Sunday, February 15, 2009

Trading Principles - 3

In my previous post (Trading Principles - 2), we discussed two concepts:
(1.) Chance of winning
(2.) Risk:Reward

OK, lets move ahead.

Sometime last year, a friend asked me what I thought about the market direction. I replied that I thought markets would go up in the near term. So he further asked me whether I had bought in anticipation of this move (being long, in trader terminology). I replied in the negative saying that I was actually short on the markets.

My friend appeared puzzled, perhaps he thought I was being a 'wise guy'. In reality, I was being totally honest. But what explained the discrepancy between my views and my action?

Lets say you toss a fair coin. If you get a heads, you get paid Rs. 2. If you get a tails, you lose Re 1. Would you play this game of chance?

For a fair coin, there is a 50% chance of getting either heads or tails.
So if play this coin toss game 100 times, you can expect 50 heads and 50 tails.
For each head, you win Rs. 2. So for 50 heads you will win Rs. 100
For each tail, you lose Re. 1. So for 50 tails, you will lose Rs. 50.
After 100 tosses of this fair coin, you will win Rs 100 and lose Rs 50 for a net gain of Rs 50.
So if you play this game 100 times, you can expect to win Rs. 50.
Hence, the EXPECTED VALUE of the gain from a single toss of the coin is Rs 50 divided by 100 = Rs. 0.5.

You can expect to win 50 paisa for every toss of the coin. This is called the EXPECTED VALUE (E) per toss of the coin toss game. Surely, you would like to play this game, as many times as possible. The more you play, the more money you can make.

Likewise, each investment/trade has an expected value. If the expected value is positive, a profit is expected on the trade and it is worth taking. If the expected value is negative, a loss is expected on the trade and the trade is not worth taking.

Let us take a couple of examples.

Trade A has a 70% chance of winning and a 30% chance of losing. The win per trade is Rs 100 but the loss per trade is 400.
The expected value (E) for this trade is (0.7)*(100)+(0.3)*(-400) = -50
Trade A has a negative E value. i.e. this trade is expected to lose you money even though it has a 70% chance of success. Thus a high chance of success does not equate with making money.

Conversely turn the above trade on its head. Take trade B that has a 30% chance of winning Rs 400 and a 70% chance of losing Rs 100.
E for this trade is +50.
So even with a low chance of winning, the trade makes you money.

Perhaps now it might make sense why I was short on the markets in spite of thinking that the markets would go up. I was expecting that if the markets went up, they would not go up much. But they went down, they would go down a lot. The Expected Value favoured a short position.

It does not matter much, if over the long run, you are more wrong than right (% success rate) or vice versa. What matters is how much you make when you are right and how much you lose when you are wrong (a high average profit:average loss ratio).

So how do we use this to make real life decisions? Suppose you have a one year time horizon. At the end of 1 year, you expect the Sensex to have a 50% chance of going up by 30%. But there is a 50% chance of it going down by 20% as well. Should you buy?

The expected value from this trade is 0.5*30%-0.5*20% = 5%

This is positive. So should you buy since E has a positive value?

Do not forget the opportunity cost. You could put your money into a bank fixed deposit and get an assured 8% (assuming the bank does not default). So in actual terms, the opportunity cost for making the Sensex trade is higher than the expected benefit from this trade.

An investment must then must not only have a positive expected value but it must be higher than the best opportunity cost. Clearly, it does not make economic sense to buy into the Sensex with these kind of statistics.

What if your time horizon is 5 years?

Say, over 5 years, there is a 90% chance of the Sensex doubling in value. But there is a 10% chance of the Sensex going nowhere. The E for this trade is 90. The opportunity cost @8% per annum is 47. So over a longer duration, the trade makes sense.

(Hence the importance of a personal time horizon for any investment.)

So what lessons can we derive from the above discussion?
(1). More important than % success rate is the reward:risk relationship. It is easier to find investments and trades that have a low success rate than one that has a high success rate, provided you obey point no. 2 below, which is
(2). Let your profits run but cut your losses short. Look at trade B above. Many investors do the converse. They sell quickly when they have a profit, lest the profit should evaporate. But they hang on to losing investments in the hope that prices will come back. In effect they follow the strategy, 'cut your profits short but let your losses run'. Typical phenomenon are short term trades becoming long term investments, Buy-and-hope investing, not willing to accept a loss, etc. All lead to the poor house!
(3). Seek and act on only those investments that have a positive E value. Finding such trades requires possessing an edge in the markets. An edge comes from experience, vision and ability to foresee, access to information, plan and discipline, patience, perseverance, or all of the above, and more.

Till next time, happy investing!

Friday, January 30, 2009

Trading Principles - 2

Ok, so outcomes in the market are uncertain and there always is a chance of losing money. Investors need to think in terms of probabilities.

But how does one do that?

First, never invest with the thinking, "this will surely go up". There is no sure thing in the markets. Avoid the lure of the 'sure'.

When faced with a choice to invest or not to invest, ask yourself the question, "What are the chances of the price going up/investment working out and hence what are the chances of the investment not working out? Is it 80%? 60%? 40%? 20%? By doing so, you immediately get into the mental framework of assessing possibilities and awarding probabilities to outcomes.

So you might think that a particular investment has a 70% chance of making you money and a 30% chance that you would lose money (neglecting the possibility of the investment going absolutely nowhere) in a given time frame.

The key question is how do we assess these probabilities? Unfortunately there is no easy answer. Investors mostly depend upon their knowledge, experience and judgment.

But to help you make an assessment, you could look into history to see what happened under similar circumstances. So if a particular outcome X occurred 7 times out of 10 when conditions A, B and C were satisfied, you can say that maybe the chance of outcome X happening again, given the presence of conditions A, B and C is 70%.

Important to note however is that the past is merely indicative of the future. Never is the future exactly like the past. There could be factors that we miss out that could produce an entirely different outcome when compared to history. For example, it is commonly believed that an increase in money supply causes inflation. In an inflationary period, gold prices go up. So with all the trillions of dollars being thrown at the current economic problems worldwide, people expect the prices of gold to go up sometime in the future. But maybe, just maybe, we are not looking at the even greater amount of money being destroyed off balance sheets. So there could be a net money contraction and maybe gold prices do not go up.

You might be wondering whether experienced investors actually assess the probabilities in terms of such percentages. They don't do this on paper, but at a subconscious level, they get a sense of the odds. They may not be able to exactly spell out the probabilities, but in their minds, they are aware of the chances, at least at an approximate level.

Fine! So, at what percent chance of winning does an investment become a good investment?

If you flip a fair coin, there is a 50% chance of getting heads and a 50% chance of getting tails. These two outcomes are random in nature and depend purely upon luck. So if a random choice gives you 50% chance of winning, should an investment with a higher than 50% chance of winning be a better investment? After all should the odds of winning not be greater than random outcomes? Also, is an investment with a 80% chance of making money a better investment than that with a 70% chance of making money?

Not necessarily!

In reality, it does not matter much if you win or you lose. What matters is how much you win when your investment works out and how much you lose when it does not work out.

The amount you end up winning is your reward. The amount you were willing to lose is your risk.

A good investment is one which if it goes wrong, it goes a little wrong; and if it goes right, it goes significantly right. In other words, the reward to risk ratio is high.

Look for an investment/trade that has a high reward:risk ratio. Elementary, my dear Watson.

But why should an investment with a 70% chance of making money not necessarily be a good investment and why should an investment with a 70% chance of losing money not necessarily be a bad investment?

That is the topic of my next post...

Saturday, January 24, 2009

Trading Principles - 1

Can you have a process behind investing and trading?
Can you carry out these activities systematically, in a logical manner?
Can you invest and trade based on sound principles?

You bet, you can!

Of course, you can also trade on the basis of news, gut feel, whims, some research report in the newspapers, tips from friends, rumour, etc, or a combination of the above. In my opinion, this mostly leads to grief and lost money over longer periods. I am sure that anyone who has had some experience in the stock markets would have fallen prey to one or more of the above sometime in the past.

So if there are sound principles that one can follow, what are these principles exactly?

Starting with this post, I propose to discuss these principles over a series of posts. The purpose is to highlight the process of establishing a framework for making decisions under uncertainty. Hopefully, it will establish a method to trade logically.

But as we all know, there is a difference between knowing the path and walking the path.

Perhaps this is why business school professors are not good businessmen, or why few doctors are in good shape physically, or why new year resolutions often remain grounded. We all know that if we seek good health, we must control what we eat and drink, exercise and remain physically active, and minimise tension and stress. Knowing is easy, it is the doing part that is so difficult.

Successful investing, like any other activity, comprises (1) knowing exactly what to do and (2) doing what you need to do, time after time. A good process needs to be correctly implemented.

The second point is responsible for 99% of trading success.

This is no exaggeration. People think that if they get a good method to invest, the money taps will automatically be opened for them. They think that if they know when and what to buy and sell, stock market riches are within their grasp. Nothing can be further from the truth.

Successful implementation is largely predicated on proper investor psychology. But psychological talk is something most novice investors and traders tend to dismiss as unimportant. Lest readers of this blog are also put off by psychological issues at the outset itself, I propose to cover the method first and discuss psychology later. Bear in mind however that methods are nowhere as important as personal psychology. At some stage, every trader realises this and internalises it. The less successful ones keep searching for methods.

Two points before we begin. Both would undoubtedly be known to all readers, yet deserve a mention.

First, like everything in life, outcomes in the markets are always uncertain, perhaps more uncertain than real life outcomes. Hence the first thing an investor or trader should focus upon is thinking in terms of probabilities and not in terms of certainty. There is no sure thing in the markets. Yes, we all want our investments to go up and most investors are focused on the profit side of the investment. But investments do go wrong and it is important for investors to think also about the possibility of things not going their way. This needs to be done not only on an intellectual plane, but at an emotional level as well. This is a concept that every investor needs to embrace, not just give it lip service.

Secondly, trading or investing, is a profession like any other. Success in this field requires the same commitment, perseverance and practice that any other profession requires. Unless you are a genius, a whole lot of effort is required to do well in trading. People should not live under the wrong assumption that their sporadic forays into the stock markets will fetch them longer term success. If you are serious about making money in the markets, you need to be serious about your effort in trying to do so. I can almost guarantee you that you are NOT going to become an investing genius merely by studying and understanding investing principles and the process. It takes much more than that.

But we all know the above two points, I only wanted to reiterate them.

So where do we start?

We start off in my next post. So keep an eye on this space...

Wednesday, December 31, 2008

Gentlemen prefer bonds!

"Gentlemen prefer bonds."
- Andrew Mellon (US Businessman, financier, philanthropist, US Treasury Secretary 1921-32. For some readers, Carnegie Mellon University might ring a bell)

It is 'common wisdom' that stocks are better investments than bonds, especially over long periods. After all stocks have earnings that grow over time while bonds only yield interest.

This might be true for single investments made over long periods. Many investors however make investments periodically, like a Systematic Investment Plan (SIP). Of course, SIPs are much advocated by the financial advisers as a prudent tool for market out performance over long periods. I had published 2 posts on this blog showing how SIPs in fact do not generate great returns even over long periods ( and

But do SIPs even beat investment in debt? It will depend upon returns from equities and the prevailing interest rates. Looking at history, I tried to compare two SIPs.
-The first was an investment of Rs 10000 in the BSE Sensex on the first trading day of every month.
-The second was an investment of Rs 10000 in a 1 year Fixed Deposit of the leading bank in India every month.

The time period for the study was from January 1991 till December 2008. i.e. a period of 18 years.

Since exact data for fixed deposit interest rates is not available, I took at these as the yield on a 10 year Government of India security plus 1%. (Currently, this yield is around 5.5% while 1 year bank FDs are giving an interest of 8.5-10.5% depending upon the bank. So 1% above G-sec yield is a realistic assumption).

The results were surprising!

(1). BSE Sensex SIP:
A total sum of Rs. 2160000 was invested.
This became Rs. 5575010 (as of 30 Dec 2008)
This implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%

(2). SIP in Bank Fixed Deposit:
A total sum of Rs. 2160000 was invested.
This became Rs. 8076625 (as of 30 Dec 2008)
This implies a return of approximately 12.5% per annum.

The SIP in Bank FD beat the SIP in BSE Sensex!! Over a period close to two decades, SIP investing in debt beat SIP investing in equities!

Many of you might recall the high interest rates in the 1990s. At their peaks, FD rates had gone up to 17% while staying in double digits for the entire 1990s decade.

Post 2002, interest rates softened and fell into single digits. So one would have expected returns from FDs to be significantly lower compared to Sensex since the start the latest bull market in 2003. So how do the two compare?

(1). SIP of Rs 10000 per month into BSE Sensex since Jan 2003 done on the first trading day of the month:
A total sum of Rs. 720000 was invested.
This became Rs. 955836 (as of 30 Dec 2008)
This again implies a return of approximately 9.3% per annum
Add about 1.5% in dividends and the return comes to 10.8%

(2). (2). SIP in Bank Fixed Deposit:
A total sum of Rs. 720000 was invested.
This became Rs. 921566 (as of 30 Dec 2008)
This implies a return of approximately 8.3% per annum

Even in a mega bull market, Sensex SIP could not significantly outperform the SIP in Bank FDs! FD SIP investors would have got returns somewhat lower than Sensex SIP but with no volatility and no risk...and would have slept much better than equity investors.

(Note that Bank FD returns are pre-tax figures)

The future is never like the past and conditions always change. Maybe in the future equities significantly outperform debt. Maybe this does not happen. We don't know, though I would tend to lean on the side of equities outperforming debt. But the study made above throws some points:
(1). SIP investing in equity is not necessarily a great tool for wealth building.
(2). Investing into equities is buying parts of businesses. Businesses are subject to competition and also have their ups and downs. Investing makes sense when businesses are available cheap. Investing makes sense when conditions for businesses are favourable. Stock prices reflect future business prospects and when prospects start appearing weak, equity investing loses money. Unless someone seeks mediocre returns, investing should not mean buy-and-hold-till-you-die. If someone wants to practice SIP investing, the same principle should apply. Do not get taken in by glib talk by some talking head in the media
(3). Learn to sell intelligently. It is selling that counts.

Sometimes, everyone should prefer bonds!

Sunday, December 21, 2008

Cheap Stocks and Value Traps

When stock prices fall, people tend to buy. Since prices have come down, stocks become cheaper and hence in the future they are expected to go higher again. Investors perceive value in stock prices that have fallen. There is a breed of investors called value investors who specialise in picking value stocks.

In the current stock markets meltdown, so many stocks have fallen 60-80% or more. Value investors are perceiving this to be a good time to pick stocks. But amidst value stocks abound many other 'value traps' - stocks that have fallen a lot but are destined to languish at low levels for really long periods. Investors should avoid such value traps since they block investor capital indefinitely without generating returns.

The reasons a stock is perceived as a value stock are (1) the share price has fallen and the stock is cheap (2) future earnings prospects are good so the company/stock would bounce back.

In contrast, a value trap is a stock whose (1) share price has fallen and the stock is cheap (2) future earnings prospects are bad and the stock/company would not bounce back.

So how does one go about distinguishing between a value stock from a value trap? There is no right or infallible answer. Even seasoned investors make the mistake of buying a value trap that looks like a value stock. Detecting a value trap is not a easy task. But can we at least have some parameters that could guide us in such an endeavour? Here are a few questions that you could answer before you try to seek value in stocks.

(1) Is the company cheap based not on trailing earnings but on future/forward earnings?
Quoted valuation metrics like PE ratio are based on historical earnings, mostly on the trailing 12 months earnings. What really matters is what earnings are going to accrue in the future. If future earnings are going to fall and future earnings down the road are not coming back to current levels again, the stock is only optically cheap and is a value trap. For example, Unitech quotes at a PE of 4.3. It looks very cheap. But if next year's earnings are going to fall by say, 90%, the forward PE is 43, which is quite expensive.

(2) Does the company have a lot of debt on its balance sheet?
Debt works both ways. In good times it boosts earnings. In bad times, it becomes a stone around the company's neck. Debt needs to be serviced in good times as well as in bad. In bad times interest payments takes up a large chunk of earnings. Beware if there is a lot of debt on the balance sheet, especially if you see an economic slowdown coming.

(3) Does the company operate in a cyclical industry?
Cyclical industries, true to the name, are subject to up cycles and down cycles. Typically, such companies have a large fixed cost of operation (usually are capital intensive and hence are loaded with debt). In an up cycle, their product prices are rising, operating efficiencies set in and profits zoom. In down cycles, product prices fall, operating leverage works in reverse and profits plunge. So SAIL might look cheap at a PE of 4.3, but if the steel cycle is down, earnings going forward could be dismal and hence the stock could be a value trap.

(4) Does the company generate free cash flow?
Cash flow is like blood flowing through the body. Stop the cash flow and the body dies. Earnings are different from free cash flow. Earnings can be massaged and managed. Not so for cash flow. Does the company have stable or growing free cash flows? Lack of cash can starve a business and you dont want to be in a company that suffers starvation.

(5) Is the company losing market share?
All businesses go through down cycles and face slowdowns and recessions. But market shares should not suffer recessions. When faced with a slowdown (and when not faced with a slowdown either), does the company maintain or increase its market share in its industry? A company that loses market to its competitors indicates a possible problem. An exception though is if competition is moving out of an industry because the industry has no future. In such a case increasing market share is not a good thing; the industry might not survive at all! Who uses typewriters? Who uses floppy discs today? (In any case you dont want to be invested in an industry that has no future).

(6) Is the stock liquid enough?
While there is no single figure to qualify a stock as liquid or illiquid, stocks need institutional (mutual funds, hedge funds, insurance companies, etc) interest to propel them higher beyond a certain level. Typically, institutions will not buy stocks that have low liquidity. Without the potential for institutional buying, a quick rebound is generally unlikely.

(7) Is the company itself/insiders buying?
It is said that insiders know best the prospects of their company. Is the company itself issuing a share buyback (suggesting that the management thinks that the shares are cheap)? Are insiders buying? Now management optimism could be misplaced and they could be wrong in their judgment of value too. Also, lack of management buying does not necessarily mean lack of value. But when the company itself is buying back its shares or insiders are buying, the share deserves a look.

Make no mistake, identifying a value trap is no mean feat. Well known investors often fail in doing so. The above points are in no way all you need to know. But they can act as a filter in weeding out value traps.

Happy Investing!

Saturday, November 22, 2008

Identifying Market Bottoms

Great fortunes can be had if you can buy stocks at market bottoms!

True, but the trillion dollar question is on how to identify market bottoms.

Catching bottoms is nigh impossible except by chance. In this statement is implicit the assumption that you are trying to get in at the exact lows. It is easier to find God than to catch the exact lows. Such market bottoms can be identified only in hindsight. But even if you can buy when markets are close to a bottom, returns thereafter can be spectacular. The bear market of 2000-2003 bottomed out in Oct 2002 (barring the spike down and sharp recovery post 9/11 WTC attacks). But anyone who had bought over 2002 and first half of 2003 would have made very good returns from stocks. Or anyone who bought stocks in 1997-1998 got very good returns by 2000.

So how do we recognise market bottoms? Market bottoms have certain traits. These are not fool proof, but taken together, they offer a good chance of identifying them. Here are some indicators:


GDP growth decline:
Typically bottoms follow busts, which follow booms. So a boom-bust cycle preceeds bottoms. While it is not neccessary that the economy slips into recession, what is common is that there is a sharp decline in economic growth. In the 2000-2003 bear market, India's GDP growth fell by 2.5%. While we cannot be sure how much of a fall there would be, it is clear that economic deceleration is a precursor. This in itself is not an indication though, it merely is a precondition. Often, corporate earnings growths go into the negative, i.e. earnings fall and EPS goes lower. Rarely do we see a cyclical bear bottom with earnings still rising. At best, they stay more or less flat.
Interest Rates:
Interest rates get to low and stable levels. Both rising interest rates and falling interest rates are not the conditions for a market bottom. Rising rates are often an outcome of rising inflation. High interest rates and high inflation are not good for stocks. Similarly, falling interest rates signify lack of demand for money. Which in turn suggests economic slowdown and possible deflation. It is only after interest rates stop falling and stabilise that the spectre of deflation gets over and growth resumes.
Commodity Prices:
Commodity prices stop falling and stabilise. This is but a corollary of falling inflation or deflation since commodity prices affect inflation levels. Stabilising commodity prices tells us that demand supply situation is getting balanced. Stability in commodity prices is generally accompanied by low inventory levels as well. While steel is the most commonly used metal, it is copper prices that have often been a lead indicator.
Liquidity levels get comfortable and the financial system is not cramped for lack of money. Ample liquidity conditions are usually an outcome of low interest rates. But markets can bottom without excess liquidity. Markets find it difficult to bottom out on tight liquidity conditions.

If bull markets end with stock prices at crazy valuations, bear markets end with prices at the other extreme. Stocks become cheap, whichever way you look at them. PE ratios and P:BV ratios go down, dividend yields become attractive.

How much down and how attractive? That is difficult to say as each bear market is different. But at some point, earnings yield of stocks (inverse of PE ratio) exceeds government bond yields. For example, in April 2003, earnings yield hit a high of close to 8% while the yield on 10 year Government of India security fell to below 6%. (Currently we have a situation where both are neck to neck).

Comparisons across bear market bottoms never yields the same result though. So it is difficult to say what exactly is cheap. In addition, comparisons are never across the same set or companies or industries. But comparing valuations across previous bottoms on parameters such as PE, PBV, Dividend yield, Earnings yield: GSec yields, Price:replacement cost, E:EBIDTA, etc, though never conclusive, is indicative of cheap valuations.

Often sentiment is a very good gauge of market bottoms. In a bull market, there is euphoria. When the first fall comes, people percieve it to be a correction and buy hoping for higher prices. Prices keep falling however and the optimism turns into anxiety. Anxiety later turns into fear as prices just keep falling. Fear converts itself into panic and there is capitulation.

At some stage however, all the selling gets over. But buying does not come in yet. Markets languish and the sentiment towards stocks slowy turns into one of revulsion. People are sick and tired of holding stocks. There is a lot of apathy and disillusionment towards stocks. There is simply no interest towards stocks. People cannot percieve how stocks will ever rise as recent experience suggests that rises do not sustain themselves. People seek comfort in fixed deposits and bonds even as returns therefrom might be pretty low. No one wants to talk stocks.

Price movements are an important indicator of market bottoms. Here are a few typical price behaviours that suggest that market bottoms might not be far away.
-Volatility in price movements goes way down and stays down
-Prices spend a lot of time inside a range, toing and froing, moving up and down.
-Volumes are low as interest in stocks is low.
-Bad news fails to move stocks lower since all the selling is done with.
-Even good economic news fails to move the markets as no one is interested in buying. In effect the markets go off to sleep.
-Generally bond prices lead the upmove in stock prices. This can happen even as stock prices languish. The impact of rising bond prices is to get the bond yields down, often lower than earnings yields on stocks. Bond prices rise and bond yields drop.

Markets can keep behaving in this manner for long periods. Typically you would see anything between 2-3 years of such behaviour. But this time period is a function of how fundamentals evolve. If fundamentals get better quickly, this base building period could last for smaller periods. Once this period is over, a new bull market starts. How do prices behave at this stage?
-Prices start rising on larger volumes and corrections are on lower volumes.
-Markets start making higher highs and higher lows on prices.
-The initial price rise is on low volatility. Price moves are not large.
-Any bad news gets quickly ignored and prices move higher on bad news.
-Leaders of the previous bull run lag as new sectors and new companies start moving faster than the rest.
-Generally, not neccessarily though, companies with high operating leverages that got hit in the previous cycle, like automobiles, take the lead in performing.
-Most people still call the rise as a bear market rally. Inspite of skepticism for the rise, prices simply keep rising astounding market participants.

It should be noted that the mere occurence of a couple of points in this long list does not indicate a bottom. The above factors should be taken in conjunction with one another. The presence of a large number of the above factors would indicate the possibility of a bottom; a few positive signs in isolation mean nothing. Having said that, markets can bottom and stay down for extended periods. The tricky question, and perhaps more relevant is getting in closer to the start of the bull market. The more relevant question than 'how to identify market bottoms' is 'how to identify a new dawn'.

Happy Investing!

Friday, October 31, 2008

Biased studies on market timing

On occasions we come across some articles that oppose the idea of market timing. To further their arguments, they show how longer term performance would get hampered if investors miss out on participating in 10/20/50 (or any other number) biggest up days in the markets. So, the studies claim that market timing is futile and not effective at all.

These studies seem to be one-sided and biased. They assume that market timers (like yours truly) will miss out on the up days while still stay exposed to all down days. Of course, with such an assumption, it can be 'proven' that market timing does not work and investors should refrain from making any attempt at timing the market.

Let us examine the truth based on hard data. Note that missing out on up days decreases your returns and avoiding down days increases your returns.

Let us examine the daily returns on the S&P CNX Nifty 50 since 1990.

If you had invested Rs. 100 in the Nifty on 3 July 1990, that would have grown to Rs. 966 as of 29th Oct 2008. This translates into an annual return of 13.2% compounded.

If you had missed out on the 10 biggest up days in the same Nifty, Rs 100 would have grown to Rs. 374 which translates into a compounded annual return of 7.5%. In contrast, if you had avoided the 10 worst days, Rs. 100 would have grown to Rs. 2661, which translates into a compounded annual return of 19.6%. So you would have given up on Rs. 592 (966-374 = 592) by missing the up days but gained Rs.1695 (2661-966 = 1695) by avoiding the down days.

If you had missed out on the 20 biggest up days in the same Nifty, Rs 100 would have grown to Rs. 192 which translates into a compounded annual return of 3.6%. In contrast, if you had avoided the 20 worst days, Rs. 100 would have grown to Rs. 5354, which translates into a compounded annual return of 24.2%. So you would have given up on Rs. 774 by missing the up days but gained Rs.4388 by avoiding the down days.

If you had missed out on the 50 biggest up days in the same Nifty, Rs 100 would have fallen to Rs. 40 which translates into a compounded annual return of (-4.9%). In contrast, if you had avoided the 50 worst days, Rs. 100 would have grown to a whopping Rs. 27678, which translates into a compounded annual return of 35.9%. So you would have given up on Rs. 926 by missing the up days but gained Rs. 26712 by avoiding the down days.

This data shows that successful attempts to avoid the worst down days would not only reduce risk (by decreasing the chance of a large decline) but gain much more than might be lost by missing some or even all of the biggest up days.

Moreover, there is no evidence in this that shows that trying to avoid the biggest down moves will result in missing the biggest up moves. Why should people think that market timers will be wrong all the time?

It is observed that most of the big up days up or down days occur in the midst of major trends. Such large trends are not too difficult to identify with simple market timing tools. These tools are not precise but are by and large effective. Market timers do not have to sell at the precise top or buy at the exact bottom. Market timers can exit in a downtrend identified ahead of major declines (like the current one). Such exits are likely to enhance returns very significantly. The same is true of entries. Market timers only need to identify that an uptrend is underway, and in most cases the big up days will follow.

Market participants, investors and speculators alike, should try to time the markets. This means 2 things:
1. Exit as quickly when a downtrend develops. This can be done via hedging a portfolio or selling out of positions. Once markets start going down, either sell out or use options/futures to protect your portfolio.
2. Enter the markets after an uptrend develops. Wait for the markets to tell you that an uptrend has developed and buy thereafter. This means not buying into a falling market even as stocks get cheaper and cheaper.

How to execute this is a different topic. However, in principle, this is one way of timing the markets and attempting to achieve superior returns.