIDEOS RADIO / LISTEN LIVE SHOP OFFERS WEBINARS NEWSLETTERS TRENDING

Follow us:

Search Articles:
Click a Company: