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TFC Commodity Trading Forum

Fundamental Focus: Understanding the Odds

Andrew Page, Optionetics.com.au
September 14, 2010

They say the odds of winning the jackpot on a pokie machine (slot machine for US readers) is about one in ten million. So low are the odds that you are nearly seven times more likely to be hit by lightening, and yet roughly a third of adult Australians have played them over the past year.

Even a cursory glance at the facts will tell you that itís a mugs game; indeed given the tax revenue generated from these machines the pokie phenomenon has been called a tax on stupidity. But what has this got to do with investing?

Well it seems to me that there is a lot of similarity between gambling on a pokie machine and trading in speculative companies; the only difference is that the odds are less well documented. Here I wish to rectify this disparity and shed some light on your chances of success.

Enter the penny dreadfuls

Perhaps the best area to focus on here is the metals & mining sub-sector of the Australian market: firstly because the majority of companies in this area are highly speculative in nature and secondly because they tend to capture the most attention from punters. Letís look at these separately.

When I say speculative, I mean that they are businesses that are yet to have any demonstrated long term viability, which is most clearly identified by looking at profitability. The majority of listed companies on the Australian market belong to this sub-sector, about 652 companies or 31% of all listed companies. Of these, only 24% made a net profit last year, and only 4.6% pay any dividend, most a fairly average one at that. Furthermore, over 90% trade with a Price to Earnings ratio [PE] well outside of the typical range. In other words, they are trading at a price that has virtually no bearing on their earnings capacity.

Why is it then that they seem so popular with traders? Well there are some remarkable success stories, such as Fortesque Metals which has seen a 1180% gain in just 5 short years. Moreover, they tend to be remarkably volatile, giving the potential for sudden and significant short term gains. In short, people see them as a means to get rich quick, and as students of the DividendKey understand, there is no such thing.

Knowing the odds

But is there any justification for viewing these types of stocks so favourably? If you track the performance of these stocks over the past 5 years the first thing you notice is that most did not exist back then. This is typical of this sector which sees a high degree of turnover, with new stocks listing and replacing others that delist.

But if we focus on the 55% of metals & mining stocks that did exist 5 years ago, we can see that their record, for the most part, is far from inspiring. For starters, about 58% of these stocks have declined in value over that time, and the losses are far from insignificant: the median loss was 63%. Indeed, 20% saw a loss of more than 80%. The odds are not looking good.

Accentuate the positive

But what about the others? Of those 359 miners that were around 5 years ago, 42% increased in value. But then again, the market as a whole (as represented by the ASX 200 accumulation index) did too, rising 26% between September 2005 and today. When you look at outperformers, 35% of these stocks beat the index, some of them spectacularly.

The average gain was in fact 456%, skewed by stocks like Andean resources, which has grown over 4000% in that time! The median figure is more telling, yet remains very attractive at 183%. So maybe the gamble is worth it after all when you consider that 20% of the stocks currently listed in the metals & mining sector have achieved a median growth of such magnitude.

Then again, youíve got to account for the fact that a lot of these gains will be offset by some of the losses that are inevitable elsewhere. And as we saw a substantial portion of stocks experienced large losses.

Your own worst enemy

But even if you assume that you can avoid these by employing Ďstop-lossí strategies, the fact is these same strategies will knock you out of those stocks that eventually outperform.

Of all of the stocks that outperformed the index over the past five years, a massive 74% experienced a loss at some point over this period. Indeed 60% lost ground in the first month alone. So while we can see with hindsight that some of the gains over this period were very attractive, the reality is that most traders would have cut and run as soon as their positions went into the red. After all, thatís one of the mantras of trading; Ďcut your losses short and let your winners runí.

Even had you managed to hold on to your stocks while they were trading at a loss in the early stages, the data tells us that a substantial 44% were trading at a loss after 3 years, so we aren't just talking about a little bit of initial volatility here.

Another factor that Iíve previously pointed out is that traders tend to lock in profit when they can. In the case of Andean resources, how many people would have resisted the urge to sell when they saw a 50% gain? What about a 100% or even 500% gain? The temptation to lock in profits is usually so great that few people get to experience all the theoretical gains due to the greed of capturing short term gains, and the fear of avoiding losing them.

The moral of the story?

The take-home message for investors is that there is an inextricable link between risk and return. If you want massive gains, you must be prepared to take massive risk. But that means exposing your capital to the very real, and as we have seen very likely, potential for loss. Even if you have the fortune (skill?) to pick an eventual winner, chances are you will sell out well before the really exciting gains will be seen.

To return to the analogy with pokie machines, while there is a potential to win a lot, there is very little likelihood of doing so. The point is you don't need to achieve unrealistic gains to build wealth over time, something that we unequivocally demonstrate in the DividendKey. While others are shooting for the jackpot, our students are confidently and quietly allocating their savings to reliable cash generating businesses and letting their capital do all the work.

Get off the treadmill and start making real progress today. For those who are interested, you can view the first lesson of the US series for free at http://events.hubb.com/p14181376/.

Make the markets work for you.

Andrew Page
Optionetics.com.au
Optionetics.com ~ Your Options Education Site

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Fundamental Focus: Understanding the Odds