The Horse Race analogy - Betting on individual companies
I have read several posts on askaboutmoney recently basically waffling on the theme that any investment in the stockmarket is just gambling and everyone would be better off just sewing their savings into the hem of the curtains. Now whilst some of the more blatantly daft posts are somewhat amusing, I feel that there is a danger that some investors might be acting on some of this nonsense and so I felt compelled to come up with an easy to understand analogy.
The first point I would make is that buying shares in a single company should be considered gambling and speculation but buying a broad index should be considered investing. My advice has consistently been never to take a concentrated position in a single company or even a single country. Buying shares in AIB or Bank of Ireland is simply speculation full stop. We have known since Louis Bachelier published the Theory of Speculation in 1900 that the expected return from speculation is zero, less your costs - so don't do it.
In short, buying individual shares is the equivalent to taking a bet on one horse in a race. We might attempt to identify the winner based on some measure of “form” and naturally we are drawn to a healthy contender with a good track record. When buying shares, investors often work in the same way, many investors are drawn to buying healthy companies with good prospects and in just the same way as race goers backing a favourite, the odds shorten. In investment terms, the compensation that investors demand for the risks they take in buying healthy companies is lower than that for distressed companies or smaller companies – i.e. they get worse odds.
The outcome of each horse race is a largely random event influenced by many factors such as the condition of the course, how many horses are running etc. In much the same way, stock prices are said to follow a “random walk” with the price of any one stock rising with good news and falling on bad news. Since future news events are random in nature, the future movement in prices is also random and impossible to predict.
Therefore investors seeking to back a single company are disproportionately affected by the good and bad luck that happens to that one company relative to the opportunities presented by all the companies in the market. If their share “falls at the first”, they are taken out of the race and cannot profit.
So to continue with the horse racing analogy, the real way an investor would think is not to bet on one horse winning the race – but to set out to own the racetrack, to own the studs, the jockeys, the trainers, the bookmakers, to own the catering company that feeds the race goers and the transport company that brought them to the meet and the utility companies providing light and heat and to own the brewery that makes the beer they drink.
In short to “bet” on the fact that racing will take place every week or every month, rather than on the outcome of any individual horse race.
That is not to say that we shouldn’t back the horses either, we should, but by laying off bets on all of them. Now in a real race, the bookies would ensure that the odds were set in such a way that it would be impossible to profit. However, when we bet on global capitalism, backing all the companies means we have a positive expected return of around 4%pa more than cash on average.
The equity risk premium is the compensation that an investor requires for putting their capital at risk in the capital markets - this is why it is called capitalism. If there was no expectation of a positive return, why would investors show up?
Finally, if we slightly increase our bets on those companies with longer odds, by tilting our portfolio towards value companies or smaller companies, then we find that overall our “odds” are better - in effect we are taking on more risk and since risk and return are related, we expect to be paid more.
Sure, we will want to hold the healthy companies in proportion, but we have a higher expected return, better odds if you will, from backing companies that are more risky. In the global capital markets, the “long-shots” tend to come in more regularly than you might imagine.
I have read several posts on askaboutmoney recently basically waffling on the theme that any investment in the stockmarket is just gambling and everyone would be better off just sewing their savings into the hem of the curtains. Now whilst some of the more blatantly daft posts are somewhat amusing, I feel that there is a danger that some investors might be acting on some of this nonsense and so I felt compelled to come up with an easy to understand analogy.
The first point I would make is that buying shares in a single company should be considered gambling and speculation but buying a broad index should be considered investing. My advice has consistently been never to take a concentrated position in a single company or even a single country. Buying shares in AIB or Bank of Ireland is simply speculation full stop. We have known since Louis Bachelier published the Theory of Speculation in 1900 that the expected return from speculation is zero, less your costs - so don't do it.
In short, buying individual shares is the equivalent to taking a bet on one horse in a race. We might attempt to identify the winner based on some measure of “form” and naturally we are drawn to a healthy contender with a good track record. When buying shares, investors often work in the same way, many investors are drawn to buying healthy companies with good prospects and in just the same way as race goers backing a favourite, the odds shorten. In investment terms, the compensation that investors demand for the risks they take in buying healthy companies is lower than that for distressed companies or smaller companies – i.e. they get worse odds.
The outcome of each horse race is a largely random event influenced by many factors such as the condition of the course, how many horses are running etc. In much the same way, stock prices are said to follow a “random walk” with the price of any one stock rising with good news and falling on bad news. Since future news events are random in nature, the future movement in prices is also random and impossible to predict.
Therefore investors seeking to back a single company are disproportionately affected by the good and bad luck that happens to that one company relative to the opportunities presented by all the companies in the market. If their share “falls at the first”, they are taken out of the race and cannot profit.
So to continue with the horse racing analogy, the real way an investor would think is not to bet on one horse winning the race – but to set out to own the racetrack, to own the studs, the jockeys, the trainers, the bookmakers, to own the catering company that feeds the race goers and the transport company that brought them to the meet and the utility companies providing light and heat and to own the brewery that makes the beer they drink.
In short to “bet” on the fact that racing will take place every week or every month, rather than on the outcome of any individual horse race.
That is not to say that we shouldn’t back the horses either, we should, but by laying off bets on all of them. Now in a real race, the bookies would ensure that the odds were set in such a way that it would be impossible to profit. However, when we bet on global capitalism, backing all the companies means we have a positive expected return of around 4%pa more than cash on average.
The equity risk premium is the compensation that an investor requires for putting their capital at risk in the capital markets - this is why it is called capitalism. If there was no expectation of a positive return, why would investors show up?
Finally, if we slightly increase our bets on those companies with longer odds, by tilting our portfolio towards value companies or smaller companies, then we find that overall our “odds” are better - in effect we are taking on more risk and since risk and return are related, we expect to be paid more.
Sure, we will want to hold the healthy companies in proportion, but we have a higher expected return, better odds if you will, from backing companies that are more risky. In the global capital markets, the “long-shots” tend to come in more regularly than you might imagine.