Distilled to its essence, stock investing is actually a bet. I believe this is true even if one treats investments in stocks as being a part owner of a business. The simple reason is that business itself is a wager. This stems from a fundamental truth: uncertainty is embedded into our very existence, as I have briefly alluded to in this post.
If stock investing is a bet on outcomes determined by uncertainty, why then are some investors more successful than others? EMH proponents will then tell you a story about monkeys, typewriters and Shakespeare. You will probably miss the footnote setting out an assumption that the number of monkeys involved exceeds the number of atoms in our known universe.
I prefer Charlie's simple answer: "My guesses are better than yours."
But why are Charlie's guesses better than mine?
The answer is also deceptively simple: by being rationale and harnessing the knowledge of fundamental truths.
But rationality has its problems too if applied in a dogmatic fashion.
Casino and Lotteries and Rationality
Consider a simple game of Sic-Bo. In this game, three six-faced dice are thrown and you bet on the outcome. One of the offered bets is Triple Sixes. The probability of Triple Sixes is easy to calculate- 6 x 6 x 6= 216. The casino offers you 198. Will you bet?
"Of course not!" you say, "You gotta be stupid. I cannot understand why people bet on this. They must be stupid too."
Let's consider a few scenarios:
1. John is a professor in mathematics specialising in statistics. He placed a bet because he figured that he will probably not make the bet more than a dozen times in his lifetime. So the mathematics is irrelevant. He is out having a good time, a rarity at his age.
2. Matthew is a quantitative analyst at a hedge fund. He knows the maths too. And he has just been paid a bonus and is out on a hot date with Jane. He figured that showing Jane a good time will increase his chances of a happy ending to the evening. So he placed a bet, and told Jane that 666 is his lucky number, because he is such a bad boy.
3. Jane is recently divorced after a difficult marriage. She is out on a date with Matthew, and she desperately wants this relationship to start well, and hopefully blossom into long term union. Matthew has just given her a $50 chip to bet on anything she wants. When she sees Matthew placing his bet, she placed the same bet, and held him tight whilst the dice are spun, sharing a nice moment of anticipation together.
4. Tim is a special guest of the casino. He is a whale, casino speak for a high roller. Tim has made a tidy living on gambling over the years, principally by obtaining favourable gambling terms with casinos desperate for his business. On this trip, Tim gets a sliding scale rebate on his gambling turnover, with rebate reaching 15% for any dollar of turnover exceeding a certain amount. Tim has already exceeded that amount in turnover, and any game he plays entitles him to the highest rebate.
5. Antonio makes a lot of money "on the side". However, he is not acquainted with any of those fancy schmancy lawyers and bankers who could legitimise his ill-gotten fortune. So the casino is the only place he knows which could turn black into white.
Each of the above participants are making rationale decisions, based on their own framework of reasoning, by assessing different risks and benefits. The lesson that the above imparts is to never assume stupidity and irrationality in human actions.
Share Market Rationality
The same lesson applies in the stock market. For every buyer, there is a seller. Sellers are not stupid. In fact, most sellers are quite rationale and smart. If a buyer consistently assumes that sellers are stupid (this happens more often than you can imagine), the chances of long term success in investing is rather slim.
A quick example: REA at current pricing is incorporating very lofty growth assumptions for the long term. On my rough model, the market at current prices is expecting REA to grow in excess of 20% per annum for 10 years. To make reasonable money with this investment, REA needs to grow at rates approaching 30% per annum for 10 years, and continue to grow beyond that. Putting it another way: sellers are locking in profits from growth of 20% per annum for the next 10 years, such growth being far from certain. Buyers are paying them to take on the uncertainty of this growth eventuating.
Who is getting the better deal here?
Buyers of REA at today's prices are assuming that the sellers are stupid. Sellers of REA stock are quite likely to be sitting on some pretty fabulous gains. Selling means that they will likely incur taxes. If REA is going to grow at 30% per annum for 10 years and still continue growing beyond, selling REA means that a lot of upside will be given to buyers by sellers, and a big slice to the Taxman. I have never heard of charity beginning in the sharemarket, though most could call it "home" given the amount of time they spend staring at screens.
More importantly, which participant is likely to have a better and more intimate knowledge of REA? A new buyer, or a seller who has probably held for a much longer period? Enough said.
Some investor says that they do not care why sellers are selling, because the sellers usually have a multitude of reasons, some of which may not relate to investment at all. The Sic-Bo examples above probably reinforces this idea. To me, this answer is always naggingly unsatisfying, not unlike an unfinished task constantly on reminder.
As they say, if you do not know who is the patsy at the poker table....
That's enough musing for the evening. Thank you for reading, and as always, enjoy and prosper.