The Importance of “Being Right”

A few days ago, Abnormal Returns raised the interesting question of whether it is more important to be right or to make money. The article cited past work, correctly noted that one could be dollar positive while losing in most cases, and showed behavioral finance literature on the concept of sticking with a thesis, even when it is losing.

This was a great article. As a front-line investment manager, we know that it is a crucial factor in the thinking of many individual investors, the people we are trying to help.

As an aside, we congratulate Tadas on his new business relationship, and wish him the greatest success. He has provided an extremely valuable service to investors and deserves some recognition and compensation.

An important bonus from his new approach is that we can now hope to get more such articles — provocative questions, actually stimulating the rest of us to think and to respond.

The Merkel Response

Another of our featured sites, The Aleph Blog, took a different perspective. Here is how David Merkel responded:

I’m going to take the other side of this one. This is a
bear/choppy market argument. During a sustained bull market, being
right makes lots of money.

When I choose stocks, I do all that I can to have the odds
tipped in my favor — industry analysis, earnings quality analysis,
valuation analysis, balance sheet analysis, free cash flow use, and
even a review of the anomalies like momentum, volatility, balance sheet
growth, etc.

It’s not perfect, but I typically have 70% winners, and my
winners are larger than my losers. Being right helps make money… does
anyone doubt that? But hubris destroys.

Does that mean I give up my risk control disciplines? No. I get
things wrong, and when I am wrong, I cut my losses. Every 20% move down
requires a review — if the thesis is intact, I buy enough to rebalance.
If not, I sell.

Also, my methods continually improve my portfolio, selling things with less potential to buy things with greater potential.

Our Take

There was a lively response to the original article, with many good ideas. It is a timely and complicated subject.

We often approach questions like this by stepping away from the instant question, looking at extreme examples from our own experience. Let us take companies that are about to go bankrupt. The topic of bankrupcy is not one that many people like to talk about, but this is a position that many people find themselves in, so it is nothing to be embarrassed about. If you are suffering financially either with your business or in your personal life, you may want to check out a site like to find out more information on what you should do to get your financial life back on track. When it comes to money, don’t think you have to go through it alone. There are several legal options in bankruptcy, so it is highly important that you do as much research as possible before committing to any significant financial decisions.

Experts know that the common stocks in these companies generally go to zero. The common has no value, since the bankruptcy forms NewCo and the bondholders get equity.

This is very difficult to explain to investors. The sentiment of the market often is focused on the general business of the company — often with good potential — rather than the economic fundamentals of the stock.

We have had several cases where investors wanted to buy a penny stock, about to go into bankruptcy. We warned that the stock was worthless.

In several of these cases, all high volatility situations, the stock doubled after our advice. Eventually , it went to zero.

Did we give poor advice? Our experience and knowledge — an understanding of the process — was correct. Anyone following the advice would have eventually been proven right. Meanwhile, major gains were missed.

Could anyone predict that the stock of a bankrupt company would double, say from 75 cents to a dollar fifty? Perhaps, but that is not our method.

The story of being right versus winning is far more complicated. The emphasis on last year — a single point in history — has a special significance since the results were so dramatic.

We plan to revisit that question. For now we wish to highlight a single point:

What is the long run?

A casino has a small edge, but makes money because there are many relevant bets and it allows the casino to offer a casino bonus. It is more difficult for the individual investor. The edge might be significant, but the occasions for testing it are smaller in number. When does one see the “long run?”

Put another way, how many major financial crises have there been? What constitutes a good record?

There is an obvious advantage to methods that get quickly into the long run. Is there a way for the individual investor to participate in this approach, controlling risk, while getting good returns?

More examples and discussion to come…..

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  • VennData June 10, 2009  

    Mr. Merkel recently stated that the Chrysler bond holders “had a case.” He was wrong.
    The partisan attention grabbers at the Indiana pension funds have done a disservice to their pensioners. They were wrong too. We should have proxies on public funds – voted upon by the pensioners – to stop this sort of gross abuse of fiduciary responsibility.
    Speaking of wrong… pension fund managers buying Chysler’s PE purchase debt? They should be fired.

  • Mike C June 11, 2009  

    “Speaking of wrong… pension fund managers buying Chysler’s PE purchase debt? They should be fired.”
    Why? Because they didn’t have the clairvoyance to know that the value they would receive after a reorganization would be subject to an Administration payback to one of their voting blocks (labor union).
    Maybe the risk-return was compelling at purchase without the crystal ball knowledge of political expropriation.
    Maybe pension funds shouldn’t buy any “risky” debt or equities period, but only “risk-free” U.S. Treasuries yielding 3-4%. But if we go down that road, then funding and taxes must go way up to make up the difference in lost return.
    The partisan attention grabbers at the Indiana pension funds have done a disservice to their pensioners.
    Huh (head spinning)? How is it a disservice to try and protect the value of the original investment made? Would a better “service” be to just say f it, hey thats OK, will just take ZERO for our bonds and you go ahead and redistribute whatever value to other parties. Cmon now, get real.

  • Penny Stocks February 19, 2010  

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