Investments Super Highway: Buckle Up!!!
In the recent centuries scientists have come to understand certain forces in the universe to the point that they can generate unfathomably accurate predictions. For instance, we have a really good grasp on the affects of gravity. We can calculate the alignment, speed, and path of non-terrestrial bodies such as planets, asteroids, and satellites far into the future with impressive precision. That ability has allowed us to forecast tides and eclipses, to land on the moon and on mars (rovers), to get XM/Sirius radio and Direct TV satellite services. Our knowledge may even empower us to prevent the same disaster witnessed in the movie ‘Armegeddon’. Of course, we would also need to recruit Bruce Willis.
Nevertheless, the ability to make such predictions falls short when you look at individual parts, like an electron, which are part of atoms that make up a collective system. Such a system, like the sun or the earth, can be predictable in its behavior. Yet electrons, which make the system work, act in a random and unpredictable way.
Though not as extreme, this behavior can be likened to the stock market. The general trend of the market is positive and relatively consistent. Thus, it is with fair amount of certainty that I can state that the market 10 years from now will be outperforming the market today. And I can say it with even greater certainty if we're talking about the market 15, 20, or 40 years from now. The longer the time horizon, the more predictable the markets relative performance to today's market will be. However, if you look at individual stocks' movements on a daily basis, there is no predictable pattern that can be discerned. Which is to say, while you may find a pattern resulting from the past, it is not much help in predicting the future. To better understand this, let's take a look at a system that behaves similarly to the market; the highway.
A highway is a medium, often made of pavement, on which cars travel. For the most part, the cars tend to go in the same direction, with majority of the cars moving at the average speed of all cars on that highway, as stocks move on an index. Of course there are outliers; some cars (AAPL) go excessively fast, while others (GE) move at an average, or below average pace. There are also cars that crash (Enron), which may directly result in loss of life (worthless stock) and indirectly cause traffic (sluggish market performance). Excessive accidents might also increase insurance premiums (Sarbanes-Oxley), which then becomes costly for all drivers (publicly traded companies).
The implications of this type of market behavior can be seen lucidly through the eyes of car insurance companies. An insurance company cannot predict which person will get into a car accident, be involved in drunk driving and speeding charges, or manage to avoid car accidents altogether. What the insurance company can predict, however, is the general statistics of the number of accidents that will occur amongst drivers. To limit the risk exposure when ensuring a driver at a certain price, the insurance company has to conduct research on the individual, as an investor ought to conduct research on a company whose stock he is considering for his portfolio.
For an insurance company, a person's risk can be attributed to statistical information about age, sex, car type, grades in school, past driving record, etc. Likewise, as an investor, you have at your disposal information about a company's management, financial situation, and market conditions, which you can use to limit your exposure to risk when making an investment. When an insurance company sets an insurance rate on a 17 year old at a 50% premium above what an average driver pays, it does so because the 17 year old has a profile of high risk. If that 17 year old doesn't get into a car accident, the insurance company makes 50% more money on the 17 year old than it does on the average of all other drivers combined. In other words, to an insurance company, a 17 year old is nothing more than a speculative small cap stock! The impact is profound if you consider the outcome if the insurance company doesn't adjust its rates based on a driver's risk. Simply put, if the insurance company treats the 17 year old as part of the average statistic they will not be compensated for taking on additional risk.
The main step in being compensated for taking on any level of risk is doing your homework. If you cannot research your investments, it is advised to buy and hold an Index fund since the flow of an index over the long term is fairly consistent and predictable. But even if you complete your homework more diligently than a Harvard grad, you cannot eliminate all risk.
Even the safest drivers are at risk of getting into accidents. Events that cannot be predicted by doing homework can still arise; weather, road conditions, driving skill, capability of the car, other motorists, and a myriad of unpredictable events can still spell disaster. Likewise, researching a stock can minimize but not eliminate risk.
While conducting due diligence on a stock is important to lower risk exposure, there exist other methods that would enhance a portfolio in such a way that can further minimize risk and maximize your profits.