brittlerock had some additional questions besides how to predict CAGR.
BTW - How do you predict CAGR? And about that risk assumption, what’s the fool proof (or Fool proof, if you prefer) way of making that assessment? And you admonish, all else being equal (Ceteris Paribus), this too seems to elude me more often than not.
Let’s start with risk. That’s an elusive term that we all think we understand but few can define in terms of a portfolio. Frank Knight distinguishes two terms that are often commingled, “Uncertainty” and “Risk” proper, stating that Uncertainty cannot be measured while Risk can.
One way to handle uncertainty is with horse sense but it is not the only way. In my prior post I said that I have been studying “the systemic nature of markets.” Short term price moves are essentially random but not entirely. According to Benoit Mandelbrot prices are fractal which is the reason why candlesticks work the same on charts of various frequencies, daily, weekly, hourly. Various techniques have been developed to take advantage of charting information. Most, it seems to me, try to predict price moves which works until it doesn’t. I do it the other way around, just react to prices: if it goes up, take profits and if it goes down, buy more but only with stocks that you want to hold long term and only with part of the position.
On to Risk proper. As far as I know, the only method used to put a number on risk is to equate volatility and risk. Since I don’t believe that volatility is synonymous with risk I have no way of measuring it. Therefore I can’t apply risk to my investing. What I do instead is to study the company’s business strategy and based on experience determine if it makes sense or not. If yes, then do a certain amount of fundamental analysis. If that passes the smell test then try to see where the stock price is in relation to history. If there is enough of a discount, then it’s a buy but only a fraction of a full position. The rest will be added as price swings permit.
Frank Knight makes interesting reading. I was only interested in the definition of “Risk” which you’ll find in the linked excerpt. While Knight talks about Risk and Uncertainty in terms of profit, it works equally well in terms of portfolios:
Risk, Uncertainty, and Profit
[excerpt]
I.I.25
Our preliminary examination of the problem of profit will show, however, that the difficulties in this field have arisen from a confusion of ideas which goes deep down into the foundations of our thinking. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein. It is around this idea, therefore, that our main argument will finally center. A satisfactory explanation of profit will bring into relief the nature of the distinction between the perfect competition of theory and the remote approach which is made to it by the actual competition of, say, twentieth-century United States; and the answer to this twofold problem is to be found in a thorough examination and criticism of the concept of Uncertainty, and its bearings upon economic processes.
I.I.26
But Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. The nature of this confusion will be dealt with at length in chapter VII, but the essence of it may be stated in a few words at this point. The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. There are other ambiguities in the term “risk” as well, which will be pointed out; but this is the most important. It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term “uncertainty” to cases of the non-quantitive type. It is this “true” uncertainty, and not risk, as has been argued, which forms the basis of a valid theory of profit and accounts for the divergence between actual and theoretical competition. [emphasis added]
http://www.econlib.org/library/Knight/knRUP.html
On to all else being equal which brittlerock claims “seems to elude me more often than not.” Seldom in life do we find identical situations. In boxing and in horse and yacht racing we have found ways to try to equalize the participants to create an even playing field. But, of course, all we ever get is an approximation.
What I mean by “all else being equal” in terms of CAGR is to compare the various positions taking into account the nature of the stocks. Compare fast growers vs. fast growers, stalwarts vs. stalwarts, increasing returns vs. increasing returns which have different natural rates of growth.
brittlerock ends his questions with a snide remark: "In fact, I’ll apply them before I buy anything, and once I arrive at the company which best displays these characteristics, I’ll load up on it to the exclusion of all others which by definition will perform less well." which means he is not following along.
As I said before, “Thanks for asking!” Portfolios have to be balanced between efficiency and sturdiness. Owning the single best asset is clearly the most efficient but it makes for a fragile portfolio, hence diversification. I hope that answers brittlerock’s question of why one has more than one stock even if they are not the absolute best. It’s exactly the same reason why one buys insurance.
Denny Schlesinger
I’ll try to get around to fast growers.