We all love predictability- just the word itself sounds great, doesn’t it? We want out cars to start on a cold winter morning. Travelers want that holiday flight to see the kids to arrive on time. All of us buy particular brands of food, because we know what we’re getting (I stick to Campbell’s Soup, thank you very much).
Investors also love predictability. They want to look at their monthly brokerage statement and see the results that they expect. Consider the pros and cons of predictability.
#1 More precise financial planning
Consider an investor who is getting close to taking money out of an investment. That person may be buying a house, or getting ready for retirement. The investor has accumulated a large sum of money. They want the investment performance to be predictable.
Assume that Bob is 5 years from retirement. In his 20s and 30s, Bob invested heavily in growth stocks. These stocks offered a higher potential for growth- but more volatility and risk of price decline.
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Now, Bob has a large nest egg. He wants less volatility, since he needs to funds to be there in 5 years. Bob decides to move 80% of his portfolio into highly rated corporate bonds. He holds the bonds until they mature. Bob earns a fixed rate of interest and gets his principal back at maturity. It’s not glamorous- but it’s predictable.
#2: Easier to understand
When the price of your stock goes up or down, is the reason for the fluctuation clear to you? If so, then that explanation is also a form of predictability.
Think about a utility company stock. We all use electricity- you’re probably using it right now. Because everyone uses electricity, a utility company can generate predictable sales and earnings. Since the earnings are predictable, utility companies can pay a larger dividend.
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Say that the broad market (S&P 500 index of stocks) declines 10%. Your utility stock only declines 5%. Well, that makes sense- the sales and earnings are more predictable. The same is true on the upside. If the S&P index increases 10%, your utility stock will probably not go up by the same amount. The stock’s performance is predictable.
Now, contrast a utility stock with a company stock in a developing country. Here are three reasons why these stock prices may be less predictable:
- Some developing countries do not firmly enforce the rule of law. Specifically, contracts may not be enforced. This has a huge impact on the ability of companies to do business.
- Accounting rules may not be clear- or not consistently followed. This obviously impacts the ability of an external auditor to perform an audit. Investors need reliable financial statements to make an informed decision about a stock.
- All foreign stocks have the issue or currency fluctuations. As funds are transferred from one type of currency into another, the parent company may incur a gain or loss on the exchange of currency. These gains and losses can have a material impact on the firm’s total profit and loss each year.
All of these factors make the stock price performance of a developing country’s stock less predictable.
#3 Finding your personal balance: risk vs. reward
Now, keep in mind that investors can be rewarded for buying a stock with less price predictability. In other words, you can be rewarded for taking more risk. Consider your investment mix between predictable and unpredictable stocks. This is simply another way to think about risk tolerance.
A great way to measure predictability is a stock’s beta. I’ve discussed beta in this earlier blog post.
Say, for example, that you’re considering 5 different stock mutual funds. You’d like some diversity between large cap and small cap, domestic stocks vs. foreign stocks, etc. Take a look at the beta for each of the stock funds. Write each of them down and average the 5. That will give you some idea of the stock price predictability of your entire portfolio.
Have used any of these tools? I’d love to hear from you. As always, consult with a financial advisor. This blog is for educational purposes only.
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