Borys Bradel's Blog: Invest in what has the highest expected return.

Invest in what has the highest expected return.

Tags: investingMay 19, 2008

I want to write a few articles about investing. The main purpose of these is to clarify my investing strategy to myself, and hopefully inform other people. The first step is to figure out where to invest. The basic idea is to invest in a way that produces the highest expected return.

There are many competing theories that exist about investing.

One is the natural tendency to keep investing in existing investments; either with the hope that the investment will do really well because that is how it did before, or in the hope that it will do really well to recover any ground that was lost.

Another is all the advice to only look at how well that investment will do relative to another investment in the future. That is, forget about everything that happened in the past and focus on the future.

Yet another is to say that the investment is part of a diversification strategy. The argument goes that the markets are always priced correctly. And even if they're not, a regular investor is not smart enough to know when an investment will go up or down.

There are problems with each theory.

Staying invested by looking at only past performance is not a good idea. There's an old saying: the only constant is change.

Ignoring the past is also a really bad idea. Not only is the past an indicator of the possibilities of events in the future, the locations of investments are based on the past, and the locations influence transaction costs.

Consider $100 of investment A. Furthermore, each buy and sell transaction is 10% of the initial value for any investment. The investment goes down to $50. Imagine that there are two choices. One is to stay in investment A, which is expected to increase by 10% and the other is to go for investment B, which is expected to increase by 20%. If you stay in investment A then the return will be 10%, for a total investment of $55. If investment B is purchased then the selling of investment A will cost $5 and the buying of B will cost $4.50. Then, $40.50 of investment B will go up by 20%, and the total investment is $48.60. Therefore the transaction costs cancel out the benefit. Although usually the transaction cost is not so high, it still has to be considered.

The final argument, about staying diversified, is not fully correct. Although diversification is a sound investing strategy, it cannot be taken out of context. Case in point: Enron. If part of a person's portfolio was in Enron for diversification purposes, that person should have sold and looked for another investment when the company was going down in value. Yes, a person's investments should be diversified. However, when an investment is sinking, that sinking is easy to see and there are almost always better investments that will still allow for diversity.

So what is a good strategy? Invest in what has the highest expected return. Easier said than done. How can this strategy be subdivided? I can see four parts: stay diversified, look towards the past, present, and future, have clear sell targets, and identify expected returns. I will look at these four parts in future blog posts.

Note: this post was written on Mar. 17, 2008.