Investing is basically not that difficult. You pick stocks you like and buy more if they get cheaper. Hang on for the ride and use common sense. I have written several articles about what not to do. But here is one trick that can help you pick winning stocks: use probability theory.
What? I am not a math whiz, you say. I can’t add two numbers together, much less use probability analysis, your mind says to me now. It’s hard enough to figure out what stocks to invest in. Don’t give me more work.
I understand. But let’s get real here. You use probability theory every day. You estimate whether it’s going to rain before you take an umbrella out. Input: news from the TV on the weather, or turn to weather.com (as long as you are not in Texas these days). Output: estimate the probability you will need an umbrella. Actually, just to be safe, you take one anyway. In other words, if the probability was greater than 50% in your mind, you take the umbrella.
The same thing occurs when you invest in a stock. You may like a name like Tesla or Facebook. But now you have to decide how much to buy. That involves your own private probability of how fast and how far they will rise.
Of course, you implicitly allow for a drop. Adding these estimates in your mind, your gut tells you how much to invest. That is using probability.
Here is how I make the probability process a little more cut and dry in my investing process.
The trick is to watch a stock long enough to believe that the probabilities it will rise are greater than the probabilities it will fall further.
There is no right answer. There is no grade. There is no site to check your estimates against. There is only your own estimate. And you may have to revise your probability estimate. The result is you derive an expected return.
I can start to give you some examples now. Two months ago, on Jan. 6, I wrote an article about Naked Brand Group (NAKD) stock. This was a downtrodden Australian and New Zealand-based intimate apparel group. It also has the US online license for Fredericks of Hollywood intimate and sportswear apparel. NAKD stock was down to 31 cents per share. They had to get the stock over $1.00 in order not to use their NASDAQ listing.
I estimated that there was at least a 40% chance that the company would fix its problems and the stock would rise 300%. That gives it an expected return of 120% (i.e., 40% times 300% is equal to 120%).
In the article I estimated, using my gut (i.e., probability estimate) that there was no greater than a 30% chance the stock would fall to zero. This gives us an expected return of negative 30% (i.e., 30% times a loss of 100% of my investment).
This leaves us 30% to decide what will happen (i.e., 40% upside scenario, plus 30% downside scenario is only 70% out of 100% of the time). I figured there was a 30% probability that NAKD stock would stay flat. That is, the expected return is 0% (i.e., 30% times a 0% return is still 0%).
Now we can add up all three possibilities: 120% expected return (ER) in the first upside scenario, -30% ER in the downside case, and 0% in the flat case. Therefore, the result is a total expected return of +90% (I made a mistake in the article and said it was +20%).
The stock skyrocketed to as high as $1.65 per share from 31 cents. I didn’t know that would happen. But I put my math to work. I bought 2,000 shares. By the time I could buy the stock was at 46.34 cents per share. So the investment cost me $926.80.
Within two weeks the stock started to pop. I started selling. I missed out on the $1.65 peak, but I still made a 69% return in less than two weeks.
I bought shares with my probability estimate and hung on. Unfortunately, I got out too early. But my probability process worked. That is what matters. I waited for the stock to hit an extreme. It also had other characteristics that made my probability estimates in my calculation worth it.
Recently I found another stock where the probability estimate is greater than 50% that the stock will double and possibly triple. I am averaging into it, as I understand why the stock is temporarily cheap. I can’t tell you about it.
But so far this year my account is over 66% and in the past year, it is up 150% using this method of investing.
As I have written in several other articles, I never buy more than five or six stocks at a time using this method. This allows me to concentrate my investment in a particular stock once I believe there is a much greater expected return on the upside than the downside.
Here is another example. Several weeks ago I wrote that Marathon Patent (MARA), a Bitcoin sum-of-the-parts play, was severely undervalued and could easily double. The stock was at $22.74 and I said it was worth over $40.00 per share.
I loaded up on the stock. My probability estimate said that the expected return was at least 50%, if not double. Today, the MARA stock is at $37.11, down from the low-$40’s.
Today I just wrote about a vaccine stock called Ocugen (OCGN). My probability theory / expected return analysis estimates that one can make at least a 24% ROI. This is not as great an expected return as I normally like to use. However, you will see that I originally estimated a 58% return, but using probability analysis, the return was lowered to 24%. It is still a positive expected return.
You can see that the idea is to force yourself to put down on paper what probability you expect for your possible best-case outcome. Then add in the ER of the worst-case scenario. That gives you the expected return. If that ER is greater than what you normally require, then make the bet.