Opinion – From Grain to Grain: Before investing, everyone should understand this concept

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Have you ever been in a situation where you made a projection that actually happened, but your investment didn’t deliver the expected result?

For example:

– You bet the economy would grow, it did, but your investment in stocks didn’t appreciate?

– Did you predict that a company’s sales would go up, they went up as you believed, but the company’s stock went down?

– Did you predict that the Selic would rise, went long on interest rates in the derivatives market, but the contracts fell instead of rising?

There is a saying in the market that goes:

“Buy at the drumbeat and sell at the sound of the trumpets.”

This saying expresses a concept organized by the Nobel Prize Eugene Fama in 1970. Fama was the researcher recognized for formulating what is called the Efficient Market Hypothesis (HME).

Basically, HME says that, in an efficient market, asset prices reflect available information.

That is, if it is fully known, there would be no more risk-adjusted profit to be captured.

Here’s the term I used: risk-adjusted earnings.

There are many critics of this theory and I am not here to argue that it is 100% valid. However, it is possible to argue that there is at least a reasonable degree of efficiency in the markets.

Thus, asset prices already reflect, at least in part, existing information.

Just because the market is efficient doesn’t mean you can’t make money. But, possibly, you would not be being rewarded for the risk you take.

This means that if you used public information to make your forecast before investing, it would possibly already be partially priced.

So, depending on the odds already considered by the market, your bet would have little risk-adjusted profit to capture.

My work in the investment area therefore involves four steps:

1 – Identify what the market believes can happen and that, consequently, would already be priced;

2 – Estimate the potential probability asymmetry between what we expect and what the market already expects;

3 – Assess whether this potential outweighs the risk of being wrong;

4 – Suggest these investment alternatives, considering the risk profile of each client.

If you want to improve your chances of investment success, you should apply these four steps to all your investments.

Michael Viriato is an investment advisor and founding partner of Investor’s House

If you have questions or suggestions for topics that you would like to see commented on here, please feel free to send them by email.

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