Economics

A Simple Calculation That Could Change The Way You Invest

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The question to everyone's answer is usually asked from within. - The Steve Miller Band

Ask an accomplished investor or a world-class poker player to list the most critical skills it takes to be a consistent winner. Common answers include hard work, situational awareness, sound money management, a set of rules and the discipline to stick to them and the ability to read your opponents.

But the number-one skill these elite players cite is the ability to calculate the odds of winning or losing on any hand, bet, trade or strategy. Investors and gamblers who do the calculation have a distinct advantage over those who don’t.

We know three things about the market:

  1. This historic bull market will come to an end.
  2. There will be another bear market and it’s coming closer every day.
  3. Nobody knows precisely when either of these things will happen.

The relationship between risk and reward is a cornerstone of Modern Portfolio Theory. It’s an easy concept to grasp – the greater the risk, the greater the reward – but how do you measure these two things?

The reward part is easy. The stock market churns out a 10% nominal annual reward, on average. But the risk part is harder. What, if anything, should you do when the market hits a rough patch? Thankfully, most of the bumps along the way will be mild and brief. That is, until the next “big one” arrives.

Nobody knows if the next drop will be mild or the beginning of a serious bear market. In 1929 investors lost 80% of their savings. It took 28 years for them to make it all back. At least half of them died before they got even.

More than anything else, investing is about managing downside risk

Let’s start with the obvious – what is risk? Most financial experts and academic types say that risk is the price volatility of an investment. There’s some truth to that, because wild price swings feel risky. But there’s an even more important aspect of risk… the chance of suffering a permanent loss of capital.

Every stock, bond or fund you buy must be sold eventually (or become worthless, get bought out or merged into another entity). At that point in time there is a terminal wealth calculation. How much you get when you sell it minus how much you spent when you bought it. If the difference between these two amounts is less than zero, you have just suffered a permanent loss of capital that you can never get back no matter how long you live. That is true risk.

Your competitive advantage

It isn’t very hard to work out probabilities in the investment realm. What it takes is common sense, a bit of logic and the willingness to test your first instinct to see if it passes the smell test. The rest of this article will explain, with examples, how to do that.

We’ll start with the widest lens, which is the entire history of stock prices going back to 1941. We could have gone back even farther, but I decided to avoid the worst part of the Great Depression era, because the losses were so pervasive that they skewed the results too far to the negative. Starting in 1941 still encompasses a large part of those dark days in the market, and World War II, which gives a realistic picture of market behavior in good times, and bad.

Read the full article here by Erik Conley, Advisor Perspectives

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