What Sensible Investors Do, And How The Ground Rules Are Changing

Includes: DIA
by: Peter F. Way, CFA

A Seeking Alpha reader comments:

I think MOST people still invest pretty much the same as always.

We INVEST 80 or 90% of our money in what we think are "decent" investments and HOPE that the rising tide lifts the boats.

And we may take 10 or 20% percent and do the TRADING that you mention. It really is just gambling. We FEEL good when we pick a winner. Of course it sucks when we pick a loser.

I don't agree with the idea that everybody is now into trading.

Some of us just like to gamble a little.

Our reply:

Reader # 19,

I share your balanced perspective of how the investing public basically operates. It makes good sense to feel mainly in control of one's capital instead of the other way around.

Yet that is easier to do in personal good times, rather than when things are not going well and pressures mount, changing one's boundaries of what is desirable. Often that is where investing mistakes get made, trying to overreach in the Return vs. Risk tradeoff.

Our effort is to bring to the investing public a realization that along with the sharp advances that have been made in information technology and in other technologies, the norms that have in the past been considered optimal and desirable by many, are now well below the averages of what can prudently be accomplished.

A parallel in technological advances can be found in the energy extraction field, where horizontal drilling and hydraulic fracturing, "fracking", have turned this nation into one of a rapidly developing self-sufficiency of oil & gas production, from a formerly desperate importer of foreign-source oil. At first (3-4 years ago) few believed; now most informed observers are convinced.

For decades stock prices have fluctuated each year by multiples of the underlying trend of annual growth in earnings of DJIA-30 stocks, singularly and collectively. That is the sign of more money being pushed through a market than it can take, by players who have lost perspective of what makes sense at the time. The perpetrators are both individuals and professionals, but in most stocks it is the pros who have the capital muscle to really move prices.

Here is how the past 52-week price ranges of the 30 DJIA stocks compare to their past 5-year earnings CAGR, and their projected next 5-year EPS CAGRs.

(Click to enlarge)

Please keep in mind these 30 stocks have an aggregate market cap of over $4 Trillion, and an annual turnover of almost $5 Trillion. Their average year's high prices are +40% above their lows, while their average next 5-year earnings CAGR is less than 9%. So typical price volatilities are 4+ times their trend growth, as forecast by street analysts reporting to Yahoo. Compared to the past 5-year actual earnings trends, the 30 stocks averaged CAGRs of only a bit over +7%, making the current annual price volatility more than 5 times past trend growth.

And these blue chips are the most liquid equity issues and most actively-traded names on the market. The current year's price histories are typical of prior multi-year averages.

(Click to enlarge)

We don't have to search for price gain opportunities in excess of fundamental supports, they abound, even among these most conservative issues. Where prospects may be less well indicated, even greater disparities exist, with price ranges usually in triple percent digits.

An often unrecognized advantage of the individual investor is his/her far greater ability to have the market absorb smaller transactions at timely points of price. Big-money funds may have to take weeks to work their way out of a no longer wanted holding, and comparable periods to build up a meaningful entering position, or see prices move away from acceptable levels.

What we encourage is not trading, in yesterday's sense of taking a quick few-day flyer on a hunch or "bright idea" of the moment, or in today's sense (and norms) of high-frequency, nano-robotics-automated market-probing.

Instead we advocate a recognition that what counts in investing is the annualized rate of accumulation of wealth. Because of advances in information technology and transaction technology, there are plentiful opportunities to capture those much higher rates in shorter-term commitments. That is so, even accounting for the actually-taken losses inevitably incurred (instead of the ignored ones that instead eat up much more expensive time). Such opportunities provide a blessing for those whose tolerances (and understanding) will accommodate this type of approach.

The keys to understanding the shift that is taking place in equities investing now, are 1) a recognition of the essential role TIME plays in the process, and 2) an understanding of the necessity of playing the players in what has become a very serious game.

Every investor is involved in the game, whether or not he/she recognizes it. Some may know full well that their style of play forces on them returns that are at a poor rate of compensation for their commitment of capital, but their circumstances are such that it does not matter to them. OK, that's their choice.

For the less complacent, eventual recognition of the rate-of-return stakes engages the combatants into what is essentially a zero-sum-game, where winners benefit at the expense of losers. We consider our assignment to be the provision for individual investors of insight into the expectations of that group of players in the game most well informed, most richly resourced, and most highly motivated to succeed. The knowledge of their intentions comes from logical and credible actions taken to protect themselves from harm, at the least possible cost.

Just identification of potential opportunities is not enough to cause capital to be put at risk. The obverse of the return coin needs to be put into the risk-reward tradeoff proposition

To this end, a continually updated score is kept on how well those forecasters' efforts have worked out in the realistic time horizon of the next few months. The score is kept in terms of percentage of profitable outcomes (ODDS of success) and size of average gain (PAYOFFS), over the required TIME period of capital commitment.

When this kind of information is used in a disciplined, time-efficient, program of portfolio management that enforces extreme diversification among both a) types of holdings and b) points of time of commitment, and employs risk mitigation practices, it no longer takes on any resulting appearance of what is commonly associated with trading, but becomes a steady flow of shorter-term investing commitments across a longer time mission with quite limited volatility (uncertainty) of results.

But such a program has to be seen performing live to be believed, otherwise it just gets dismissed as TGTBT. Is it just another "fracking" investment scheme?

Of course, even with satisfying results, it might not have the same excitement and entertainment thrills of a spur of the moment Broad & Wall fling or a Vegas wager.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. The author has an investment interest in the website blockdesk.com which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors. Both brief and extended-time subscriptions for single or multiple issue inquiries should be at quite reasonable and manageable costs for individuals. Announcement of its opening is hoped for in the 4th quarter of this year.