To answer this question, we need to consider how an actuary assesses an applicant for a life insurance policy.
Think of when you were applying for life insurance, what did the application form ask in the medical condition questions, the questions are worded very carefully. The questions asked are not, “Are you going to stop smoking?” but rather “Do you smoke?”. The actuary is asking a question that provides the reality as it is today not a forecast for the future. From the answers to these types of questions, the actuary can determine the risk of placing this applicant in the pool of insured persons.
So, what does this have to do with investing in shares?
The thinking behind life insurance can be utilised in the building of share portfolios.
Therefore, like the actuary, needing to know the current truth about the life insurance applicant, we need to determine what we actually know about a listed company?
Speaking to the quantitative analysts at New Age Alpha, an asset management company in New York, they tell me that we only know two things for sure about a listed company. That is, the current share price and the profitability of the company declared in their published financial statements.
Using this data and a discounted cash flow model, New Age Alpha is able to generate the probability of a company not being able to deliver on the promise built into their share price. This is similar to the life insurance actuary being able to calculate the probability of the applicant claiming on their policy and thereby putting the pool of insured persons at risk.
If we think about it, in a share portfolio we would like to include those shares which have the highest probability of delivering the results promised by the current share price. So those companies who have a low probability of NOT delivering the growth implied in the current share price are those that we would like to include in a portfolio.
However, we now need to add that like in a life insurance pool of insured persons, in any given year there will be some claims on policies, we cannot expect that every share included in the portfolio using the probability-based investment I have been alluding to will provide a good capital return, the idea is that by utilising this probability approach to portfolio management, 60% of the shares in such a portfolio managed in this manner should provide a return.
The quantitative approach used by New Age Alpha is referred to as “Avoiding the Human Factor” as H-Factor for short. The general approach is like that of life insurance – to avoid forecasting performance but basically only to use information that is known for sure. New Age Alpha’s approach is to consider any listed company analysis where an analyst is forecasting the future performance of the share based on a projection of future earnings is flawed in much the same way as the actuary asking the life insurance applicant to forecast at which point the applicant will stop smoking in the future. It is simply an unknown variable that may or may not occur.
If you would like to know more about using the H-Factor strategy to manage share portfolios, please contact us at Global & Local Asset Management.
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