The Investment Odds Don’t Need to be Stacked Against You

Matthew Waterman, Investment Writer, New Age Alpha
Jun 10, 2021 1:02:45 PM 9 min read

Imagine you’re sitting, minding your own business, and your buddy, Louie, shoulders up to you and begins his sentence saying, “What are the odds…?” With such an introduction, his next words will almost certainly detail a plan with little chance of success. Whether it involves a sketchy business venture or his shot at a career in the big leagues, the implication is that the possibilities are not in his favor. Why is that? Why, when people speak about odds, does it always seem to carry a negative connotation? Perhaps it’s because we’ve been trained that way—by casinos, by bookies, by even life itself? When it comes to odds, humans seem to naturally assume the worst and conclude there’s nothing they can do about it. Because the truth is, there’s a better way.

“I will lay odds that, ere this year expire, we bear our civil swords and native fire.”

The use of the term, “odds,” dates back to the 1500s with one of its first, and most famous, usages occurring in Shakespeare’s Henry IV, Part 2: Act 5. Generally regarded at the time as an expression signifying, "unequal things, matters, or conditions," many believe it evolved from the more numerically focused concept for, "things that don't come out even." While the connotation of the word is different now, it’s important to remember this etymology. Because, when investing or gambling, the odds will never be equal. So, it’s up to you to shift them in your favor.

How can one do this? Approach the endeavor differently. When gambling, for example, the outcome is often a bifurcated event—either the ball lands on black or red, and you either win or lose. Investing is a different beast, however. Here, there are chances to impact the odds. For example, diversification forms a key part of risk management for many investors. They believe that spreading one’s investments across similar stocks or industries can avoid a disastrous, unexpected event in any single company. It is important, no doubt. But true risk management doesn’t end there since this approach does nothing to mitigate the risk of human behavior bias. We believe this is where investors have a unique opportunity to alter the odds.

Think of it like the classic European roulette wheel. If a person believes that the ball will land on black—a faulty assumption, for many reasons, as discussed further here—that person can spread their chips across all the 18 black outcomes. They think this crude diversification will help since, in the abstract, it would make their odds 50-50 versus the red slots. However, while the wheel is composed of an equal number of these black and red slots, it also has one outlier in the green slot bearing a zero (“0”). It doesn’t seem like much, but that single slot means the long-term distinction between winning and losing. It’s an edge to ‘The House’ of a mere 2.7%. Only 270 basis points, in financial-speak. Yet that’s enough over the long haul to ensure casinos can continue to light the lights, comp the free drinks and employ hundreds of thousands. Think about that. That crucial 270 bp detail is the foundation of the notion, “’The House always wins.”

But what if we told you there was a way to metaphorically carve out your own 38th slot on the wheel?

“If One is to Engage in Gambling, then One Should BE the Casino.”

Most gamblers and investors would likely kill for the ability to alter the odds in such a way. It would offer the chance to mitigate risk without impacting potential upside—in essence, an utterly new type of diversification. How can investors apply this approach to their portfolio? We believe the best way to mitigate the risk of human behavior is to avoid the losers. In our opinion, most investors think in terms of picking winners—but this means investors are forced to predict the future that, by definition, is unknowable. This is akin to guessing and it plays directly into the hands of oddsmakers such as sports bookies or casinos. They’ve already mastered the art of odds-making; they simply sit back and allow others to take on that risk. By, instead, avoiding the losers, you’re playing the role of the casino or bookie.

New Age Alpha has built a solution suite using probabilities that aims to deliberately avoid the losers. By doing so, we have divorced ourselves from traditional portfolio management ideas and, instead, drawn on the actuarial principles of the insurance industry.

Below, we present the Up and Down Capture Rates as of May 31, 2021 of the U.S. Large-Cap Leading 50 Index and the U.S. Small-Cap Leading 50 Index that are benchmarked against the S&P 500 and the S&P SmallCap 600 Index, respectively, which are generally recognized as primary representatives of the U.S. equities markets. A high Up Capture indicates that the Index beat the benchmark during periods when the market, overall, was notching higher. Conversely, when the market went down, a low Down Capture indicates that the Index avoided many of those companies in the benchmark that went down.

While we believe the Up Capture across each Index and time period is noteworthy, in our opinion, the Down Capture truly stands out. Over the last year buffeted by uniquely unusual events such as the pandemic, market stimulus and the rise of the retail traders, our Indexes weathered the down moments with Down Captures entire quartiles lower than the respective Indices’ value of 100. Unto itself, we believe that’s an impressive accomplishment for our methodologies. But this belies the most important aspect of the offerings: this performance was achieved with very little overlap in the largest names of the respective benchmark. By using our actuarial-based approach to focus solely on known information, our Indexes avoided those stocks most impacted by human behavior bias and utilized the same universe to provide different exposures. In the process, we created a differentiated source of return that can be used to complement any of the major benchmarks.

Table_Morningstar Direct

Gambling and investing are entirely different activities. Any proper investor knows that. But one thing both activities share is their reliance on odds. Seemingly, people refer to ‘odds’ when they’re stacked against them—as in the case of casinos or sports bookies—but they don’t use the term as much in relation to their investment portfolios. Perhaps they should. If all it takes is a new investment option such as these, why wouldn’t they want less correlation with the overall market while potentially producing the same or better performance?

About Us

New Age Alpha is ushering in a new age of asset management by applying an actuarial-based approach to investment portfolios. Utilizing these principles built by the insurance industry, we construct portfolio solutions, indexes, and tools that aim to identify and avoid a mispricing risk caused by investor behavior. Embedding well-established principles of probability theory in our investment methodology, we construct solutions that aim to avoid overpriced stocks in a portfolio—losers. We combine the alpha potential of active management with the advantages of rules-based investing to build differentiated equity, fixed income and ESG-themed portfolios that drive long-term outperformance.

Citations

Disclosures

New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC and New Age Alpha Advisors, LLC (“New Age Alpha Advisors”). Investment advice is offered through New Age Alpha Advisors, LLC a wholly owned subsidiary of New Age Alpha LLC. New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements.

This material should not be construed as an offer to sell or the solicitation of an offer to buy any security. We are not soliciting any action based on this material. It is for general information purposes only. To the extent that it includes references to securities, these references do not constitute a recommendation to buy, sell or hold such security, the information may not be current and it should not be read to suggest that it is an endorsement of New Age Alpha or its products or strategies. There is no intention for New Age Alpha to include these securities in its portfolios unless they become part of the established universe of eligible securities that are part of each specific investment strategy.

Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or strategy made reference to directly or indirectly in this material, will be profitable or equal to corresponding indicated performance levels.

Any charts, graphs or tables used in this document are for illustrative purposes only and should not be construed as providing investment advice. Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated, does not give effect to any fees or costs of trading and should not be considered indicative of the skill of New Age Alpha.

Information contained herein and used in the analysis provided by New Age Alpha has been obtained from sources believed to be reliable, but not guaranteed. It has been prepared solely for informational purposes on an “as is” basis and New Age Alpha does not make any warranty or representation regarding the information. Investors should be aware of the risks associated with data sources and quantitative processes used in our investment management process. Errors may exist in data acquired from third party vendors.

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