Author: Ron Dembo
Let’s say you are trying to decide between purchasing stock in Tesla and General Motors. Both of those stocks have an uncertain future. But not the same uncertain future.
The risk factors affecting the profits for Tesla over the next year – like competition in the electric vehicle market, Elon Musk’s leadership, and the cost and efficiency of electric batteries – are wildly different from a more traditional automobile company such as General Motors. GM might be more dependent on fluctuations in fossil fuel prices and taxation or depend heavily on their ability to fund research and development into electric vehicles.
Which is the better pick? Is Tesla stock a better investment than General Motors?
It’s Wrong to Say One Stock Is ‘Better’ Than Another
Asking this question is like asking whether there is going to be rain tomorrow. As we saw in our previous blog [LINK to What Is Uncertainty], saying either ‘yes’ or ‘no’, ‘Tesla’ or ‘General Motors’, is a very deterministic way to look at a problem which is clearly full of uncertainties (stochastic elements).
In a world of radical uncertainty, we need to think differently about how we might compare two companies, or portfolios, or one stock against another. We need some new metrics, new ways of benchmarking and conducting strategy.
As risk thinkers, we could survey a large quantity of experts in the automotive industry to create a frequency distribution on the expected profits or losses of each company. We could present these in a graph to gain a clearer picture.
Here we have laid our two options over the top of one another (GM in transparent blue, Tesla in full colour). On the bottom axis, we have a set of possible scenarios from a 1% loss to a 10% loss and a 0% gain to a 14% gain. The bars are the number of times each scenario was picked by the experts. Sometimes we also weight the forecasts of experts by how accurate they might have been in the past.
Near the middle of the graph is a vertical line that splits the red from the green. This line is very important. It is what divides our upside (on the right-hand side) from our downside (on the left-hand side). In this case, the line is the current price of the stock, with the horizontal axis being the deviation from today’s price.
Compare the Upside Versus the Downside Risk Instead
When you look at the two options here, it’s impossible to say definitively which stock is the better option. Under some scenarios one dominates the other and vice versa. Sometimes Tesla has more instances of gains than GM, in other cases the reverse is true. Adding all the bars below zero gives the downside. Adding all the bars above zero gives the upside. So, one way to compare the stocks is to ask, does Tesla have more upside than GM?
Another way of comparing the two stocks is to look at the Upside divided by the Downside. This ratio is known as the risk-adjusted value of the Upside (RAV). If RAV > 1 then the Upside is greater than the Downside on a risk-adjusted basis. Another way of saying this is that there is more likelihood of Upside than Downside. This is a great way to obtain a single figure that expresses the uncertainty of a stock, and we think it is far more helpful than a forecast of the exact value of the stock at a set future date.
As we can see, it is simplistic and misleading to say that one particular stock is better than another. That falsely imposes a deterministic mindset onto a fundamentally stochastic problem. The real picture is much more nuanced. And that is the true nature of a stochastic, or radically uncertain world. What risk thinking can help us do is illuminate that more nuanced field of view by codifying uncertainty in a way that allows us to strategize effectively.