Growing up I earned money sweeping floors at my dad’s manufacturing plant. One day I was wandering around the plant fascinated by the huge milling machines. As I stood by one, I grabbed an odd-looking tool and, imagining I was blasting off in a spaceship, touched it against a control panel. The blinding flash, loud pop and immediate darkening of the entire shop brought my dad running from his office in a panic. His relief at finding me alive spared me any punishment, but he taught a lesson I have not forgotten. He said, “Remember that children love to play with tools that they do not yet know how to use.”
Investing has many tools that people commonly use without really understanding how they work. One of these is in the area of statistics. Stats guide so many of our daily decisions. If Siri forecasts a 50% chance of rain we might cancel a planned outdoor activity. In doing so we may not realize that a 50% chance of rain only means that half of the area covered by the report will likely see some measurable precipitation. It also only needs to rain for a couple of minutes to make the report accurate. Understanding what the statistic means to our unique situation would make it more useful.
Stats that list percent changes in corporate production or earnings can be misleading. Imagine that an airline reported a 300% increase in revenue. That’s pretty impressive unless you discover that the statistical starting point was May of 2020 when airline travel was essentially closed down.
A commonly used but challenging statistic is the price to earnings ratio, or P.E. that investors use to value a stock. The math is simple. If a company earns $1 dollar a year and its stock is selling for $20 a share, the P.E. ratio would be 20-1. The higher the ratio, the more expensive the stock is compared to its earnings. Taken by itself an investor might think the best priced stocks are the ones with the lowest P.E. ratios, yet some of the best performing stocks have had extremely high P.E. ratios. A rapidly growing company with great potential may presently have very low earnings. Great companies that just suffered a bad year (like 2020) might also have very low earnings, skewing the ratio, and there are many in this category right now.
Standard deviation is also a valuable statistic to investors, though often little understood. It relates to volatility more than an actual rate of return. This number is critical because it measures the emotional stress an investment is likely to impose on its owner. We jokingly call it the peaceful nights’ sleep number.
Rates of return, inflation, beta, alpha and r-squared along with many other statistical reports can be valuable if understood and used correctly, but they can also be harmful if misused. The key is the lesson my dad taught me. Never use a tool you are unfamiliar with. You don’t want to see sparks flying in your investment portfolio.