"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 (http://shashankjogi.blogspot.com/2008/06/do-sips-really-work.html and http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html.)
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!
Wednesday, December 31, 2008
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!
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:
FUNDAMENTAL FACTORS:
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:
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.
VALUATIONS:
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.
SENTIMENT:
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 ACTION:
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!
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:
FUNDAMENTAL FACTORS:
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:
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.
VALUATIONS:
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.
SENTIMENT:
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 ACTION:
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.
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.
Monday, October 27, 2008
Process and Outcomes
In times of great market turbulence, it is a natural tendency for us to focus on market developments and on the turbulence. Stocks and discussions on stocks and the markets often assume prominence at parties and social gatherings. So we tend to discuss the state of the markets, what caused the turbulence, how things have panned out, what markets would do next and what we should do in response or in anticipation of market moves.
Each of us will have an opinion. Such opinions are often biased by our personalities, the recent performance of the markets, our positions in the markets, etc. For example, a cautious person might see more pain ahead. An utter pessimist might go to an extreme and paint a very bleak picture of the world. A sadist might take pleasure at others' losses and pain. An optimist might see market bottoms. Someone who is long might hope the markets recover, while those who are short might get biased by their position and expect further declines.
We are almost never objective in our analysis, much as we want to be or believe we are. Call it the limitation of the human mind. The truth is that markets are always uncertain and we are rarely objective. This is a deadly combination in analysing any situation. Uncertainty means we dont know what might happen. Being biased means we see possibilities where none exist. No wonder market analysis is so tough!
And then we make an investment decision. Any investment decision can only lead to three outcomes: we either make money, lose money or break even. And investors tend to focus merely on the outcome: whether or not the investment was profitable. This is understandable. At the end of the day the bottom line is all that matters. And outcomes can be seen objectively, the Profit&Loss statement states clearly whether the outcome was favourable or not.
But every outcome is a derivative of a process. An investment outcome is a derivative of some thought process and some analytical process (however sound or unsound that process might be). A focus on achieving outcomes (money to made somehow, anyhow) might make us neglect the all important process. It is the process that leads to results.
There are perils of evaluating the process from the outcome alone. It is seen that if the outcome is favourable, we assume that our thinking was correct and we made a good decision. If the outcome is unfavourable and we lose money, we assume a flaw in our analysis. Can we really make this conclusion? Hardly!
Any domain where outcomes are uncertain, is governed by probabilistic models. Many times, a sound process could lead to an unfavourable outcome (bad luck). Conversely, a flawed process could lead to a favourable outcome (good luck). On other occassions, a good process could mean a good outcome (deserved success) and a bad process can lead to a bad outcome (poetic justice). You can toss a coin to decide whether to buy or sell. If you make money, thats by sheer luck. If you lose money, you deserved to lose, life is fair! On the other hand, you can have a very logical process to invest. Should you lose, bad luck! Should you win, congratulation, you deserved your success.
In the longer run however, repeated several times, a good process will lead to a good overall results while a bad process will lead to a bad overall results, though any single outcome could be divorced from the process. A good process acts like a light house for our investing decisions. It creates a framework for decision making and limits the biases that creep into our thinking. A good process guides out thinking and keeps us from making random decisions.
Many investors go about investing in random methods, often guided by emotion, gut feel and market sentiment. Sometimes they make money, sometimes they lose it. Over the long run however, without a solid guiding process, they find little progress in either their investing knowledge or their net worth. So the next time you find yourself discussing stocks in a social gathering, you might want to stop discussing outcome and start discussing process. You would do yourself a lot of service in focussing on the process above the outcome. Using a sound investment process makes investing far less stressful, profitable and, unfortunately, quite boring.
Happy investing!
Each of us will have an opinion. Such opinions are often biased by our personalities, the recent performance of the markets, our positions in the markets, etc. For example, a cautious person might see more pain ahead. An utter pessimist might go to an extreme and paint a very bleak picture of the world. A sadist might take pleasure at others' losses and pain. An optimist might see market bottoms. Someone who is long might hope the markets recover, while those who are short might get biased by their position and expect further declines.
We are almost never objective in our analysis, much as we want to be or believe we are. Call it the limitation of the human mind. The truth is that markets are always uncertain and we are rarely objective. This is a deadly combination in analysing any situation. Uncertainty means we dont know what might happen. Being biased means we see possibilities where none exist. No wonder market analysis is so tough!
And then we make an investment decision. Any investment decision can only lead to three outcomes: we either make money, lose money or break even. And investors tend to focus merely on the outcome: whether or not the investment was profitable. This is understandable. At the end of the day the bottom line is all that matters. And outcomes can be seen objectively, the Profit&Loss statement states clearly whether the outcome was favourable or not.
But every outcome is a derivative of a process. An investment outcome is a derivative of some thought process and some analytical process (however sound or unsound that process might be). A focus on achieving outcomes (money to made somehow, anyhow) might make us neglect the all important process. It is the process that leads to results.
There are perils of evaluating the process from the outcome alone. It is seen that if the outcome is favourable, we assume that our thinking was correct and we made a good decision. If the outcome is unfavourable and we lose money, we assume a flaw in our analysis. Can we really make this conclusion? Hardly!
Any domain where outcomes are uncertain, is governed by probabilistic models. Many times, a sound process could lead to an unfavourable outcome (bad luck). Conversely, a flawed process could lead to a favourable outcome (good luck). On other occassions, a good process could mean a good outcome (deserved success) and a bad process can lead to a bad outcome (poetic justice). You can toss a coin to decide whether to buy or sell. If you make money, thats by sheer luck. If you lose money, you deserved to lose, life is fair! On the other hand, you can have a very logical process to invest. Should you lose, bad luck! Should you win, congratulation, you deserved your success.
In the longer run however, repeated several times, a good process will lead to a good overall results while a bad process will lead to a bad overall results, though any single outcome could be divorced from the process. A good process acts like a light house for our investing decisions. It creates a framework for decision making and limits the biases that creep into our thinking. A good process guides out thinking and keeps us from making random decisions.
Many investors go about investing in random methods, often guided by emotion, gut feel and market sentiment. Sometimes they make money, sometimes they lose it. Over the long run however, without a solid guiding process, they find little progress in either their investing knowledge or their net worth. So the next time you find yourself discussing stocks in a social gathering, you might want to stop discussing outcome and start discussing process. You would do yourself a lot of service in focussing on the process above the outcome. Using a sound investment process makes investing far less stressful, profitable and, unfortunately, quite boring.
Happy investing!
Sunday, September 28, 2008
Modified SIP
There is a class of stock market participants that believes in Systematic Investing Process (SIP). Of course, financial advisors, mutual fund managers and various other vested interests love to push SIPs. And why not! It is in the interest of fund managers to get a steady stream of money to invest (and increase the assets under their management).
Under a SIP, the investor invests a fixed sum in a stock or a mutual fund regularly preferably over long periods. The logic behind a SIP is that the investor buys more units of the fund when the markets are down and less when markets are up. Over time, a SIP is supposed to generate superior returns for the investor.
In one of my previous blogs, I had given some empirical evidence showing how a SIP is in reality an inferior investing strategy (http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html). It generates lower returns and yet is subject to the same kind of risk and volatility.
Why?
There is one important aspect of investing that a SIP misses out on. And it is an exit strategy. There is no mention of selling in a SIP. In reality, it is selling that counts! Intelligent selling is the key to above average returns. Why is selling so important even if you are a long term investor? Here is an example that clarifies this matter.
Look at the following annual returns in 2 portfolios:
Portfolio A: 15%, -5%, 100%, -40%, 10%
Portfolio B: 15%, -5%, 100%, -10%, 10%
A rupee invested in portfolio A would become 1.44 after 5 years. This implies an annual return of 7.6%
Similarly, a rupee invested in portfolio B would have become 2.16 after 5 years, implying an annual return of 16.7%
Now note the annual returns of the 2 portfolios. In 4 out of the 5 years, the returns are exactly the same. In year 4, portfolio B managed to avoid large losses achieving a loss of 10% compared to a loss of 40% in portfolio A. Just one year made all the difference!
In one of my earlier blogs I had discussed how downside volatility in returns is harmful for your portfolio (http://shashankjogi.blogspot.com/2008/07/avoid-price-volatility.html). Investors seeking above average returns should try to cut out such volatility from their portfolios.
So how do we cut out large downsides in our portfolio? Typically, although not always, large negative returns occur when markets run up excessively and become expensive. Be it in 1992, 1994, 2000 or 2008, valuations get very expensive and what follows is a crash. If an investor can stay out of most parts of the crash, he/she would be able to avoid large losses, and hence be able to generate significantly above average returns.
Returning to our focus on SIPs, SIPs do not require the investor to sell. Hence in a SIP, an investor's portfolio is subject to large downsides that the markets undergo when the process of expensive to reasonable occurs.
Instead, let us modify our SIP investing approach. We maintain our discipline of investing regularly using a SIP when the markets are not expensive. If they get expensive, we sell all our holdings and wait on the sidelines with cash. When markets correct and stocks become reasonable again, we restart the SIP. (One can use many methods to determine what is expensive and what is reasonable).
So what does empirical evidence suggest?
I looked at data on the BSE Sensex from 1995 till September 2008. I set up a SIP investing the same fixed amount every first trading day of the month. I set up a simple criterion for establishing when markets are expensive (to sell all equity holdings) and when they become reasonable again (to restart the SIP again). Lets call this a modified SIP. Then I compared this with a normal SIP without any selling decision.
Standard SIP: CAGR = 14%
Modified SIP: CAGR = 22%
And the modified SIP made only 2 selling decisions over a 13 year period! Practically no short term capital gains. So no tax liability! And the volatility and equity swings in a modified SIP turns out lower than those in a regular SIP.
(I could send the details for those who are interested)
How does a difference between 14% and 22% shape up over 20 years?
On an initial investment of Rs. 1 lakh:
At 14%, Rs. 1 lakh becomes Rs. 13.74 lakhs
At 22%, Rs. 1 lakh becomes Rs. 53.35 lakhs, nearly 4 times that at 14%!
A few simple sell decisions can convert a mediocre return into a excellent return with very significant difference in the end result for investors.
Clearly, investors should sell. While this is the most obvious statement one can make about investing, many investors do not sell. And SIP investors do not sell either.
Incorporating a selling discipline in a SIP can significantly boost returns. The modified SIP looks like a better approach to systematic investing than the conventional SIP advisors love to push.
Under a SIP, the investor invests a fixed sum in a stock or a mutual fund regularly preferably over long periods. The logic behind a SIP is that the investor buys more units of the fund when the markets are down and less when markets are up. Over time, a SIP is supposed to generate superior returns for the investor.
In one of my previous blogs, I had given some empirical evidence showing how a SIP is in reality an inferior investing strategy (http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html). It generates lower returns and yet is subject to the same kind of risk and volatility.
Why?
There is one important aspect of investing that a SIP misses out on. And it is an exit strategy. There is no mention of selling in a SIP. In reality, it is selling that counts! Intelligent selling is the key to above average returns. Why is selling so important even if you are a long term investor? Here is an example that clarifies this matter.
Look at the following annual returns in 2 portfolios:
Portfolio A: 15%, -5%, 100%, -40%, 10%
Portfolio B: 15%, -5%, 100%, -10%, 10%
A rupee invested in portfolio A would become 1.44 after 5 years. This implies an annual return of 7.6%
Similarly, a rupee invested in portfolio B would have become 2.16 after 5 years, implying an annual return of 16.7%
Now note the annual returns of the 2 portfolios. In 4 out of the 5 years, the returns are exactly the same. In year 4, portfolio B managed to avoid large losses achieving a loss of 10% compared to a loss of 40% in portfolio A. Just one year made all the difference!
In one of my earlier blogs I had discussed how downside volatility in returns is harmful for your portfolio (http://shashankjogi.blogspot.com/2008/07/avoid-price-volatility.html). Investors seeking above average returns should try to cut out such volatility from their portfolios.
So how do we cut out large downsides in our portfolio? Typically, although not always, large negative returns occur when markets run up excessively and become expensive. Be it in 1992, 1994, 2000 or 2008, valuations get very expensive and what follows is a crash. If an investor can stay out of most parts of the crash, he/she would be able to avoid large losses, and hence be able to generate significantly above average returns.
Returning to our focus on SIPs, SIPs do not require the investor to sell. Hence in a SIP, an investor's portfolio is subject to large downsides that the markets undergo when the process of expensive to reasonable occurs.
Instead, let us modify our SIP investing approach. We maintain our discipline of investing regularly using a SIP when the markets are not expensive. If they get expensive, we sell all our holdings and wait on the sidelines with cash. When markets correct and stocks become reasonable again, we restart the SIP. (One can use many methods to determine what is expensive and what is reasonable).
So what does empirical evidence suggest?
I looked at data on the BSE Sensex from 1995 till September 2008. I set up a SIP investing the same fixed amount every first trading day of the month. I set up a simple criterion for establishing when markets are expensive (to sell all equity holdings) and when they become reasonable again (to restart the SIP again). Lets call this a modified SIP. Then I compared this with a normal SIP without any selling decision.
Standard SIP: CAGR = 14%
Modified SIP: CAGR = 22%
And the modified SIP made only 2 selling decisions over a 13 year period! Practically no short term capital gains. So no tax liability! And the volatility and equity swings in a modified SIP turns out lower than those in a regular SIP.
(I could send the details for those who are interested)
How does a difference between 14% and 22% shape up over 20 years?
On an initial investment of Rs. 1 lakh:
At 14%, Rs. 1 lakh becomes Rs. 13.74 lakhs
At 22%, Rs. 1 lakh becomes Rs. 53.35 lakhs, nearly 4 times that at 14%!
A few simple sell decisions can convert a mediocre return into a excellent return with very significant difference in the end result for investors.
Clearly, investors should sell. While this is the most obvious statement one can make about investing, many investors do not sell. And SIP investors do not sell either.
Incorporating a selling discipline in a SIP can significantly boost returns. The modified SIP looks like a better approach to systematic investing than the conventional SIP advisors love to push.
Friday, August 15, 2008
Investing Myths - 2
Investing Myths....(Continued from the previous post)
Myth 4:
Asset Allocation is the key to investing success:
A big fat lie!
The investment community loves to push this idea. Allocate your money across various assets. Have a clear plan of how much of your money should go into equities, how much into debt, how much into real estate, how much into gold, etc.
The basic idea behind recommending an asset allocation plan is that when one asset class goes down, some other will go up. Also there would be an automatic rebalancing of portfolio, selling when an asset goes up and buying when it goes down. Buy low, sell high! How nice!
Except that is it far from nice!
Asset allocation is good if two conditions are satisfied:
1.) The assets have no co-relation or are negatively co-related with one another. i.e. the movement in one asset is independant of the movement of the other asset (un-corelated) or if one asset moves up, the other moves down (negatively co-related).
But in real life, stocks and bonds (paper assets) are positively corelated. Gold and stocks might be negatively corelated. Even this relationship breaks down at times. Over the last 5 years, all assets have gone up, stocks, bonds, real estate, commodities, art, etc. Sometimes all assets go up together, sometimes all come down together.
2.) The assets offer more or less, equal return prospects over time. If we assume that bonds will give lower returns than stocks, creating an asset allocation between bonds and stocks will lower overall returns (but also offer lower volatility).
Asset allocation, the way the investment community preaches, lowers portfolio volatility but also lowers returns. I had written a post earlier demonstrating the returns from one particular asset allocation method. The link is: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html
There is no substitute to ability.
Myth 5:
Now that the market is down, it’s especially attractive and you should buy all you can and just hold it.
Being down does not equal attractive. Markets move from extremes of optimism and pessimism. Hence valuations move from seriously overvalued to seriously undervalued on and off. When prices fall, even 30-50%, it does not automatically make stocks attractive. If you are a value investor, you should buy when stocks are cheap, regardless of the extent of rise or fall in a stock.
Again, the investment community loves to give Warren Buffet's example. If Warren Buffett holds on through 50% drops, because then things really are a bargain, then you should do so as well.
In reality, Warren Buffet buys stocks when they are quoting at 50 paise to the rupee. Most of us do not have the capability that he possesses. We get misled by expensive stocks masquerading around as value stocks. We do not have an understanding as deep as Buffet has about most businesses. So we tend to pay Rs 2 for a stock worth Re.1, thinking that we are paying Rs.2 for something worth Rs.4.
How many people bought stocks into the first crash in January 2008? Many did and now they are stuck. We saw a period between 2000 and 2003 when stock prices went down 50%. After each 10% fall, stocks looked better but kept going down. So many highflying stocks on the tech bubble have vanished now.
The bottomline is:
-There is a time to buy and there is a time to sell.
-There is an environment when stocks do well and there is an environment when stocks do poorly.
-Stocks go down for good reasons.
-Understand the reasons, evaluate if there is merit and then buy. Not just because stocks are down.
Myth 6:
Stocks are an excellent hedge against inflation
Yes, but only if...
Have you heard how stocks give returns much higher than inflation, while with Fixed Deposits and bonds, inflation makes real returns tiny? So the Sensex has given an 18% compounded return over the last 29 years while inflation has been 8% on an average. Doesn't it show the power of equity investing in trumping inflation?
But why did stocks not beat inflation in the period 1992-2003? The sensex gave a negative 3% return compounded. Stocks not only lost money in nominal terms, it also lost more money in real terms. Stock market investing over this period impoverished investors, in general.
Stocks do well in a low and stable inflationary and low and stable interest rate environment. Both, high inflation and deflation are bad for stocks. If you recall, the mid to late 1990s was a period of high inflation 8-10% and rising interest rates. The period between 2000-2003 was a period of a global recession and a slowdown in the Indian economy. We then saw a period of low inflation (4-6%) and low interest rates between 2003-2007 which was one reason among many that fuelled the bull market in stocks.
Over the last 30 years, favourable conditions on a general basis ensured that stocks do well. Who is to say how the future will be like? Will it be like the 1970s where inflation was high and interest rates were ratched up? Or will calmer times return. The answer to this question will determine whether stocks are able to beat inflation by a whopping margin. A blanket statement saying that stocks are good against inflation is assuming such good times will remain.
I have merely highlighted a few myths that are commonly held. There are many more. A wise investor will always look for reason and evidence in any such statements before accepting such assertions.
Myth 4:
Asset Allocation is the key to investing success:
A big fat lie!
The investment community loves to push this idea. Allocate your money across various assets. Have a clear plan of how much of your money should go into equities, how much into debt, how much into real estate, how much into gold, etc.
The basic idea behind recommending an asset allocation plan is that when one asset class goes down, some other will go up. Also there would be an automatic rebalancing of portfolio, selling when an asset goes up and buying when it goes down. Buy low, sell high! How nice!
Except that is it far from nice!
Asset allocation is good if two conditions are satisfied:
1.) The assets have no co-relation or are negatively co-related with one another. i.e. the movement in one asset is independant of the movement of the other asset (un-corelated) or if one asset moves up, the other moves down (negatively co-related).
But in real life, stocks and bonds (paper assets) are positively corelated. Gold and stocks might be negatively corelated. Even this relationship breaks down at times. Over the last 5 years, all assets have gone up, stocks, bonds, real estate, commodities, art, etc. Sometimes all assets go up together, sometimes all come down together.
2.) The assets offer more or less, equal return prospects over time. If we assume that bonds will give lower returns than stocks, creating an asset allocation between bonds and stocks will lower overall returns (but also offer lower volatility).
Asset allocation, the way the investment community preaches, lowers portfolio volatility but also lowers returns. I had written a post earlier demonstrating the returns from one particular asset allocation method. The link is: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html
There is no substitute to ability.
Myth 5:
Now that the market is down, it’s especially attractive and you should buy all you can and just hold it.
Being down does not equal attractive. Markets move from extremes of optimism and pessimism. Hence valuations move from seriously overvalued to seriously undervalued on and off. When prices fall, even 30-50%, it does not automatically make stocks attractive. If you are a value investor, you should buy when stocks are cheap, regardless of the extent of rise or fall in a stock.
Again, the investment community loves to give Warren Buffet's example. If Warren Buffett holds on through 50% drops, because then things really are a bargain, then you should do so as well.
In reality, Warren Buffet buys stocks when they are quoting at 50 paise to the rupee. Most of us do not have the capability that he possesses. We get misled by expensive stocks masquerading around as value stocks. We do not have an understanding as deep as Buffet has about most businesses. So we tend to pay Rs 2 for a stock worth Re.1, thinking that we are paying Rs.2 for something worth Rs.4.
How many people bought stocks into the first crash in January 2008? Many did and now they are stuck. We saw a period between 2000 and 2003 when stock prices went down 50%. After each 10% fall, stocks looked better but kept going down. So many highflying stocks on the tech bubble have vanished now.
The bottomline is:
-There is a time to buy and there is a time to sell.
-There is an environment when stocks do well and there is an environment when stocks do poorly.
-Stocks go down for good reasons.
-Understand the reasons, evaluate if there is merit and then buy. Not just because stocks are down.
Myth 6:
Stocks are an excellent hedge against inflation
Yes, but only if...
Have you heard how stocks give returns much higher than inflation, while with Fixed Deposits and bonds, inflation makes real returns tiny? So the Sensex has given an 18% compounded return over the last 29 years while inflation has been 8% on an average. Doesn't it show the power of equity investing in trumping inflation?
But why did stocks not beat inflation in the period 1992-2003? The sensex gave a negative 3% return compounded. Stocks not only lost money in nominal terms, it also lost more money in real terms. Stock market investing over this period impoverished investors, in general.
Stocks do well in a low and stable inflationary and low and stable interest rate environment. Both, high inflation and deflation are bad for stocks. If you recall, the mid to late 1990s was a period of high inflation 8-10% and rising interest rates. The period between 2000-2003 was a period of a global recession and a slowdown in the Indian economy. We then saw a period of low inflation (4-6%) and low interest rates between 2003-2007 which was one reason among many that fuelled the bull market in stocks.
Over the last 30 years, favourable conditions on a general basis ensured that stocks do well. Who is to say how the future will be like? Will it be like the 1970s where inflation was high and interest rates were ratched up? Or will calmer times return. The answer to this question will determine whether stocks are able to beat inflation by a whopping margin. A blanket statement saying that stocks are good against inflation is assuming such good times will remain.
I have merely highlighted a few myths that are commonly held. There are many more. A wise investor will always look for reason and evidence in any such statements before accepting such assertions.
Monday, August 11, 2008
Investing Myths - 1
There are many investing myths that go around as gospels and the ultimate truth in investing. As humans, if someone repeats something sensible sounding repeatedly, for a long enough period, we start believing it to be true. We then do not question its validity and take it for granted. Thats how we are.
Many of these myths are held even by professionals in the investing arena. Some are lies perpetuated knowingly or in ignorance. Some are damn lies, but statistics tell a different story!
I have highlighted a few of them. Take a look:
Myth 1:
You should buy and hold to make money.
Now, how many times have you heard mutual fund managers and other experts stating this? They have 'well chosen' examples to substantiate their claims. Buy and hold stocks for the long run and you will be rich at the end. Afterall, the logic goes, stock markets reflect corporate fundamentals, which in turn are derived from economic fundamentals. For growing economies like India, economic fundamentals in the long run remain positive.
First, how long is this long run? For most people, 10 years is long enough. Over 10 years, stocks always do well.
Or do they?
A quick look at history will reveal different results. There have been many period in the past where stocks have gone nowhere in a 10 year period.
-From 1992 to 2003, the BSE Sensex went down 33% (aggregate not CAGR). Indian GDP grew at close to 6% in real terms during this period.
-The US stock markets have shown many long periods of poor performance inspite of positive economic growth. Between 1964 and 1982, US stock markets gave a 0% return inspite of growing at a 3% real growth rate. Till date, any index investor in the USA would have got no returns for money invested in 1998, a period of 10 years gave no returns.
-The Japanese markets peaked out in 1989 and after nearly 20 years, is still down 60% from those highs.
Experts love to say that stocks should go up because GDP will grow. Not true!
-The Chinese economy is the fastest growing economy in the world, growing at breath taking speeds of 10% or so over many years. Yet its stock market went down 50% from 2001 to 2004. It is down 60% from the peaks hit last year! China might win many gold medals at the Olympics, but its stock market is perhaps the worst performer in the world!
-Someone who had invested in the Indian BSE Sensex in Feb 2000 would have got a compounded return of 10.9% from stocks till date. Not a return to die for. During this period, the Indian economy recorded a 7% real GDP growth.
Let me state this very clearly. Stocks do well in an environment of low and stable inflation and interest rates. Rising inflation and (often hence) rising interest rates are bad for stocks (USA from 1969-1982). A deflationary (falling prices) environment means economic contraction, which is also bad for stocks (Japan from 1989).
Stocks are good for the long run if your starting point is good. If you start off at the begining is a bull supercycle, stocks will give great returns. If you start off at the lower end of valuations, stocks will give good returns. If you are caught in a bear supercycle, stocks will languish.
Stocks are not always a good buy and hold asset class...No asset class is! Each asset class needs a particular environment to do well.
Myth 2:
You cannot time the market.
By this, if someone means catching tops and bottoms precisely by design (and not by accident), I agree. But this is not what market timing is about. By market timing I mean buying when conditions are in your favour and selling when they are against you. Even if you can imprecisely time the markets, in an inperfect manner, your returns will get boosted. I had earlier written a post on this blog showing how one particular market timing strategy achieves superior returns with less risk and lower volatility. (Link: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html)
Market timing is THE essence of successful investing. Traders try to time the markets. Even long term value investors time the market, buying when stocks become cheap and selling when they get expensive. Momentum investors time the market and buy when momentum starts building up and sell when momentum starts fading or reversing.
So do not hide behind the cover of "I dont have time to trade" defense mechanism. You dont need to look at the market every day or every week. Learn how to time the markets, afterall it is your money.
Myth 3:
Making money is all about picking stocks.
Another big myth!
No doubt, stock picking is important. You want to be in a stock that goes up. But merely picking a winning stock is of little significance if you get the other things wrong. You will not make much money.
What are the other things?
Intelligent exits and proper volumes of purchase
Not much fun in picking up Unitech at 100 to see it go to 550 and then back to 130.
You need to sell sufficiently high to benefit from the big price move.
And you need to buy in good volumes on such stocks to make significant money. Your 'position sizing' needs to be correct. Buy too little and you wont make much money. Buy too much and you run the risk of large losses if losses come about.
Look at the portfolios of various mutual funds. 90% of the variance in their performance comes from position sizing, i.e.from their decision on how much to buy. Only 10% comes from superior stock picking.
You don't need to be a great or even a good stock picker to make a lot of money.
Being average is fine as long as you follow a few cardinal rules in investing:
-Trade with the trend. That is where large profits originate.
-Let your profits run but cut your losses short
-Manage risk. Buy enough to make you a bundle, but short of anything that could lose you a lot of money.
Continued.....
Many of these myths are held even by professionals in the investing arena. Some are lies perpetuated knowingly or in ignorance. Some are damn lies, but statistics tell a different story!
I have highlighted a few of them. Take a look:
Myth 1:
You should buy and hold to make money.
Now, how many times have you heard mutual fund managers and other experts stating this? They have 'well chosen' examples to substantiate their claims. Buy and hold stocks for the long run and you will be rich at the end. Afterall, the logic goes, stock markets reflect corporate fundamentals, which in turn are derived from economic fundamentals. For growing economies like India, economic fundamentals in the long run remain positive.
First, how long is this long run? For most people, 10 years is long enough. Over 10 years, stocks always do well.
Or do they?
A quick look at history will reveal different results. There have been many period in the past where stocks have gone nowhere in a 10 year period.
-From 1992 to 2003, the BSE Sensex went down 33% (aggregate not CAGR). Indian GDP grew at close to 6% in real terms during this period.
-The US stock markets have shown many long periods of poor performance inspite of positive economic growth. Between 1964 and 1982, US stock markets gave a 0% return inspite of growing at a 3% real growth rate. Till date, any index investor in the USA would have got no returns for money invested in 1998, a period of 10 years gave no returns.
-The Japanese markets peaked out in 1989 and after nearly 20 years, is still down 60% from those highs.
Experts love to say that stocks should go up because GDP will grow. Not true!
-The Chinese economy is the fastest growing economy in the world, growing at breath taking speeds of 10% or so over many years. Yet its stock market went down 50% from 2001 to 2004. It is down 60% from the peaks hit last year! China might win many gold medals at the Olympics, but its stock market is perhaps the worst performer in the world!
-Someone who had invested in the Indian BSE Sensex in Feb 2000 would have got a compounded return of 10.9% from stocks till date. Not a return to die for. During this period, the Indian economy recorded a 7% real GDP growth.
Let me state this very clearly. Stocks do well in an environment of low and stable inflation and interest rates. Rising inflation and (often hence) rising interest rates are bad for stocks (USA from 1969-1982). A deflationary (falling prices) environment means economic contraction, which is also bad for stocks (Japan from 1989).
Stocks are good for the long run if your starting point is good. If you start off at the begining is a bull supercycle, stocks will give great returns. If you start off at the lower end of valuations, stocks will give good returns. If you are caught in a bear supercycle, stocks will languish.
Stocks are not always a good buy and hold asset class...No asset class is! Each asset class needs a particular environment to do well.
Myth 2:
You cannot time the market.
By this, if someone means catching tops and bottoms precisely by design (and not by accident), I agree. But this is not what market timing is about. By market timing I mean buying when conditions are in your favour and selling when they are against you. Even if you can imprecisely time the markets, in an inperfect manner, your returns will get boosted. I had earlier written a post on this blog showing how one particular market timing strategy achieves superior returns with less risk and lower volatility. (Link: http://shashankjogi.blogspot.com/2008/07/comparing-5-investing-strategies.html)
Market timing is THE essence of successful investing. Traders try to time the markets. Even long term value investors time the market, buying when stocks become cheap and selling when they get expensive. Momentum investors time the market and buy when momentum starts building up and sell when momentum starts fading or reversing.
So do not hide behind the cover of "I dont have time to trade" defense mechanism. You dont need to look at the market every day or every week. Learn how to time the markets, afterall it is your money.
Myth 3:
Making money is all about picking stocks.
Another big myth!
No doubt, stock picking is important. You want to be in a stock that goes up. But merely picking a winning stock is of little significance if you get the other things wrong. You will not make much money.
What are the other things?
Intelligent exits and proper volumes of purchase
Not much fun in picking up Unitech at 100 to see it go to 550 and then back to 130.
You need to sell sufficiently high to benefit from the big price move.
And you need to buy in good volumes on such stocks to make significant money. Your 'position sizing' needs to be correct. Buy too little and you wont make much money. Buy too much and you run the risk of large losses if losses come about.
Look at the portfolios of various mutual funds. 90% of the variance in their performance comes from position sizing, i.e.from their decision on how much to buy. Only 10% comes from superior stock picking.
You don't need to be a great or even a good stock picker to make a lot of money.
Being average is fine as long as you follow a few cardinal rules in investing:
-Trade with the trend. That is where large profits originate.
-Let your profits run but cut your losses short
-Manage risk. Buy enough to make you a bundle, but short of anything that could lose you a lot of money.
Continued.....
Monday, August 4, 2008
Retirement Planning and Stock Market Returns
Retirement planning is good.
It helps you in having adequate funds when you retire from active worklife and in the rest of your life thereafter. It ensures that retirement is pleasant and you can goof off all day long without getting caught at it.
But any planning involves assumptions.
And retirement planning involves assumptions of returns on money deployed, among other things.
Today, there are a host of products that are available to help you plan for retirement. Without passing judgements over whether such products are good or not, we have many products sold by reputed names. Almost all have a 'paper asset' (stocks and bonds) inclination, that they will invest your money in equities or in debt or a combination of the two.
In the past 5 years, the Indian stock markets have seen spectacular returns and the frontline indices have given 35%+ returns compounded.
Buoyed by such handsome returns, Sales departments of many fund houses have been selling their retirement products on the basis of high return assumptions. While nobody talks about 35% returns going into eternity (such a return would leave the BSE sensex at a level of 11.8 crores after 30 years from its value of 14600 today!!), is the commonly assumed return even of 15-20% possible?
Fund managers would have us believe that a 15-20% return from the stock markets of a fast growing country like India is imminently possible over the long run. After all, they demonstrate that the BSE Sensex has grown from 100 in 1979 to 14600 today. This translates into a return of 18.75% compounded over 29 years. So why should it not grow, if not faster, at least at the same rate in the future?
India's GDP grew in nominal (real terms + inflation) terms at the rate of 13.8% from 1979 till 2008(estimates). Going into the future, it is difficult to imagine nominal growth rates higher than 13-14%. Why? Here is why.
If India grows at 10% in real terms, it is likely that inflation would have to be low, at around 4% or so. But since growth brings in inflationary pressures, a higher inflation would be met by higher interest rates, which would drive down growth rates (as also cut down corporate earnings). The best we can hope for is a high growth rate (7-9%) and low inflation (4-6%) thereby giving a nominal return of 13-14%.
To see what has happened over the last 5 years of high growth, India's GDP has grown at a nominal rate of 13.6%. In the past, we have occassionally grown at 15-16% nominal, but in all cases, it was because inflation was high at 9-11% with real growth being at 5-6% or less. Such period of high inflation were followed by periods of low real growth.
Ok, but why is it difficult to get 18% from stocks over a 30 year period?
Currently the market capitalization of India stocks (value of all stocks listed on the stock exchange) stands at around 1.1 times India's GDP (market cap to GDP ratio = 1.1). Whether this ratio suggests overvaluation or undervaluation is a matter of debate. Some people argue that this is a high number sugesting stocks are overvalued. Others respond by saying that this tool is not a accurate measure since new companies get listed and also corporate debt gets replaced by equity boosting the market cap of stocks.
Regardless of arguments and counterarguments, we note that this ratio stood at about 0.25 in March 2003. It stood at about 0.6 in March 2000 at the height of the technology bubble. It stood at 0.32 in 1979 (considering Sensex growth as the proxy for market cap growth).
It also stood at around 1.5 in January 2008.
We got handsome returns from stocks over the last 5 years because stocks were indeed deeply undervalued. We got our 18.75% returns from stocks since 1979 because stocks were undervalued.
We got a drubbing on the stock markets since January this year because stocks were overvalued. I reckon at at 1.1 times, we still are not undervalued. (With a PE ratio of 18.2, a Price:Book ratio of 3.8 and a dividend yield as low as 1.26, stocks still do not look cheap to me).
Even during the 'mother-of-all-bubbles' technology bubble in the USA, the market cap to GDP ratio of all US stocks was 1.9.
While we may not be able to say whether stocks are somewhat cheap or expensive using this ratio, very high values (>2) have perhaps not been attained even in prior bubbles. Similarly, very low values perhaps suggest undervaluation.
So if the Indian stock markets keep growing at 18.75% for the next 30 years and the Indian economy grows at 13% nominal, at the end of 30 years, the market cap to GDP ratio of Indian stock market would become an improbable 4.8!! Thus Indian stocks would be valued at 4.8 times the total output of the country. A extremely unlikely event considering that it has never happened.
It is more likely that market cap to GDP ratio would be around 1 after 30 years, giving a likely return of 12.6% on the stock markets. Even if you assume this ratio to be 1.5, stock returns would then be 14.1%.
Thus, the likely scenario for stock market returns for long retirement durations is likely to be between 12 and 15% and not the 15-20% as many assume.
Note also that since most of our money would be with fund houses (through retirement accounts and ULIPs and such), returns post their expenses and mortality charges (for ULIPs) would be lower to the tune of 2-3%. So on average, such retirement funds would generate 10-12% over the very long run.
There definately will be some outperformers. But most accounts will not outperform the broader markets. In addition, it is also very difficult to generate outperformance over long periods consistantly. Many funds perform well and then slip up later.
As far as building a corpus is concerned, a difference of 3% per annum in returns (between 12% and 15%) makes a lot of difference to the amount required to be saved per month. At 12%, to achieve a corpus of Rs.10 crores after 30 years, you would need to save aproximately Rs. 34500 per month. The same figure would be Rs.19100 per month at 15% rate of return, Rs. 10500 per month at 18%. Small differences in returns does make a big difference in the amount required to be saved and invested.
In closing, I would like to say that it is always a prudent practise to have a realistic (perhaps even conservative) estimate of returns you would get on your retirement money. You dont want to overestimate expected returns and realise at retirement that you will fall short of the money you need into retirement.
It helps you in having adequate funds when you retire from active worklife and in the rest of your life thereafter. It ensures that retirement is pleasant and you can goof off all day long without getting caught at it.
But any planning involves assumptions.
And retirement planning involves assumptions of returns on money deployed, among other things.
Today, there are a host of products that are available to help you plan for retirement. Without passing judgements over whether such products are good or not, we have many products sold by reputed names. Almost all have a 'paper asset' (stocks and bonds) inclination, that they will invest your money in equities or in debt or a combination of the two.
In the past 5 years, the Indian stock markets have seen spectacular returns and the frontline indices have given 35%+ returns compounded.
Buoyed by such handsome returns, Sales departments of many fund houses have been selling their retirement products on the basis of high return assumptions. While nobody talks about 35% returns going into eternity (such a return would leave the BSE sensex at a level of 11.8 crores after 30 years from its value of 14600 today!!), is the commonly assumed return even of 15-20% possible?
Fund managers would have us believe that a 15-20% return from the stock markets of a fast growing country like India is imminently possible over the long run. After all, they demonstrate that the BSE Sensex has grown from 100 in 1979 to 14600 today. This translates into a return of 18.75% compounded over 29 years. So why should it not grow, if not faster, at least at the same rate in the future?
India's GDP grew in nominal (real terms + inflation) terms at the rate of 13.8% from 1979 till 2008(estimates). Going into the future, it is difficult to imagine nominal growth rates higher than 13-14%. Why? Here is why.
If India grows at 10% in real terms, it is likely that inflation would have to be low, at around 4% or so. But since growth brings in inflationary pressures, a higher inflation would be met by higher interest rates, which would drive down growth rates (as also cut down corporate earnings). The best we can hope for is a high growth rate (7-9%) and low inflation (4-6%) thereby giving a nominal return of 13-14%.
To see what has happened over the last 5 years of high growth, India's GDP has grown at a nominal rate of 13.6%. In the past, we have occassionally grown at 15-16% nominal, but in all cases, it was because inflation was high at 9-11% with real growth being at 5-6% or less. Such period of high inflation were followed by periods of low real growth.
Ok, but why is it difficult to get 18% from stocks over a 30 year period?
Currently the market capitalization of India stocks (value of all stocks listed on the stock exchange) stands at around 1.1 times India's GDP (market cap to GDP ratio = 1.1). Whether this ratio suggests overvaluation or undervaluation is a matter of debate. Some people argue that this is a high number sugesting stocks are overvalued. Others respond by saying that this tool is not a accurate measure since new companies get listed and also corporate debt gets replaced by equity boosting the market cap of stocks.
Regardless of arguments and counterarguments, we note that this ratio stood at about 0.25 in March 2003. It stood at about 0.6 in March 2000 at the height of the technology bubble. It stood at 0.32 in 1979 (considering Sensex growth as the proxy for market cap growth).
It also stood at around 1.5 in January 2008.
We got handsome returns from stocks over the last 5 years because stocks were indeed deeply undervalued. We got our 18.75% returns from stocks since 1979 because stocks were undervalued.
We got a drubbing on the stock markets since January this year because stocks were overvalued. I reckon at at 1.1 times, we still are not undervalued. (With a PE ratio of 18.2, a Price:Book ratio of 3.8 and a dividend yield as low as 1.26, stocks still do not look cheap to me).
Even during the 'mother-of-all-bubbles' technology bubble in the USA, the market cap to GDP ratio of all US stocks was 1.9.
While we may not be able to say whether stocks are somewhat cheap or expensive using this ratio, very high values (>2) have perhaps not been attained even in prior bubbles. Similarly, very low values perhaps suggest undervaluation.
So if the Indian stock markets keep growing at 18.75% for the next 30 years and the Indian economy grows at 13% nominal, at the end of 30 years, the market cap to GDP ratio of Indian stock market would become an improbable 4.8!! Thus Indian stocks would be valued at 4.8 times the total output of the country. A extremely unlikely event considering that it has never happened.
It is more likely that market cap to GDP ratio would be around 1 after 30 years, giving a likely return of 12.6% on the stock markets. Even if you assume this ratio to be 1.5, stock returns would then be 14.1%.
Thus, the likely scenario for stock market returns for long retirement durations is likely to be between 12 and 15% and not the 15-20% as many assume.
Note also that since most of our money would be with fund houses (through retirement accounts and ULIPs and such), returns post their expenses and mortality charges (for ULIPs) would be lower to the tune of 2-3%. So on average, such retirement funds would generate 10-12% over the very long run.
There definately will be some outperformers. But most accounts will not outperform the broader markets. In addition, it is also very difficult to generate outperformance over long periods consistantly. Many funds perform well and then slip up later.
As far as building a corpus is concerned, a difference of 3% per annum in returns (between 12% and 15%) makes a lot of difference to the amount required to be saved per month. At 12%, to achieve a corpus of Rs.10 crores after 30 years, you would need to save aproximately Rs. 34500 per month. The same figure would be Rs.19100 per month at 15% rate of return, Rs. 10500 per month at 18%. Small differences in returns does make a big difference in the amount required to be saved and invested.
In closing, I would like to say that it is always a prudent practise to have a realistic (perhaps even conservative) estimate of returns you would get on your retirement money. You dont want to overestimate expected returns and realise at retirement that you will fall short of the money you need into retirement.
Thursday, July 31, 2008
Don't look at your portfolio every day
Suppose I offer you a bet: I flip a fair coin. If it lands up heads, I pay you Rs 2000. If it lands up tails, you pay me Rs.1000.
Would you accept the bet?
Rationally speaking, you should accept the bet. If the coin is fair, there is 50% chance of heads and a 50% chance of tails.
So the expected outcome is 0.5*2000-0.5*1000 = 500
You would expect to win, on average, 500 rupees per flip of the coin.
Most people however do not accept the bet. Why not? Because there is a 50% chance of losing Rs. 1000. Behavioural scientists have estimated that in humans, the pain of a loss is more than the pleasure of a profit. Some studies show that on average, humans value the pain from a loss at 2.5 times the pleasure from an equal gain. Thus we are likely to feel pained 2.5 times as much in losing Rs. 1000 as the pleasure of making Rs 1000. Alternatively speaking, the pain from a Rs 1000 loss is equal in intensity to the pleasure of a Rs. 2500 profit.
What implications does this have on investing? Many, but we shall discuss one.
If you are an investor with a portfolio, your portfolio is going to fluctuate every day depending upon what the market does. If your portfolio goes up, you will feel pleasure. If it goes down, you will feel pain. So, if you look at the value of your portfolio every day, you will swing between pleasure and pain. You would have a emotional roller-coaster ride, feeling happy one day and sad another day.
Assume you indeed are such an investor who looks at the value of your portfolio daily. If you had been invested in the Nifty-50 since 1991, here is what you would see (I shall spare you the statistical calculations):
Chance of making money = 52%
Average Daily Profit = 1.26%
Average Daily Loss = 1.27%
So 52% of the times you would have felt happy making money while 48% of the times you would have felt the pain of losing.
Assume that each percentage gain gives you one unit of pleasure. So one percentage of loss would give you 2.5 units of pain.
Considering 4308 trading days, the total pleasure accruing to you will be 0.52*4308*1.26*1 = 2822 units of pleasure.
And the total pain you would feel would be 0.48*4308*1.27*2.5 = 6565 units of pain.
So you would have an emotional balance of 2822-6565 = 3743 units of pain.
Overall, you would have felt a lot of pain!! OUCH!!!
Instead, you decide that you would look at your portfolio only once every year on 31 March of each year.
During this period, this is what you would have noticed:
Chance of making money = 66%
Average Yearly Profit = 59%
Average Yearly Loss = 15%
Total number of periods = 17
Your emotional statement would look like this:
Pleasure = 0.66*17*59*1 = 662 units of pleasure
Pain = 0.34*17*15*2.5 = 216 units of pain
Net Balance = 662-216 = 446 units of pleasure.
Overall you would have felt some amount of pleasure rather than net pain experienced in the first case.
Also note that your chances of making money go up from 52% to 66%
And in both cases, you make the same amount of money.
So, by not looking at your portfolio once every year rather than once every day, your chances of making money over the period of observation goes up and you feel more pleasure.
Extending this even further, If you chose to look at your portfolio over longer periods, the chances of making money go up further to 75% (3 year period) and 77% (5 year period).
By taking a longer term view of your portfolio, you increase the chances of making money over that horizon. Not only that, you also are saved of the emotional turmoil of pain and pleasure and overall face much less emotional stress and tension.
Ergo, don't look at your portfolio all to frequently. It will only drain you emotionally without adding a paisa to return.
Would you accept the bet?
Rationally speaking, you should accept the bet. If the coin is fair, there is 50% chance of heads and a 50% chance of tails.
So the expected outcome is 0.5*2000-0.5*1000 = 500
You would expect to win, on average, 500 rupees per flip of the coin.
Most people however do not accept the bet. Why not? Because there is a 50% chance of losing Rs. 1000. Behavioural scientists have estimated that in humans, the pain of a loss is more than the pleasure of a profit. Some studies show that on average, humans value the pain from a loss at 2.5 times the pleasure from an equal gain. Thus we are likely to feel pained 2.5 times as much in losing Rs. 1000 as the pleasure of making Rs 1000. Alternatively speaking, the pain from a Rs 1000 loss is equal in intensity to the pleasure of a Rs. 2500 profit.
What implications does this have on investing? Many, but we shall discuss one.
If you are an investor with a portfolio, your portfolio is going to fluctuate every day depending upon what the market does. If your portfolio goes up, you will feel pleasure. If it goes down, you will feel pain. So, if you look at the value of your portfolio every day, you will swing between pleasure and pain. You would have a emotional roller-coaster ride, feeling happy one day and sad another day.
Assume you indeed are such an investor who looks at the value of your portfolio daily. If you had been invested in the Nifty-50 since 1991, here is what you would see (I shall spare you the statistical calculations):
Chance of making money = 52%
Average Daily Profit = 1.26%
Average Daily Loss = 1.27%
So 52% of the times you would have felt happy making money while 48% of the times you would have felt the pain of losing.
Assume that each percentage gain gives you one unit of pleasure. So one percentage of loss would give you 2.5 units of pain.
Considering 4308 trading days, the total pleasure accruing to you will be 0.52*4308*1.26*1 = 2822 units of pleasure.
And the total pain you would feel would be 0.48*4308*1.27*2.5 = 6565 units of pain.
So you would have an emotional balance of 2822-6565 = 3743 units of pain.
Overall, you would have felt a lot of pain!! OUCH!!!
Instead, you decide that you would look at your portfolio only once every year on 31 March of each year.
During this period, this is what you would have noticed:
Chance of making money = 66%
Average Yearly Profit = 59%
Average Yearly Loss = 15%
Total number of periods = 17
Your emotional statement would look like this:
Pleasure = 0.66*17*59*1 = 662 units of pleasure
Pain = 0.34*17*15*2.5 = 216 units of pain
Net Balance = 662-216 = 446 units of pleasure.
Overall you would have felt some amount of pleasure rather than net pain experienced in the first case.
Also note that your chances of making money go up from 52% to 66%
And in both cases, you make the same amount of money.
So, by not looking at your portfolio once every year rather than once every day, your chances of making money over the period of observation goes up and you feel more pleasure.
Extending this even further, If you chose to look at your portfolio over longer periods, the chances of making money go up further to 75% (3 year period) and 77% (5 year period).
By taking a longer term view of your portfolio, you increase the chances of making money over that horizon. Not only that, you also are saved of the emotional turmoil of pain and pleasure and overall face much less emotional stress and tension.
Ergo, don't look at your portfolio all to frequently. It will only drain you emotionally without adding a paisa to return.
Wednesday, July 30, 2008
New Blog
I have started a new blog with the title "Current Issues". The link to this is as follows:
http://shashankcurrentissues.blogspot.com/
The new blog is intended to discuss current developments and issues relating to the financial markets with a bias towards the Indian stock markets.
The current blog (titled "On Investing") shall discuss general principles on investing and trading.
http://shashankcurrentissues.blogspot.com/
The new blog is intended to discuss current developments and issues relating to the financial markets with a bias towards the Indian stock markets.
The current blog (titled "On Investing") shall discuss general principles on investing and trading.
Saturday, July 26, 2008
What long term charts tell us
Asset classes follow long cycles.
Consider stocks for example. Empirical evidence suggests that stocks follow long cycles (called secular cycles) that last many many years, sometimes even more than a decade. We see evidence of secular bull cycles followed by secular bear cycles both lasting for long periods.
A secular bull cycle is a period when stock prices generally rise over time.
A secular bear cycle, in contrast, is a period when stock prices either fluctuate in a broad range (if corporate earnings keep going up) or stock prices go down (if corporate earnings fall).
Each cycle is characterised by a change in the P/E ratio of stocks and the markets as a whole.
In a secular bull cycle, P/E ratios start at low levels and keep rising to end at a absurdly high level. This accompanied with rising corporate profits means a fast rise for prices.
In a secular bear cycle, there is a compression/fall in the P/E ratio of the markets. P/E ratios start at very high levels and keep falling overall till they become very low. If corporate profits rise, they compensate the fall in PE ratios and the markets remain range bound. If profits also fall, it is a double whammy for prices.
How do such cycles start?
Each secular bull cycle starts with low valuations. Markets are really cheap but there is very little interest for the same. There is general apathy and dis-illusionment among people regarding stocks. Trading volumes are low and retail participation is also low. People's savings as a percentage of their total savings is also very low. The secular bull cycle is preceeded by a long secular bear phase where many people have ended up either losing a lot of money or not making anything. The secular bull cycle needs a catalyst to trigger it off.
Each secular bear cycle if the mirror image of a secular bull cycle. It starts off with the end of the secular bull cycle. Valuations get very high. Prices have shown a parabolic upmove. Mass particpation is high, frenzy pervades the markets and people are very optimistic. There are million reasons thrown around as to why "it is different" this time around and why high valuations are justified. It starts off with a big bust in the secular bull cycle.
However, a secular cycle does not mean that prices keep moving up or down all the time. There are counter-cyclical moves that happen on and off within the larger supercycle. Secular bull cycles witness bear markets lasting a while and secular bear cycles witness bull markets that also last a while. But such counter-cyclical moves do not change the direction of the secular cycle.
Let us now look at the long term chart of the stock market to see what it tells us.
The chart for the BSE Sensex from 1979 till June 2008 is shown below.
Despite my efforts to make it clearly visible, the chart does remain a bit hazy. For the original chart, you can go to the following link:
http://www.chartsrus.com/chart.php?image=http://www.sharelynx.com/chartstemp/free/chartind1CRUl.php?ticker=^BSESN
The chart is in log scale so as to bring out the ups and downs better. The X axis represents time and Y axis represents the value of the sensex. You would note that since the chart is in in log scale, the Y axis numbers are spaced unevenly.
We see that from the period 1979 till about 1992, the markets had an upswing marked by some corrections on the way. The sensex went up 42 times or thereabouts in a period of 13 years starting at the value of 100 in 1979 and ending in 4200+ in 1992. i.e a 42+ fold increase in value! This was a secular bull cycle
Even this secular bull cycle was interrupted by bear markets and sharp corrections. There was a bear market that started in 1986 and lasted till 1988 correcting by about 40% or so. Then there was another sharp pullback in 1990 that gave back 30-35% of its value.
Also note that every such bear market has occured after a sharp upmove. I call this a mini-bubble within the overall secular bull market.
From the period of 1992 top till about 2003, the sensex was largely range bound in a secular bear cycle. Note that even secular bear cycles have the occassional bull runs (1993-95, 1997-98, 1999-2000). But each get sold into and the market falls back either back into a range or lower still.
So with little piece of history, let us analyse what is happening currently.
Revisit the chart to see that from mid 2003 onwards, we are in a secular bull cycle again. Recall the mood and the sentiment in 2003, recall the valuations then and recall the period before 2003. Conditions were ripe for a secular bull cycle and that is exactly what we have seen.
Prices have been generally up since 2003. Prices broke out of the broad range establised between 1992-2003. Valuations also rose in PE terms. Participation has increased. The bull cycle was interrupted by corrections in 2004 and 2006, but that did not change the general direction of the market, which was up. Each time the markets made a new high. This was also characterised by high earnings growth of Indian corporates.
Note however that in 2008, this secular cycle has been interrupted by a bear market. In January 2008, valuations hit a mini-bubble level. People were enthusiastic about stocks and prices were rising very sharply. Everything looked rosy and the stage for a bear market was set. And we have got a counter-cyclical bear market within a secular bull cycle.
Why is it only counter cyclical and why does this not signal the end of the secular bull run? Because valuations got 'only' to mini-bubble levels and not to totally absurd levels. Participation was nowhere as high as is witnessed at the end of a secular cycle. There was some frenzy but not a total mania.
Markets will peak out and the current secular bull cycle will end when earnings growth peaks out as also expectations of earnings growth peak out. This has some distance to go, maybe 6-8 years or so, who knows. Going by history, we could see much higher levels, even to the tune of 50000+ on the sensex before the markets peak out in this secular cycle.
So what about the current bear market? How long could it last and how low can it go?
Looking at previous bear markets, it could last for 2 years or so. So assuming it started in Jan 2008, it could go on till end of 2009. It would start exactly the way a secular bull market starts, though in a lesser degree. People would need to give up hope and lose interest in stocks for the secular bull run to resume again. Right now, there is too much hope among the retail investors that we could see the resumption soon, just as we saw it in 2004 and 2006.
How low could it go?
The current PE ratio of the Nifty stands at 18.17 as per NSE data. Bull markets dont commence at such high PE ratios. Valuations need to come down to lower levels, say 12-14. Assuming that the bull market resumes by late 2009, assuming a forward PE ratio of the markets at 10-12, and assuming a EPS for Sensex at 1050 for FY2010, we can say that the market could go down to anything between 10500-12600. This would be about a 40-50% correction from the top, which is in line with prior bear markets as well.
So all is not lost, far from it. There will be opportunities in the future, very profitable opportunities, in my opinion.
PS:
Assets like Gold, Silver, Crude Oil, all are showing signs of being in classic secular bull cycles. So while in the near term, we dont know what could happen to their prices, my own sense is that there is a long way to go up for these commodities before they peak out...so Gold at $980/ounce or crude at $148/barrel may not be the eventual peaks.
Crude at $200 could be very bad for India and may upset the extent of the secular bull cycle case...India imports 76% of its crude oil. India's oil import bill this year will be around $110 billion to $120 billion. This is 11-12% of our GDP...we would be handing over 12% of our total income to foreign countries! What would that do to our currency and what would that do to a neutral currency like Gold? The wise investor stays alert...
Consider stocks for example. Empirical evidence suggests that stocks follow long cycles (called secular cycles) that last many many years, sometimes even more than a decade. We see evidence of secular bull cycles followed by secular bear cycles both lasting for long periods.
A secular bull cycle is a period when stock prices generally rise over time.
A secular bear cycle, in contrast, is a period when stock prices either fluctuate in a broad range (if corporate earnings keep going up) or stock prices go down (if corporate earnings fall).
Each cycle is characterised by a change in the P/E ratio of stocks and the markets as a whole.
In a secular bull cycle, P/E ratios start at low levels and keep rising to end at a absurdly high level. This accompanied with rising corporate profits means a fast rise for prices.
In a secular bear cycle, there is a compression/fall in the P/E ratio of the markets. P/E ratios start at very high levels and keep falling overall till they become very low. If corporate profits rise, they compensate the fall in PE ratios and the markets remain range bound. If profits also fall, it is a double whammy for prices.
How do such cycles start?
Each secular bull cycle starts with low valuations. Markets are really cheap but there is very little interest for the same. There is general apathy and dis-illusionment among people regarding stocks. Trading volumes are low and retail participation is also low. People's savings as a percentage of their total savings is also very low. The secular bull cycle is preceeded by a long secular bear phase where many people have ended up either losing a lot of money or not making anything. The secular bull cycle needs a catalyst to trigger it off.
Each secular bear cycle if the mirror image of a secular bull cycle. It starts off with the end of the secular bull cycle. Valuations get very high. Prices have shown a parabolic upmove. Mass particpation is high, frenzy pervades the markets and people are very optimistic. There are million reasons thrown around as to why "it is different" this time around and why high valuations are justified. It starts off with a big bust in the secular bull cycle.
However, a secular cycle does not mean that prices keep moving up or down all the time. There are counter-cyclical moves that happen on and off within the larger supercycle. Secular bull cycles witness bear markets lasting a while and secular bear cycles witness bull markets that also last a while. But such counter-cyclical moves do not change the direction of the secular cycle.
Let us now look at the long term chart of the stock market to see what it tells us.
The chart for the BSE Sensex from 1979 till June 2008 is shown below.
Despite my efforts to make it clearly visible, the chart does remain a bit hazy. For the original chart, you can go to the following link:
http://www.chartsrus.com/chart.php?image=http://www.sharelynx.com/chartstemp/free/chartind1CRUl.php?ticker=^BSESN
The chart is in log scale so as to bring out the ups and downs better. The X axis represents time and Y axis represents the value of the sensex. You would note that since the chart is in in log scale, the Y axis numbers are spaced unevenly.
We see that from the period 1979 till about 1992, the markets had an upswing marked by some corrections on the way. The sensex went up 42 times or thereabouts in a period of 13 years starting at the value of 100 in 1979 and ending in 4200+ in 1992. i.e a 42+ fold increase in value! This was a secular bull cycle
Even this secular bull cycle was interrupted by bear markets and sharp corrections. There was a bear market that started in 1986 and lasted till 1988 correcting by about 40% or so. Then there was another sharp pullback in 1990 that gave back 30-35% of its value.
Also note that every such bear market has occured after a sharp upmove. I call this a mini-bubble within the overall secular bull market.
From the period of 1992 top till about 2003, the sensex was largely range bound in a secular bear cycle. Note that even secular bear cycles have the occassional bull runs (1993-95, 1997-98, 1999-2000). But each get sold into and the market falls back either back into a range or lower still.
So with little piece of history, let us analyse what is happening currently.
Revisit the chart to see that from mid 2003 onwards, we are in a secular bull cycle again. Recall the mood and the sentiment in 2003, recall the valuations then and recall the period before 2003. Conditions were ripe for a secular bull cycle and that is exactly what we have seen.
Prices have been generally up since 2003. Prices broke out of the broad range establised between 1992-2003. Valuations also rose in PE terms. Participation has increased. The bull cycle was interrupted by corrections in 2004 and 2006, but that did not change the general direction of the market, which was up. Each time the markets made a new high. This was also characterised by high earnings growth of Indian corporates.
Note however that in 2008, this secular cycle has been interrupted by a bear market. In January 2008, valuations hit a mini-bubble level. People were enthusiastic about stocks and prices were rising very sharply. Everything looked rosy and the stage for a bear market was set. And we have got a counter-cyclical bear market within a secular bull cycle.
Why is it only counter cyclical and why does this not signal the end of the secular bull run? Because valuations got 'only' to mini-bubble levels and not to totally absurd levels. Participation was nowhere as high as is witnessed at the end of a secular cycle. There was some frenzy but not a total mania.
Markets will peak out and the current secular bull cycle will end when earnings growth peaks out as also expectations of earnings growth peak out. This has some distance to go, maybe 6-8 years or so, who knows. Going by history, we could see much higher levels, even to the tune of 50000+ on the sensex before the markets peak out in this secular cycle.
So what about the current bear market? How long could it last and how low can it go?
Looking at previous bear markets, it could last for 2 years or so. So assuming it started in Jan 2008, it could go on till end of 2009. It would start exactly the way a secular bull market starts, though in a lesser degree. People would need to give up hope and lose interest in stocks for the secular bull run to resume again. Right now, there is too much hope among the retail investors that we could see the resumption soon, just as we saw it in 2004 and 2006.
How low could it go?
The current PE ratio of the Nifty stands at 18.17 as per NSE data. Bull markets dont commence at such high PE ratios. Valuations need to come down to lower levels, say 12-14. Assuming that the bull market resumes by late 2009, assuming a forward PE ratio of the markets at 10-12, and assuming a EPS for Sensex at 1050 for FY2010, we can say that the market could go down to anything between 10500-12600. This would be about a 40-50% correction from the top, which is in line with prior bear markets as well.
So all is not lost, far from it. There will be opportunities in the future, very profitable opportunities, in my opinion.
PS:
Assets like Gold, Silver, Crude Oil, all are showing signs of being in classic secular bull cycles. So while in the near term, we dont know what could happen to their prices, my own sense is that there is a long way to go up for these commodities before they peak out...so Gold at $980/ounce or crude at $148/barrel may not be the eventual peaks.
Crude at $200 could be very bad for India and may upset the extent of the secular bull cycle case...India imports 76% of its crude oil. India's oil import bill this year will be around $110 billion to $120 billion. This is 11-12% of our GDP...we would be handing over 12% of our total income to foreign countries! What would that do to our currency and what would that do to a neutral currency like Gold? The wise investor stays alert...
Thursday, July 24, 2008
To invest or not to invest, that is the question.
"We have given a return of 35% compounded over the past 5 years. You should invest with us."
"The stock markets have not lost money over any 10 year period. So you should invest in the stock markets with a long term horizon."
"At this stage, there is very little risk in the markets. So let us help you invest now."
Such claims and more are frequently made to gullible investors by mutual funds sales people and individual investment managers/advisors alike. Most get sucked in by such talk and invest. Some realise later that they made a mistake.
How should you evaluate whether an investment or a money manager is worthy of your hard earned money? Should you invest with someone who has returned 30% over someone else who has returned 20%?
There are many standard tools (Risk-adjusted returns, standard deviation, Sharpe ratio, Treynor ratio, Sortino ratio, etc) to measure investment performance. I am not sure they represent the correct way to measure investment performance. Hence allow me to present how you should do this.
At the core, whether you should invest boils down to this: Will the investment help you achieve your return objectives in your time horizon without causing financial ruin or discomfort? If yes, then invest. If no, let it go.
But first, let us understand and, more importantly, embrace the concept that in investments (as is the case with all things involving chance) luck is an important element in determining success. While all of us might like to believe that investment success is an outcome of skill, that is only partially true.
It is quite possible that an overall beneficial environment can make an poor money manager look brilliant while a brilliant manager might look mediocre. So how do you know whether a money manager has succeeded because of luck or skill? While theoritically you may never come to know about this, you can come to a conclusion based on the long term performance of the money manager.
How long is long? There is no right answer but 10 years is a long enough time for you to get an idea. The basic idea behind choosing 10 years is that in 10 years, hopefully, the money manager would have seen bull and bear markets. So you would know how the manager has fared through different market cycles.
Should the manager be process driven? There are some managers who have special skill in managing money. Others follow a sound process. There is no right answer for this and in my opinion, following a process is not a criterion you should use to evaluate performance.
Rather what is more important is whether the fund manager follows one/more investing philosophies. An investing philosophy guides decision making. Of course, the fund manager should have an investing philosophy that is based on reason. And he should be able to explain this philosophy to you in 2 minutes. ' Technical analysis' or concepts that have a wide scope cannot be an investing philosophy. Within technical anlysis one investing philosophy could be trend trading. That's a valid answer rather than merely stating broad concepts.
Having established that the fund manager has a long track record using a valid investing philosophy, you come to performance parameters.
Return:
This is quite obvious. We all seek higher returns. What returns has the money manager obtained over the long term?
Should returns be stable? That depends upon the investor. Some people like stable returns, some do not mind swings in performance. As long as the compounded returns in your desired time horizon are upto your satisfaction, that is fine.
(Note however that if your time horizon is not long, and returns by the money manager are not stable, you might not be able to achieve your returns over this shorter time period. Hence you are better off with an investment/money management that gives stable returns.)
Risk:
But looking at returns without consideration for the risks is incomplete. People talk about risk adjusted returns. Many do not understand what risk really is. Academicians talk about Beta as a measure of risk. But Beta is merely a measure of volatility, not of risk. Similarly standard deviation is a measure of volatility of returns, not a measure of risk.
Risk to you refers to the chance of not meeting your desired returns in your desired time horizon. Let me repeat this: risk to YOU refers to the chance of not meeting YOUR desired returns in YOUR desired time horizon.
So let us say that your investment horizon is 3 years. You are evaluating the performance of a money manager over the last 10 years. In 10 years you will have eight 3-year performances (assuming year start or year end dates only). If you see that across all such periods, your investment returns of 15% have been met, then the manager did a wonderful job of managing risk FOR YOU. What happened between any 3 year period is simply volatility and not risk. You could have taken money out at the end of any 3 year period and felt satisfied having met your desired returns.
If however you see that in 4 of the 8 3-year periods, your expected return has not been met by a maximum of 4%, risk to YOU is 4%. Whether a 4% risk is acceptable to you is a personal decision.
But, if your time horizon is 1 year and the maximum deviation in any one year between achieved return and desired return is -30%, the investment bears very high risk regardless of the fact that over any 3 year period, the manager might not have lost money!
Risk is time dependant!
Volatility does bother us and we dont like to see our net worth go down, at least not go down much.
So we come to...
Draw downs:
Draw down is the crest to trough move in our capital. It is the difference between the max level in our money and the min level in our money before a new high in capital is achieved. So if the value of our investments goes up from 100 to 150 and corrects to 130 before it moves higher, the draw down is 150-130 = 20.
Draw downs can make us uncomfortable and anxious. No one really likes to see their wealth go down, even if it is only on paper. The smaller the draw downs, all other things being equal, the better is the investment performance. Some people are comfortable with large draw downs, others want it to be small. Look at the investment performance if the manager and see what has been the (1) largest draw down and (2) average draw down. If both are within your comfort zone, the investment is ok for you. If not, you should invest less such that the drawdown on your total capital is acceptable to you.
Knowing what is an acceptable draw down and what is not is somewhat tricky. You might think that a certain draw down is acceptable to you. But when that draw down comes, you might realise that it was set too high or too low. It requires some experience with draw downs (and with investing) to arrive at a comfortable number to draw down.
So we say that, any investment or money managent that helps YOU achieve YOUR return objectives in YOUR given time horizon without causing financial ruin or discomfort, is investment worthy.
Notice how I have not even mentioned yearly returns, or standard deviation of returns or fancy terms like Sharpe Ratio, Sortino Ratio, or Information ratio. I have not alluded to alpha or beta or other Greek alphabets that experts love to talk about.
Investing is a financial journey. You want to get to your destination within a given time without losing your life and without the journey being uncomfortable. You should take any vehicle that meets your requirements.
"The stock markets have not lost money over any 10 year period. So you should invest in the stock markets with a long term horizon."
"At this stage, there is very little risk in the markets. So let us help you invest now."
Such claims and more are frequently made to gullible investors by mutual funds sales people and individual investment managers/advisors alike. Most get sucked in by such talk and invest. Some realise later that they made a mistake.
How should you evaluate whether an investment or a money manager is worthy of your hard earned money? Should you invest with someone who has returned 30% over someone else who has returned 20%?
There are many standard tools (Risk-adjusted returns, standard deviation, Sharpe ratio, Treynor ratio, Sortino ratio, etc) to measure investment performance. I am not sure they represent the correct way to measure investment performance. Hence allow me to present how you should do this.
At the core, whether you should invest boils down to this: Will the investment help you achieve your return objectives in your time horizon without causing financial ruin or discomfort? If yes, then invest. If no, let it go.
But first, let us understand and, more importantly, embrace the concept that in investments (as is the case with all things involving chance) luck is an important element in determining success. While all of us might like to believe that investment success is an outcome of skill, that is only partially true.
It is quite possible that an overall beneficial environment can make an poor money manager look brilliant while a brilliant manager might look mediocre. So how do you know whether a money manager has succeeded because of luck or skill? While theoritically you may never come to know about this, you can come to a conclusion based on the long term performance of the money manager.
How long is long? There is no right answer but 10 years is a long enough time for you to get an idea. The basic idea behind choosing 10 years is that in 10 years, hopefully, the money manager would have seen bull and bear markets. So you would know how the manager has fared through different market cycles.
Should the manager be process driven? There are some managers who have special skill in managing money. Others follow a sound process. There is no right answer for this and in my opinion, following a process is not a criterion you should use to evaluate performance.
Rather what is more important is whether the fund manager follows one/more investing philosophies. An investing philosophy guides decision making. Of course, the fund manager should have an investing philosophy that is based on reason. And he should be able to explain this philosophy to you in 2 minutes. ' Technical analysis' or concepts that have a wide scope cannot be an investing philosophy. Within technical anlysis one investing philosophy could be trend trading. That's a valid answer rather than merely stating broad concepts.
Having established that the fund manager has a long track record using a valid investing philosophy, you come to performance parameters.
Return:
This is quite obvious. We all seek higher returns. What returns has the money manager obtained over the long term?
Should returns be stable? That depends upon the investor. Some people like stable returns, some do not mind swings in performance. As long as the compounded returns in your desired time horizon are upto your satisfaction, that is fine.
(Note however that if your time horizon is not long, and returns by the money manager are not stable, you might not be able to achieve your returns over this shorter time period. Hence you are better off with an investment/money management that gives stable returns.)
Risk:
But looking at returns without consideration for the risks is incomplete. People talk about risk adjusted returns. Many do not understand what risk really is. Academicians talk about Beta as a measure of risk. But Beta is merely a measure of volatility, not of risk. Similarly standard deviation is a measure of volatility of returns, not a measure of risk.
Risk to you refers to the chance of not meeting your desired returns in your desired time horizon. Let me repeat this: risk to YOU refers to the chance of not meeting YOUR desired returns in YOUR desired time horizon.
So let us say that your investment horizon is 3 years. You are evaluating the performance of a money manager over the last 10 years. In 10 years you will have eight 3-year performances (assuming year start or year end dates only). If you see that across all such periods, your investment returns of 15% have been met, then the manager did a wonderful job of managing risk FOR YOU. What happened between any 3 year period is simply volatility and not risk. You could have taken money out at the end of any 3 year period and felt satisfied having met your desired returns.
If however you see that in 4 of the 8 3-year periods, your expected return has not been met by a maximum of 4%, risk to YOU is 4%. Whether a 4% risk is acceptable to you is a personal decision.
But, if your time horizon is 1 year and the maximum deviation in any one year between achieved return and desired return is -30%, the investment bears very high risk regardless of the fact that over any 3 year period, the manager might not have lost money!
Risk is time dependant!
Volatility does bother us and we dont like to see our net worth go down, at least not go down much.
So we come to...
Draw downs:
Draw down is the crest to trough move in our capital. It is the difference between the max level in our money and the min level in our money before a new high in capital is achieved. So if the value of our investments goes up from 100 to 150 and corrects to 130 before it moves higher, the draw down is 150-130 = 20.
Draw downs can make us uncomfortable and anxious. No one really likes to see their wealth go down, even if it is only on paper. The smaller the draw downs, all other things being equal, the better is the investment performance. Some people are comfortable with large draw downs, others want it to be small. Look at the investment performance if the manager and see what has been the (1) largest draw down and (2) average draw down. If both are within your comfort zone, the investment is ok for you. If not, you should invest less such that the drawdown on your total capital is acceptable to you.
Knowing what is an acceptable draw down and what is not is somewhat tricky. You might think that a certain draw down is acceptable to you. But when that draw down comes, you might realise that it was set too high or too low. It requires some experience with draw downs (and with investing) to arrive at a comfortable number to draw down.
So we say that, any investment or money managent that helps YOU achieve YOUR return objectives in YOUR given time horizon without causing financial ruin or discomfort, is investment worthy.
Notice how I have not even mentioned yearly returns, or standard deviation of returns or fancy terms like Sharpe Ratio, Sortino Ratio, or Information ratio. I have not alluded to alpha or beta or other Greek alphabets that experts love to talk about.
Investing is a financial journey. You want to get to your destination within a given time without losing your life and without the journey being uncomfortable. You should take any vehicle that meets your requirements.
Monday, July 21, 2008
Avoid Price Volatility
Some people advise making use of market volatility. Market go up and they go down. So according to this view, one should profit from market volatility, i.e. buy when prices go down and sell when prices go up. Of course, this is the classic 'buy low sell high' approach. Nice in theory, but not so easy to practise. After all no one really knows how low is low and how high is high, and for how long the low and high states will remain.
Then there are others who suggest that since volatility is a part of the market, one should accept volatility and expect markets to give good returns over a longer run. This view suggests that one assumes market volatility as given and ignore the period to period fluctuations in prices with an eye on the longer term end result.
However, market volatilty is not good for your portfolio.
Take an example as follows. There are two portfolios. Portfolio A is quite volatile with returns swinging between positive and negative. Portfolio B is very stable, returning the same 14% return year after year.
Lets assume that portfolio A has the following returns over a 10 year period:
50%, -20%, 65%, -30%, 40%, -15%, 100%, -45%, 70%, -35%
The average of all the above 10 figures is 18% per annum. One could be tempted to think that over a 10 year period, one would get a 18% return on the initial capital. That is unfortunately not true. A rupee invested at the begining of year 1 would become 2.004 after 10 years. This implies a return of only 7.2% per annum compounded (You can do your own calculations).
Because the returns were volatile, the compounded returns were less than half of that of the arithmetic mean. Volatility causes returns to diminish!
Instead if you assume that portfolio B gives a steady return of 14% per annum, a rupee invested in portfolio B at the begining of year 1 becomes 3.70 after 10 years.
Even though portfolio B has a lower arithmetic mean (14% per annum) than portfolio A (18% per annum), it still gives a higher compounded return than portfolio A.
A quick look at the BSE sensex from 31 March 1979 to 31 March 2008 paints a similar picture. The arithmetic mean of yearly returns comes out to be 27.6% per annum. However, the compounded returns are 19% per annum.
The implications of this need to be noted.
First, we tend to dislike volatility on a psychological level. We generally dont like our portfolios to keep swinging wildly. We feel uncomfortable and anxious when volatility kicks in. But on a returns plane as well, volatility (or more correctly, downside volatility) tends to reduce returns regardless of the order in which the volatility occurs. (A positive 20% and a negative 20% leads to a negative 4% absolute regardless of the order in which returns come in). So when markets become volatile, we are well advised to trade less or not at all.
Secondly, if you are a long term investor, you will benefit even more by minimizing volatility in your portfolio. Considering the sensex example above, at 27.6% since 1979, the sensex would have been at 117400 and not 15644 as of March 31 2008! This is a multiple of close to 7.5. i.e. by avoiding volatility you could have been more than 7.5 times richer than by accepting volatility.
It is a common belief that if you know what to buy and buy it at the right time, the money taps would be opened for you. I have maintained my stance that what to buy and when to buy and not as important as it is made out to be. There are many other hidden factors (like avoiding volatility) that are quite neglected from our investing plans. It may not be a bad idea to consider means of avoiding portfolio volatility.
Then there are others who suggest that since volatility is a part of the market, one should accept volatility and expect markets to give good returns over a longer run. This view suggests that one assumes market volatility as given and ignore the period to period fluctuations in prices with an eye on the longer term end result.
However, market volatilty is not good for your portfolio.
Take an example as follows. There are two portfolios. Portfolio A is quite volatile with returns swinging between positive and negative. Portfolio B is very stable, returning the same 14% return year after year.
Lets assume that portfolio A has the following returns over a 10 year period:
50%, -20%, 65%, -30%, 40%, -15%, 100%, -45%, 70%, -35%
The average of all the above 10 figures is 18% per annum. One could be tempted to think that over a 10 year period, one would get a 18% return on the initial capital. That is unfortunately not true. A rupee invested at the begining of year 1 would become 2.004 after 10 years. This implies a return of only 7.2% per annum compounded (You can do your own calculations).
Because the returns were volatile, the compounded returns were less than half of that of the arithmetic mean. Volatility causes returns to diminish!
Instead if you assume that portfolio B gives a steady return of 14% per annum, a rupee invested in portfolio B at the begining of year 1 becomes 3.70 after 10 years.
Even though portfolio B has a lower arithmetic mean (14% per annum) than portfolio A (18% per annum), it still gives a higher compounded return than portfolio A.
A quick look at the BSE sensex from 31 March 1979 to 31 March 2008 paints a similar picture. The arithmetic mean of yearly returns comes out to be 27.6% per annum. However, the compounded returns are 19% per annum.
The implications of this need to be noted.
First, we tend to dislike volatility on a psychological level. We generally dont like our portfolios to keep swinging wildly. We feel uncomfortable and anxious when volatility kicks in. But on a returns plane as well, volatility (or more correctly, downside volatility) tends to reduce returns regardless of the order in which the volatility occurs. (A positive 20% and a negative 20% leads to a negative 4% absolute regardless of the order in which returns come in). So when markets become volatile, we are well advised to trade less or not at all.
Secondly, if you are a long term investor, you will benefit even more by minimizing volatility in your portfolio. Considering the sensex example above, at 27.6% since 1979, the sensex would have been at 117400 and not 15644 as of March 31 2008! This is a multiple of close to 7.5. i.e. by avoiding volatility you could have been more than 7.5 times richer than by accepting volatility.
It is a common belief that if you know what to buy and buy it at the right time, the money taps would be opened for you. I have maintained my stance that what to buy and when to buy and not as important as it is made out to be. There are many other hidden factors (like avoiding volatility) that are quite neglected from our investing plans. It may not be a bad idea to consider means of avoiding portfolio volatility.
Sunday, July 13, 2008
The hype, the party and the hangover
It is not easy to resist falling prey to hype.
Over the last 4-5 years, India became a much hyped country.
Tailwinds were strong.
Interest rates were low.
Inflation was benign.
Domestic capacity was adequate to meet rising demand.
Riding on such benign conditions, India recorded 4-5 years of high growth.
The economy boomed.
Incomes started rising.
Corporate profits rocketed.
Asset prices rose; stocks rose, real estate rose.
Every investor became a genius.
Lets party, said the people.
So the party began.
People danced to the music.
Drinks flowed like water.
Everyone was happy and cheerful.
And also drunk.
India had arrived, the experts claimed.
We will become an economic superpower, they asserted.
No one can afford to ignore us, they said.
We thought we had become a asset class in ourselves.
Foreigners threw money at our stocks and stock valuations went higher.
Lets party more, we said to ourselves.
And we did party harder.
And got high on our own success.
Till one fine day.
The DJ stopped the music.
No more drinks, said the bartender.
The party came to an abrupt end.
A few wise men had already left the party.
A few others took the cues and started leaving too.
The rest stayed on and protested.
We want the party to continue, they exclaimed.
We demand more music and more drinks, they said.
But all the huffing and puffing could not start the party again.
Some said that the party would start soon.
Others advised people to wait for a 'longer' period.
But the party simply would not resume.
And the effect of the liberal drinking and wild dancing started showing up.
Those who chose to stay had a severe bout of hangover from the drinking.
And sore muscles from the excess dancing.
It will take time for the hangover to go away.
It will take time for the untoned muscles to recover again.
Till that time there will be pain and misery.
We fell prey to hype.
Some had shouted BRIC.
Some had shouted Great Growth Story.
Some had shouted decoupling.
Some had shouted domestic consumption.
And we believed every word of it.
All of the above is true to some extent.
But not to the extent the consensus thought.
Potential exists, that woud make investors money.
Hype simply leads to ruined plans and shattered dreams.
Every upswing sows the seeds of its own demise.
And a downswing follows as upswing.
India would continue to grow.
But not at 10% per annum.
Beneficial external conditions and excess capacities lulled us into believing that 9% growth was a given.
And that investing was the easiest game around.
That investing did not require any skill, experience or hard work.
When external conditions start acting like headwinds, they put the brakes on growth.
Inherently, we do not have the ability to grow at such high rates for ever.
Not enough infrastructure, not enough political ability, not enough maturity among ourselves.
So not enough returns from stocks.
We should have avoided hype when there was such.
We should continue to avoid it.
But things are not gloomy at all.
Foreign money drives our stock markets.
Foreign money will come back again.
History suggests it behaves exactly the same way time after time.
Foreign money is not neccessarily smart money.
It will come again.
India will become hype again.
Spring follows Winter.
Be ready for Spring.
Be ready with your money.
Be ready to ride the hype again.
But dont fall prey to it at the end.
You can again make a lot of money.
Over the last 4-5 years, India became a much hyped country.
Tailwinds were strong.
Interest rates were low.
Inflation was benign.
Domestic capacity was adequate to meet rising demand.
Riding on such benign conditions, India recorded 4-5 years of high growth.
The economy boomed.
Incomes started rising.
Corporate profits rocketed.
Asset prices rose; stocks rose, real estate rose.
Every investor became a genius.
Lets party, said the people.
So the party began.
People danced to the music.
Drinks flowed like water.
Everyone was happy and cheerful.
And also drunk.
India had arrived, the experts claimed.
We will become an economic superpower, they asserted.
No one can afford to ignore us, they said.
We thought we had become a asset class in ourselves.
Foreigners threw money at our stocks and stock valuations went higher.
Lets party more, we said to ourselves.
And we did party harder.
And got high on our own success.
Till one fine day.
The DJ stopped the music.
No more drinks, said the bartender.
The party came to an abrupt end.
A few wise men had already left the party.
A few others took the cues and started leaving too.
The rest stayed on and protested.
We want the party to continue, they exclaimed.
We demand more music and more drinks, they said.
But all the huffing and puffing could not start the party again.
Some said that the party would start soon.
Others advised people to wait for a 'longer' period.
But the party simply would not resume.
And the effect of the liberal drinking and wild dancing started showing up.
Those who chose to stay had a severe bout of hangover from the drinking.
And sore muscles from the excess dancing.
It will take time for the hangover to go away.
It will take time for the untoned muscles to recover again.
Till that time there will be pain and misery.
We fell prey to hype.
Some had shouted BRIC.
Some had shouted Great Growth Story.
Some had shouted decoupling.
Some had shouted domestic consumption.
And we believed every word of it.
All of the above is true to some extent.
But not to the extent the consensus thought.
Potential exists, that woud make investors money.
Hype simply leads to ruined plans and shattered dreams.
Every upswing sows the seeds of its own demise.
And a downswing follows as upswing.
India would continue to grow.
But not at 10% per annum.
Beneficial external conditions and excess capacities lulled us into believing that 9% growth was a given.
And that investing was the easiest game around.
That investing did not require any skill, experience or hard work.
When external conditions start acting like headwinds, they put the brakes on growth.
Inherently, we do not have the ability to grow at such high rates for ever.
Not enough infrastructure, not enough political ability, not enough maturity among ourselves.
So not enough returns from stocks.
We should have avoided hype when there was such.
We should continue to avoid it.
But things are not gloomy at all.
Foreign money drives our stock markets.
Foreign money will come back again.
History suggests it behaves exactly the same way time after time.
Foreign money is not neccessarily smart money.
It will come again.
India will become hype again.
Spring follows Winter.
Be ready for Spring.
Be ready with your money.
Be ready to ride the hype again.
But dont fall prey to it at the end.
You can again make a lot of money.
Thursday, July 10, 2008
What should investors do now?
"What should investors do now?"
With the markets having melted down, the popular media, especially television media poses such questions to 'market experts'. The underlying thought is what investors should do at the current juncture to make money (or not lose it).
But let me ask you a different question:
"Why do you think you will at all make money in the market? What makes you think you are capable of making money from the markets?"
We walk into the trading arena hoping to make money. We see others making money or hear about others making money in the stock markets and enter to get our share in the loot.
There is a large class of people (mainly in the acedemic world) that thinks that markets are very efficient. They believe in what is commonly called the Efficient Market Hypothesis (EMH). According to this, the markets are very efficient and prices reflect all known information. i.e. they are never overpriced nor underpriced, just perfectly priced. New information gets assimilated in the price almost instantaneously. Markets behave rationally. Everyone knows all the information available and hence no single investor can get more than market returns over time.
We all know that the EMH fails miserably in the real world. There are people who make a lot of money consistantly, there are people who fail all the time. Markets do not behave rationally and there are booms, manias, crashes and busts that take place over and over again.
That markets behave irrationally is to be expected since markets are a social process. People behave irrationally. This leads to pricing mistakes. Pricing mistakes create prospects of above-average profits. All active investing is in reality an attempt to take advantage of such errors. We try to exploit others' errors as others try to exploit ours. Superior returns come from successfully exploiting such errors.
But markets are a zero sum game. One man's gain is another man's loss. So why should we think that we can gain at someone else's expense? What skills do we possess that would give us the ability to profit at others' mistakes? Why would others give us their hard earned money?
The answer partially lies in our investing philosophy (and every investor should have one). What is an investing philosophy? An investing philosophy is a coherant way of thinking about how markets work, how they don't work, and what mistakes they make. It is our view of how the market functions, and when it is right and when it is wrong. Viewed through the lense of our investing philosophy, we percieve certain market outcomes as correct and certain others as errors. It is then these errors that we attempt to exploit.
Behind every investing pilosophy is the assumption that markets make pricing errors. An example of one investing philosophy could be that markets tend to overvalue growth and underestimate the value of existing assets. This could lead to different investing strategies designed to exploit such conditions, whenever they exist. Or you could have a philosophy that works on the irrational human tendency to join herds, which could lead to various momentum and trend following strategies. Perhaps you think that people get very pessimistic at times and stocks get very cheap which give great buying opportunities...that is also a valid thought.
Most people roam around the marketplace without any definitive investing philosophy. Trading the markets without one is like driving a boat without a rudder. You simply cannot move in the direction of your choice. Anchoring decisions to an investing philosophy is critical for longer term success.
Having understood this, we must note that markets do not make the same mistake every day or every week or every month or even every year. In some years, the mood might be so pessimistic that stocks get seriously undervalued. In other years, herd mentality might dominate so much that stocks take off in parabolic fashion. While in other times, markets might simply move up and down without going anywhere. Hence no investing philosophy would make money all the time.
Every investor needs to follow his/her investing philosophy/philosophies regardless of market conditions. If you believe in value investing, you should search for stocks that are cheap. If you believe in trend trading, you should search for stocks that are trending higher or lower. If you believe in arbitrage, you should seek arbitrage opportunities. There is no single correct answer.
"What should investors do now?" Such questions reflect a basic lack of understanding of the investing process. Investors need to reflect and develop a workable investing philosophy suited to themselves and their objectives, develop sound investing strategies around it and stick with them regardless of external conditions.
With the markets having melted down, the popular media, especially television media poses such questions to 'market experts'. The underlying thought is what investors should do at the current juncture to make money (or not lose it).
But let me ask you a different question:
"Why do you think you will at all make money in the market? What makes you think you are capable of making money from the markets?"
We walk into the trading arena hoping to make money. We see others making money or hear about others making money in the stock markets and enter to get our share in the loot.
There is a large class of people (mainly in the acedemic world) that thinks that markets are very efficient. They believe in what is commonly called the Efficient Market Hypothesis (EMH). According to this, the markets are very efficient and prices reflect all known information. i.e. they are never overpriced nor underpriced, just perfectly priced. New information gets assimilated in the price almost instantaneously. Markets behave rationally. Everyone knows all the information available and hence no single investor can get more than market returns over time.
We all know that the EMH fails miserably in the real world. There are people who make a lot of money consistantly, there are people who fail all the time. Markets do not behave rationally and there are booms, manias, crashes and busts that take place over and over again.
That markets behave irrationally is to be expected since markets are a social process. People behave irrationally. This leads to pricing mistakes. Pricing mistakes create prospects of above-average profits. All active investing is in reality an attempt to take advantage of such errors. We try to exploit others' errors as others try to exploit ours. Superior returns come from successfully exploiting such errors.
But markets are a zero sum game. One man's gain is another man's loss. So why should we think that we can gain at someone else's expense? What skills do we possess that would give us the ability to profit at others' mistakes? Why would others give us their hard earned money?
The answer partially lies in our investing philosophy (and every investor should have one). What is an investing philosophy? An investing philosophy is a coherant way of thinking about how markets work, how they don't work, and what mistakes they make. It is our view of how the market functions, and when it is right and when it is wrong. Viewed through the lense of our investing philosophy, we percieve certain market outcomes as correct and certain others as errors. It is then these errors that we attempt to exploit.
Behind every investing pilosophy is the assumption that markets make pricing errors. An example of one investing philosophy could be that markets tend to overvalue growth and underestimate the value of existing assets. This could lead to different investing strategies designed to exploit such conditions, whenever they exist. Or you could have a philosophy that works on the irrational human tendency to join herds, which could lead to various momentum and trend following strategies. Perhaps you think that people get very pessimistic at times and stocks get very cheap which give great buying opportunities...that is also a valid thought.
Most people roam around the marketplace without any definitive investing philosophy. Trading the markets without one is like driving a boat without a rudder. You simply cannot move in the direction of your choice. Anchoring decisions to an investing philosophy is critical for longer term success.
Having understood this, we must note that markets do not make the same mistake every day or every week or every month or even every year. In some years, the mood might be so pessimistic that stocks get seriously undervalued. In other years, herd mentality might dominate so much that stocks take off in parabolic fashion. While in other times, markets might simply move up and down without going anywhere. Hence no investing philosophy would make money all the time.
Every investor needs to follow his/her investing philosophy/philosophies regardless of market conditions. If you believe in value investing, you should search for stocks that are cheap. If you believe in trend trading, you should search for stocks that are trending higher or lower. If you believe in arbitrage, you should seek arbitrage opportunities. There is no single correct answer.
"What should investors do now?" Such questions reflect a basic lack of understanding of the investing process. Investors need to reflect and develop a workable investing philosophy suited to themselves and their objectives, develop sound investing strategies around it and stick with them regardless of external conditions.
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