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From the vault | Issue 135 • 5 September 2003
Right decision, wrong result
Making the right decision doesn’t always lead to the right result—especially inthe short-term. Here, we hed down to the oc csino to expin why, nd how sh sn.
Investing, at best, is an inexact science. In fact many argue that it’s part art, part science,
a view with which we have more than a lit tle sympathy.
Stock valuations are based on assumptions rather than hard facts and the thundering
herd, gulled by new economies, tulips or whatever else takes its fancy, is only too willing
to suspend rational behaviour.
Faced with such circumstances, investors who simply ‘crunch the numbers’ to three
decimal places are likely to be condemned to mediocre performance. Similarly, those
who slavishly look to short-term share price performance as a measure of success will
probably do worse.
Didvtg
Which brings us to the focus of this article: At The Intelligent Investor we’re often
contacted by subscribers tormented by a stock recommended as a Sell which hassubsequently continued to rise, or a Buy recommendation that has since fallen in price.
Now, we’re the first to admit our mistakes—we’ve made enough in the past and,
unfortunately, we’ll make more in the future—but our experience is that panicking because
a price moves against you is rarely a wise course of action.
Frustrating as it may be, such disadvantageous price movements typically aren’t the
result of a poor decision but of a market price being bashed about by fear, greed, or just
plain old boredom.
If a collection of investors with dif ferent opinions and motives is able to make a share
too cheap, then why shouldn’t it make it a bit cheaper still?
And if the market is able to make a share overpriced, then there’s no reason why it
can’t become more overpriced.
In the short run, therefore, it’s perfectly possible to make the right decision andexperience the wrong result—and vice versa. Unfortunately, it’s a fact that simply has to
be recognised and remembered. It cannot be avoided.
A useful analogy can be found on the blackjack table at your local casino. For the benefit
of our wiser, and probably richer, subscribers who’ve never set foot in a casino, blackjack
Judgements & results:good, bad, right, wrong
report coMpiled February 2011
If you regularly bet against
the odds, you’re
bound to lose.
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is the simplest card game around.
The punter bets against the dealer, with the aim of getting to 21, or at least closer to it
than the dealer, without busting (getting over 21).
Here’s your first hand: a queen and an eight, making a total score of 18. You have two
options: you can ‘sit’ on 18 or take another card.
An experienced punter will tell you that your best course of action is to sit.
The reason is that, at 18, only three different cards—an ace, two or three—would
improve your position.
So, of the 52 possible cards, only 12 are favourable to you and 40, or 77%, are
against you.
You know that if you bet against the odds on a regular basis, you’re bound to head
home in tears (after the delicious, subsidised, six-dollar roast of course) so you sit on 18.
Then the dealer gets lucky, hits 19 and you lose your money.
Experienced punters in such a situation know full well that they made the right decision,
even if chance dished up the wrong result. Only the inexperienced, irritated by the winnings
forgone, would express regret. Indeed, next time it may even tempt them to take the risk.
Plig dd
Now, playing the odds doesn’t guarantee profits at the tables every time (the casino isthe ultimate master of the odds) but it’s highly likely that you’d do better than the punters
who look to lady luck to make their calls.
How does this relate to the stockmarket? Back in issue 128/May 03, we believed we were
making the right decision by placing a Better Value Elsewhere recommendation on bHp
Steel, now blueScope Steel. It’s a tough business and the odds are usually against
shareholders in steel stocks. So even though the stock has risen 56% since then, we stand
by our decision—even with the benefit of hindsight.
The same is true of FKP. It had risen 117% between our strong buy recommendation
in issue 84/Jul 01 and our first sell recommendation in issue 120/Feb 03. It has risen a
further 48% since then. We would argue that FKP was deeply underpriced at the time of
issue 84 and is now highly overpriced.
At this stage we have got only half of the equation right—time will tell if we get itall correct.
Equally, we’re not perturbed by the fac t that Miller’s Retail has dropped 10% since our
first Strong Buy recommendation back in issue 112/Sep 02 (Strong Buy—$2.05). As long
as the business continues to travel reasonably well, we’re happy to sit on our cards.
Clearly, we make no attempt to pick a stock’s high and low, although we are aware that
technical analysts claim they can pick a changing trend as a prelude to it. That may be so
although, as a group of individual investors, we’re skeptical.
Pfitbl ttg
Our analysts have yet to meet a rich char tist and those that have flirted with it, even
with some success, eventually concluded that value investing was a more profitable
long-term strategy.
It’s our view, and our experience, that those investors who keep the odds on their sideby concentrating on knowable facts will do far better over the long term than those who
concentrate on price in the short-term.
The focus should always be on making the right decisions, rather than on how those
decisions actually work out over the short-term. By approaching it this way, investing
becomes less of an art and more of a science, and therefore, much easier.
It’s our view, and our
experience, that those
investors who keep the odds
on their side by concentrating
on knowable facts will do far
better over the long term than
those who concentrate on price in the short-term.
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Special Report | Judgements & results: good, bad, right, wrong
3
From the vault | Issue 160 • 16 September 2004
Bad luck or bad judgment?
in v s f ss 135/S 03, w sss hw ’s ss mkh gh nvsmn sn g h wng s. H w sngsh nnk s fm sn.
It’s the first thing every financial advisor tells you and we’re about to tell you the same
thing—buying shares is risky. With every investment, there is some chance that you will
sustain a permanent loss of some, or perhaps all, of your money.
The solution is to under take an investment only when the potential reward for assuming
the risks is greater than the potential loss if it all goes wrong. What follows is an explorationof the mental processes needed to do this effectively. We’ll start of f with a quick trip down
to the pub.
Imagine your local alehouse has a promotion that costs you a dollar to play. After you’ve
paid, the bartender flips a coin, asking you to shout ‘heads’ or ‘tails’. Guess correctly and the
pub will give you $5 back. Get it wrong and you lose your $1. Would you play the game?
Of course—you’d probably play it as many times as you could. Why? Because half the time
you’ll collect $5 and the other half you’ll lose only a dollar. On average, you’ll get $2.50
back for your $1 investment (a profit of $1.50).
Wiig wh l
Michael Mauboussin, in the annual report of US fund manager Legg Mason, writes that
every time you play a game like this you’ve earned something—even when you lose. Hequotes professional poker player David Sklansky; ‘any time you make a bet with the best of
it, where the odds are in your favour, you have earned something whether you actually win
or lose the bet. By the same token, when you make a bet with the worst of it, when the odds
are not in your favor, you have lost something, whether you actually win or lose the bet.’
That’s how a good investment choice can still lose you money and a bad investment
decision, like lotto, can be profitable. To work out if you made a smart decision in a game
of poker or a coin-flipping game requires some basic mathematics. But in the sharemarket,
there’s no sure-fire way of calculating probabilities and expected payoffs. In fact , this line
of reasoning could be used as an excuse for a poor investment—‘it was the right decision,
I was just unlucky’. So, how do you tell the difference between a good investment decision
and a poor one?
We’ve already learnt that to focus on the result is a mistake. Concentrate instead on the
process that leads to the outcome, as that’s the part you can control. In our coin-flippingexample, deciding to play the game was a simple decision once the process of calculating
the expected return was complete. If an investment doesn’t work out (or even if it does),
you should analyse how you arrived at your decision. If your process was f lawed, then you
made a mistake. If you can’t find any flaw in your process then you probably made the
right decision but got the wrong result.
Quoting Mauboussin again, ‘at the core of long-term success in a probabilistic field is
a disciplined and economic process…while satisfactory long-term outcomes ultimately
define success, the best focus on process and let the outcomes take care of themselves.’
But what is that ‘disciplined and economic process’ for analysing stocks?
F ti
Warren Buffett asks himself the same four questions every time he considers buyinga stock: Do I understand the business? Does the business have a sustainable economic
advantage? Am I comfortable with management? Is it available at an acceptable price?
These four questions provide Buffett with a framework, or process, for analysing every
single stock he comes across. There are no prizes for guessing that, here at The Intelligent
Warren BuFFeTT’s 4 key quesTIonsn Do I understand the business?
n Does the business have a sustainable economicadvantage?
n Am I comfortable with management?
n Is it available at an acceptable price?
Buying shares is risky...the
solution is to undertake an
investment only when the
potential reward for assuming
the risks is greater than the
potential loss if it all
goes wrong.
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Investor , our process is pretty much the same, although we can only aspire to emulate his
results. Think of it as a set of scales where, using Buffett ’s four questions as a framework,
we put all of the reasons we think a par ticular stock would make a good investment on one
side and all the negatives on the other. If the scales tilt significantly towards the positive
side we’ll recommend the stock to you.
aristocrt leisure is a great example. In issue 129/Jun 03 we highlighted three points
that we thought made a compelling argument for buying shares in this company, despite
a leadership vacuum weighing heavily on the negative side of the scales. As we said back
then, ‘the company has a growing source of steady income with which to service its annual
interest bill of around $23m’. In other words, we didn’t believe the company was about
to go bust. Secondly, the Australian operations ‘remain [highly] profitable’ and ‘we expect
them to remain profitable and, eventually, to improve’. Finally, we crunched the numbers
and ‘[struggled] to arrive at a value of less than $1 per share’.
Given you could buy the shares at the time for $1.15 each, we came to the conclusion
that a ‘level-headed assessment of the facts points to the current turmoil of fering a great
opportunity.’ Our logical and rational process allowed us to block out the emotion being
displayed by some other investors and make a decision based on facts.
Could an investment in Aristocrat have gone wrong? Of course—the company was
operating without a CEO. It’s just that, when you could buy the shares for $1.15 each, youwere being more than adequately compensated for that risk and, were this situation to play
out many times, on average it would turn out to be an extremely profitable investment.
But we also previously recommended this stock at levels higher than $1.15 and, whilst
subscribers who followed those recommendations would be quite happy now, at the time,
after the situation worsened considerably, those recommendations fell into the category of
‘right decision, wrong result’. In other words, just because a stock you purchased has risen
20%, that doesn’t mean you made the right decision. And just because it has fallen 20%
doesn’t mean you made the wrong decision either. You’ve made the right decision if—and
only if—your decision was arrived at after a logical and rational process.
How should this influence the way you use The Intelligent Investor ? Every detailed
review should outline the process used to arrive at our recommendation—the review of
Hills Motorway is an especially good example. This means that you can add to, or subtractfrom, either side of our decision-making scales. If you think we’ve missed a key point, or
placed the wrong amount of emphasis on a particular point, you can adjust your decision
accordingly (please feel free to let us know). In the sharemarket, nothing is absolute. But a
structured, rational way of thinking about how you make your decisions, and your reasons
for making them, is the best way of preventing poor judgment, whatever the outcome.
ImPorTanT InFormaTIon
th ingn invsPO Box 1158 | Bondi Junction NSW 1355T 1800 620 414 | F (02) 9387 [email protected]
www.intelligentinvestor.com.au
WarNiNG This publication is general information only, which means it does not take into account your investment objectives, financial situationor needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advicefrom a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.diSclaiMer This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we s trongly suggest you seek
advice before acting upon any recommendation.copyriGHt© The Intelligent Investor Publishing Pty Ltd 2010. The Intelligent Investor and associated websites and publications are published byThe Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box 1158 Bondi Junction NSW 1355. Ph: (02) 83056000 Fax: (02) 9387 8674.diScloSure As at 1 February 2011 in-house staff of The Intelligent Investor held the following listed securities or managed investmentschemes: AAU, AAZPB, ABP, ACK, AEJ, AGIG, AHC, ALL, ALZ, APH, ARP, AVG, AVO, AWC, AWE, AYT, BBG, BER, CAH, CBA, CCK, CFE, CIF, CLS,CMIPC, CNB, CND, COH, COS, CRC, CSL, CTE, CUE, CVW, DVN, EBT, EFG, ELDPA, FGL, FLT, FXL, GRB, HVN, IAG, IDT, IFL, IFM, IMF, IVC, KRS,LMC, LWB, MAP, MAU, MFF, MLB, MNL, MQG, MTS, NABHA, NBL, NWS, OEQ, ONT, PLA, PTM, QBE, QTI, RCU, RFL, RHG, RNY, ROC, SDG,SDI, SFC, SGN, SGT, SHL, SHV, SKIDA, SOF, SRH, SRV, STO, STW, TAN, TGP, TIM, TIMG, TIMHB, TRG, TRU, TWO, WBC, WDC, WHG and WRT.This is not a recommendation.date oF publicatioN 1 February 2011
Just because a stock you purchased has risen 20%,
that doesn’t mean you made
the right decision. And just
because it has fallen 20%
doesn’t mean you made the
wrong decision either.
