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.
Thursday, July 31, 2008
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.
Sunday, July 6, 2008
Comparing 5 Investing Strategies
"Don't try to time the markets".
"SIP is the best way an average investor can participate in the stock markets."
"Asset Allocation is critical. Allocate your assets across stocks and bonds according to your risk profile".
"Hold stocks for the long run".
The professional investment community loves to push such advise to the average investor. Investors, in turn, fall in line and play along thinking that the advisors are experts and hence know best. Such statements become gospels and people follow them blindly.
Do such statements really hold weight? An examination is worth the time spent.
But first, let us figure out what constitutes a good investment.
The most obvious thing is return on investment. Everyone wants this to be as high as possible. Thats a no-brainer.
However returns are not risk free. An investment that offers higher return than another one with the same amount of risk is a better investment (all other things being equal). We like to make a lot of money with the least risk possible (unless one seeks thrill out of risk taking). Hence risk is another parameter of an investment.
Returns can be stable or returns can be volatile. When returns are volatile, we experience large swings in our equity. While we love it when we get large upswings, large downswings cause large depletions in our equity, they cause anguish and anxiety. Normal people would, given all other things being equal, rather not have such large downswings. Hence a downswing (peak to trough move called a drawdown) is another parameter we should measure.
Some people might seek high returns and be willing to tolerate high drawdowns. Others may be happy with lower returns but a lower drawdown. It depends upon the investor. To equalise drawdowns, we compare it with the return and arrive at a ratio (lets call is the Stress Ratio) as drawdown per unit return. i.e Drawdown/Return.
The lower the Stress Ratio, the lesser is the drawdown compared to the return, hence the lesser the stress caused to the investor.
(I have not considered standard measures such as te Sharpe Ratio, Treynor Ratio etc since they are period dependant for calculating the standard deviations)
With this little background, let us compare 5 different investing strategies.
All of them have been back tested on the S&P CNX Nifty from July 1990 (max data available) till July 2008, i.e. 18 years. Each assumes a transaction cost of 0.6% mainly as brokerage. The strategies are as follows:
1.) Buy and Hold:
You bought the Nifty in July 1991 and held on without any activity over the entire duration. Stay invested for the long run.
2.) Asset Allocation based on Price:
You split your money in the ratio 70:30 between the Nifty and 1 month Fixed Deposit and rebalanced your portfolio every month to maintain this 70:30 ratio. So if stocks went up and the ratio of stocks in your portfolio exceeded 70%, you sold some stocks and put the proceeds into a 1 month fixed deposit so as the restore the ratio to 70:30. When stocks fell, you did the reverse. Automatically, you bought stocks low and sold them high...seems nice, doesnt it?
3.) Asset Allocation based on valuation:
You use the Price to Earnings ratio (PE) of the index to decide your equity and debt allocation. You set a percentage for equity (100% in equity if PE <=15 linearly decreasing to 50% for PE = 25 and then linearly decreasing faster till equity = 0% for PE>=30) depending upon whether the index is cheap or expensive. Automatically, you bought stocks when they were cheap and sold them when they got expensive...again, seems very sensible.
4.) Cost Averaging or SIP
You invested a fixed sum of money into the markets through the Nifty first trading day of every month, month after month. You bought more units when markets were down and bought lesser units when markets were up. Some kind of cost averaging here. This is what advisors propound. Of course, mutual fund houses love this (they get a regular and assured stream of money coming into their schemes).
5.) Market Timing using Trend Following:
While no one knows market tops and bottoms, here you buy the Nifty after market bottoms have been established and markets start moving up and sell after market tops have been established and markets start moving down. One such strategy is used. This strategy means you wait for a bottom to form and once you identify a bottom, you buy. Similarly for selling, you sell once prices start to fall. We follow certain rules for buying and selling. Essentially you (imperfectly) time the markets.
So how do these strategies compare? Given below is a table depicting their performance:
(Theoritically, price can go down to zero. Hence in the first 4 strategies, risk is equal to the equity exposure)
Clearly, Trend Following (a kind of market timing) gives you the best return with the least risk and the least maximum drawdown. Also, the Stress ratio is lowest at less than 1.
The difference between market timing and other popular strategies is striking. Market timing gives a higher return at lower risk with lesser stress. Note the difference in the ending amounts for Rs. 1 lakh invested (last column).
Another observation not reflected in the table is that trend following gives much lower drawdowns compared to the other 4 methods. Also, drawdowns are recovered faster with trend following.
Ok, you may say. The 1990s had long periods of bad market performance. How about the performance in the bull market that started in April 2003? Here is the same till date:
A raging bull market makes buy and hold the best approach but with a large drawdown. So is the case with PE based asset allocation which has shown a better drawdown and hence a better Stress Ratio. Trend following has a lower return but a better drawdown performance and a superior stress ratio. Again, SIP is poorest in terms of return performance as in terms of stress ratio.
Note however that if you remove the period from April 2003 till date, the performance of the first 4 strategies turns out pretty bad. The returns for July 1990 till March 2003 for the first 4 strategies come in at 9-11%, while that for Trend Following comes in at 20.1%. Trend following is more consistant in good and bad times.
Perhaps we can draw some conclusions from the above analysis:
-We compared 5 rule based investing non-discretionary methods.
-Market timing can work. In fact, over long periods, the performance of one such method (trend following) seems markedly superior to the other popular methods.
-Popular methods like buy-and-hold, Asset Allocation and SIP do not have risk control mechanisms. Prices can go down and keep going down and cause a great deal of anxiety.
-SIP and Asset Allocation stategies are defensive in nature. They prevent greater losses than what would have occured otherwise. They do not make you more money.
-Market timing creates more wealth with less risk and lower stress. We should attempt market timing of some kind instead of avoiding it.
"SIP is the best way an average investor can participate in the stock markets."
"Asset Allocation is critical. Allocate your assets across stocks and bonds according to your risk profile".
"Hold stocks for the long run".
The professional investment community loves to push such advise to the average investor. Investors, in turn, fall in line and play along thinking that the advisors are experts and hence know best. Such statements become gospels and people follow them blindly.
Do such statements really hold weight? An examination is worth the time spent.
But first, let us figure out what constitutes a good investment.
The most obvious thing is return on investment. Everyone wants this to be as high as possible. Thats a no-brainer.
However returns are not risk free. An investment that offers higher return than another one with the same amount of risk is a better investment (all other things being equal). We like to make a lot of money with the least risk possible (unless one seeks thrill out of risk taking). Hence risk is another parameter of an investment.
Returns can be stable or returns can be volatile. When returns are volatile, we experience large swings in our equity. While we love it when we get large upswings, large downswings cause large depletions in our equity, they cause anguish and anxiety. Normal people would, given all other things being equal, rather not have such large downswings. Hence a downswing (peak to trough move called a drawdown) is another parameter we should measure.
Some people might seek high returns and be willing to tolerate high drawdowns. Others may be happy with lower returns but a lower drawdown. It depends upon the investor. To equalise drawdowns, we compare it with the return and arrive at a ratio (lets call is the Stress Ratio) as drawdown per unit return. i.e Drawdown/Return.
The lower the Stress Ratio, the lesser is the drawdown compared to the return, hence the lesser the stress caused to the investor.
(I have not considered standard measures such as te Sharpe Ratio, Treynor Ratio etc since they are period dependant for calculating the standard deviations)
With this little background, let us compare 5 different investing strategies.
All of them have been back tested on the S&P CNX Nifty from July 1990 (max data available) till July 2008, i.e. 18 years. Each assumes a transaction cost of 0.6% mainly as brokerage. The strategies are as follows:
1.) Buy and Hold:
You bought the Nifty in July 1991 and held on without any activity over the entire duration. Stay invested for the long run.
2.) Asset Allocation based on Price:
You split your money in the ratio 70:30 between the Nifty and 1 month Fixed Deposit and rebalanced your portfolio every month to maintain this 70:30 ratio. So if stocks went up and the ratio of stocks in your portfolio exceeded 70%, you sold some stocks and put the proceeds into a 1 month fixed deposit so as the restore the ratio to 70:30. When stocks fell, you did the reverse. Automatically, you bought stocks low and sold them high...seems nice, doesnt it?
3.) Asset Allocation based on valuation:
You use the Price to Earnings ratio (PE) of the index to decide your equity and debt allocation. You set a percentage for equity (100% in equity if PE <=15 linearly decreasing to 50% for PE = 25 and then linearly decreasing faster till equity = 0% for PE>=30) depending upon whether the index is cheap or expensive. Automatically, you bought stocks when they were cheap and sold them when they got expensive...again, seems very sensible.
4.) Cost Averaging or SIP
You invested a fixed sum of money into the markets through the Nifty first trading day of every month, month after month. You bought more units when markets were down and bought lesser units when markets were up. Some kind of cost averaging here. This is what advisors propound. Of course, mutual fund houses love this (they get a regular and assured stream of money coming into their schemes).
5.) Market Timing using Trend Following:
While no one knows market tops and bottoms, here you buy the Nifty after market bottoms have been established and markets start moving up and sell after market tops have been established and markets start moving down. One such strategy is used. This strategy means you wait for a bottom to form and once you identify a bottom, you buy. Similarly for selling, you sell once prices start to fall. We follow certain rules for buying and selling. Essentially you (imperfectly) time the markets.
So how do these strategies compare? Given below is a table depicting their performance:
(Theoritically, price can go down to zero. Hence in the first 4 strategies, risk is equal to the equity exposure)Clearly, Trend Following (a kind of market timing) gives you the best return with the least risk and the least maximum drawdown. Also, the Stress ratio is lowest at less than 1.
The difference between market timing and other popular strategies is striking. Market timing gives a higher return at lower risk with lesser stress. Note the difference in the ending amounts for Rs. 1 lakh invested (last column).
PE based Asset Allocation also gives a better performance compared to the other three. Buy and Hold strategy gives a higher return than an SIP or price based asset allocation, but has the largest drawdown.
Note how an SIP is the worst in terms of returns and also in terms of the Stress ratio. So much for the merits of an SIP!!
Note how an SIP is the worst in terms of returns and also in terms of the Stress ratio. So much for the merits of an SIP!!
Another observation not reflected in the table is that trend following gives much lower drawdowns compared to the other 4 methods. Also, drawdowns are recovered faster with trend following.
Ok, you may say. The 1990s had long periods of bad market performance. How about the performance in the bull market that started in April 2003? Here is the same till date:
A raging bull market makes buy and hold the best approach but with a large drawdown. So is the case with PE based asset allocation which has shown a better drawdown and hence a better Stress Ratio. Trend following has a lower return but a better drawdown performance and a superior stress ratio. Again, SIP is poorest in terms of return performance as in terms of stress ratio.Note however that if you remove the period from April 2003 till date, the performance of the first 4 strategies turns out pretty bad. The returns for July 1990 till March 2003 for the first 4 strategies come in at 9-11%, while that for Trend Following comes in at 20.1%. Trend following is more consistant in good and bad times.
Perhaps we can draw some conclusions from the above analysis:
-We compared 5 rule based investing non-discretionary methods.
-Market timing can work. In fact, over long periods, the performance of one such method (trend following) seems markedly superior to the other popular methods.
-Popular methods like buy-and-hold, Asset Allocation and SIP do not have risk control mechanisms. Prices can go down and keep going down and cause a great deal of anxiety.
-SIP and Asset Allocation stategies are defensive in nature. They prevent greater losses than what would have occured otherwise. They do not make you more money.
-Market timing creates more wealth with less risk and lower stress. We should attempt market timing of some kind instead of avoiding it.
Saturday, July 5, 2008
The big guys got it wrong!
Even the big guys got the markets wrong. The Mint has reported this in it's 4th July edition. Here are some excerpts of the same. After the first fall in the stock markets in mid January this year, most brokerages recommended that investor should buy stocks as the worst was over. Clearly, the worst was not over!! The markets have continued to fall since then.
Macquaire Research on 23 Jan 2008:
Correction provides an opportunity.
- The worst is over and we maintain our bullish stance.
- RBI will cut interest rates by 25 basis points and accelerate the fall in interest rates
- Top picks: ICICI Bank, HDFC Bank, Axis Bank, DLF Ltd.
- Fundamentals remain strong
- Underlying India story remains strong and this correction remains an ideal opportunity to enter for the long term.
Deutsche Bank on 23 Jan 2008:
Long term investors should increase their India exposure
-Surprised by the ferocity of the fall
-Long term investors should increase their India exposure
-Focus on large cap domestic plays
-Overweight: autos, private banks, capital goods, cement and media
-Underweight: IT, metals, oil and gas/petrochemicals, pharmaceuticals
CLSA on 21 Jan 2008:
India growth story not at risk
-The Indian growth story, led by an upsurge in investments and domestic consumption, remains largely intact.
-The government is likely to keep liquidity strong
-Remain buyers of our 2008 conviction picks—Bharti Airtel Ltd, Bharat Heavy Electricals Ltd, ICICI Bank Ltd, ITC Ltd and Tata Power Co. Ltd
Lehman Brothers on 23 January 2008
We expect 33% return from the market over 12 months
-The recent 20% correction in the market has brought valuations to reasonable levels
-This is not an unreasonably expensive (market) in view of growth and its relative insulation from global credit problems and the US slowdown
-The fall presents a good buying opportunity across several sectors and stocks
-The Indian market is now attractively priced
-From the current levels, the market should see a broad-based rally
Credit Suisse on 23 January 2008
Not the time to sell, even with a dire world view
-For a value investor that does not have positive views on external flows, only a Sensex fall below 13,000 would represent an entry point justified from a valuation viewpoint.
-That said, this is not the time to sell, even for those with dire views on the world economy.
-India is likely to be on a highly reflationary policy drive in the coming weeks unlike most others in the emerging world.
-The market fall has raised the chances of both interest and tax rates cut by February end
-As risk aversion rises and we see more earnings downgrades, this could easily come down to around 13,000
Morgan Stanley on 25 January 2008
Keep a close watch on earnings
-The fact that earnings appear to be well above trend, slowing macro growth due to high real rates, and the dependence on margins to sustain earnings growth given that topline growth is harder to come by
-Earnings a bit more vulnerable than at any point over the preceding four years
-Base of upward revisions is likely to be tested in the coming weeks and the growth itself could be in the low-to mid-teens
Sharekhan Ltd on 23 January 2008
A strong opportunity to buy
-Several of our stock ideas have corrected significantly and are currently available at very attractive valuations
-We view this correction as a strong opportunity to buy
ICICI Securities Ltd on 23 January 2008
The pain seems to be completely behind us
-We firmly believe that the sharp declines in stock prices are not a reflection of any significant adverse impact on fundamentals and provide a very attractive opportunity to buy
-We reiterate our Sensex target of 25,500 by December 2008
Even the large guys with their battery of analysts and experts and years of experience get the economy and markets wrong. The dominant thinking in January was that fundamentals were strong, earnings would continue to be robust and interest rates were headed down. This world view has now been turned upside down.
For most parts, the world looks nice and comfortable and keeps chugging along smoothly with few hiccups. Then one day, without notice, it gets slammed with disaster. Many days of comfort lulls us into believing that things will remain good forever. Investing seems like a walk in the park and making money from markets seems like the easiest job in the world...untill the storm sneaks upon us and destroys a lot of wealth created in the good years. As the legendary investor, Warren Buffet, said, "Speculation is most dangerous when it looks easiest". So if you have made some easy money, you should stop and think whether it is time for the tide to turn.
Things beyond our understanding do go wrong, often terribly wrong. Investors should accept the possibility of such events (they keep happening on and off) and be prepared to protect themselves when they happen. Otherwise they would be left with 40-70% or even more of their wealth destroyed, as has happened this time around.
Macquaire Research on 23 Jan 2008:
Correction provides an opportunity.
- The worst is over and we maintain our bullish stance.
- RBI will cut interest rates by 25 basis points and accelerate the fall in interest rates
- Top picks: ICICI Bank, HDFC Bank, Axis Bank, DLF Ltd.
- Fundamentals remain strong
- Underlying India story remains strong and this correction remains an ideal opportunity to enter for the long term.
Deutsche Bank on 23 Jan 2008:
Long term investors should increase their India exposure
-Surprised by the ferocity of the fall
-Long term investors should increase their India exposure
-Focus on large cap domestic plays
-Overweight: autos, private banks, capital goods, cement and media
-Underweight: IT, metals, oil and gas/petrochemicals, pharmaceuticals
CLSA on 21 Jan 2008:
India growth story not at risk
-The Indian growth story, led by an upsurge in investments and domestic consumption, remains largely intact.
-The government is likely to keep liquidity strong
-Remain buyers of our 2008 conviction picks—Bharti Airtel Ltd, Bharat Heavy Electricals Ltd, ICICI Bank Ltd, ITC Ltd and Tata Power Co. Ltd
Lehman Brothers on 23 January 2008
We expect 33% return from the market over 12 months
-The recent 20% correction in the market has brought valuations to reasonable levels
-This is not an unreasonably expensive (market) in view of growth and its relative insulation from global credit problems and the US slowdown
-The fall presents a good buying opportunity across several sectors and stocks
-The Indian market is now attractively priced
-From the current levels, the market should see a broad-based rally
Credit Suisse on 23 January 2008
Not the time to sell, even with a dire world view
-For a value investor that does not have positive views on external flows, only a Sensex fall below 13,000 would represent an entry point justified from a valuation viewpoint.
-That said, this is not the time to sell, even for those with dire views on the world economy.
-India is likely to be on a highly reflationary policy drive in the coming weeks unlike most others in the emerging world.
-The market fall has raised the chances of both interest and tax rates cut by February end
-As risk aversion rises and we see more earnings downgrades, this could easily come down to around 13,000
Morgan Stanley on 25 January 2008
Keep a close watch on earnings
-The fact that earnings appear to be well above trend, slowing macro growth due to high real rates, and the dependence on margins to sustain earnings growth given that topline growth is harder to come by
-Earnings a bit more vulnerable than at any point over the preceding four years
-Base of upward revisions is likely to be tested in the coming weeks and the growth itself could be in the low-to mid-teens
Sharekhan Ltd on 23 January 2008
A strong opportunity to buy
-Several of our stock ideas have corrected significantly and are currently available at very attractive valuations
-We view this correction as a strong opportunity to buy
ICICI Securities Ltd on 23 January 2008
The pain seems to be completely behind us
-We firmly believe that the sharp declines in stock prices are not a reflection of any significant adverse impact on fundamentals and provide a very attractive opportunity to buy
-We reiterate our Sensex target of 25,500 by December 2008
Even the large guys with their battery of analysts and experts and years of experience get the economy and markets wrong. The dominant thinking in January was that fundamentals were strong, earnings would continue to be robust and interest rates were headed down. This world view has now been turned upside down.
For most parts, the world looks nice and comfortable and keeps chugging along smoothly with few hiccups. Then one day, without notice, it gets slammed with disaster. Many days of comfort lulls us into believing that things will remain good forever. Investing seems like a walk in the park and making money from markets seems like the easiest job in the world...untill the storm sneaks upon us and destroys a lot of wealth created in the good years. As the legendary investor, Warren Buffet, said, "Speculation is most dangerous when it looks easiest". So if you have made some easy money, you should stop and think whether it is time for the tide to turn.
Things beyond our understanding do go wrong, often terribly wrong. Investors should accept the possibility of such events (they keep happening on and off) and be prepared to protect themselves when they happen. Otherwise they would be left with 40-70% or even more of their wealth destroyed, as has happened this time around.
Friday, July 4, 2008
Why? Wrong causation
"The markets crashed on rising crude oil prices."
"Banking, Realty stocks hit on high inflation data."
"Markets bounce back on the back of prospects that the UPA government will survive its full term".
You would have heard or read such comments quite frequently on business channels and in newspapers. The media tries to explain every market move. It tries to find reasons for changes in price. So if stocks go down and crude oil prices also have also risen, they simply put together a causation: Rise in crude prices caused stock prices to fall.
(These days there is a popular view that stock are falling primarily because crude oil prices are so high. Absent the rise and stocks would rise, is the implicit logic. I think this is just an excuse.)
I have often noticed how this explanation is far removed from what happens on floor of the stock markets. Sometime ago, on a particular friday, inflation figures came our slightly higher than expectations, but not too divergent from the expected figure. The markets promptly went up with the Nifty gaining 20 points. The markets stayed high for a few more hours but eventually collapsed at the end of the day to close in the negative. The newspaper headlines next day screamed how markets were spooked by high inflation.
The truth was that markets actually went up after the news and stayed there for quite some time. Clearly, the inflation figure did not cause markets to fall. What caused them to collapse? - we don't know for sure. All we know is that the prices went up when inflation figures were released and they went down at the end of the trading day.
According to the media, a $2 rise in crude oil prices caused stock markets to go down on a particular day. However, on another day, a $5 rise in crude oil prices saw the stock markets going up without any other positive news. So why did a greater rise in oil prices not cause markets to go down with even greater force? We don't know!
Media will keep searching for reasons behind price movements. It simply draws cause and effect relationships with an external event and market moves. However this might just be a convinient excuse to explain market phenomenon. As we have seen, the same external event causes diametrically opposite moves in the markets, across time. Sometimes markets fall after bad news. Sometimes markets rise after receiving the same bad news. The fact is that we really do not know why markets move on any given day. The only thing we can say is that if selling is greater than buying, prices fall. If buying is more than selling, prices rise. That is the most obvious thing there is, but in reality that is all that we know about price movements.
So the headlines should be like:
"Markets went down as selling exceeded buying. Reasons unknown!"
I doubt we would ever see such a headline. For us, what matters however is whether prices are up or down. True reasons perhaps we shall never know...and don't even need to know.
"Banking, Realty stocks hit on high inflation data."
"Markets bounce back on the back of prospects that the UPA government will survive its full term".
You would have heard or read such comments quite frequently on business channels and in newspapers. The media tries to explain every market move. It tries to find reasons for changes in price. So if stocks go down and crude oil prices also have also risen, they simply put together a causation: Rise in crude prices caused stock prices to fall.
(These days there is a popular view that stock are falling primarily because crude oil prices are so high. Absent the rise and stocks would rise, is the implicit logic. I think this is just an excuse.)
I have often noticed how this explanation is far removed from what happens on floor of the stock markets. Sometime ago, on a particular friday, inflation figures came our slightly higher than expectations, but not too divergent from the expected figure. The markets promptly went up with the Nifty gaining 20 points. The markets stayed high for a few more hours but eventually collapsed at the end of the day to close in the negative. The newspaper headlines next day screamed how markets were spooked by high inflation.
The truth was that markets actually went up after the news and stayed there for quite some time. Clearly, the inflation figure did not cause markets to fall. What caused them to collapse? - we don't know for sure. All we know is that the prices went up when inflation figures were released and they went down at the end of the trading day.
According to the media, a $2 rise in crude oil prices caused stock markets to go down on a particular day. However, on another day, a $5 rise in crude oil prices saw the stock markets going up without any other positive news. So why did a greater rise in oil prices not cause markets to go down with even greater force? We don't know!
Media will keep searching for reasons behind price movements. It simply draws cause and effect relationships with an external event and market moves. However this might just be a convinient excuse to explain market phenomenon. As we have seen, the same external event causes diametrically opposite moves in the markets, across time. Sometimes markets fall after bad news. Sometimes markets rise after receiving the same bad news. The fact is that we really do not know why markets move on any given day. The only thing we can say is that if selling is greater than buying, prices fall. If buying is more than selling, prices rise. That is the most obvious thing there is, but in reality that is all that we know about price movements.
So the headlines should be like:
"Markets went down as selling exceeded buying. Reasons unknown!"
I doubt we would ever see such a headline. For us, what matters however is whether prices are up or down. True reasons perhaps we shall never know...and don't even need to know.
Wednesday, July 2, 2008
Why losses should be kept small - A mathematical view
"Cut your losses short and let your profits run."
I keep repeating this cliche ad nauseum. Seasoned traders swear by it. Amateurs flout it (to their own detriment). I believe it is key to investment success. Intuitively we might agree that it is important, but can we really prove it's worth?
Investors seek returns from their investments and trading decisions. Amateur investors like to make money on every trade/investment. While we might want our investments to be winners, there are too many imponderables that could put a spanner in their wheels. Ergo, we can land up with losses as well (whether or not we book them). In the markets all outcomes are uncertain. Profits and losses, both, are part of the trading landscape. (In fact, successful speculators lose more often than they win)
Since every outcome is uncertain, winning merely has probability, as has losing. So over time, we would have some winning investments and some losing investments. Lets consider the following:
W = Probability of Winning (0<=W<=1)
L = Probability of Losing (0<=L<=1, L=1-W assuming no breakeven trade)
AP = Average size of profits (AP>0)
AL = Average size of losses (AL<0)
This brings us the what is termed as the Mathematical Expectation (E) of our investing decisions. E is the Expected Profit per trade.
E = W*AP + L*AL
(Note that the product L*AL is negative since AL has a negative value.)
E denotes what profit we will make on an average per trade. All other things being equal, the larger the value of E, the better it is for our returns. Traders should strive to achieve a high value for E from their trades.
Look at the right hand side of the above equation. For E to be high, the first part (W*AP) of the sum needs to be high while the second part (L*AL) needs to be kept to a small (negative) value.
For W*AP to be high, either W needs to be high or AP needs to be high or both.
But W has an upper limit and cannot get higher than 1. (1 implies all winning investments)
AP in contrast does not have any upper bound. Though profits don't go to the moon, large profits are not uncommon.
Just to illustrate, say,
AP = 4% and W = 0.8 (80% chance of success), W*AP = 3.2%
AP = 8% and W = 0.6 (60% chance of success), W*AP = 4.8%
AP = 16% and W = 0.4 (40% chance of success), W*AP = 6.4%
AP = 50% and W = 0.2 (20% chance of success), W*AP = 25%
Your profits go up even as your winning percentage goes down. It is easier to find investments with a lower success rate. Most people want to maximise the chance of winning. Professionals focus on maximising profit instead, not the chance of winning. If risk is properly managed (which it should be), it is much easier to find trades that have a lower chance of making money than ones that have 80%, 90% or higher chance of success.
In the product, W*AP, it is AP that plays a much dominant role compared to W in determining the product. Average Profit is more important than the Winning Percentage. Try seeking a high value for average profits - LET YOUR PROFITS RUN
Using the same logic, on the other part of the equation, L*AL, average losses are more important than chance of loss. For example,
L= 2% and L= 0.6 (40% chance of success), L*AL= 1.2%
L= 5% and L= 0.5 (50% chance of success), L*AL= 2.5%
L= 10% and L= 0.4 (60% chance of success), L*AL= 4%
L= 20% and L= 0.3 (70% chance of success), L*AL= 6%
The chance of success is increasing, but your losses are also going up.
An 5 fold increase in average loss needs to be compensated by a 80% decrease in your losing percentage. If average loss increases from 2% to 10%, your winning percentage (initial value = 50% = chance of heads on a coin flip) needs to increase to 90%, not an easy task. It is much easier to keep a loss down to 2% and get a 50% success rate than to let losses increase to 10% in an attempt to get a 90% success rate.
The bottomline is: Keep average losses small - CUT LOSSES SHORT
Let profits run and cut your losses short! When you have a profit, don't sell under the fear that the markets would take away your profits. Let profits become big. When you have a loss, don't hope that it would turn around. Don't let losses get big.
It does not matter whether you win or lose. What matters is how much money you make when you win and how much money you lose when you don't win.
It does not matter whether you win or lose. What matters is how much money you make when you win and how much money you lose when you don't win.
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