Update 6/30/2009: I have collected my discussion of stock purchases that I characterize as lottery tickets in this Gateway Post: LOTTERY TICKET PURCHASES: LINKS IN ONE POST
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Holding a single security or an asset class over long periods of time can increase risk and reduce it, depending on the the duration of the holding period. I am going to call this the duality of risk. I would like to draw three examples from my weekend reading.
First, I am starting to wade through Taleb's book "Fooled by Randomness" and made it to page 38 before starting to nod off and having an overwhelming desire to take a nap. Before dosing off, he recounted a story, which I will take some liberty in the retelling, of an eccentric billionaire who offered a 20 year old MIT statistician and recognized wizard 10 million dollars to play Russian roulette with one bullet in a six chamber revolver. The young man quickly calculated the risk/reward, accepted the offer and fortunately was lucky. The eccentric said that he would do this once a year for as long as the young man wanted to do it again. The young man came back the next year, calculated the odds which seemed to be in his favor, pulled the trigger and collected the 10 million again. Being a wizard, he developed complex mathematical models for esoteric trading in the market and before long he was on the Forbes 400 list of the richest Americans right behind R. Allan Sanford. But he could not resist coming back and playing that game, calculating that the odds were in his favor and lo and behold on the 15th time of playing the game his good fortune came to an abrupt and unfortunate end.
My much older older brother asked me today whether I had read the article, which I had, and then he launches into some statistical mumbo jumbo about Bayesian techniques. I never took a class in statistics, never will make an effort to understand it, but I did not need a statistician to tell me what was contained in the Bayesian statistical analysis of the long trends of the stock market. As Mark Hulbert said and my brother was explaining to me, Bayesian "analysis is often used to assess the uncertainty of future outcomes, based on a formula for updating probabilities of given events in the light of new evidence". The result of using this analysis is that the volatility of the market is 1 1/2 times greater at 30 years than at 1 year. Okay, I really do not understand statistical analysis but I may be a Bayesian myself nonetheless.
From my point of view, the longer the period an asset is held creates more risk that an unanticipated event may occur that will decimate the value of the asset. This does relate to what Taleb is saying about the black swan events. I may do okay in the stock market for 15 years and then something happens in year 16 that takes away 50% of my gains, something that I could not anticipate and model, no mater how many MIT pets that I employed or the sophistication of my models. Those who have been investing every year in the stock market since say 1996, with equal contributions every year, know first hand about the point that I am making and it may feel like the bullet was in the chamber. The bullet is always there and the longer the game is played, exactly as before, the odds increase of an unpredictable and potentially catastrophic loss.
From my point of view, the longer the period an asset is held creates more risk that an unanticipated event may occur that will decimate the value of the asset. This does relate to what Taleb is saying about the black swan events. I may do okay in the stock market for 15 years and then something happens in year 16 that takes away 50% of my gains, something that I could not anticipate and model, no mater how many MIT pets that I employed or the sophistication of my models. Those who have been investing every year in the stock market since say 1996, with equal contributions every year, know first hand about the point that I am making and it may feel like the bullet was in the chamber. The bullet is always there and the longer the game is played, exactly as before, the odds increase of an unpredictable and potentially catastrophic loss.
The third article is in Barron's written by Lawrence Strauss. Barrons.com The twenty year treasury bond has now outperformed the S & P 500 index from 1968 through February 2009. Bonds also beat stocks between 1803 to 1871 and 1929-1949. Now, if I change my measuring stick some, stocks handily beat bonds from 1932 to 2000. What does this tell me? For one, it tells me to be suspect about those who are promoters of stocks as the magic elixir. My other conclusion would be that stocks may beat bonds for the next thirty years particularly when the twenty year treasury is yielding such a paltry amount and the S & P 500 index has just been shellacked.
So then I did a quick calculation, adding thirty years to my age, counting with fingers on both hands, and realized that I might actually live another 30 years. For the sake of argument let's assume that I live another 35 years. So, would I be better of in a 3.5% 30 year treasury bond or the S & P 500 index, making the choice now, for the next thirty years as opposed to say making a choice between a ten year treasury and the S & P index for 10 years. Then, at the end of ten years, I would decide again. In the meantime, assume stocks had had a record similar to the 1990s and the treasury had been decimated in price and rising in yield to say 8%. What then? What would be the better choice if I had to choose one or the other?
My gut told me that stocks would do better than the 30 year treasury bond bought now with a 30 year time horizon but what if something unexpected happened causing the market to fall 70% near the end of that 30 year period. The longer that I stayed with the S & P 500 index, the odds of an outlier event happening increases which would decimate my returns. That might happen several times over the course of thirty years but would be devastating to me if it occurred in year 29 with only a few years left to recover. So, in this example, the duration of risk becomes important in the long term analysis, so I would pick the S & P 500 over the 10 year treasury bond for just the next ten years, or stocks over the 5 year Treasury. So, I have in the last analysis more confidence in the risk with a shorter duration, but not so short as a day, a month or even a year.
So then I did a quick calculation, adding thirty years to my age, counting with fingers on both hands, and realized that I might actually live another 30 years. For the sake of argument let's assume that I live another 35 years. So, would I be better of in a 3.5% 30 year treasury bond or the S & P 500 index, making the choice now, for the next thirty years as opposed to say making a choice between a ten year treasury and the S & P index for 10 years. Then, at the end of ten years, I would decide again. In the meantime, assume stocks had had a record similar to the 1990s and the treasury had been decimated in price and rising in yield to say 8%. What then? What would be the better choice if I had to choose one or the other?
My gut told me that stocks would do better than the 30 year treasury bond bought now with a 30 year time horizon but what if something unexpected happened causing the market to fall 70% near the end of that 30 year period. The longer that I stayed with the S & P 500 index, the odds of an outlier event happening increases which would decimate my returns. That might happen several times over the course of thirty years but would be devastating to me if it occurred in year 29 with only a few years left to recover. So, in this example, the duration of risk becomes important in the long term analysis, so I would pick the S & P 500 over the 10 year treasury bond for just the next ten years, or stocks over the 5 year Treasury. So, I have in the last analysis more confidence in the risk with a shorter duration, but not so short as a day, a month or even a year.
This big picture type analysis of looking at risk in duration terms is used by me when looking at an individual security.
I mentioned the other day buying CB Richard Ellis at $2.39. I do not know whether this company will be around in 30 years. I do not know when there will be a recovery in the commercial real estate market. Maybe that will start to occur later this year or maybe in 2010. If I can hold the position for five years, then my confidence in a recovery goes way up, not to certainty but close enough for a stock selection. When that happens, then the price of this stock will recover provided CBG does not bankrupt before an upturn takes root. My choice to buy was based not on a 30 year probability forecast or even a 10 year. As far as I know, in another 10 years, we could be in the same soup that we are in now. Instead I am just suggesting that my confidence in a significant recovery starting sometime between the end of this year and 2011 is high and my lost opportunity risk arising from the possibility of acquiring CBG at less than $2.39 is low, insignificant or just immaterial. I can now hold for a possible 10 bagger. By being willing to hold this security now if need be for 3 to 5 years, I do not have the risk of the day trader, trying to predict the variations in price over short periods of time which is not possible on a consistent basis. If I had to make a new decision every day on whether to go long or to short, I would surely lose. By taking a longer duration approach, I reduced my risk compared to that assumed by someone trading the security since nothing has to happen tomorrow, this month or even this year. I can wait. But the duration of the risk can not be 30 years because hundreds of adverse developments could occur over such a long duration that would actually increase my risk the longer I stayed with the investment. This brings me to the topic for this weekend which is risk assessment and management in an extremely small category of my portfolio.
For the hearty souls who venture into purchasing stocks priced at less than $5, an article in Barron's this week is worth a read. Barrons.com
Once that five dollar barrier is breached to the downside, the odds of finding a winner amid the rubble are slim. Last year, of the 637 stocks that broke $5 and stayed over $1, the total decline was 61%. I do venture into this area some, and I refer to my purchases as lottery tickets. While they have more potential to win then my powerball picks, the characterization is still applicable since many will ultimately fail or at least lose more after my purchase. To make this worthwhile, I will need to trade some that spike, and volatility in those low priced stocks is normal. More importantly, there will be a few purchases where I will need to hold for a long time for a potential ten bagger which is where the real juice comes with these kind of purchases. CB Richard Ellis is one of my recent buys that at least has the potential to return to its price from 2007 which would translate into a ten bagger. CB RICHARD ELLIS GRP Share Price Chart I do not have a clue whether that will happen or when, except that it will require a recovery in the commercial real estate market. At my cost of $2.39, the odds are increased of a substantial percentage return. SOLD NADX IN IRA/BOUGHT Kraft & NESTLE/ Bought Lottery Ticket in CBG at 2.39/ Drags: TALF, AXP and GE However, if it goes poof, I will have lost about $125, or more by adding the profit that I am foregoing by not selling it now. By 10 bagger, I mean a $1250 profit on this $125 investment. That kind of gain would in all likelihood be harvested since I would not wait for the outlier event to come along and crush an unrealized gain to smithereens. I am playing with the house's money on that one too, with a profit realized in 2007 on trades of $330. CB Richard Ellis/Mortgage Rates/PFX/ SLM-OSM
In 2007, at the prices bought and sold, and under the circumstances then existing, I did not have any confidence about increasing my gains based on extending the duration of the holding period.
Some well known mutual funds rode CBG up into the 30s and down to 2 and change. I do not see the wisdom of those decisions. CBG: Major Holders for CB RICHARD ELLIS GRP
So, what makes venturing into this area worthwhile is to realize a few large percentage gainers with very little money exposed to the entire class of lottery tickets. It also helps to keep me involved during a major bear market without risking too much capital. Possibly, the one that I sold on Friday, AINV, for a quick gain would have potential for more gains, but I lack confidence in the duration of its potential upside.
This entire asset class of low priced stocks is inherently risky and gains need to be harvested here and there simply to mitigate and moderate the overall risk of this sub asset class. And, it is also important to recognize that some may need to be sold at a loss to prevent a potential total loss. I will give more leeway on the downside to them as long as I am somewhat confident that the company will survive. The lottery tickets currently owned include less than a $2,000 total exposure, contain many positions where I have already harvested more in gains that I currently have at risk or close to it, and include the following:
100 Sunopta (STKL)
100 Napco Security (NSSC)
100 Glimcher Reality (GRT)
100 Glimcher Reality Pr F
100 C B Richard Ellis (added 50 in main account prior to last purchase)
100 Taseko Mines (TGB)
100 CBL Properties (CBL) (added some since last mention)
100 Solta Medical (SLTM)
50 Ciber (CBR)
50 GP Strategies (GPX)
40 Given Imaging (GIVN)
100 Sinclair Broadcasting (SBGI) (bought at $1)
50 National Dendex (NADX) ( sold 50 on a spike)
50 Lexington Pr (LXPPRD) (sold 50)
100 Ariad Pharmaceuticals
40 First Industrial (FR)
50 Regions Financial (RF)
50 Webster Financial (WBS)
Of those stocks, only CBG is being held now with a long term perspective, although STKL and LXPPRD are borderline and may ultimately be so classified. Sinclair could fall into that category whenever I become convinced the company has an handle on paying off or refinancing its huge debt. I am confident that there will be a recovery in advertising which is not my concern with it. The purchase of GRTPRF was at 2.9. GRTPRF: A WALK ON THE WILD SIDE/ KTN add I would not buy more at the current price. It is an extremely risky cumulative preferred. GPX was bought at 4 and I will not buy more due to my concerns about its business with GM. Buy of 50 Shares of GPX: Limit at 4 filled-investing only cash flow The last buy of Taseko Mines was at 80 cents. More on GE/Merrill Lynch Bonuses/Barron's Roundtable/More on AEB/add of TGB in IRA/tax law changes: property taxes
Sunopta is another one where I am well into playing with the house's money with close to a $800 profit on this security from a prior trade, and the last purchase was at $1.65. The prior trade was not a lottery ticket but the last purchase definitely fit within that category. Madoff: Lawsuits starting to fly against advisors/Buy of Sunopta: Highly Speculative
Napco was bought at $1.02. ROK/Balancing Risk & Reward on SNTA/Buy 100 NSSC at $1.02/Electronic Medical Records & the Stimulus Bill/M & DKQ I am playing with house's money on that one and may buy more Buy of 50 Shares of GPX: Limit at 4 filled-investing only cash flow. I am also close to playing with the house's money on both CBR and GPX, within about a $100. Buy of 50 Cyber/Starting Position in CSCO Buy of 50 Shares of GPX: Limit at 4 filled-investing only cash flowI have one more that I am not going to mention since I bought 500 shares at just 26 cents, and I am barely positive on it so far. Webster and Regions, two large regional banks, were recently added this month and I have no trading profits in either of them. So a certain amount of opportunistic trading has reduced my risk in my mind's eye and makes me more willing to take the risk again, usually at a much lower price than my prior purchase which was sold.
Some say do not combine longer term holds with trading. That many be good advice for many or most, but would be wrong for me.
The ones sold this year so far include LXPPRD, SCMP, AINV, and NADX. The National Dentex was the best percentage move, going from $1.27 to 4 really quick.
I certainly agree with the mutual fund manager interviewed in the Barron's article, Preston Athey that many of these low priced stocks will expire in bankruptcy. The risk of a total or substantial loss is omnipresent which is why I never devote much money to any of them with a current limit of $300 per name. I was not familiar with the two that Atney mentioned in the Barron's article but I did add them to my list of potential lottery ticket purchases which has about 200 names on it. I will adjust the $300 (used to be $200 until RB change the rule) up by previous profits in the security. So I could buy a lot more of Sunopta, which I am not going to do, or another 100 of Cyber which would put me over $300 this round but not after the adjustment for the previous profit made on that stock. As RB said in an earlier post, LB has developed rules on top of rules, modifications and adjustments to rules, exceptions to rules, exceptions to exceptions, all designed to manage risk, and this is just some of the rules on purchasing stocks that are less than $5 and have been thrown out with the trash by most other investors.
The duration of risk that I am willing to assume for the consumer product stocks that I have purchased is no longer than 10 years. I know that a fifteen year bull market is pushing my luck. At the prices paid, I am comfortable evaluating my risk/reward in a 2 to 5 year time frame. I can not say what will happen this month or this year with them. Just that I comfortable that my reward with them over a 2 to 5 year period is likely to be better than 10% with their dividends, and I can pick my exit point later during that longer duration period to achieve that limited goal. With a little luck, it is possible that I may be able to harvest a double in five years with the dividends. With favorable economic conditions, I might hold for 10 years. The risk has to be assessed constantly, in that something unforeseen and extremely negative may happen causing me to reevaluate one or more of the companies. But that is part of an ongoing risk analysis. The analysis that I made about them now is a duration risk over a relatively short period of years, not decades, not days or months.
DISCLAIMER:
I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. I have never worked for a financial institution and never will. In these posts, I am acting as an unpaid financial journalist and an occasional political commentator. I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine. Any discussion made by me of particular securities is not a recommendation to buy or to sell. Trade at your own risk. Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons. The sale may before or after the post. Before buying or selling any stock, even one recommended by a trusted financial advisor, please research it and make up your own mind which is what I always try to do. Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news. In this post, and all others by me, I am merely describing my reasons for purchasing or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale. The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile. By way of example, it is unlikely that I will ever need the funds contained in my retirement accounts. Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments. Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed. These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities. All content in these posts is provided for informational and entertainment purposes only, and it is a form of entertainment for me.
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