| As mentioned in "Prisoner's Dilemma" I posted a while | | | | eventually initiate sell orders creating price drops, yet |
| ago, most efficient teamwork requires absolute faith | | | | there is not of anyone recommitting in buying shares of |
| and discipline from every player. Conflict between | | | | the same stock needed for a rally. This observation |
| individual and collective payoff exists in continuous time. | | | | alone puts the downside bets at better odds than |
| On top of all this, majority of people do not act | | | | upside. |
| rationally. It then makes sense that most business type | | | | Behaviorally speaking, even the professional fund |
| games do not operate in the most efficient manner | | | | managers "panic" when it comes to low grade |
| where maximum potential payoff could occur. The | | | | holdings. As soon as they realize how worthless |
| next logical suggestion sets forth that the average | | | | anything has become, they would want to dump as |
| multi-staff business has a higher probability toward | | | | much of it as possible while trying to preserve capital. |
| failure than success. | | | | Of course the potential buyers would demand |
| OK, the question lies in how we can exploit this for | | | | substantial discounts for taking on further risks. This |
| profit. Most simply, downside bets on the stock | | | | phenomenon explains partially why asset values tend |
| markets. Allow me to illustrate why and how it is done. | | | | to decline at higher velocity than growth. Another |
| An economist visited AUT early 2007 and lectured | | | | advantage toward the downside bets. |
| regarding corporate crisis management. He mentioned | | | | Two simple approaches exist to accomplish this for |
| that 1 out of 3 corporations experience a crisis every | | | | individual stocks. |
| 5 years that it will never recover from. Sounds pretty | | | | 1. short-selling positions |
| serious. Enron, WorldCom, AMD, CROX and the New | | | | 2. Put options |
| Zealand finance companies come to mind. | | | | I will not get into details of what they mean. Look them |
| David Birch, former head of a business data mining | | | | up, a sea of information on them exist on the internet. |
| firm, proposed the following Survival Rate of new | | | | Research becomes easy when you look for a |
| businesses.o First year: 85%o Second: 70%o Third: | | | | hopeless business. With the past corporate accounting |
| 62%o Fourth: 55%o Fifth: 50%o Sixth: 47%o Seventh: | | | | shenanigans, we all know companies like to fudge their |
| 44%o Eighth: 41%o Ninth: 38%o Tenth: 35% | | | | financial statements to appear profitable with promise |
| The numbers show that the conventional "90% failure | | | | of further growth. However, they do not have as |
| rate" stands completely unfounded. Despite that, new | | | | much incentive to present misleading negative |
| businesses in general have the odds against them | | | | information as demand for their stocks is needed in |
| after five years of operations. According to this data, 1 | | | | order to finance business operations. |
| in 2 businesses face failure after first 5 years of | | | | With that, if the financial statements look great, it still |
| operation. This also concurs generally with the | | | | remains questionable; yet if the numbers seem awful, |
| "business cycle" theory of economics majors. | | | | they are probably true. I would suggest the following to |
| Keep in mind if the business goes completely under, | | | | precede downside bias for a listed company.o Low |
| your investment on the downside bet would profit | | | | total cash holding vs. Market Capo High P/E ratioo High |
| close to 100%. E.g. in the last couple of bullish years, a | | | | Debt/Equity ratioo Low Short Interest |
| downside bet on the NZ financing companies would | | | | Low cash means the company will not likely able to |
| have taken losses of 10%-15% each year; and as the | | | | afford any repurchase of their own stocks, drying up |
| funds became fudged, the downside bet would have | | | | supply. A high P/E ratio would give institutional traders |
| made well over 50-90%, hence a positive expectancy. | | | | a sentiment of "over-valued", and consider selling to |
| What moves the prices of stocks? The gist of it lies in | | | | take profit. A high debt/equity ratio displays how |
| supply and demand on the exchanges. When volume | | | | financially disconcerting the company has become. |
| in initiated buy orders overwhelms sell orders, price | | | | Lastly, the earlier you get in on the short action, the |
| moves up, and vice versa. Rational long term investors | | | | more you will likely make in profit. You do not want to |
| or short term traders may put in large buy orders | | | | come "late to the party". |
| making price climb, but sooner or later they will want to | | | | Of course a wealth of additional information could |
| take profit, or cut losses. All the while, there is | | | | provide a trader with higher winning rate. The above |
| absolutely no guarantee whether the seller would | | | | would give anyone a definite edge compared to some |
| repurchase the stocks. | | | | newbie "investor" who buys and holds hoping for some |
| In other words, there is certainty that stock holders will | | | | Warren Buffet pipedream. |