Commentary | Portfolio Yoga

Cost of huge Returns

Michael Batnick who is Director, Research at Ritholtz Wealth Management tweeted out the following chart of Amazon

Implicit in the message (my presumption since nothing was blogged / tweeted) was that its not enough to buy a great stock, you need to have the stomach to take big draw downs like Amazon say (90%+ after the IT bubble crashed in 2000).

But what is missed is the fact that Amazon was one of the very few survivors of the carnage of the 2000’s. While I don’t have the actual stats, my guess is that greater than 80% of the stocks that were listed at that point of time don’t even exist (in any form) today. Pet.com / Webvan.com / eToys.com being some of the biggest losers.

The same is the case with Indian IT stocks as well with very few surviving the carnage. In Bangalore which was and has been a Infotech hub, we had stocks like Shree MM Softek, International Computech, Cybermate Systems among others (50 IIRC) that no longer even exist. Bigger ones you may remember would be Pentafour Software / DSQ Software / Aftek Infosys among many others.

Returns don’t come from suffering unbearable draw-downs. Returns come when you are able to balance out the risk with probable rewards and if your stock is down 80% or more, you have a 20% or lower chance of ever getting your money back. Things like Amazon / Apple happen, but only in hindsight do we recognize the great opportunity that it was.

And last but not the least, while its seem one easy way to avoid total destruction would be to be well diversified, it has to be across asset classes / sectors / industries. Buying 10 NBFC companies (Today’s hot sector) or 10 Pharma would either make you very rich or very poor and is not definitely for someone who wants to achieve returns greater than what a simple Index fund would provide.

A small table listing out % of stocks that are at different draw-down levels. Remember, these are those who survived and continue to be listed – many don’t.

Random thoughts, Financial Planning

Till very recently, Finance was simple. You earned X, spent Y and the remainder Z was usually put away in a Fixed Deposit for a rainy day or as savings for a future goal – House / Marriage, etc. Equity exposure was the last thing most people had in mind unless of course you were in Mumbai or Gujarat where it seems markets run through their blood veins.

Most articles on finance end with a phrase “Please consult your financial adviser or investment adviser” when it comes to advising on what to Buy / Sell. But who is a financial adviser in the first place?
When it comes to other fields, you have recognized degrees that suggest that the person you are approaching for advice has the necessary qualifications to help you. A Doctor for example needs to study and pass a 5 ½ year course in Medicine before he can start advising on what medicine you need to take, a Lawyer needs to pass a Law Exam (once again after 6 years of study (non-Integrated)).

While I can prepare my company’s balance sheet, I cannot sign it off and that falls to a guy who has passed his CA exam (which takes time given the low passing percentage) and this after spending a minimum of three years working under an existing chartered accountant.

But when it comes to advising one about how to achieve one’s goals, there was no exam as such and anybody could and did claim to be a financial advisor even though many barely had a clue on how to guide the person who came to him for help in managing his finances.

These days everyone claims to be a financial advisor, be they selling tips on what stocks to buy or advising you on what mutual fund to invest in with most of them now flaunting a SEBI Certificate that enables them to claim to be a registered investment advisor.

Most of the Indian middle class I doubt has much exposure to a financial advisor who can advise on our finances in totality. The Mutual Fund distributor advises on which funds to buy, the distant aunty of ours throws in a few LIC policies which she claims shall secure our and our children’s future while the stock broker (if you haven’t yet gone fully online) provides you with ideas on what stocks to Buy and last but the biggest of all, our neighborhood friendly PSU Bank offers to sell Fixed Deposits.

In other words, financial advice is based more on what they want to sell than what we really need to buy but then again, Finance for long has become a push based strategy than pull. But are we well served by buying what is advised by those who honestly do not have a clue on what our requirements are, let alone our goals / dreams and fears?

Yesterday I decided to ask my twitter followers the one thing they look forward when choosing their financial advisor. Some of the answers I received;

“Credible track record, transparency around compensation, Strong grounding in ethics. Trust. That comes from multiple factors – incentive structure, track record, investment philosophy, clear communication etc, Trustworthy, Integrity.”

As W. Edwards Deming once said, ““In God we trust; all others bring data.” Trust is important, but trust without data to back it up it is nothing more than a cognitive bias more specifically referred to as Dunning–Kruger effect.

When we invest for a Goal, we are investing in a uncertain future with the only road map being of the past and it’s hence important that we select the right people to help us in that journey of ours since if one screws up, the impact is one for the life time.

A lot of friends compare advising (finance) to how a Doctor advises his patient but the fact they miss out is not only are there specialist but even they (many a time) ask you take a second opinion when it comes to say a operation / method of treatment. When it comes to investing, how many advisors have you met who say, why not take a second opinion on whether this path is right for you or not?

An advisor is not a seller, Period. He needs to assess your financial position, your goals, your wishes, your fears and provide you with advise based on what is best based on current set of data and one that could undergo change as time passes by. An Advisor has a Fiduciary duty to act in the best interest of you and you alone. He will of course charge you a fee for doing the work, but then again, we all understand there is no free lunch.
While it’s easy to believe that choosing the best stock / best fund will make a large difference to our final results, the truth is that its Asset Allocation that is more important than the never ending search for the holy grail of funds / stocks.

If you have invested 90% of your money in the wrong asset classes, even great investing of the remainder 10% barely will scratch the surface. Empirical evidence has shown that most funds find it tough to beat a simple 60 / 40 allocation that is rebalanced regularly and yet, we get impressed by the tip selling friend who claims great returns on back of his advise.
It’s shown (once again data backed) that costs are the prime killer of returns in the long run, but based on selective / recency bias, funds that charge as much as 3% of your AUM on a yearly basis continue to gain fresh funds.

Most investment advisors I have seen seem to suggest strategies which believe that you shall continue to earn and save for the next 20 /30 years. What if economy went into a recession and you lost your job not to mention the unmentionables – health / death, etc. Is your plan still worth the paper it’s written on?
Preparing for all contingencies is essential and if you cannot ask the right questions, you shall be taken for a ride since end of the day, the risk is yours only. Gains if any are always shared.

Dipa Karmakar and the Risk Quandary

Before the start of this Rio Olympics, I am sure that less than one percent of people had even heard about the name of the Gymnast coming from a small state in North East India but by yesterday, she was a toast in the media with most of us hoping that she may defy the odds and provide us with the first medal. Finishing fourth is a proud achievement given the kind of support system she had versus the support system of other competitor’s and it’s entirely due to her hard work that she is now recognized and has made a name in the world of gymnastics.

But there is a dark side as well as Dipa was one of the only(?) gymnast in this Olympics to try out the artistic gymnastics vault called “Produnova” and is only the 5^th to complete it successfully in a international competition. But as Wikipedia says and I quote,

“Controversy was sparked after Fadwa Mahmoud’s first competitive Produnova attempt, where she nearly landed on her neck.

As long as the gymnast lands on her feet first, she will get credit for the vault, and because of the Produnova’s massive difficulty value, it is easy to get a high score even with poor execution. This has led several gymnasts in countries that lack funding for gymnastics to attempt the vault in order to increase their chances of medaling and therefore obtaining more funding. There have been calls for the Produnova vault to be banned due to the high level of risk”

Now, compare this to the risk taken by amateur traders. Given that most of them lack capital, they essentially try to for broke by risking big and hoping that it pays off. Unfortunately that is seldom the case as most traders end up broke after a few such try outs as high risk never means high reward all the time since otherwise it couldn’t be high risk in the first place.

For a few months now, I have been tracking open interest data of FII’s and Clients and for me, it holds up as to how Institutions think versus how Retail folk think. For starters, FII’s are never short put options (Net) which means that they Buy Put options as an Insurance policy (as its designed to be) against their Long positions. Retail on the other hand are happy to be short Puts almost all the time.

In fact, since 2012 from where my data starts, they are short futures as well as short call options and furthered by long puts only 20% of the time. 39% of the time, they are Long Futures, Calls and Puts and 41% of the time, they are either Long or Short Futures and Long or Short Call Options while remaining long puts.

In markets history, there have been very few instances of a Market Melt up while Meltdown is an often repeated headline that occurs in a regular fashion and when such a incidence happens, you know how retail clients will be positioned.

The basic idea of having options was to provide a way to limit losses by buying Insurance but given the leverage it provides, it has been happy hunting grounds for those looking for quick bucks since it provides the kind of leverage no other product does.

While stocks can take months or years for it to return 100% return, in an option you can witness 100% and more within a single day and sometimes within a few minutes. No wonder that it attracts clients who are more than happy to stake a bet hoping that lady luck favors them.

The fact that you are risking 100% of the capital posted since it can as well as easily (and normally) does goes to Zero is often overlooked with the premise being that you lose only what you bet and no more.

In the Race Course, in a Casino as well as in the Lottery business it’s always the bookies who end up on the winning side all (or almost all) the time. While there will always be a few winners in extreme short term, over the long term the only guys going to the Bank to deposit their winnings are those on the other side.

Both in the Casino and the Options market, it seems that both the Player and the house have equal advantage but as everyone knows, “The house always Wins” even though its edge is not too great. In the derivative markets, it’s said that 95% of all options expire worthless but that doesn’t mean that option writing is an easy way to generate profits. I should know it better since nearly a decade back; I nearly went bankrupt writing options. Victor Niederhoffer blew his fund as well as personal money selling put options. Nick Leeson blew up Barings Bank selling put options on the Nikkei among many other disasters (mostly of the unspoken kind).

I find it amusing when experts say, “Risk only money you can afford to lose” which to most I am sure seems to suggest that it’s better to invest in Gold / Real Estate where such investments do not merit such statements (though the same, heck, even bigger risks exist in those asset classes).

Everyone who has made it big has risked it all (thanks to Survivor Bias, we can safely ignore those who failed), be it in Land / Gold or going solo (Entrepreneurship). But risking it all doesn’t have to mean losing it all – there is a wide difference between those two and the key to survival (remember, Survival not Success) is to understand that difference.

Motilal Oswal has a motto that says “Bet Right, Sit Tight”. I on the other hand think, Bet Right (at least hopefully its Right), Bet Big (no point scoring a few pennies when you are right, Right?) and be ready to change your view if the market doesn’t move in the direction you assumed it would (Sitting tight is equivalent to sticking one’s head in the sand and hoping that the storm will eventually pass over).

As much as I wish Dipa Karmakar well, I do hope that the lessons future gymnasts not take from her success is to try out the most risky moves in an attempt to win honor and medals.

Save or Spend

Yesterday I finished reading, Pit Bull by Martin S. Schwartz which while being on the lines of the famous Jesse Livermore book hasn’t gained that much fame despite the fact that unlike Livermore who died broke, Martin has been a exceptionally good trader who never came close to Bankruptcy despite being a full time trader and one who while not swinging for the fences did take enormous risks in the course of his career.

I believe the book contains various nuggets of wisdom throughout which are applicable both for the trader as well for the common man. One of the things that appealed to me was his view to taste the fruits of success rather than investing the same elsewhere where it could have given even more gains.

Quoting from the book,

“Over the last two years there had been many times when I’d said to myself, gee whiz, why did I dump one third of my net worth into that beach house? If I’d put that money into mutual funds, it’d be worth well over a million now and that would have made my entire family more secure.

That was the trap that a lot of traders fell into. Most big-time traders didn’t taste the fruits of their labors until they’d climbed to the very top of the tree, and in some cases, they never tasted them at all. To them, making money was the fruit, because to them, money was power, and power was the only way they could feed their giant egos. I wasn’t interested in power. I wanted to taste my fruits all the way up the tree, which meant that I didn’t mind spending money, lots of money.

……………..

If Audrey and I wanted a beach house, we’d buy a beach house. If we wanted a twelve-room apartment on Park Avenue, we’d buy that, too. There came a time when you had to spend the money you’d been making so you could understand why you’d been killing yourself”

I was reminded of a recent advertisement by a Mutual Fund house where the child admonishes her parents for spending money on Handbag / Car when they could make it even bigger by putting them in a Mutual Fund (‘n’ years down the lane).

As I commented on Twitter upon seeing that advertisement, while saving is important, there also needs to be a balance in living a good life. After all none of us can carry over our savings to the other world, so what is the whole point in struggling throughout our lives to save more and more without a clue as to when we can actually start using it.

A secondary learning from the book was that there would always be some one who made more and not everyone can take the pressure required to accomplish that (without it coming at cost of family / health). Knowing one’s limits goes a long way in ensuing that we don’t get onto a race we know we cannot win even if we put everything on the line.

Martin is a wonderful trader (based on his record) but if some one takes the book to mean that day trading is the way to go, he is going to crumble very soon since its one thing to read about the success of one person and quite another to pass through the fire like many before him would have and yet not get burnt. Do remember, History is written by the Winners.

Buy the New High

At the very heart of Trend following is the concept of buying at new high with the assumption being that market knows something that we don’t. While the logic works on literally all time frames and tickers, some are better suited than others. Indices for example are better suited than even its Individual components, Commodities better than the End Users among others.

In bull markets such as the one we are currently in, every day you see a large list of stocks that are hitting new highs and vice versa when the markets are bearish. The chart below plots the sum of All stocks that hit new 52 week highs subtracted by All stocks that hit 52 week lows. As you can see, its been bullish (though not overly we we saw in 2014) for quite some time now.

Buying at a new high is tough mentally speaking. After all, you have witnessed a rally (that you may or may not have participated in) and its normal to wonder whether one is too late to enter. Nifty 50 for example is 26% above its 52 week low which got posted just a few months ago (29th Feb 2016). The question hence is, after missing out of that 26% move, does it make sense to commit now especially when analysts are calling the market as being highly over-valued and primed to fall.

Spreading fear is easy in markets, after all, markets do tend to move higher at a very slow pace but fall precipitously when we hit a speed breaker. Nifty 50 hit its first 52 week high (based on look back of 240 days) after having previously hit a 52 Week low on 25th July 2016. So, lets take a look at what history says has happened when Nifty 50 hit its first 52 Week High.

The above table is a list of dates when Nifty 50 hit a new 52 week high and what happened later on. The last column showcases the returns between when it hit its first 52 week high and the return at the time when it hit a new 52 week low. Even ignoring that, what the table above suggests is that save for 1997, markets have provided positive returns in the days and months ahead.

Lets also look at the same table but when markets hit a new (first time) 52 week low.

Surprise, Surprise. Buying the new 52 week low isn’t as bad (if you could have withstood the draw-down) as it sounds in theory. But as with anything else, we have a problem and the problem is that there isn’t really sufficient data to draw conclusions we want to draw upon. Yes, we are using around 20 years of data, but our data points are too few to provide us with a realistic view.

Given that we are wanting to test our theory, there is no better way than to use the same logic on the Dow Jones Index which has around 120 years of data to back it up. What is the outcome if we test the same concept there.

First, lets start with data of what happened when Dow hit a new 52 week high.

And now, the same when Dow hit a new 52 week low.

Unlike the data of Nifty 50, here with more data we can easily see why it makes more sense to buy a 52 week high than buying a 52 week low.

On 4th June of this year, I wrote a blog post titled “Start of a New Bull Market?” where I showcased why I felt this was maybe a start of a new bull run. As on date, we are up around 6% and I do feel we have some distance to go before we crash. But then again, no one knows the future and the only way to go is to work with probabilities and know all the exit doors in case the trend doesn’t go as we anticipate it will.

Narrative Fallacy & We

After years of being in a terminal decline, Yahoo finally decided to sell off its core business to Verizon for $4.8 Billion. Given that adjusted for its holding of Alibaba and Yahoo Japan, the core business was actually valued at Zero.

Nassim Taleb explains Narrative Fallacy and I quote

The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.

—Nassim Nicholas Taleb, The Black Swan

On Twitter, the reactions to the Yahoo sale were wide though one picture seemed to suggest how badly it had played it out

In fact, the above missed out the fact that at one time, Yahoo was pretty close (closer than it was with Google) at acquiring Facebook for $1 Billion (Market Cap of FB today being $350 Billion) or the fact that what Microsoft offered was for the Entire company and not just its core business. But, hey, why spoil a good story with facts.

Hindsight is 20/20. As investors / traders, we too fall for this phenomenon which can be illustrated by the following Whatsapp message that I received today

Wonders of Market :

22nd Jan 2009 – price of Bajaj Finance Rs.55/-
26th July 2016 – it touches Rs.9745/-

Investment of Rs.55000 becomes Rs.97.45 Lakhs.

How wonderful it would have been if we could have invested just 5,500 Rupees in 2009 and see it grow to nearly 10 Lakhs today. No Real Estate investment has grown by such a measure in the same period.

But the bigger question that is missed is whether there were any signs of such greatness in Jan 2009 given that the market itself was in doldrums and all the signs were of further doom and gloom to come.

In 2000, at the height of the Infotech bull run when Yahoo was valued at $125 Billion, we had our own Infotech boom with stocks that had anything (or even nothing other than having a name that reflected it being a Infotech company) getting valued wildly.

Then as now, the thing that everyone thought was, what if I had invested just 13K in the IPO of Infosys, today I would have been a Crorepati. Then as now, very few had any clues and even those who did somehow hold on to the stock (I know friends who held) sold very little for the assumption was that this rally will go on forever and it was stupid to sell (I know many a client who got destroyed buying IT stocks which then couldn’t be sold since when the cards tumbled, there wasn’t a easy way to exit).

Everyday Jokers who come on Television try to explain why the market or stock did what it did making us wonder why we did not think about it earlier. For instance, today morning a Television Anchor explained the bullishness in markets as Liquidity driven and went on to say “This is the market in which momentum is on your side and there is no fun in missing out.” And despite all the buying by FII’s, markets closed the day negative – where did that liquidity go one wonders.

In a Freakonomics podcast, Authors of the book – Think Like a Freak, Stephen Dubner and Steve Levitt tell us that the hardest three words in the English language are “I don’t know,” and that our inability to say these words more often can have huge consequences.

No one really has a clue as to what stock will double (in a given period of time) or how the markets will behave over the coming days / months and yet, day after day we are bombarded by information most of which we don’t really require to manage our money better.

To me, the way to be a better investor is to read good books rather than watch business channels or read the pink papers. Then again, the human mind is always looking for easy ways to accomplish our needs and business that want to exploit that are dime a dozen.

Right time to Buy

Yesterday was a pretty lucky day for me. Some kind soul had triggered my stop loss on Wednesday and while I had cursed him that day and the next day as well, man, was I happy to be neutral in markets as it tumbled on the opening bell in response to the Britain Referendum results.

Too many (and I am Guilty of being one of them) use Buffet quotes when it suits us best. Many a fund manager harp on value buying like Buffet while loading their portfolio up with momentum stocks at premiums. Its one thing to say that I can wait for eternity for buying good stocks at right price and yet another thing to twiddle one’s thumb even as market rockets one way.

With plenty of time on my hands, I created a poll on Twitter asking what people (those who follow me) were doing. The question itself was bit slanted to suggest this as being a opportunity. Here are the final results of the same.

While majority of folks seem to be waiting, folks outside seem to be rushing to use the opportunity to buy. Manoj Nagpal tweeted that yesterday saw equity mutual fund purchases being three times the normal.

For the record I did not buy since I am a systematic trader and no system had triggered a buy signal. On the other hand, Juicy volatility attracted me to sell some options in the belief that with the event being over and small time frame to expiry, Implied Volatility is sure to crash.

But is this or was this a opportunity to Buy? While markets at one point of time were down by nearly 4%, they recovered some of the losses to close the day with a loss of 2.20%. While I strongly believe “Prediction is Impossible”, that has not stopped me from trying to predict where the markets could be headed (once in a while).

Initially I had thought of having the header as “Blood on the Streets. What Next”. But a casual search revealed that I had already used that heading twice.

In 2014, I wrote suggesting that the fall wasn’t much and it maybe prudent to wait. Markets though had their own agenda as they shot up another 9.75% in the coming months before finally topping out.

In 2015, I once again tried to predict and thanks to a bit more experience I suggested that at best you could increase your allocation to equity slightly since one can never time the bottom. This time around, markets continued to see downward pressure for months to come with the final bottom being around 12% from where I wrote.

The reason most advisers recommend SIP is because they believe timing the market is tough if not impossible. At the same time though, they some how seem to believe that they can select the right fund manager (who will time the market correctly). One of the biggest funds has had a horrendous few years because the fund manager bet on the right set of stocks at the wrong time.

As much as people hate timing and think that it shouldn’t be done, your results are all based on the timing of when you decide to enter and when you decide to exit unless of course you are investing for the sake of investing alone and have no requirement of the money forever.

A fund claims that it tries to steer investors from trying to invest when markets are hot by closing fresh investments. While the PE Ratio at time of when it closed and when it re-opened did not suggest it being a big game changer, fact remains that the fund is trying to time the market using historical Price Earnings Ratio. Once again, they are trying to time the market using historical PE Ratio as the reference for their actions.

Will we once again see a PE ratio of Nifty at 10.68 (low of 2008)? I don’t have a clue but if there is no time frame for such prediction, of course, it could happen – decades later if not now. But I am digressing.

How do you come up with right time to Buy or Sell? In my opinion, the only way is by way of some kind of timing algorithm. If you are from the Technical side, it may be as simple as a 200 day Moving Average and if you are from the Fundamental arena, a simple PE ratio could be your tool.

Was yesterday a good time to Buy? The narrative depends on how the markets move in the coming days. If we strongly bounce back and start testing new highs, this was a opportunity. On the other hand, if the fall continues, this was a time to Sell (and one which only 9% voted). But since we don’t know how the future will unfold, only some kind of timing system would help you take that call (as long as the logic is validated and tested).

To conclude, if you are averse to timing but yet want to get market returns, ETF is the best route given that regardless of changes in fund manager or even the house, returns will be close to market it tracks.

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