The heart of this guide exists in this section, the simple matter is that in order the make money from investing, speculating, trading or gambling, there is only one proven method that works. It is slightly unconventional to use the parallel of gambling on horses to talk about investment but convention is something that stifles investors and is the reason why most investors often go in the wrong direction.
There is a proven method of making money on the horses which I will now describe.
Most punters when they have a bet try and identify the winner of a race. This is doomed to failure. What punters should do, and what successful and professional gamblers do, is bet on horses where the odds are better than the probability of winning. A simple example can illustrate this better.
Imagine that you were setting yourself up as a professional gambler that specialised in backing horses that were always 100-1 to win. If you could identify 100-1 shots that have a 1 in 70 chance of winning the race, you would have a winning system because out of every 700 bets that you placed you would have 10 winners at 100-1, producing a return of £1000 to every £700 that you staked. In other words, the probability of a horse winning, if it could be measured accurately as being 1 in 70, would give you an edge over the bookmaker. What is incredibly important here to understand is that 69 times out of 70, on average, you would be backing horses that did not win but you would still having a winning strategy in the long run but you would have to accept the fact that you would have considerable periods of time waiting for the return which would be excessive when it occurred.
If we look at another example using horses it may illustrate the point further. If, instead of backing 100-1 shots you backed ‘even money’ shots, you are now betting on horses that have, according to the odds, a 1 in 2 chance of winning. If you were only to ever back horses at even money you would need to make sure that your selection actually has a probability of winning that was better than 1 in 2 otherwise you would lose money. Let us say that for every 10 horses you backed, 6 win at even money and 4 lose. In this example, for every £10 you spent you would get £12 back, a 20% return. This is equivalent to the difference in the odds and the probability, the odds are saying you have a 1 in 2 chance of winning but in reality you have a 6 in 10 chance of winning, the difference between 1 and 2 (5 out of 10) and 6 out of 10 is 20%.
Of course we are working on a very simplistic basis here but it does illustrate that in setting yourself up to invest in horses you would have to have regard to how likely it is a horse is going to win a race rather than if it is going to win a particular race. This subtle shift in thinking is huge in terms of generating a return. It is not whether you are going to get something that works or not, I’ve already covered off the thinking that everything you try will not work, you have to play the percentages and find the edge where the value is with you rather than against you. In investment terms, generally speaking, you’re not offered odds when you take out an investment, there are types of investment where this may occur, but in the main you are asked to pay a price for an investment.
Let us say you decide to invest in property, clearly the most important part of any property investment is the price you are asked to pay for the property. If you are able to buy a £500,000 property for £400,000 then you clearly see you have an edge, the same with shares. If for whatever reason an individual share is depressed due to reasons that you have identified and the price of the share is £1 and really should be £2, then you should be snapping up as many of the £1 shares as you can get your hands on. The price should really be double this and your expectation and investment logic tells you that sooner or later, as long as your assessment is broadly correct, you will find that the price that you bought at against the price that you assessed was the fair value will marry up and this is where significant profits can be made.
What I am describing here is nothing short of the bedrock upon which people like Benjamin Graham and Warren Buffet have built their investment fortunes and it is also one of the reasons why scientists and mathematicians have often proved to be exceptional investors because they use numbers to assess what an investment is worth and they are often the best people, using mathematical basis, for finding the difference between what something should be worth and what they are able to purchase it at.
This is also one of the reasons why investing into Funds is almost always inevitably doomed to failure. Most funds invest into underlying assets which are wide spread. So a UK Growth Fund for example may invest into 200 underlying shares, one of the aspects of the system that I am describing is that the search for undervalued investments means that you are often looking for the very small proportion of investment opportunities that exist where the price doesn’t reflect the value. We know from the efficient market hypothesis that nearly all shares and the market as a whole is efficiently priced so it can only be the very rare exceptions where something is missed or an edge can be found. The problem with funds is that by their very nature they have to spread their investment across a wide base and they cannot find an edge in a 100 different scenarios within the market. Or, if they can find such an edge on enough occasions, other funds will inevitably start to follow and this will get rid of the edge.
Alternatively, we don’t know which fund managers have the magic or lucky touch and as such we are doomed to be guessing if we use funds to make our investments.
One final part which we must touch on in this section is the associated problem of how to allocate your money. Just imagine that my summary argument above is fully accepted and you now have a determination to find undervalued opportunities. WHAT DO YOU DO WHEN YOU FIND THEM?
This is not as simple a question to answer as it may at first appear. For so many reasons! One is that it is unlikely you can be certain that your assessment is right, so you have to tread carefully. Another – and this is fundamental – is that even if you are right you will only be right inone respect, and that is that you are betting that your probability is a better bet than the odds. But even if this is the case you are still going to take losses along the way, yes you will eventually win, but it is not a staright line! So how much money do you bet or invest when you uncover your edge? Do you bet the house or do you inch in. To illustrate this further read this little story…..
Imagine a gambling den in the heart of Istanbul where by some small miracle you have found out there is a very peculiar game on offer called Heads and Tails, and you know (but they don’t) that the coin is biased!
This is a game where the dealer in the den spins a coin and you can back ‘heads’ and you can back ‘tails’ and you receive an even money return should your selection come in and lose all of your money should you choose the wrong options. Due to some special monitor we have, we know that the coin that they are tossing has a 60% chance of falling on heads and a 40% chance of failing on tails. This is the same as the even money shot we described earlier - with the horses where we had a 6 in 10 chance of winning.
In your excitement and with £1000 you fly to Istanbul as quickly as possible and enter the gambling den in the sure fire knowledge that you have an edge over the dealer. However, you still have a problem in that you have to manage your money correctly. Let us say that in this fictitious example there are only 50 spins per evening of the coin and you only have one evening in which to use this knowledge before it is revealed. How do you go about allocating your money to maximise the return?
The reason this is important is because if you walked in and put £1000 on heads straight away, knowing that you have a 60% chance of winning, you still have a 40% chance of losing and, consequentally, a very high probability of total wipe out so you would not want to put your £1000 down and have the 40% occurrence because you would have wasted your trip, your money and you would have no further chance of maximising the potential return from the edge that you currently have. You would therefore allocate a figure that is roughly the right sort of level to try and keep yourself in the game and maximise the return. Most people would therefore start low and build it up, but this also, whilst more low risk and certain, might still not produce the goods and certainly is unlikely to maximise your return.
Of course the 40% chance of loss can occur at any time at any given spin of the coin so you need to have some form of method of working out the best way of managing your money. This is basically best done by using the KELLY system which we will touch on elsewhere.
However for the time being please look at all times to trade in terms of odds, not winners and getting an edge over the positions you take and then also think hard about how to allocate your money in order to maximise the edge you get. I believe if you do not follow this basis when investing or follow someone who follows this basis, you should wish for extreme luck or place your money in a nice cash earning or government bond earning account and make sure you enjoy your life to the full.
The above is an extract from Matthew Morris’s forthcoming guide “how to make money from investing”.
