HH A Universal Theory Of Stock Market Investing

An investor’s edge may lie in her ability to find advantageous factors like these and to leverage them efficiently.

Tenet 5: Low-volume stocks present the most opportunities.

The more people investing in a stock, the more complex the system of factors that sets its price; the fewer people investing in it, the more likely one can find some reason and rhyme to the stock’s price, and the easier it is to estimate the odds of its success or failure.

I use the word easier in a purely relative way: estimating the odds on a stock, no matter its size, is almost infinitely complex. But low-volume stocks, while expensive and difficult to buy and sell, are less complicated to evaluate. Jim O’Shaughnessy wrote a terrific article on this, which I recommend.

Tenet 6: In the stock market, risk and reward are related but not correlated.

Whether risk is measured as price variability, the likelihood of bankruptcy, or the likelihood of a steep loss in value, the relationship of risk and reward follows a curve that looks a bit like this. 

Risk-reward curve 2

In other words, the highest reward is achieved by taking some risk, but not too much, and the worst losses result from taking too much risk.

How does this relate to investor expectations, probabilities, and factors? Well, according to the conventional idea that the higher the risk, the greater the reward, a factor that lowers risk shouldn’t work. However many of the best factors are precisely those that lower risk. For example, investing in stocks with low share turnover lowers risk while increasing returns precisely because it goes contrary to investor expectations about the market as a whole. Looking at a company’s quality by measuring its accrual ratios, the stability of its cash conversion cycle, the stability of its quarterly sales figures, and so on are wise things to do not only because one lowers risk but also because most investors don’t bother to look at these important indicators of a company’s potential.

Tenet 7: Consider as many factors as possible (within reason) when examining a stock.

This is advantageous for a number of reasons:

  • you’re lowering your risk by “checking under the hood,” looking at everything that could go wrong;
  • you’re maximizing the chance of using both types of factors: those that drive investor interest and those that confound expectations;
  • while you may be introducing type 1 errors (relying on a factor that doesn’t really work), you’ll be avoiding type 2 errors (ignoring a factor that does work), which tend to have greater consequences;
  • you’re mirroring, to some degree, the complexity of how stock prices are actually set.

Tenet 8: Mechanical judgments are more likely to succeed than discretionary ones.

In order to consider all these factors, the investor can either use her own discretion or can employ computer-based tools. Discretionary judgments are more fallible than those made by an objective calculation and are more likely to conform to the judgments of the majority of investors, thus denying the investor an edge. For example, in evaluating the management of a company, the investor would be better off relying on a deep, intelligent, careful, and original analysis of the company’s earnings statements and analyst estimates than on employee assessments or Internet scuttlebutt, since the latter are more likely to be already reflected in the stock’s price.

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Disclosure: My top ten holdings right now: ZIXI, ARC, GSB, CTEK, KTCC, PERI, HALL, OSIR, CRNT, NTWK.

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