Opinion and Investing Column

KIM: For long-term investment treats, don't be tricked

October 29, 2011

KimIn my most recent column, I noted that it is understandable for investors to focus on performance (outcome), choosing to ignore how that performance was generated (process). After all, you can spend performance, but you can’t spend process.

However, we believe a sound investment process is a vital foundation for generating outstanding, long-term investment outcomes. Over the short term, a good outcome does not imply a good process and a bad outcome does not imply a bad process. I’d like to expand on this thought.

We live in a society that values immediate gratification, which is the antithesis of the value approach. Value stocks are typically out of favor and “dead in the water.” It takes an indeterminate period of time for the fundamentals to improve to the point that other investors start to take notice. Psychologically, it’s much easier to go with the crowd and just buy what’s already working.

Being a contrarian is difficult because you are constantly going against the crowd and your stocks are bound to remain out of favor for periods of time. You may even look like you’re foolish and don’t “get it.” However, because value investing goes against human nature and most investors don’t have the patience to wait it out, studies have shown it outperforms growth investing over the long term.

Credit Suisse First Boston published the research piece “Be the House” in 2003, and the message rings true today: The expected value of any investment can be modeled using the possible payoffs and the probabilities of those coming to pass.

We try to identify situations where there is a significant gap between our calculation of the expected value of the investment and the current price of the security. This gap is referred to as positive expected value. Because of the laws of probability, any single investment can yield a negative payoff. However, if we are correctly applying probabilities and payoffs to form a portfolio of investments with positive expected values, over the long haul we should do quite well.

Though investing is obviously not gambling, the casino business is a purely probabilistic endeavor and relatively easy to understand. For example, take the casino game roulette, which has a wheel with the numbers 1-36, 0 and 00.

If a gambler places a $10,000 bet on the number 23 and that number comes up, the wager is paid at 35 to 1, or $350,000. This is clearly a bad outcome for the casino, but the casino is happy for the gambler and hopes all its customers witnessed the win and rush to put $10,000 on 23 (or any other number, for that matter).

The reason for this apparent conundrum is, the true odds of any single number’s appearing on the wheel are actually 37-to-1 (the wheel contains 38 possibilities). With true odds of 37-to-1, but winning single-number bets only paid off at 35-to-1, the casino’s (“house”) advantage is 5.3 percent.

What this means is, for every $10,000 bet placed on 23, the gambler expects to lose $530 (5.3 percent x $10,000) and the house expects to win $530. In other words, the gambler has a negative expected value of $530 and the house has a positive expected value of $530, every spin.

Now, for any given spin (i.e. the short term), the gambler may win $350,000 or lose $10,000. However, if the gambler sits at the table long enough, the casino eventually will win all his money.

This is a simplistic example of why a good short-term outcome does not imply a good process. It’s also why you want to “be the house”—building a portfolio of investments with positive expected values.

Don’t let the excitement and envy of somebody else’s hitting an improbable jackpot blind you to the cold, hard, mathematical probabilities of long-term investment success.

“Be the house,” or your hoped-for treat could end up being a trick.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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