Excerpts from the Book
Buy, Sell, or Hold?
We now turn to the third and final step in the expectations investing process: the buy, sell, or hold decision. In this chapter, we show how to translate expectations opportunities into investment decisions. We do this by converting anticipated expectations revisions into an expected value for a stock. We then compare expected value with the current stock price in order to find expectations mismatches—buying or selling opportunities. Finally, we provide specific guidelines for when to buy, sell, or hold stocks.
You have identified the turbo trigger and formulated expectations that differ from the consensus. But that is not enough to make a confident buy or sell decision. No analysis is complete without accounting for risk. You must acknowledge that the future direction of market expectations is highly uncertain. Fortunately, you can structure this uncertainty to gain a better idea of the relative attractiveness of a stock with expected value analysis.
Expected value analysis is extraordinarily useful for evaluating uncertain outcomes. Expected value is the weighted average value for a distribution of possible outcomes. You can calculate it by multiplying the payoff for a given outcome, in this case stock price or shareholder value, by the probability that the outcome materializes. You then sum up the results to obtain expected value. Think of it as a single number that captures the value of a set of possible outcomes.
Questions Addressed in Chapter 7
To use expected value analysis to find expectations mismatches, Chapter 7 answers the following questions:
- How do we determine the payoffs and probabilities used in an expected value analysis?
- How do we accurately assess the probability of a future scenario coming to be?
- How does value variability affect the attractiveness of a stock?
- How can we achieve superior returns when the market consensus is the likeliest scenario?
- How do we apply this theory to a practical case study?
- How do use expected value analysis to decide whether to buy, sell, or hold a stock?
- How do taxes affect this decision?
Essential Ideas in Chapter 7
- Whenever the expected value is greater than the stock price, you have an opportunity to earn an excess return.
- The magnitude of the excess return depends on how much of a discount a stock trades relative to its expected value and how long the market takes to revise its expectations. The greater the stock price discount and the sooner the market revises its expectations, the greater the return.
- As an investor, you have three potential reasons to sell: a stock reaches its expected value, a more attractive stock exists, or your expectations have changed.
- Before you decide to sell a stock, consider the important role of taxes and transaction costs.
- Beware of behavioral traps before you sell.
Please contact the authors via e-mail if you have found a potential erratum in the book.
List of Errata in this Chapter
- The text on page 106 reads "You calculate it by multiplying the payoff for a given outcome, in *- case stock price or shareholder value . . . ." It should read "You calculate it by multiplying the payoff for a given outcome, in this case stock price or shareholder value . . . ."