Guide to recommendations
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Our qualitative recommendations are simple and easy to understand:
- Buy: Suitable for purchase now
- Accumulate: Undervalued but there is time to purchase
- Hold: Appropriately priced, neither buy nor sell
- Reduce: Sell part holding
- Sell: Sell all holdings now
- Avoid: Not investment grade
Fixed interest investments have a capped upside but a massive possible downside. Because of this, we'll often be recommending a sell on investments which are going to do ok. And we know numbers of them are going to do ok. And you too, should be selling investments that you expect are going to do ok. Confused yet?
Let's imagine we have a company, XYZ with a hybrid XYZPA. XYZ is in a bit of trouble. We think there's a 60% chance they'll do ok, but a 40% chance they'll go broke. To make the maths easy, let's assume they'll pay out $100 if they do ok, but $0 if they go broke. You own some XYZPA hybrids. The hybrids are on the market at $70.
What should you do? Six times out of ten, you'd expect to make $100, and four out of ten, you'd expect to loose it. So your expected returns are $60. Given the hybrid is at $70 on market, you should sell. But what's the most likely thing to happen? It's most likely (over 50% chance) that XYZPA will end up being worth $100, which is a $30 return over the market. We'll be recommending a sell, but we know the most likely outcome, with a more than 50% chance, is that you as an investor will be up $30.
How do we resolve this? The problem is that we've removed risk from the equation. Let's imagine you have $700 dollars to invest in ten different hybrids all with a market price of $70. For half, there's an 80% chance they're worth $100 and a 20% chance they're worth $0. For the other half, there's a 60% chance they're worth $100 and a 40% chance they're worth $0. For each individual, it's most likely you'll get $100, but with a lot of risk. But if you invested in all 10 it's most likely that you'll just break even, and we can be much more confident in that statement. If you decide to invest just in the five good hybrids you'd expect four to do well and one to do badly - and be up $100 for your trouble.
So why are we sometimes recommending a sell when the most likely outcome is to make money? Because the risks aren't worth it. An investor who tried this strategy would make money once or twice, maybe even a few times, but like a gambler in a casino the odds are stacked against him and eventually he's guaranteed to loose his money. The only way to make money in the long term is to look at places where the odds are stacked in your favour. And that's what we mean by “buy” - it's a place where we think the odds are stacked in your favor. A “sell” is where we think they are stacked against you. Because the odds are so short with hybrids, you can often still do ok on a “sell”, but we don't think it's worth the risk.