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« EMPIRICAL EVIDENCE: YOU MUST USE PROBABILITY-WEIGHTED RETURN TO SIZE POSITIONS | Main | "Think Twice" - Mauboussin's New Book »

January 6, 2010

To Price Target or Not to Price Target…that is the question

The other day, I was doing what I spend much of my days doing – talking to a portfolio manager about Alpha Theory. He told me that Alpha Theory makes terrific sense for firms that calculate price targets, but that he didn’t believe in price targets. When I asked him why, he responded that there is a lot of instinct that price targets do not capture and it is his instinct that makes him successful. I explained that instinct and price targets are not mutually exclusive because price targets are estimates. Instead of estimating whether to buy or sell (pure instinct), you’re estimating reward and risk (price targets). To drive the point home, I asked him, “What are the 5 best ideas in your portfolio? Are they your 5 biggest positions?” He did not know. Is there any more proof needed?

Using price targets is not about being precise; it is about being directionally accurate. Price targets define why you are making the decisions you are making and do not require that you strip away the instinct that may be a primary component of your abilities. In fact, it is quite the opposite.  Because price targets are part science and part art, instinct plays a critical and indispensable role. This is especially true if you use probability weighted price targets because the art-to-science ratio is even higher. If you are already good at estimating price targets and probabilities, you will create a far superior portfolio if you discipline yourself to write them down. If you are not good at estimating price targets, well … you probably would not be successful anyway.

The only way to justifiably choose against the use of price targets is to take the position that instinctual decision making is not detrimentally affected by cognitive biases.  Before taking this position and relying solely on your instinct, however, it is an enlightening exercise to review a list of Cognitive Biases and consider whether any of them affect your decision making. Believers in the instinct assume (implicitly or explicitly) that instinct reflects logic. This assumption is compellingly supported by the studies of people like Gerd Gigerenzer, Daniel Goldstein, and Malcolm Gladwell.  Unfortunately, however, these studies become much less compelling when they are applied to investing. In this area, there is much more support for non-instinct based decision making. Behavioral Finance and Neuroeconomics research shows how logic-based decision process is critical in achieving successful long-term results (see the work of, for example, Amos Tversky, Daniel Kahneman, Michael Mauboussin, Ron Howard, Jason Zweig, James Montier, and Matthew Lieberman).

To illustrate why price targets are critical, ask yourself this simple question, “Why did you buy this stock?” Your answer is probably some version of “I believe I can sell it for a higher price down the road.” If your decision is only about that one stock, that’s a great answer and you can responsibly stop the analysis right there. If, however, you have many stocks to choose from and you have capital that must be efficiently allocated between too much risk and too little return, then you have to consider each asset’s impact on the overall portfolio. To responsibly measure this impact, you must quantify the potential reward and its probability as well as the risk you are taking on and its probability, the combination of which is a probability weighted return. Instinct can, and perhaps, should be a primary component of these estimates, but it cannot responsibly stand alone.  Repeatable success requires disciplined price targets that explain the fitness of a decision within your portfolio.

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