Prashanth Krish | Portfolio Yoga

Predictions, Probability and Position Sizing

Most of us know that Astrology is bunkum and yet that doesn’t stop us from reading what the astrology section of the Sunday newspaper. Reading that does no harm, Right. After all, its more of just keeping ourselves aware or more of a time pass in nature.

Prediction in markets happen regularly and here there are two types of prediction. The Implicit kind and the Explicit kind. Let me explain each with a example.

We trend followers are staunch believers in fact that future cannot be predicted and we can only rely on the past and take signals based on what we believe the trend is. But the moment we make a trade, we are Implicitly predicting that price will move in the direction our trade dictates. If it does, we have caught the right trend and we make money, if it doesn’t, we call it a Whipsaw, scratch out the trade and await a fresh signal for the next trade.

On the Explicit side are strategies such as Elliot which not only spell out where the markets should / shall go but also the time frame within which it will reach such a target. Take for instance this prediction by Mark Galasiewski, a very well know Analyst from Elliott Wave International

On April 13, 2009 speaking with CNBC TV18, he made a very famous predicition

See Sensex at 100,000 in 15 yrs: Elliott Wave International

The prediction contains two elements required to make a trade. A target price and the target time. Given these two parameters and assuming you have confidence in the said analyst, the next question would be, “How much to Bet”

On the day, he made that call, Sensex was close to 11,000 mark and hence this prediction if it were to come true would mean a CAGR return of 15.85%. Here is the thing, 15.85% isn’t extraordinary returns.

CAGR Returns since Inception of Nifty Bees (then managed by Benchmark and now by Goldman Sachs) is 16.62% (as of Aug 2016). While we don’t know whether the next 15 years will provide similar returns, we at the very least have a number we can work with.

In April 2010, Chris Roberts of Mizuho Securities Asia Limited made a similar prediction, this time we have a chart providing us a better guideline as well

But lets go back to 2009. Markets are down but definitely not out and you believe in the said analyst prophecy. So, what next – Buy Nifty / Sensex would be the way forward – but the bigger question is, how much to bet. Should you bet 10 / 20 / 30% of your existing portfolio or go all out and bet 100% or go still further, Sell your House and invest everything?

The reason why people are so attracted by Real Estate is due to not the percentage of returns (which has been good till very recent times) but the amount that one sees as the outcome. But unlike stocks, in real estate, the minimum required is way higher.

When people invest into houses / land, most of the time they are betting way more than 100% of their networth (since most go with a loan, its actually multiple times their networth). Would you do that with Sensex or Nifty (lets not take stocks since we all know that not all stocks are the same) and if not, why not?

The biggest fear is the fear of not knowing what the future holds, especially decades from now. While the same risk exists in Real Estate, we comfort ourselves saying that even if the worst happens, I still will be able to hold onto the asset.

Its a fact that most world markets have at some point or other seen a 85% draw-down from peaks. While our data (public) exists only from 1979 and has a max draw-down of around 50% thrice and in those times, even the guy who has strongest belief may find it tough to hold onto his investments let alone add.

A fun fact (Fun b/c I am not sure about the source of the data): Indian markets fell 73% from their peaks of 1920 and recovered only by 1945 (25 years).

Lets cut back to our original problem. If we have a forecast, how do you action the same? This question was what engrossed me in a twitter match when I replied to a particular prediction by a Analyst who is the head of Research at a major brokerage firm

There were essentially two questions that I posted.

What is the probability that we shall reach 9410 by Diwali
Based on that probability, what should be the position size of the same.

The analyst who made the above prediction came back with the following reply

“Isn’t position sizing matter of capital allocation and risk appetite rather than probability of success?”

In my opinion, probability of success is what should drive capital allocation and not the other way round. In the above example, I based on distribution of returns calculated that at best there was a 11% probability of 9410 coming into play in the next month. Using VIX, Vasishta (@Uptickr) gave a even lower probability of 5%.

Given the above numbers, what should be your bet size. Do note that since the original forecast was made, the markets are down 4% (target was 5.5% approx) making the original prediction look like a one to one on a risk reward basis

So, why is position sizing important? As @ReformedBroker tweeted the other day,

Replace the word hedge fund manager and place yourself there. What do you spend the maximum time upon?

Selecting the right securities are betting big when you think you have found the one that will provide the returns you think you deserve.

Switch on the Idiot Box and all you can see is analyst upon analyst predicting either where Index would be n days from now or which security should one buy.

Probability of Returns is always two sided. One way to calculate the probability of returns is to use Chebyshev’s Inequality, but that will still give you the probability of returns and not provide you with a way to determine how much position size should be taken based upon the historical reliability of your signal.

The simplest position sizing when you are dealing with a portfolio of stocks is to have uniform capital allocated to each and every pick.

But what if you are trading a single ticker like Nifty or Bank Nifty and come across predictions such as the one above? How do you decide how many contracts to buy for every Signal?

With Deepawali coming up, every Television channel will be pulling up every analyst they can to provide them with a view on the coming year and a list of stocks that investors should buy for the year ahead. So, should you go ahead and buy those stocks and if so, once again, how much should you be betting?

As Investors and Traders, we love predictions and if you are on Television, what better way to get noticed than make either a very dire forecast (like Marc Faber does every year) or make staggering bullish forecasts that once again make news.

While I have no idea if anyone has created a data set of predictions by brokerage houses and the error ratio’s, out in United States, Salil Mehta writing his blog Statistical Ideas, provided a humongous amount of data and aptly named the post as “Strategists: full of bull“. If some one were to do a similar anlaysis in India, I don’t think one would find any major difference in the hit rate of such predictions.

The key to position sizing in any asset class / stock / index / sector is conviction. Think of a experiment you can try out at home. Announce to your family members that you have 20 Lakhs with you and will invest that into buying a 1 Crore property (by taking a loan 4x your investment). If you are part of a normal Indian family, you should receive more queries on property than query on whether it makes sense financially taking such a big loan.

Now, what if a few days later say that you have dropped the idea of buying the home but will invest the same into market (remember, no loans, only investing what you already have saved). The reactions now will be way different and more or less you will be taken as a gambler who is out to destroy his savings.

The difference comes from the conviction we folk have in Real Estate / Gold vs investing in Equity. Conviction cannot be build while having faulty premises that fail at critical times.

Postscript: Thinking deeply, felt that unfair to name a single individual just because I was engrossed in a debate with him while the rest of the guys get a free pass. I have hence removed the tweet. My Apologies.

Fire your Financial Advisor?

In today’s Mint, Monika Halan has a post titled “When to fire your financial adviser“. While I am sure she knows way better than me when it comes to advisers, I felt that she had used a large brush without providing contexts when its right and when its wrong. So, here I go as usual with my thoughts;

MH: An adviser who gives you the average without separating out the asset classes when disclosing returns needs to be questioned.

Me: Assuming your have your entire networth here, its actually how much your networth is growing. Now, if we start splitting, why stop with Debt vs Equity since not all Debt or all Equity are the same. The difference in returns between investing in a large cap equity fund vs a Thematic equtiy fund can be huge. But that difference arises due to one being of a much lower risk than another. If Equity returns are bumped up due to a couple of them, is your advisor a Genius or one who is taking bigger risks?

Coming to Debt, are all Debt funds the same? Of course, not but will you understand what risk he is taking or what time frame he is looking at just by concentrating on the returns he has generated?

MH: If you have more than a total of 10 funds—across all categories—you need to question your adviser.

Me: To me, this answer once again misses the context. Its not about how many funds you are having that is the problem. The problem will be in terms of how correlated they are and how much portfolio overlap you are seeing. A large number of CTA’s trade as many as 100+ non correlated assets at any point of time. If you are having multiple funds but very little correlation between them, you are actually pretty well diversified. Of course, this could also mean lower returns, but volatility will be lower too.

MH: The guy is churning you; maybe to win a junket his fund house is offering.

Me: This is the risk of going to some one who you think offers his services for Free but makes money in the back-end. Fee based advisors have on the other hand no such conflict – they receive a fixed amount and hence are less susceptible to making you churn your investments.

So, how do we know whether my advisor is doing the job or is it time to fire him?

The biggest issue that is not addressed in the article is what benchmark is the one you should aim for. In my opinion, if you are a risk averse person but one who wants a bit of higher returns for his investments, you should ideally got for a split of 40 : 60 in favor of Debt to a max of 60 : 40 in favor of Equities.

It would have been lovely if we had a ETF similar to Vanguard Total Stock Market ETF, but given that we don’t have that, our best bet will be to use the GS Nifty Bees as the Equity component benchmark and something similar to the LIC MF G-Sec Long Term Exchange Traded Fund as our Debt fund benchmark.

Now, lets get back to our starting point. Assume you invested a year ago. Download data for the ETF’s you have selected – the debt fund ETF above may not have that much data in which case you will have to use the Index it tracks.

Once done, assume your investment was made in the ratio you are comfortable with or are invested in. Based on present value, does you returns match or is higher than this? If Yes, your advisor has generated better returns which is good.

But Rewards are one side of the coin – on the other side you have Risk. So, using the same data you now need to calculate the volatility of your investment and compare (not sure you can easily get such data from your advisor, but you pay him and he needs to provide you with it at the minimum). Here, our aim is to see if we are having a lower volatility. A high volatility means that you are taking a much higher risk to generate the said returns – seems acceptable in good times, its only in bad times that we wonder what hit us. Yes, doing such Analysis is tough, but hey, its your money and the least you can do is try and understand how its doing once in a while.

Either way, understanding what your financial advisor is bringing to the table is the key in deciding whether to continue with him or fire him. Nothing comes for free but not all costs are acceptable.

Where is your Edge

A friend of mine has a shop selling something which in theory has no moat whatsoever. If you wish, you could easily put up something right next to him and start doing business. Margins are good which means that there is pretty high attraction to getting into his business. Where there were just 2 a few years ago, I now count 6 within walking distance from his shop.

For now, everyone seems to be happy and have enough business, but as my friend knows, the business runs in cycles and there are times when he has hardly any sales. But he has a edge that the others don’t. While others need to make enough to at least cover their rents (and the area is notorious for its sky high rents), he owns his shop making it much easier for him to overcome those dull times.

Mutual Fund and Distributors are these days spending money and time trying to convince you that investing in a Mutual Fund via SIP is the best way to save for your future goals. Theoretically they are right, its much better to save more systematically each month as it all adds up over time.

But when it comes to Mutual Funds, there are literally hundreds of choices out there. How do you choose the one or the select few that you think will help you in reaching those goals.

Stock Advisory is as old as the Stock Market itself – why bother to research on your own when you can just pay a small fee and be provided the stock to buy / sell rather than you having to wade through hundreds and thousands of stocks.

And then there is Insurance. If you were to carefully check out advertisements of Insurance Policies, you would have heard “Insurance is the subject matter of solicitation” but have you thought about what it really means? . Not many customers bother which means sellers have a field day.

What is common among sellers of all the above products?

They all profess that they can help you reach your goals which generally is about making X amount of money by Y time. Some are qualified, most are not but as long as they have the gift of gab and have the ability to make things up as they go, how many will really question things they claim to be true but which aren’t.

When you go out to buy a product, lets take a Cell Phone for instance, we do plenty of research before we even hit the showroom. We ask Friends about the one they use, we browse the internet trying to find out more details and finally figure out the brand which we want to buy.

Having done all that, its still easy to fall to the talk of a sales guy who tells you how great this new Cell Phone is is and how much its been selling in the market (even though before this day you would have barely heard its name). A few years ago, me and my friend went out after doing research to buy a Samsung phone but ended up buying a Karbonn since we fell to the talk of the sales guy who in all probability would get more commission to sell a phone like Karbonn than selling Samsung.

The phone wasn’t as great as it was advertised and after a couple of years using it, my friend junked it for a better one. But while he was unhappy with the phone, he seldom felt the same about the seller despite the fact that the sales guy had the Edge in terms of being more knowledgeable than we were.

The reason we get misled in finance though comes down to our aversion to learn even the basic things about savings and how the various choices pan out against each other.

The web is filled with information that you seek but you need to search it out for it to be of any benefit. While most of us are happy to slog for 8 hours, when it comes to learning / understanding about finance, we are just too tired and want some one else to make the decisions for us.

That some one needs a motivation – it maybe in terms of a trailing commission as in case of Mutual Funds and Insurance or a fixed fee per month in case of stock advisers or a one off payment in cases such as the Real Estate broker who helps you find a house to invest your money.

When it comes to investing in Mutual Funds, how many times have you heard your adviser speak about Quantum Mutual Fund – a fund that has outshone its peers in recent times and stands among the best even when comparing with others on 5 year returns. How many times have you heard your Insurance agent talk about Insurance not being a Investment and hence you should look for Term plans vs Moneyback Plans or ULIP for instance. How many bank employees have advised you that if you were in the highest bracket when it comes to Tax, you maybe better off with a lot of other debt based assets that yield more after tax than a simple Fixed Deposit.

You don’t hear any of the stuff because saying so would mean cutting off their own money tree and who in the right mind would want to do that. Advisory is supposed to be a Fiduciary duty and yet for most, its what makes their dough that is the biggest concern, not what is right for you.

To say that you need to save more is easy, To say that you can save more by investing better is way tougher because the future is uncertain and non one has a clue other than to look at history and hope that history repeats itself.

If you are reading this, I would guess that you already have a Edge. You know what works for you and what doesn’t and aren’t swayed by glossy advertisements about returns that seem out of the world. You know about the various biases you can fall into them without even our knowing.

But then you are part of the minority (and this applies equally to any country you can think of). The reason for starting this site were many and one of them was to help provide perspectives to investors and traders alike. While I have no clue whether my posts here or my rants on twitter are doing anything, the way it has rattled some tip sellers I hope means that I have hit some right spots.

So, back to the Question. What is your Edge when it comes to Investing? If you can answer that (and hopefully is data backed), you have ARRIVED.

The Framing Effect

Framing Bias is a congnitive bias. From Wikipedia;

“The framing effect is an example of cognitive bias, in which people react to a particular choice in different ways depending on how it is presented; e.g. as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.”

Consider this example, posed by Dr. Daniel Kahneman, Nobel Prize-winning author of Thinking Fast and Slow:

1. Would you accept a gamble that offers a 10-percent chance to win $95 and a 90-percent chance to lose $5?

2. Or, would you rather pay $5 for a lottery ticket with a 10-percent chance to win $100 and a 90-percent chance of winning nothing?

Think before you choose either. Have you decided? No Peeking. So, comfortable with and believe you have made the made the right choice?

The answer is both are the same, but research says most people when presented with the above options and who think themselves as rational decision makers would opt for Choice 2. Why?

Because of the way the question has been framed you feel that buying a lottery ticket for just $5 is way better than a 90% chance to lose the $5.

The other day I wrote on why I believe that Individual Traders / Investors are better off not trading in Individual Stock Futures and in a way (which I really didn’t intend to) was framing it in a way that people felt that there was a way higher risk than what they perceived.

Before we get further, let first understand what stock futures are and why more people end up loosing than what a simple coin toss odds will foretell.

From time immemorial, people have taken on debt to try and achieve their goals earlier than what it would if one needed to save the whole amount. Think of a housing loan for instance. How many home buyers can afford to buy a home if they were required to put up 100% of the amount vs the current concept of putting up a small initial deposit and pay the rest with interest as time passes by.

If no one is allowed to take debt for buying their own house, the housing market will crash for the simple reason that disciplined saving is way tougher compared to the discipline of paying off the EMI since otherwise you may tend to loser ownership of that house and its not just the financial loss that will pain you but the ignominy of being seen as a failure by those who know you.

Now, lets come back to Stock Futures and how similar it is to the Housing Loan.

Lets assume that you believe that government will focus on Infrastructure and hence Infra companies that have been bogged down could see better days. Lets assume based on the above rationale, you choose J P Associates as the company you want to invest into.

Lets assume you currently have around 2.5 Lakhs that you want to risk in the market. The rational thing to do would be to spit that into 10 or 20 equal measures and invest each such measure into a individual stock. That would mean that you could buy 2170 shares of JP Associates if you invest 10% of your capital into that company (25,000) or 1085 shares if you were to allocate 5% of your money into the said company.

Lets for sake of understanding assume that you have done a lot of research and that research tells you that JP Associates will bloom in the future and given that its all time high is 339, if you are right, this stock could go way way higher.

Given this scenario, would you opt for buying 2170 shares or 1085 shares or would you think on lines of, given how much I know why not take a loan and pump in more money since the rewards will then multiply by the leverage factor.

Lets for a moment get back to the housing example. Two friends analyze the housing market and feel that its ripe for a big up move and they should take advantage of the coming boom. Person A saves a lot of money and finally buys a house without taking a loan for 50 Lakhs. Person B saves a small amount (10% of the value of the house) and takes a loan for the rest 90% and buys a house for 1 Crore.

With housing prices booming, lets assume that property prices acquired by both Person A and Person B have appreciated by 100%.

For Person A, its a pure doubling money. He had invested 50 Lakhs and sees a profit of 50 Lakhs. He is happy until he turns around and sees that Person B who put in 10 Lakhs is now seeing a profit of 1 Crore, 10x the investment. Given that both had done the same analysis, do you think that person A will really be happy with the outcome he is seeing now?

Lets get back to our JP Associates case. You feel that this being one sure bet, maybe you should bet it all – 2.5 Lakhs and wait for it to move up as your Analysis tells you it will. 2.5 Lakhs will get you 21,000 Shares. At this time comes in the Spider who tells you that why stop at 21K, when the same 2.5 Lakhs can get you exposure to 68,000 shares.

In earlier days (and even these days) brokers offer what is called margin finance where you buy stocks while putting up only a part of the investment. If you are right, your returns explode and who thinks that things can go wrong – always be Optimistic is what he have learnt in Life.

But for JP Associates, you don’t need a kind broker to help you. The exchange itself will provide a medium where you can borrow. All it asks you is that you fulfill the margin requirement as well as the day to day, Marked to Market difference.

If you are not exposed to Futures and Options, you may think which irrational fool will take that path, but then again all you need to do is visit a broker’s place and see for yourself how the herd behavior will influence one to take more risks that he should if had analyzed the whole scenario much more carefully.

So, now that we are convinced that JP Associates will move higher, way way higher and we aren’t satisfied with just a small token quantity, we convince ourselves that nothing will go wrong and jump into buying a single contract of JP Associates.

We are now proud owners (not in real sense) of 68,000 shares of JP Associates which means that every time it goes up by One Rupee, we are seeing a profit of 68,000 and since our capital is 2.5 Lakhs, we are up by a awesome 27% of our capital (remember, a Fixed Deposit gives you 7.5% for giving it money for a year). Man, we can start dreaming.

A couple of days later, comes a news item that a certain bank is proceeding with confiscating certain assets of JP Associates and the stock promptly goes down like a brick. Theoretically that shouldn’t cause a problem, after all we have put in 2.5 Lakhs right and even though the stock is down 10% from our entry, its just a loss of 68,000 and big as it may sound, we still have 1.80 Lakhs available.

In 2007 when housing prices started to fall in the United States, those who have taken loans to buy their houses found that many banks had started to ask for them to make up the difference (since most housing loans were to the extent of 100% of the property value). But having invested everything they had, how the hell were they to come up with more money. By 2008, prices had fallen so much that even those who had paid back a lot found that their house value was lower than they still owed to the Bank. With job losses, many were forced to relinquish their homes, something they had paid a lot for (in monthly installments) while getting back nothing.

Back to our JP Associates trade. While we think we still have money, we are actually in negative equity since NSE demands that you plonk up 2 Lakhs as Margin for every contract you wish to hold. Given that we had 2.5 Lakhs to start with, with the loss of 68,000, you are now having a debit balance of 18,000.

Depending upon your broker, you will either see him closing out your position without even giving a chance for you to replenish the amount or shall call you up and ask you to immediately replenish or else position will be cut. Either way, you will need to put in more money to hold that position.

But if we had invested the whole capital we had, where else can we bring fresh capital from? I have seen clients Beg or Borrow from others in the hope of maintaining the said position. In fact, years earlier, I myself had come to face a very similar situation and its in those situation you not only realize who your real friends are but realize how stupid you have been with your money.

But that is for later, what comes first is the requirement of more capital. If you can bring it in the time they provide, your position will be saved, else, its closed and regardless of how JP Associates moves from here, you will have nothing to lose or gain.

So, when I said 95% of clients on the longer term end up loosing, its not because they were stupid but because most of them were financially unprepared. When you use Leverage, its a double edged sword and yet people believe that only one edge is what matters to them without focusing on the dangers brought by the other edge that could cut your neck in no time.

Stock futures are a good product if you can use them wisely (more on that in another post) but if you are using it as a quick way to becoming rich, Good Luck. The 5% who are out there eating up the losses of the rest 95% losses (remember, futures is a Zero sum game) know for sure that Luck can only last so long. Some point or the other, you will throw in the towel after having seen your capital being decapitated several times.

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. – Mark Twain

The Ultimate Strategy

The holy grail of returns would be if you could get equity like returns while having bond like volatility. While in theory such possibilities do exist, the question that arises is whether its feasible / practicable in execution where reality meets fantasy.

Motilal Oswal Mutual Fund has indeed launched one such fund aptly named – Motilal Oswal MOSt Focused Dynamic Equity Fund. In the words of Aashish Somaiyaa, CEO, Motilal Oswal AMC;

Now, as a systematic trader, my ears perk up when people talk about how great a system has been in back-test. Having build and buried thousands of systems that look great in back-test but fail miserably when it comes to the real world, there is a very high risk of the out performance being more of a mirage that seems to be out there but never can be reached.

To ascertain how long has the system been back-tested and how long its running in real time, I asked him details of the same and here is the reply;

The back-test period encompasses both bull markets and bear markets making at the very least it having some kind of validation about having shown its out performance when times were good as well as when times were bad.

But does that provide any sense of understanding given that any and every data mined strategy will pass the back-test with flying colors?

A better way to test would be to run the data through some statistical testing and see if it really is as good as it claims to be.

Unfortunately the Index is not really a Index as it is bounded and will move between a lower and a upper end making it more like a Stochastic.

But Motilal Oswal in a presentation of April 2016 has the following picture

While the comparison between Inception to April looks tremendously good, do note that much of the data is from the back-test. On the other hand, data from 2 Years on wards is of walk forward and hence more reflective of how good it is.

Below find a correlation chart of 100 period returns of MOVI vs future 100 day returns of Nifty 50.

Since the strategy is contra (Buy when market goes down, Sell when market goes up), do note that we need to focus on when strategy is positively correlated vs Nifty and when its Negative. On the face of it, it seems to do the job though the true picture can only be obtained after a few years of operation by this fund.

The key idea behind the launch seems to be with the idea that since Investors cannot digest large volatility (downside), by having a strategy that sells when markets are expensive and buys when markets are cheap, its volatility will be lower and hence hopefully the investor will stay longer.

In 2010, Motilal Oswal launched a Smart Beta ETF on the Nifty 50. The premise here as defined in the leaflet is as below;

What is MoSt50 basket?
MOSt 50 Basket is a fundamentally weighted basket based on S&P CNX Nifty Index (Nifty). The methodology is conceptualized and developed by Motilal Oswal AMC. MOSt 50 includes all the Nifty 50
stocks but not in the same proportion as Nifty. Weightage of a stock in MOSt 50 basket is determined by using Motilal Oswal AMC’s proprietary pre-defined methodology that assigns weights based on
stock’s fundamentals such as ROE, net worth, share price and retained earnings. This is to ensure that companies with good financial performance and reasonable valuation get higher weightage.

Once again, it was a good concept. After all, if you could buy more quality stocks and less of the bad quality, you theoretically should outperform the Index. The said leaflet also had a chart to showcase its advantage vs Nifty 50

As the chart and the accompanying table shows, the strategy was perfect. While you got the same volatility of the Index, returns were way higher. Since the above chart has both back-test data and walk forward, its tough to notice that it had started to deteriorate. So, how did it perform after being listed vs Nifty Total Returns and Nifty Bees;

As the chart clearly shows, the fund more or less under performed Nifty Bees most of the time and not surprisingly the fund house decided that it was going to follow the regular model from Oct 2014 instead of being fundamentally weighed.

This issue is not just of Indian funds. Take the ETF, First Trust Dorsey Wright Focus 5 ETF for instance. Using a concept of Relative Rotation among sectors that are showing strong momentum, the fund showcased how it has trumped S&P 500 returns

As the table showcases, it yielded strong +ve returns vs the S&P 500. Given that fact that in United States, majority of Mutual Funds under perform the Index, this was a real breakthrough or so the Investors must have felt.

So, once again, how has been the real time performance of the fund vs S&P 500

Once again, there is disappointment in store as forget out performance, for now the fund is not even performing in line with S&P 500. Then again, the time frame is short and who knows how it could perform in future.

Sometime back, NSE introduced a new index Nifty Quality 30. The fact sheet quotes “The ‘Quality’ investment strategy aims to cover companies which have durable business model resulting in sustained margins and returns”.

Once again, the idea is right. High Quality companies can and shall (in theory at least) out perform Low Quality companies and this is proved even in their back-test data.

Does the Nifty Quality 30 whip the asses of Nifty Total Returns. Holy Grail Unveiled, or is it?

Once again, its too short term to make conducive large term forecasts, but Quality 30 seems to be facing some strong headwinds as of now. Will it do better in future? I have no clue though if you believe, you now have the opportunity to invest in the Index through ETF’s such as Edelweiss ETF – Nifty Quality 30.

What is common in all of the three above examples is that the heart is at the right place – how to do better than Index with similar or lower risk. But the result is not as one would expect. Would Motilal Oswal fund be different?

Once again, I have no clue but would rather (as a Investor) wait for data rather than rosy forecasts / back-test data which may or may not be the best way to ascertain which strategy is good and which isn’t.

A known devil is better than an unknown angel.

Travails of a Trend Follower

Over the last few decades, Trend following has really taken off with a lot of believers flooding the streets so as to say. After all, if I were to sell you with charts like the one below, why would you not be convinced about its benefit

But then again, I choose that particular chart out of the 1000’s available because I could use it to show what I wanted to show. Selection Bias / Survivor Bias and what not come into picture the moment I select a single or even multiple instruments from a set of data.

But trend following is tough and this makes one starting to question premises even when we can show from history that what is happening is exactly something that has happened in the past and will happen in the future as well. But, past is the past and the future is unknown. Present is the key and our emotions aren’t really concerned with either the past or the future but the moment on hand.

Yesterday for instance I had a debacle day for me. In the morning my stops got stopped out and I went long. Well before the close though, I once again got stopped out and went back to the original short mode. But markets had not ended and while I did not get any fresh signal markets did move a lot higher than the point that my longs got stopped out and I went short once again.

This is a rarity for my system with system exiting 2 trades in a single day being just 5% of the time, but it hurts and not surprisingly is the costliest (per trade) whipsaws as the chart below will showcase

What is striking in the above chart is that whenever the trend ends fairly soon, you end with negative results that are the primary contributor to the adverse win-loss ratio most trend following systems have. In the above system for example, if you are in the trade for more than 7 days, the probability that you shall still end up in a loss is pretty low. The chart below plots the same

Its amazing to see how not a single trade (out of 365 in above example) could close in +ve if the reversal happened in the first couple of days. Once that hurdle is crossed, the probability keeps going lower until it hits zero and stays there.

Since 1996, Nifty has moved up by around 8000 points. But if you were a trader, you could have gained that 8000 points by being rightly positioned on just 36 days (which is just 0.70% of the total number of trading days). If you were having a trading system that traded daily, if you slept for the first 10 years (1996 – 2006) and applied your theory on just those 36 days, you will have in theory outperformed all 99.3% of the other days (all this being theory, but please bear it with me for a moment).

In other words, you could have been long since 1996 and gained exactly the same points as some one who entered and exited daily on just 36 occasions. Of course, if only we knew about these 36 days in ahead, why would we bother would be the question in your mind and you are absolutely right.

But think on the contrary you were long for all the time and yet were out of the market on those 36 days. What would you be staring at? You would be looking at having the same capital as you did 20 years ago.

Now, lets take a trend following system equity curve. What is the cost of missing a few trades (which inadvertently turn out to be the best trades you could have taken)?

As can be seen above, more the trades you miss, lower the returns. Since the number of trades scrutinized above is around 365, missing 15 trades is missing only 5% of the Signals and yet the returns can be disastrous. You could always argue that maybe the trades you missed weren’t the best but the worst and hence the returns actually are better. But if you could do that in real time, your success rate will be closer to 100% since you can easily over ride all bad trades similar to the way many advisors just remove their bad calls while showcasing their good ones.

So, given this relationship, why do traders still try to skip few trades in the hope that those skipped will be a loser and hence be advantageous. Think of a coin toss. Theoretically odds of a fair coin falling either on its head or tail is 50:50. But if you were to toss the coin n number of times, you can get streaks of heads or tails. But does that change the probability of the next coin toss to something like 40:60? Of course not.

Trend following systems have a average winning of 40 trades vs losers of 60 in a sample of 100. But that doesn’t mean anything since you can have 10 or 12 or even 20 consecutive losers without one single intermittent win. But does that really change the overall ratio? I say Nope. It still remains 40:60 in favor of Losers.

I keep hearing various remarks about how you should know when to ride the system and when to over-ride, how one should not take a trade before a big event (which is actually of a lower risk compared to the risk of the Unknown event we take when we carry positions home everyday), how January is not a good month for longs among various other theories.

When you have a loser after loser, its easy to believe a lot of nonsense that gets sprouted. But as showcased above, data indicates that missing can cause more harm than participating in each and every trade. All we can control is Risk and that is better controlled by modifying our position size than by skipping a few trades.

Book Review: Deep Work

There are books and then there is this book. Deep Work: Rules for Focused Success in a Distracted World by Cal Newport. One of the key reasons for me to read books is with the hope they inspire me (Directly by putting up ideas or Indirectly by showing the right path) to do better in my life and in that aspect I believe book comes among the top in terms of its ability to showcase the benefits of how we use our time and how we can better ourselves.

Malcom Gladwell in his book Outliers made the following famous quote

“In fact, researchers have settled on what they believe is the magic number for true expertise: ten thousand hours.”

Now, there has been a lot of debate on whether this is really backed up in terms of scientific evidence and whether you really need 10,000 hours. But what is missed is that its not hours that count – after all, if you spend 10,000 hours watching Television, you wouldn’t be any better a judge of Television than your Mom who watches multiple family dramas.

Lets take the stock market – who are the experts out here? Are the guys who sermonize all day long on Twitter (me included?) or Television make them a expert.

We all like to Quote Warren Buffett / George Soros among the other greats, but do we really work the way they do. Buffett for instance claims to read 5 – 6 hours a day. Below is a quote of his taken from Farmstreet Blog

But I read five daily newspapers. I read a fair number of magazines. I read 10-Ks. I read annual reports. I read a lot of other things, too. I’ve always enjoyed reading. I love reading biographies, for example.

As much as we want to be successful, the question is how much effort we are willing to put in for that effort. August – September is the season of Annual Reports out here in India and if you are a stock investor, you surely would have received some of them. If you think yourself a investor who looks at the fundamentals, how many have you read?

And then there is Soros. As some one once mentioned, if you can read and digest his “The Alchemy of Finance“, you really have achieved something. But then again, most of us are happy to just quote him and move along. Yeah, he is great, but I don’t think I can trade / invest like him.

Distractions are part and parcel of our lives and the book is all about how eliminating them provides us with the right context and time for what we really need / want to do.

Valuewalk has very detailed notes from the book, Do Read. Link: Notes

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