Sometimes, when you say you are both an economist and an investor, you can get rather bemused questions. Do you try to make predictions? Surely that isn’t possible? Do you have a crystal ball or something? Let me try and put an end to such questions once and for all.
The answer is no, I don’t have a crystal ball. Financial markets and economic trends are indeed difficult to predict. When I attempt to explain my profession to students, clients or others, I always include two key learnings: first, you can try to get it right slightly more often than average. Second, you need to limit the losses if you are wrong. It’s generally one or the other: only the best among us can do both. Let me start with probability distribution. We all know that the market is random. One of the most irritating common comparisons is the one involving dart-throwing chimpanzees. That’s also random. Investors ought to do it better: what is their hit ratio? Is it higher than 50 percent? That’s good, they possess skill. It really doesn’t need to be 60 percent. That was one of the first lessons I learned when I started out. The crux lies in how often you can use this skill. The comparison to a casino speaks volumes. In a casino, the ‘house’ has little skill but does have a huge advantage: it can spin the roulette wheel frequently.
Our industry is no different. As an investor, you need to identify your skill and seek ways to apply it as often as possible. There is no crystal ball involved. I prefer to compare it to a random process, in which our job is to influence the probable outcome of such process to our advantage by means of analysis. Do we possess better or more background information? Can we analyse it better? And can we then implement these findings better? In one or a combination of these points lies the difference from a fully efficient market; this difference generates a hit ratio that is slightly above 50 percent.
We aren’t done yet though: if you’ve got it right, it’s great if it also yields a return. And if you can succeed in limiting the losses if you’re wrong. We can scale positions such that winning positions yield more return than the losing positions cost us. You will recognize an old market maxim here: cut your losers and let your winners run. That’s easier said than done. Academics always bring up the disposition effect here. This is the psychological problem that we have a tendency to fear losing out on profits and sell stocks too soon. At the other end of the spectrum you have hope, i.e. the hope that the losing positions will bounce back. We hold on to that hope for too long.
I don’t have a crystal ball, but I do have a couple of suggestions for further reading. If you fancy taking the time to read more about this, you should try searching online for the ‘fundamental law of active management’ and the ‘Kelly criterion’. You’ve just read the briefest possible summary of these here.
We hope you have enjoyed Salomon's Judgement and we would like to inform you that this is the last edition.