Editor’s note: This article was first published in July 2011, and its Inditex example, trading at €63 and up 7% in a week, reflects share prices in July 2011.
A few months ago I thought about writing this article to explain a way of controlling risk when investing in the stock market. It’s the system I’ve always used, but when I sat down to write it, it struck me as so absurd that I expected criticism from all sides, and that it might even make me look terribly unprofessional.
Imagine my pleasant surprise when I came across an article on Rankia discussing this very approach to risk control, and an even bigger surprise to learn that Justin Mamis wrote about it in his book The Nature of Risk. So now we can explain this absurd theory without anyone thinking I’m the only “madman” who believes in it.
Justin Mamis explains clearly in his book that investing in a rising market carries more risk than investing in a market that has fallen. The logic is hard to argue with.
Every stock has a ceiling and a floor
When we ask for investment advice, we usually hear something like: “Inditex is a good stock, it’s up 7% in the last week.” Excellent, but if Inditex is trading at €63, common-sense risk control tells us there’s a 90% chance it won’t go above €65, so the stock is more likely to fall than to rise. Inditex would have been a better buy if we’d been told it had dropped 7%, or 23%.
Likewise, when a stock has suffered a sharp fall and is touching bottom, the only move it is likely to make is upward (as long as the company isn’t about to go under).
What we mean is that looking for a stock that has lost value is usually more profitable than looking for one that has gained, always taking its past performance into account. If a stock once reached €30 and is now at €3.50, it’s more likely to go up than down.
On the other hand, if a stock that has never traded at €30 manages to reach €31, the company may be excellent, but traders will quickly start selling, and a fall becomes more likely than a further rise.
In short:
- Stock trading high: 90% chance of falling.
- Stock trading low: 90% chance of rising.
And if the stock is in the middle (neither high nor low), the probability is 50%, which can rise or fall depending on what we know about the company.
Personally, I’ve never invested in a company while its share price was high, however good the company, because I’ve never put in enough capital for the dividends to make it worthwhile. I have sometimes invested when the price was in the middle, though. Sometimes it worked out in the short term; other times I had to wait for the long term.
An even more absurd explanation
Think about how a ball moves. If you throw a ball into the air, it rises until at some point it stops and begins to fall. It falls and falls until it hits the ground, and once it hits the ground… what does the wretched ball do? It bounces and starts rising again.
Investing in the stock market is as simple, or as complicated, as watching the ball and trying to catch it just before or right after the bounce.
That’s what the stock market is: a restless ball that sometimes goes up and sometimes comes down.
Remember Warren Buffett, who has said that he likes companies with potential that are cheap because they’re going through a temporary rough patch. What Buffett means is that he wants to catch the ball while it’s falling or close to the point where it bounces.
Some may think otherwise, but this is a very serious article, even if we compare the stock market to a bouncing ball 🙂
Further reading
Featured image: MichaelMaggs Edit by Richard Bartz, CC BY-SA 3.0, via Wikimedia Commons.
