Does it make sense to invest in a share that you think has a more than a 50% chance of declining? If you get the answer to this one right you can make a lot of money. I asked this question on the ADVFN bulletin board when I was considering buying French Connection (LSE:FCCN) in July 2013. You might find the answer useful – it’s a simple principle, but one we humans are apt to Forget.
July 2013 post: I have been reading the intelligent debate between PaulyPilot and CR [on ADVFN BB] with great interest. Thank you for bringing such thoughtfulness and expertise to the table. I have an idea that I think may help. As you’ll see I agree with both of you!!
First let me start with an analogy: You go to the racecourse with two friends. One friend says that the positive points about a particular horse outweigh the negative, the other says that the negative outweigh the positive.
After listening to the debate you think that the chances of the horse being a winner are only 40%. Should you place a bet?
Rationally, that depends on the odds you are being offered. If you can get 5 to 1 odds then, even though the pessimistic person is more likely to be right, if you bet on many horses like this then over a period of time you will come out fine.
Paul, with a great deal of industry knowledge, says that if the management do get their act together then this can be a multi-bagger. I agree, but that is a big ‘if’.
If I do buy now at 30p, then in three years the chances (say 60%) are that I will look back and say that the company fell at a fence and I lost my Money.
Does that make it a bad investment decision? No.
Benjamin Graham and Warren Buffett tell us that investment is not about getting every decision right in the sense that every one turns out a winner. You must factor in the odds as well.
Thus if you purchase 10 shares in this category of Graham’s Net Current Asset Value shares over a period of years you will come out fine. You might like to see the evidence for such an assertion. As well as Graham’s record you might like to look at an academic paper I wrote with Xiao Ying for The Journal of Investing. Being a statistical piece of work we were unable to filter out plain no-hopers or those with hidden liabilities and yet, even with that constraint, the overall portfolio performance was very good over two decades.
We have to be prepared to take a chance on an individual share when it forms part of an out-performing portfolio.
In the paper we did not manage to include an analysis of the proportion of shares that individually underperform within a high performing portfolio. However, in another paper examining the return reversal method we found that that only 47% of share bought earn positive market-adjusted returns during the five years following portfolio formation. On average, 7% are liquidated during the 5 years, leaving 46% that survive but under-perform the market. Despite this this 'loser' portfolio outperformed the market by 8.9% per year on average.