The four methods listed above are not exhaustive by any measure as investors can be very creative when choosing ways to make their buy or sell decisions. Of these four methods, however, only 2 can be consistently applied using numbers and analysis: (1) studying the past, or (2) analysing and forecasting the future. Here, CashBench will focus on looking into the past.
Why looking into the past is useful:
Any investor will know that the past does not guarantee the future. This is perfectly true, but looking into the past performance of stocks or any other assets is still needed and very useful overall. Why? Simply because the past gives us a foundation to base our investing decisions. Of course, the past is not sufficient to make the final call. The best approach is to make use of this foundation and then develop a forecast of the future and from there, make a final decision. If you feel that forecasting is too difficult, you need to minimally look into the past for clues on what stocks to buy and what to avoid.
In fact, all banks and asset management companies know the usefulness of historical performance, and readily provides this information for the range of unit trusts they sell. However, it is much less likely for full historical information on stocks to be provided. The typical stock brokerage firm will provide investors with charting tools that plot the performance of stocks on a 1-year horizon. This is rarely sufficient for an investor who wants to properly analyse the past performance of a stock. Given a choice, what are the 3 indicators we should look out for when studying historical information of stocks?
(a) Stock Return Performance:
“… 50% profit for a stock sounds very good, but if the profit was earned over a 10-year period, the simple annualized return is only 5% per year…”
Stock Performance is a very obvious indicator we need to know. However, historical performance can be reported in many different ways. The discerning investor will not only look at short-term performance over a week or a month, but also look at how the stock has performed over a 1-year, 3-year, 5-year or even 10-year period. Doing so will give you a very good idea if there’s any point in holding onto the stock. Another key performance measure CashBench readers must know is annualised return. This is the annual profit that an investor has enjoyed over a given period. For example, a 50% profit for a stock sounds very good. but if the profit was earned over a 10-year period, the simple annualized return is only 5% per year, which doesn’t sounds impressive anymore!
(b) Volatility of Return:
“A stock that is very volatile is also very risky. Only investors who can take the risk involved should buy these stocks.”
Volatility is another important indicator for stocks. However, it is not as well understood as stock performance. Put simply, historical volatility tells us how stable is the price of a stock.
For example, if a stock’s price stayed close to $5.50 for the entire year, it has low volatility. An investor who buys this stock is typically more certain of the price he has to pay today, tomorrow or even next month. However, the stock may not offer much potential for gains over a short period.
On the other hand, another stock may be much more volatile with a lot of price uncertainty. Its price may be $2 this week, but shoot up to $4.50 next week and then drop to $1 two weeks later. The investor will be much less certain how much profit or loss he can get from buying this stock. This stock is therefore risky to buy, and the investor may get a large profit or large loss over a short period.
As a general rule-of-thumb, a stock that is very volatile is also very risky. Only investors who can take the risk involved should buy these stocks.
(c) Risk-adjusted Returns:
This is yet another measure of stock performance, but takes into account the risk faced by an investor when measuring the performance of the stock he bought. The most common risk-adjusted measure is the Sharpe ratio. CashBench readers who have bought unit trusts will likely be familiar with this ratio. Besides stock performance, the Sharpe ratio considers 2 other factors.
“... aim to buy stocks that can out-perform risk-free returns. If not, why bother to take the risk with stocks!”
The first factor is the Risk-Free Return that we can get from guaranteed investments such as cash left in our savings and CPF accounts, or money invested in SGS Bonds. We are 100% certain that we will get our monthly or half-yearly interest from these investments, hence the gains we receive are risk-free. We must therefore aim to buy stocks that can out-perform risk-free returns. If not, why bother to take the risk with stocks!
Risk-Free Return is however subjective, and depends on where we get our spare cash to invest. If we use the rate for a Singapore savings account to represent risk-free return, it’ll typically be about 0.25% per year. If we use the rate for CPF ordinary accounts, it’ll be much higher at 2.5%.
The second factor in the Sharpe ratio is the volatility of a stock as explained earlier. Together, the Sharpe ratio can be presented using the following formula:
| [ Stock Performance – Risk Free Return ] / Volatility |
For most unit trust investors, they never need to calculate the Sharpe ratio themselves as it’s usually pre-calculated and presented in a unit trust fact-sheet. Stock investors are less fortunate, as the Sharpe ratio for stocks is less often provided.
“Stocks that have high volatility will get low Sharpe ratios even if they have very good past performance.”
A stock with the highest Sharpe ratio is usually the best choice for investment. It tells us that based on historical performance, this stock has out-performed the risk-free return that we can get elsewhere. Also, the return from this stock is the highest among all stocks being compared after taking into account the volatility of its price. Stocks that have high volatility will get low Sharpe ratios even if they have very good past performance. However, do note that negative Sharpe ratios are meaningless and should not be used as the basis for an investment decision.
CashBench does the hard work:
Now, you must be asking a very important question. Since pre-analyzed historical information of stocks is not that readily available, why bother knowing all these useless details? Here’s where CashBench makes a big difference. :) CashBench will be following up this post with the results of a detailed analysis on the blue chips in Singapore and around Asia. The indicators we have just discussed will be used to uncover stocks with good potential. Understand these indicators as discussed and then sit-back, relax, and look out for the next update from CashBench.
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