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Investor Information: Another Casino?

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We all know that if there are more buyers than sellers the price of a stock goes up and if there are more sellers than buyers the price goes down.

If one could identify what the institutional investors (big money movers on the markets) are going to buy or sell, it would be a "piece of cake" to make a fortune on the Securities Exchange.

Unfortunately, even these seasoned and experienced investors do not make all their decisions based on obvious logic, common sense and basic tested business rationale. Just like all the less seasoned ordinary investors they are also often influenced by market noise, investor myopia, personal bias, mob behaviour, investor psychology and other unpredictable behaviour based on often unjustified rationale and investor sentiment. It could, therefore, appear to the less informed investor that the markets mostly move in an unpredictable and random manner and most of the time these moves make no sense at all, even to the seasoned investors. The above syndrome becomes even more evident during strong bull market trends when many investors often respond more to "market hype" than to any real substance.

In order to fully understand the intricate characteristics of the equity markets it is sometimes useful to compare it with other popular wagering facilities, for example a gambling casino.

One should not confuse the Securities Exchange with a casino, but, there are certain elements one has to understand related to these two wagering facilities that may give one more insight to some of the basic principles involved.

The common parables

  • Both can be very rewarding and a lot of fun if you know what you are doing and both can also be very costly and devastating if you don't know what you are doing.
  • In both, you will win some and you will lose some and in both, the objective is to win more times than you lose.
  • In both, the human flaw of greed is present and need to be controlled and guarded against.
  • In both, the principles sometimes referred to as the laws of odds and probabilities are the key to winning more times than you lose.

The primary difference

  • In the casino if you lose the wager you lose everything you "invested", whilst with shares your loss is determined or limited by the price you get when you "exit the game".
  • In the casino the odds in a particular game basically remain the same no matter what happens during play. The odds are built into the design of the game and only the probabilities may change from time to time.
  • In the equity markets the odds relate to a bottom up approach and it is based on the enterprise and its many business elements, branding and reputation, financial disciplines, corporate soundness, innovative marketing, product superiority and/or monopoly, dynamic leadership, etc.
  • In the casino the probabilities mainly relate to things surrounding the game and these are things you, as a player, may influence if you know enough about it.
  • In the equity markets probabilities may also be contained mainly in the environment surrounding the business, but you and I have very little, if any, means apart from timing of influencing those probabilities.

In a nutshell, one could probably say...gamblers are willing losers who occasionally win and equity traders are willing winners
who occasionally lose.

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Any serious and successful gambler will tell you that if you want to win more than you lose the first thing you need to understand is the difference between odds and probabilities.

Odds can be described as internal factors which are built into the design or compilation of the game, whilst probabilities can be seen as external or environmental factors surrounding the game.

Example

  • If one takes the popular game of Blackjack played in a casino, the odds remain constant (obviously always in favour of the casino). These odds can only be changed if the rules are changed by the casino, such as allowing higher or lower bet limits, adding or reducing the number of cards in the dealer's shoe, etc.
  • The probabilities, however, can be influenced by the gambler, such as which and how many hands you play, how focussed and sober you remain during the game, how disciplined you are in complying with the basic unwritten rules of the game (when to stand, split, etc).
  • Some gamblers also attempt other sometimes frowned upon (even illegal) strategies, such as counting the cards, playing in "shadow teams", bending or marking some cards and so on.

Seasoned successful gamblers know what the odds are in the gambling games they play and they also know how to recognise, use and even manipulate some of the probabilities linked to the game.

One could, therefore, say that the primary reason for people losing money in casinos probably is because they do not understand the difference between odds and probabilities.

Often they also have no idea of what the odds are in the games they play (some actually believe that if you toss a coin and it falls "heads up" twenty times in a row, the odds of it falling "tails up" improves, whilst, in fact, the odds stay 50/50, no matter how many times it already repeated a specific outcome).

For example, the greatest losses ever recorded and suffered by gamblers were on a roulette table in Monte Carlo, many years ago, when black came up 184 times in succession.

After twenty or so spins most inexperienced gamblers probably fell into, what is sometimes referred to as, the trap of momentum where they all started to double their previous bets believing that the odds are becoming much more favourable, whilst, in fact, it still remains almost even. Just consider how quickly the maximum bet is reached when you double your previous bet every time.

One can see in the above example how soon they all started to lose great sums of money with each bet they made against black coming up again while having almost no chance of ever recovering their accumulated losses.

So what does this have to do with investments on the equity markets?

The primary reasons for equity investors to lose money on the markets are almost exactly the same as the reasons described above for gamblers losing money in the casinos.

Therefore, each company or its stock listed on the equity markets can be seen as a separate or different game, each with its own odds and subject to specific or even unique probability factors.

The odds for a particular listed stock relate directly to the fundamental value (internal factors) of the business enterprise elements in the company that issued the stock, such as:

  • Leadership and management expertise
  • Innovative marketing and competitive products
  • Revenue and earnings
  • Building tangible assets
  • Creating shareholders equity
  • Return on equity and investment
  • Cash situation and cash flow generating abilities
  • Financial controls and business disciplines
  • Debt and gearing situation
  • Dividend and other distribution issues, etc.

If the data and information supplied by companies are correct and reliable, one can with enough research arrive at a fairly reliable assessment of the odds for winning or losing, if one should invest in that company.

The probability factors relating to equity performance are the external and/or environmental factors surrounding the company or its stock, such as:

  • General Industry developments
  • Economic indicators and developments
  • Interest rate impact issues
  • Forex differentials and exchange issues
  • Commodity price movements and market cycles
  • Investor sentiment, fear, greed, etc.

Just like inexperienced gamblers, novice investors also fall into the trap of momentum where they start buying into a stock during the latter part of its strong upward trend not realising that the higher the price of the stock rises, the more the odds and even the probabilities are likely to turn against them.

The higher price often considerably reduces the value (odds) as well as the market force cycles (probabilities) and the stock may reach the end of the favourable performance cycle.

It is wise to understand that being involved as a trader on the equity markets is a bit like living in an earthquake zone.

The fact that there is more risk when living in an earthquake zone will, however, not stop people from moving there or even building bigger and higher buildings in those areas. In fact, the better risk reward or barrier price scenario that applies in those earthquake areas often attracts many property investors and other real estate developers.

However, to cope with this potential higher risk the buildings are better designed with stronger foundations or underpinning to protect them against future quakes that may occur sooner or later.

It is important to protect yourself in the equity markets by investing in stocks with more substance and value and stocks that will be able to withstand the "financial quakes" when it comes, as it will without a doubt.

Therefore, if one wants to gain a competitive edge with investments in equity markets, it is essential to assess and evaluate the odds and the probabilities in and surrounding a particular stock at any given time to ensure that there is reliable substance to cope with serious downturns when it occurs.

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