LogFAQs > #948677307

Loosely responding/commenting on some of the points in CoolCly's very detailed and informative post:

I absolutely agree that it's a good idea to have someone else manage a portion of your assets. This is a form of diversification, where even the asset manager is diversified. It avoids the very serious risk of oneself making one or more major mistakes, and not realizing it until after a large percentage of the portfolio has been lost.

Regarding discounted cash flow analyses, I do think that in theory, the value of a stock should equal its discounted future cash flows. The trouble is that a DCF analysis has a lot of unknown parameters, so it can't really be calculated with any great degree of accuracy. The biggest unknown is the future growth or decline of the company - and a DCF analysis requires you to make predictions about these events, which lie in the future and therefore can't possibly be known.

In practice, the problem with doing DCF analyses myself is that I don't think I can do it better than the analysts at Wall Street banks and hedge funds doing the same thing as their job. In fact, I'd probably do it worse than them, and wind up making worse investments for relying on subpar DCF analyses. I have no advantage, and I probably would have a disadvantage if I tried to do this.

Which leads into what I am looking for in a stock, which is an advantage. A reason I believe that I have an edge over other market participants with regard to that trade. Usually, the only consistent advantage that can be found is willingness to take on riskier positions. This is because people are risk averse, so they are willing to pay a premium to avoid risk. And there are market participants such as pension funds that are highly risk averse, and are willing to give up a lot of risk premium to avoid that risk. This is why stocks usually have better average returns than bonds - they are more risky. And why growth stocks have better average returns than stalwarts - they are more risky.

I am of the opinion that you can use the risk premium concept as a guide to timing individual stocks as well. Warren Buffett says to buy when people are fearful, and sell when they are greedy, and I believe this is why. When people are fearful, they are willing to pay more in risk premium. When they are greedy, they are willing to pay less in risk premium.

Looking at the other side of this trade illustrates it well. Suppose we have a fearful trader who has done a very thorough analysis of ABC corporation and believes its stock should be worth $25, based on a 50% chance of going bankrupt and a 50% chance of being worth $50 if the company survives. The stock is trading at $20 so he buys it. Unfortunately shortly after buying, the stock craters to $15. Fearful trader is so fearful of losing all his money that he sells a stock for $15 that he thinks should fairly be valued at $25. You want to be on the opposite side of the trade. Fearful trader is paying you $10 a share to take on the risk of this trade. That $10 is above the fair value of the company, and, provided it's a small enough portion of your portfolio that you can handle the risk, it's basically pure profit to you. That is your "advantage."

And this is also why trading based on fear will get you worse results on average than choosing stocks randomly.

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September 1, 2003; November 4, 2007; September 2, 2013
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