Newsletter
September 15, 2007
Willpower: How Do You Look At It?
The Lakonishok Approach
Largest Changes In Raw Numbers (21 Days)
Willpower: How Do You Look At It?
One of the biggest challenges traders face, is sticking with their trading plans. Rather than show self-control, many traders abandon trading plans prematurely. One set of factors concerns beliefs and attitudes about willpower.
Do you believe that a person's ability to show self-control is limited, or do you believe it's possible to increase your ability to show greater self-control when necessary? A study by researchers Anirban Mukhopadhyay and Gita Johar (2005) illustrates that belief about willpower influence people's ability to follow through on their plans.
Study participants were classified as believing that willpower was either malleable or limited. Participants made plans for achieving a specific goal, and researchers followed them over time to see if they actually stuck with their plans and achieved their goals. Results of the study suggested that people's beliefs about willpower predicted whether or not they stuck with their plans. People who believed that willpower was changeable and unlimited tended to stick with their plans and achieve their goals. People who believed that willpower was something that you were born with, limited and unchangeable tended to give up on their plans.
An interesting aspect of this study concerned people's beliefs in their abilities. People who believed that they had a high level of ability, in that they thought they could easily achieve their goals, tended to stick with their plans until they gained success, regardless of whether they believed that willpower was malleable or fixed. This finding suggests that it doesn't matter what you believe regarding your willpower if the goal you're striving for is relatively easy to achieve.
These findings have a direct bearing your ability to stick with your trading plan. If you believe that your ability to exhibit self-control is limited, and question your general trading ability, you will abandon your trading plans. If you believe your ability to exhibit willpower is endless you will stick with your plans, even though you may question your trading ability. You can take from this study that it is extremely important for you to monitor your belief about your willpower. It will greatly affect your ability to maintain self control, stay disciplined, and follow your plan.
Although it may be difficult to maintain discipline, it may be easier than you think it is. If you can change your beliefs about your ability to stay disciplined, you'll increase your odds of sticking with your trading plan. Don't underestimate your ability to stay disciplined. You can stay disciplined if you try.
The Lakonishok Approach
Professor-turned money manager, Josef Lakonishok, is one of the principals at Chicago-based LSV Asset Management, which manages over $6 billion in assets for both institutional and individual accounts. Other firm principals include: fellow academicians Andrei Schleifer of the University of Chicago and Robert Vishny of Harvard University. The firm's philosophy is to buy out-of-favor companies that are beginning to show signs of awakening.
Perhaps the classic study (value vs. growth) appeared in the prestigious academic Journal of Finance more than a decade ago. "Contrarian Investment, Extrapolation, and Risk," by Josef Lakonishok, Andrei Shleifer, and Robert Vishny of the University of Illinois at Urbana Champaign, Harvard, and the University of Chicago, respectively.
It turns out that often investors big mistake is not in believing that certain companies will grow faster than others. The professors found that, on average, companies with the highest price-to-earnings ratios exhibit faster future growth in earnings, sales and cash flow than companies with the lowest PE ratios - at least over one to two years into the future. Where the market fails, according to the professors, is in its expectations of how fast or slow these companies will grow. Rarely do high-PE companies grow fast enough to justify their high prices, and rarely do low-PE companies grow slow enough to justify their low prices. These results help us to reframe the age-old debate between growth and value investing; growth stocks are priced for near perfection, while value stocks are priced for near extinction.
To make money when investing in growth stocks, therefore, the news has to turn out even better than the good news that is already reflected in those stocks' prices. To make money when investing in value stocks, in contrast, the news just has to turn out to be less awful than is already reflected in prices. When put this way, it is easier to understand why, historically, value stocks have produced better average returns than growth stocks over longer time frames.
To be sure, it feels a lot better betting on a winner than a loser. When investing in value stocks you often find yourself purchasing stocks of companies for which the recent news has been terrible. It takes the courage of one's convictions to do that. Lakonishok believes that patience is the most important tool of value investing. You have to be prepared to go against the flow. If you are looking for that "quick hit," then value investing is not for you. Furthermore, before you invest in any "value" company, it is important to research the company to gain insight into why the market is discounting it.
Value outperforms growth, according to Lakonishok, because investors don't expect much from it. When a value stock does better than expected, investors are pleasantly surprised and more apt to reward the company by bidding up the stock.
To locate potential value firms, Lakonishok uses the most common measures of value-price-to-book ratio, price-to-cash-flow ratio, price-earnings ratio, and the price-to-sales ratio.
A company's sales and earnings are useful measures of performance, but in order for a company to survive, it must have the cash to finance its activities. Companies that generate sufficient cash can expand during periods of economic expansion as well as cover expenses when sales decline during slowdowns.
The higher the price-earnings ratio, in theory, the more confidence people have in the future prospects of the company and, therefore, the greater the price they are willing to pay for today's earnings. Likewise, a low price-earnings ratio signals higher uncertainty concerning future earnings, or a lower expected growth in earnings.
The price-earnings ratio is ineffective at gauging the quality of companies with erratic earnings, or no earnings at all. For this reason, the price-to-sales ratio is often used in its place. It measures how much a shareholder is willing to pay for $1 of a company's revenues. The price-to-sales ratio is also helpful when looking for value companies that do not have price-to-book or price-to-cash flow values because of negative book value or cash flow.
Lakonishok views the main risk in value investing as being the case where the market's recognition of value never materializes. For this reason, he looks for value companies that are beginning to show some sign of movement, either in terms of price movement or in terms of improving analyst estimates.
Sources:
LSV Asset Management
Pension Finance
Value Review, LSV
Journal of Finance
Largest Changes In Raw Numbers (21 Days)
NOTE: The presentation of this report has now been changed to an excel spreadsheet format containing all Industry Groups, ETF's, and Indexes, allowing you to sort all from best to worst. In addition each weeks report will appear next to the last weeks report and so on, allowing I believe much easier research on your part.
[ Reserved for supporting members, in members area ]
Have A Great Week!
Bill
Prudent Trader.com
Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.
|
|
