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Stock markets: Know the odds

A look at the numeric probabilities of investment success and how you might be better off simply avoiding the losers.

The biggest problem with Wall Street? Everyone is too busy pricing the upside without pricing the risk of failure. Read as we dig into the numeric probabilities of investment success…and how you might be better off simply avoiding the losers.

In Iceland, there is a sign near one of its famed hot springs that announces: “You are here at your own risk.” In big, bold letters it proceeds to list seven warnings about the dangers of the geysers and how badly one can get burnt. Finally, in a stroke of genius at the eighth bullet point, it states simply: “The nearest hospital is 62 km away.”

Let’s think about the ruthless efficiency of that for a moment – it’s effectively stating, “Look, if you haven’t processed a word of these cautions, just know that you’re going to be in serious agony for a long time if you try to get cute.” Perhaps the stock market should come with a similar warning?

No one is pricing the risk of failure

Words, by their very nature, carry connotations. With regard to the sign in Iceland, that final line hits people from the opposite angle of the first seven for a very specific reason. The authors knew that the opening list describing the risks of the geysers would resonate with most people. But, wisely, they also knew that a certain slice of the population would only see the list as a spoilsport, nagging harridan trying to ruin their fun. That was the connotation heard by their ears. Thus, the need for a different tack those people would actually appreciate.

In the investment world, connotations also play a very important role. Words like ‘aggressive’ or ‘opportunistic’ take on unintended meanings, particularly when compared to traditional counterparts such as, ‘conservative’ or ‘stable value’. Blame it on Mountain Dew, Extreme Sports or on the general Hollywood-ification of people’s attitudes towards risk. For better or worse, reaching for the stars appears macho. In actuality, however, those investment terms are merely different names for number values and nothing more.

Yet such attitudes lead to another, more insidious unintended consequence: a one-directional assessment of risk. The first seven warnings on that sign address the situation prior to any potential injury. That’s what a warning is, after all. But the eighth warning? That addresses the aftermath of any mishap. In effect, investors are only focusing on the upside – the potential for outperformance –without accounting for the potential for underperformance.

This is human behaviour bias at work and it causes investors to accept a risk they have no idea they’re taking. Perhaps they should simply avoid the losers?

Know the number

If one were to imagine a true assessment of risk, a good example might be the signage at the top of a Black Diamond ski slope. Sure, the traditional sign should be warning enough. But what if they put a probability number to one’s chances of catastrophic injury? Suddenly this would force the intrepid skier to reprice their risk tolerance.

As an example, (though well-scrutinised data is hard to achieve) anecdotal evidence points to a 0.3% chance of injury for most skiers. That number is almost certainly higher on the Black Diamond slopes, though. Upon hearing such a number, one’s risk of failure suddenly hits closer to home. Is a 1% chance of injury still worth a run? How about a 5% chance? Immediately, the cost-benefit is reversed and it’s more important to quantify the possibility of loss than potential enjoyment.

Taking this one step further, the follow-up question seems obvious: How would this apply to the investment world? What are the odds of failure at the average investment house? The truth is: no one knows! That’s because outperformance vs the benchmark is the standard measuring stick. The theoretical risk-free rate of return assumes some level of return in the positive sphere no matter what. But, as has been shown in the market over and over, what an investor thinks will happen…doesn’t necessarily happen. In effect, Wall Street only prices the upside, not the downside. No one is pricing the risk of failure.

At Global and Local Asset Management, we believe investors deserve to know both. Unlike other managers that rely on a manager’s stock picking and a leap of faith, we use New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). The Human 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.

In practice, we believe the Human Factor and the H-Factor System allow investors to make much more informed choices regarding their portfolio construction. In this manner, we – and our investors – can manage risk like an actuary, not like a portfolio manager. Rather than attempting to pick winners, we simply aim to avoid the losers. It is an approach rarely seen on Wall Street…one that allows investors to weigh both the potential upside and the potential downside.

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 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.

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Mauro Forlin

Global & Local Asset Management

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