On occasions we come across some articles that oppose the idea of market timing. To further their arguments, they show how longer term performance would get hampered if investors miss out on participating in 10/20/50 (or any other number) biggest up days in the markets. So, the studies claim that market timing is futile and not effective at all.
These studies seem to be one-sided and biased. They assume that market timers (like yours truly) will miss out on the up days while still stay exposed to all down days. Of course, with such an assumption, it can be 'proven' that market timing does not work and investors should refrain from making any attempt at timing the market.
Let us examine the truth based on hard data. Note that missing out on up days decreases your returns and avoiding down days increases your returns.
Let us examine the daily returns on the S&P CNX Nifty 50 since 1990.
If you had invested Rs. 100 in the Nifty on 3 July 1990, that would have grown to Rs. 966 as of 29th Oct 2008. This translates into an annual return of 13.2% compounded.
If you had missed out on the 10 biggest up days in the same Nifty, Rs 100 would have grown to Rs. 374 which translates into a compounded annual return of 7.5%. In contrast, if you had avoided the 10 worst days, Rs. 100 would have grown to Rs. 2661, which translates into a compounded annual return of 19.6%. So you would have given up on Rs. 592 (966-374 = 592) by missing the up days but gained Rs.1695 (2661-966 = 1695) by avoiding the down days.
If you had missed out on the 20 biggest up days in the same Nifty, Rs 100 would have grown to Rs. 192 which translates into a compounded annual return of 3.6%. In contrast, if you had avoided the 20 worst days, Rs. 100 would have grown to Rs. 5354, which translates into a compounded annual return of 24.2%. So you would have given up on Rs. 774 by missing the up days but gained Rs.4388 by avoiding the down days.
If you had missed out on the 50 biggest up days in the same Nifty, Rs 100 would have fallen to Rs. 40 which translates into a compounded annual return of (-4.9%). In contrast, if you had avoided the 50 worst days, Rs. 100 would have grown to a whopping Rs. 27678, which translates into a compounded annual return of 35.9%. So you would have given up on Rs. 926 by missing the up days but gained Rs. 26712 by avoiding the down days.
This data shows that successful attempts to avoid the worst down days would not only reduce risk (by decreasing the chance of a large decline) but gain much more than might be lost by missing some or even all of the biggest up days.
Moreover, there is no evidence in this that shows that trying to avoid the biggest down moves will result in missing the biggest up moves. Why should people think that market timers will be wrong all the time?
It is observed that most of the big up days up or down days occur in the midst of major trends. Such large trends are not too difficult to identify with simple market timing tools. These tools are not precise but are by and large effective. Market timers do not have to sell at the precise top or buy at the exact bottom. Market timers can exit in a downtrend identified ahead of major declines (like the current one). Such exits are likely to enhance returns very significantly. The same is true of entries. Market timers only need to identify that an uptrend is underway, and in most cases the big up days will follow.
Market participants, investors and speculators alike, should try to time the markets. This means 2 things:
1. Exit as quickly when a downtrend develops. This can be done via hedging a portfolio or selling out of positions. Once markets start going down, either sell out or use options/futures to protect your portfolio.
2. Enter the markets after an uptrend develops. Wait for the markets to tell you that an uptrend has developed and buy thereafter. This means not buying into a falling market even as stocks get cheaper and cheaper.
How to execute this is a different topic. However, in principle, this is one way of timing the markets and attempting to achieve superior returns.
Friday, October 31, 2008
Monday, October 27, 2008
Process and Outcomes
In times of great market turbulence, it is a natural tendency for us to focus on market developments and on the turbulence. Stocks and discussions on stocks and the markets often assume prominence at parties and social gatherings. So we tend to discuss the state of the markets, what caused the turbulence, how things have panned out, what markets would do next and what we should do in response or in anticipation of market moves.
Each of us will have an opinion. Such opinions are often biased by our personalities, the recent performance of the markets, our positions in the markets, etc. For example, a cautious person might see more pain ahead. An utter pessimist might go to an extreme and paint a very bleak picture of the world. A sadist might take pleasure at others' losses and pain. An optimist might see market bottoms. Someone who is long might hope the markets recover, while those who are short might get biased by their position and expect further declines.
We are almost never objective in our analysis, much as we want to be or believe we are. Call it the limitation of the human mind. The truth is that markets are always uncertain and we are rarely objective. This is a deadly combination in analysing any situation. Uncertainty means we dont know what might happen. Being biased means we see possibilities where none exist. No wonder market analysis is so tough!
And then we make an investment decision. Any investment decision can only lead to three outcomes: we either make money, lose money or break even. And investors tend to focus merely on the outcome: whether or not the investment was profitable. This is understandable. At the end of the day the bottom line is all that matters. And outcomes can be seen objectively, the Profit&Loss statement states clearly whether the outcome was favourable or not.
But every outcome is a derivative of a process. An investment outcome is a derivative of some thought process and some analytical process (however sound or unsound that process might be). A focus on achieving outcomes (money to made somehow, anyhow) might make us neglect the all important process. It is the process that leads to results.
There are perils of evaluating the process from the outcome alone. It is seen that if the outcome is favourable, we assume that our thinking was correct and we made a good decision. If the outcome is unfavourable and we lose money, we assume a flaw in our analysis. Can we really make this conclusion? Hardly!
Any domain where outcomes are uncertain, is governed by probabilistic models. Many times, a sound process could lead to an unfavourable outcome (bad luck). Conversely, a flawed process could lead to a favourable outcome (good luck). On other occassions, a good process could mean a good outcome (deserved success) and a bad process can lead to a bad outcome (poetic justice). You can toss a coin to decide whether to buy or sell. If you make money, thats by sheer luck. If you lose money, you deserved to lose, life is fair! On the other hand, you can have a very logical process to invest. Should you lose, bad luck! Should you win, congratulation, you deserved your success.
In the longer run however, repeated several times, a good process will lead to a good overall results while a bad process will lead to a bad overall results, though any single outcome could be divorced from the process. A good process acts like a light house for our investing decisions. It creates a framework for decision making and limits the biases that creep into our thinking. A good process guides out thinking and keeps us from making random decisions.
Many investors go about investing in random methods, often guided by emotion, gut feel and market sentiment. Sometimes they make money, sometimes they lose it. Over the long run however, without a solid guiding process, they find little progress in either their investing knowledge or their net worth. So the next time you find yourself discussing stocks in a social gathering, you might want to stop discussing outcome and start discussing process. You would do yourself a lot of service in focussing on the process above the outcome. Using a sound investment process makes investing far less stressful, profitable and, unfortunately, quite boring.
Happy investing!
Each of us will have an opinion. Such opinions are often biased by our personalities, the recent performance of the markets, our positions in the markets, etc. For example, a cautious person might see more pain ahead. An utter pessimist might go to an extreme and paint a very bleak picture of the world. A sadist might take pleasure at others' losses and pain. An optimist might see market bottoms. Someone who is long might hope the markets recover, while those who are short might get biased by their position and expect further declines.
We are almost never objective in our analysis, much as we want to be or believe we are. Call it the limitation of the human mind. The truth is that markets are always uncertain and we are rarely objective. This is a deadly combination in analysing any situation. Uncertainty means we dont know what might happen. Being biased means we see possibilities where none exist. No wonder market analysis is so tough!
And then we make an investment decision. Any investment decision can only lead to three outcomes: we either make money, lose money or break even. And investors tend to focus merely on the outcome: whether or not the investment was profitable. This is understandable. At the end of the day the bottom line is all that matters. And outcomes can be seen objectively, the Profit&Loss statement states clearly whether the outcome was favourable or not.
But every outcome is a derivative of a process. An investment outcome is a derivative of some thought process and some analytical process (however sound or unsound that process might be). A focus on achieving outcomes (money to made somehow, anyhow) might make us neglect the all important process. It is the process that leads to results.
There are perils of evaluating the process from the outcome alone. It is seen that if the outcome is favourable, we assume that our thinking was correct and we made a good decision. If the outcome is unfavourable and we lose money, we assume a flaw in our analysis. Can we really make this conclusion? Hardly!
Any domain where outcomes are uncertain, is governed by probabilistic models. Many times, a sound process could lead to an unfavourable outcome (bad luck). Conversely, a flawed process could lead to a favourable outcome (good luck). On other occassions, a good process could mean a good outcome (deserved success) and a bad process can lead to a bad outcome (poetic justice). You can toss a coin to decide whether to buy or sell. If you make money, thats by sheer luck. If you lose money, you deserved to lose, life is fair! On the other hand, you can have a very logical process to invest. Should you lose, bad luck! Should you win, congratulation, you deserved your success.
In the longer run however, repeated several times, a good process will lead to a good overall results while a bad process will lead to a bad overall results, though any single outcome could be divorced from the process. A good process acts like a light house for our investing decisions. It creates a framework for decision making and limits the biases that creep into our thinking. A good process guides out thinking and keeps us from making random decisions.
Many investors go about investing in random methods, often guided by emotion, gut feel and market sentiment. Sometimes they make money, sometimes they lose it. Over the long run however, without a solid guiding process, they find little progress in either their investing knowledge or their net worth. So the next time you find yourself discussing stocks in a social gathering, you might want to stop discussing outcome and start discussing process. You would do yourself a lot of service in focussing on the process above the outcome. Using a sound investment process makes investing far less stressful, profitable and, unfortunately, quite boring.
Happy investing!
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