The Independent Market Observer

3/17/14 – Changing the Odds on Investing

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Mar 17, 2014 11:50:50 AM

and tagged Commentary

Leave a comment

I wrote last week about how investing is, or should be, significantly different from gambling. Despite those differences, though, there are many things we as investors can take away from the gambling perspective. One of the most valuable is the concept of edge, which is closely related to the notion of odds.

“Edge” can be defined as how much a gambler, or the house, can expect to make over time. A 1-percent edge, for example, would result in a profit of 1 percent of the amount wagered. Take the game of baccarat, where, on average, the house has an edge of 1 percent per hand, which doesn’t sound like much. Given that baccarat is usually played at the rate of 70–80 hands an hour, however, even a 1-percent edge can mean serious money.

We don’t make 70–80 investments per hour, but we do have periods of years or decades to work with, so a 1-percent edge can be equally important for us as investors. A common way to find an edge is to manage and reduce expenses. Lowering your expenses can be a risk-free way of pursuing higher returns. It may be worth considering, if at all possible. There are also other ways to try and get an edge, such as risk management.

A simple and easy way to potentially manage risk is to rebalance regularly. Why might this be helpful? First, you’re locking in profits by selling some of the winners. Second, you’re buying at cheaper levels by putting more money into the recent losers. You can consider rebalancing a form of market timing, in the sense that you’re selling expensive assets to buy cheap ones—and it can be effective, over time.

Another way to try and get an edge is to find indicators that help you understand what’s coming next. Like rebalancing, it would be easy to confuse this with market timing, but it is different. Market timers believe they can predict the market; they can’t. Investors looking for an edge don’t need to predict the market; they just need to find signals that have worked reliably in the past and that can possibly indicate what might happen.

In other words, if I’m playing poker, and my opponent has three aces showing and is betting very aggressively, I don’t know that he has the fourth ace, but it had better affect the way I bet. Similarly, for investing, if something happens now that has indicated a significant decline in the market eight out of ten times in the past, I probably want to know that when I invest. In a sense, this is pure market efficiency—after all, aren’t you assumed to take all information into account?

Over the next several posts, I’ll talk about different indicators and how and why they might be useful. No one indicator, or even several, is predictive, but they can help you set the odds. As noted above, even a small advantage is worth having over time.


Subscribe via Email

Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®