Friday, August 3, 2012

The big question: Risk vs Return, Part 2

So stocks.

These are high risk investments that involve very high volatility. You can experience gains of 1000% magnitude in a few years, you can also experience losses of close 100% in a couple of years. So how do we approach stocks?

One way, is to pick a few stocks yourself. Generally, the fewer stocks you pick, the higher volatility. Why? Well, unless stocks are at least 100% correlated, when one of the stocks' price changes, other do not follow suit proportionally, and therefore acts as dampening the change. Of course, if you happen to find stocks that are more than 100% correlated, then you can expose yourself to extra volatility by buying more stocks. This approach is heavily dependent on your luck (some call skill).

There are actually two camps on this approach: ones relying completely on technical data, and ones relying completely on fundamentals of a stock. Most people are actually in between. So the technical camp claims that the stock's fundamentals are already "considered" when it comes to stock pricing, and therefore all those nice curves are able to give us all the information we are ever gonna get about the company whose stock we are trading. The fundamentals guys, on the other hand, says that all that matters for a stock is how well the company behind it is performing, and therefore they pay attention to things like Price/Earning ratios (Actually P/E ratio is only a small part). Personally, I think the technical stuff is pure bullshit. Given a reasonable time frame, I am totally convinced that fundamentals guys will always outperform. Think about it, humans are often nuts, therefore those pretty curves mean nothing! They are the product of trading activities performed by some crazy, irrational beings, and how is that going to help me find stocks?

The other way is to broadly diversify, often through some kind of broadly diversified fund. The good thing is that the volatility is vastly lower. It's not uncommon for the price of a single stock to fall by 30 percent in a single day, (Zynga) but it is very rare to see the S&P 500 to fall even 5% in a day, in fact, a 3% percent drop would be termed as "plunge" by the new agents already. On the other hand, broadly diversified funds rarely rise 3% or more in a day either.

Remember, those two approaches do not have to be mutually exclusive. Personally, when it comes to equities investing, I'd like to have a core portfolio consisting of broadly diversified index funds, and then a few individual stocks here and there, acting as supplementary investments. Of course, since I am a complete non-believer of technical analysis, I'd only pick stocks based on their fundamentals. (hmm, FB is looking increasingly attractive at this point)

In the next post, I'll do a high-level discussion on stock picking strategies.

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