Wednesday, December 19, 2007

Mark Sellers: Rational investors should rejoice

Two months ago in my Financial Times column, I listed some of the things I have learnt about the stock market over the years. I likened the market to a game of online poker, with anonymous opponents and continuously evolving probabilities. I received some good reader feedback, so this month I’ve decided to revisit the topic. Here are a few more things I’ve learnt about the stock market.

1. People can’t handle high returns.

People say they want to make a lot of money in the stock market but, because of human psychology, very few can handle the volatility that comes with this pursuit. The pain of losing $1, even temporarily, is much greater than the pleasure of making $1.

The book Fortunes Formula details the origins of a formula developed by Bell Labs mathematician John Kelly. His formula allows a gambler to determine the optimal bet size if the gambler can estimate the odds of winning the bet and the pay-off for winning compared with the penalty for losing. The formula can also be modified so that it applies to multiple simultaneous bets – in other words, a stock portfolio.

By studying the Kelly formula, as I have, it becomes apparent that in order to get optimal portfolio returns, an investor has to be willing to endure a lot of volatility. That is because the Kelly formula will have you making large, concentrated bets when you find favourable risk/reward opportunities. And concentration brings volatility.

This is unacceptable to most people because they irrationally equate short-term volatility with risk. So rather than achieving optimal portfolio returns coupled with high volatility, people would rather achieve sub-optimal portfolio returns coupled with low volatility. And that’s why few funds stand out from the crowd; they’re giving their customers what they want.

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