Commentary | Portfolio Yoga

Selection & Survivor Bias

One of the stories that was often told to newbie’s in the stock market was how investing just a small sum of 14,500 in 1993 public issue of Infosys would have been worth a few million rupees as on date. There is no falsehood in the statement either since Infosys had for long been a darling stock of the market and has provided unprecedented returns to any investor who invested when it IPO’ed and held on to the stock till date.

But what is not immediately seen is how this return is due to pure Selection and Survivor Bias. Selection Bias is defined in Wikipedia as

“Selection bias is the selection of individuals, groups or data for analysis in such a way that proper randomization is not achieved, thereby ensuring that the sample obtained is not representative of the population intended to be analyzed. It is sometimes referred to as the selection effect.”

When we select Infosys, we are selecting one among maybe hundreds of IPO’s that was seen in the same year (1993). Compounding the error, we fall prey to another common bias which goes by the name “Survivor bias”. Once again, the definition of the bias from Wikipedia

“Survivorship bias, or survival bias, is the logical error of concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not because of their lack of visibility. This can lead to false conclusions in several different ways.”

The reason we selected Infosys was that it was a survivor among the hundreds if not thousands of companies that traded in those days. If you remember a company (which was a hot stock in those days) by name, Orkay Silk Mills, you will know what I am leading you towards.

When analyzing financial databases, its very important that both these factors are taken into consideration as otherwise your results will be very biased and in all probability under estimates the risk and over estimates the reward.

When Mutual Funds are analyzed, you need to keep a eye open to these biases since over time, its a list of those funds / fund houses that could survive. Bad funds generally get merged with a better fund, small AMC’s get taken over and their funds merged with other schemes.

In other words, if you were to get a list of say the best funds of 2000, its very much probable that a lot many funds don’t even exist today. Bad funds don’t survive for long since it showcases failure of the fund manager / AMC and faster it gets deleted, the better it is.

Using ValueResearchOnline, I found 169 funds which have been merged with other schemes and are no longer quoted. Even this list (post 2003) misses fund houses such as IL&FS and hence not complete. Add to that, I could also find another 124 funds that were “Redeemed”.

The question is, what would your return be if you were invested in any of those funds that got merged over time and how does that compare to what the fund that now in existence (into which it was merged) performed.

The art of investing has to begin by starting to ask the right questions. Do remember, there is no Free Money out there. A large cap fund cannot outperform its benchmark by a yard unless it did something different. Now, whether this out performance came in due to additional risk (investing in a large mid cap stock for instance) or cutting of risk (going into cash) comes with its own Pro’s and Con’s. Understanding that aspect enables you to understand performance better and stick with it for a much longer period that you otherwise would have been comfortable with.

If you are serious about learning the biases and fallacies that affect our judgement, do read Thinking, Fast and Slow by Daniel Kahneman, am sure it will provide you with a perspective that is easily missed by majority of investors out there.

Of theories and biases

Over last couple of days, my timeline has witnessed immense activity between various persons on whether or not SIP is the best way to save and invest in markets. My last two posts were a consequence of trying to put my thoughts on the same.

To clarify before I move further, I am not against saving and not against SIP as a medium to save. But, please, lets not consider it wealth building giving it value more than what it deserves. Adjusted for Risk, any investment that provides a positive value adds to our kitty, but the definition of Wealth is somewhat different since it brings out dreams of one being able to afford things that he doesn’t seem to think is possible in the current.

While SIP’s in Equities can provide a much better return than Bonds, please do note that if you are not used to seeing months of gains wiped out and threat that even the principal maybe at risk, you may not be the ideal candidate to make such investments. For better or worse, sticking to tried and tested methods will ensure you get a good night sleep even if your returns are below what can be optimally achieved by taking a small dose of risk.

Difference of opinion in markets is normal – I for instance have for long received brickbats for insisting that any and every strategy needs to be validated using non discretionary tools. As a Technical Analyst, we as a group are held at ridicule by investors / advisers who believe that Balance Sheets and Cash Flow provide a better understanding of the company than how the price moved over the last ‘n’ periods.

Efficient Market Hypothesis, a subject that is taught to every Management student claims that stock prices reflect all available information about companies and investors can’t beat the market indexes by stock picking. In fact, when some one says markets cannot be timed, he is knowingly or unknowingly reflecting the same. But ironically the same persons then go out in search of funds that are consistent in beating the markets.

Every fund manager tries to time the market in his own ways. The fund manager of Quantum for example took to timing by reducing exposure to stock in the hope that markets will weaken at which point he can re-enter providing value and a better return to his clients. He had done this before and it worked, but this time, he went to cash a bit early and given the current fall, added exposure a bit more early.

Prashant Jain of HDFC is a case of taking risk on a sector which did not turn out the way he would have thought it will. But go back in history, and risks taken by him gave him a pretty large addition that what other managers could deliver.

You can see this in the International arena as well with Bill Ackman having a ball in 2015 but facing literal rout in 2016 (even though we are just 1.5 months into it). LTCM delivered superlative returns for 4 years before it fell of the sky and went under.

On the other hand, we have John Bogle of Vanguard who makes the following points when it comes to Mutual Fund investing

The vast majority of managed funds underperform their respective relevant market indexes
There is no reliable way to predict which few managed funds will outperform the market
The intelligent investor therefore invests in index funds

He believes that most investors are better off with a cheap (and his company Vanguard has shown time and again, how cheap index investing can be) ETF that tracks the Index.

When it comes to leverage, literally everyone is against it. But does it mean that leverage trading / investing is bad?

I believe the bulk of what we believe is based on two factors

What appeals to us the most
What seems to provide what we are looking for (Long Term Returns / Regular Income / Stability {Real Estate}

For me, the appeal has been to Technical Analysis since end of the day, I believe that trying to gauge the quality of management of a company or my ability to understand the nitty-gritties of how the business is run is beyond my understanding and abilities

But some one who has the abilities I am missing on the other hand will be fascinated by how one can go about picking great business which can provide returns better than market.

In India, Mutual funds are pushed since historically they (or at least funds that have survived) have proven to be market beaters. But without the evidence that comes from analyzing survivor free database, its similar to claiming that if only you had invested 10K in the Infosys IPO, you could have retired way before time.

As a full time trader and investor, my bias is towards attaining absolute return regardless of the behavior of markets. This cannot be done without some kind of timing tool and while my time frame is short, testing (by self and others) have shown that you can get way better returns by having a simple 60 – 40 (Equity:Bonds) asset allocation than by trying to select the best funds and hoping that the fund manager does the right things all the time.

Each and every one of us develop our own biases based on either the focus of our work or what we have observed over time. This bias affects our judgement to make the right decisions and hence the reason to turn towards experts. But unfortunately experts too are biased and would not change their view even if provided with contradictory data.

Most of us spend 8 hours or longer to earn the Income, a part of which gets saved. If you cannot spend a bit more time in understanding the various facets of market and what is that you are really looking for, nothing really can help you out.

As a Idiom goes “You can lead a horse to water, but you can’t make it drink”. How you deal with your money should be your concern, else some one will take the decision on behalf of you – something that could turn out to be good though generally its outcome is lousier than the worst thing you could have accomplished yourself.

To Sip or not Slip

While we all learn from our childhood the importance of savings, Governments and experts believe that if left to our own devices, we would either splurge out or make wrong investments that is bound to hurt when we need it the most.

Using a combination of Carrot and Stick, the policies of the government try to ensure that one ends up with a decent amount of savings by the time of his retirement. So, a part of one’s income is deducted and which goes into a Provident Fund Account which over time, thanks to one’s own investment + employer’s contribution + the accruing interest makes it a sum worthwhile to retire upon.

Housing Loan payments are set off against tax liability to make it worthwhile (rightly or wrongly) for everyone who desires to get a roof above his head. Same goes for various other deductions which essentially are investments for the future (one’s own or of ones children).

Investing in equities, specifically mutual funds has been pushed by providing various tax benefits, benefits that hopefully provide a impetus for the investor to make it a worthwhile asset class to invest, risk not withstanding.

One of the ways for many investors to invest is to set up a Systematic Investment Plan (SIP) so as to ensure

A continuous contribution to equity which can provide a better return than other fixed asset classes
Enable one to average out his purchase price by buying with total disregard to happenings in market

Systematic Investing is pushed a product for all seasons. Any attempt to provide perspective on the nature of the markets and hence how SIP’s can actually be detrimental to the wealth of a investor falls upon deaf ears and more fixed positioning.

Lets start with asking a basic question.

Who or what kind of Investor is SIP meant for?

The answer I have heard and read about is that this is the best and maybe only possible way for those with a full time profession and unable to understand the market or valuations as such. SIP is also a tool I am told that enables those with buttery fingers when it comes to spending to save a bit from their Income. In other words, SIP is a attempt to force those with no clue of markets to invest in the hope of a better tomorrow (which generally means a decade or two from now).

Despite the good (?) intentions, one of the cribs of fund managers is that even when people enroll for a long tenure of, say, five years, they generally stop after two-three years. Should not one question what makes one stop their SIP early than what they signed up for?

To me, the biggest reason would be under-performance. Just today I tweeted this

If the Mutual fund you are invested in has correlation of 1 to Nifty 50, any SIP started after November 2012 will be under water.

— Prashanth, CMT (@Prashanth_Krish) February 12, 2016

Being a full time professional I understand that markets moves in cycles and how even this bear market will end at some point of time. But what of a lay man who has been promised a CAGR return of 17% (since that is what Sensex has supposedly delivered) over time and how this is a way better investment than any other asset classes.

How many advisers out there start of by showcasing the risks that come with investing in Mutual Funds? Funds have dropped 50% / 60% and more from their high points. Is a lay investor ever educated with the risk he is taking?

In times like these, when theoretically one should be adding to allocation, those chaps would actually be jumping off the burning bridge. Its laughable when advisers say that they shall hand hold the client (and hence justify their fees) during tough times such as these and help them to continue investing.

But how many actually provide them with the real picture of what to expect and the probabilities of what is the worst case scenario’s. Most advisers try to shove the risk under the carpet while showcasing only the good parts. How different this is to real estate builders printing out brochures where it seems that you will be surrounded by nature when the reality is the fact is that the builder has absolutely no control of what happens outside.

Markets deliver higher returns because there is a risk involved, a risk that can lay waste to investments. Mutual funds can help by enabling one’s investment to be handled by a professional and by pooling reduces the risk of a single bad apple destroying the whole basket. But extrapolating the last 20 years over next 20 years which most advisers do while being the easiest path, is certain to bring disappointments on your way.

To conclude, SIP is a good way to instill investment disciple. But unless the risks are fully known and accepted, the risk of early abandonment after being disappointed is pretty huge. Preparing the investor for the risk rather than focus on reward (Gains / Goals) is a much preferable way.

Yet, despite all that, a investor who only knows to invest but is clueless about times when he should reduce is bound to get average returns and in-turn be disappointed by the whole system. There, only Allocation and continuous re-balancing holds the key to a more satisfied client and a better off investor.

Theory and Practise

In the movie, Inception, there is a interesting dialogue which I quote below;

“Mal: Pain is in the mind, and judging by the decor we’re in your mind, aren’t we, Arthur?”

When investors / traders enter the market, they know that they shall experience some amount of pain – pain of draw-down is guaranteed. But its one thing to experience pain in back-testing / historical insights and quite another when faced with the real thing.

As a well quoted quote by Mike Tyson goes

“Everyone has a plan ’till they get punched in the mouth”

Most trading systems – Trend following or Mean Reversion experience strong draw-downs. Streaks of losses are fairly common as well.

But when faced with the uncertainty of every trade going to dogs and the fear of further losses make most investors and traders first behave like a Deer caught in the Headlights Syndrome and then at some point beg for them to be removed themselves from the trade, even if its at a big loss since the pain (of losing money) is just too great to bear.

As markets decline without there seeming to be a iota of support, blame is distributed across the spectrum – from the crony bankers to Raghuram Rajan to the broker who wouldn’t allow them to hold on to a few days more. But none and am sure I could include myself here, would blame oneself for the mess one finds himself in.

Most investors and traders just don’t have a Plan B. A plan that is to be put to action if Plan A fails – most hope that Plan A is so good that there isn’t even a need to put a Plan B in place let alone come to a point where its activated.

Everything is a give and take. When markets were rolling just a few months ago (which now seems like eons earlier), the place to be was the small and mid cap. Large cap investing wasn’t even considered a option.

But when mid caps and small caps crumble, its the large caps that seem rock solid (even after accounting for their own falls). In 2000, when Infotech stocks were going through what seemed to a never ending rally, most old favorites were languishing at multi year lows. But once the rally ended, the divergence suddenly started to collapse till we reached a point where brick and mortar was again the fashion and eCom (nearly every one of them) was out of fashion.

Fast forward a few more years and the survivors who stuck out did better than what even the most optimistic report at that time would have predicted.

Recent fall in PSU Banks have come on back of the troublesome NPA’s again rearing its head. But is every back going to dogs? At what price do they start making sense again? Which banks shall survive and thrive and which won’t?

Dr Raghuram Rajan made a interesting point during this CD Deshmukh lecture and I quote the same

The Finance Minister has indicated he will support the public sector banks with capital infusions as needed. Our estimate is that the support that has been indicated will suffice, especially when coupled with other capital sources that are usually available to banks.

Banks are going down but at some point they shall make sense as a investment yet again. The question though is, Do you have a plan and more importantly Do you have a plan B if plan A fails.

Nifty and Bear Markets

Whenever market corrects, one fears it may be the start of yet another bear market and this fear is largely due to historical experiences of those bear markets which literally took investors and even traders to the washers. A bear market is depressing in more days than one since its said that the pain of a loss is always greater than the happiness of a win and a bear market is one such painful process.

The general definition of a bear market is of either a 20% drop from the top or the break of the 200 day Moving Average. But these definitions suffer from fact that even deep corrections are mislabeled as a bear market when its actually just markets being a bit more volatile than normal.

Another definition of a bear market which seems to adjust for corrections comes from Ned Davis Research, a firm that is able to crunch and plot data in ways one did not even thought is possible. Their definition is that a market is considered as having entered a bear phase if it is down greater than 13% after 145 days from day of last high. 145 trading days equates to around 6 months of calendar days.

Based on above definition and taking data from 1990 on wards, Nifty 50 has seen 9 Bear Markets with 10 being underway currently. Below is the table that lists the same

How to read the above table

Start -> Start of this leg (Day after the last new High)

Max D/D -> Maximum Drawdown seen in the fall

Max Date -> Date of the Maximum Drawdown

Days to Max -> Trading days it took to go from 0 to Max D/D

Days to NH – > Days it took for the D/D to travel from 0 (previous high) to 0 (New High)

Investor Education

One of the pet peeves of Mutual Fund advisers and Fund managers is that the lay investor needs to be educated about the benefits of equity. If only more people knew the riches that could be obtained by investing long term in equity, much of their problems will be solved.

While its one thing to educate the public on options when it comes to the asset classes available to invest, its quite another to take them for fools who don’t know the difference between a stone and a diamond. The common investor is much more educated and knowledgeable than many are willing to accept.

Investing in Gold / Real Estate as much as they may be hated asset classes has done a world of good. While there is always the question as to whether the next 20 – 30 – 50 years will be as good as the previous, one really cannot just ignore the stark reality that the bulk of the returns generated by vast majority of folks has been via their investments in real estate.

Recency Bias affects everyone of us and that is the reason why money flows into asset classes which are showing momentum (even when it comes to Mutual funds as I showcased the growth in Mid and Small Cap funds as the market started hotting up). When the tide turns, money flows out to destinations which otherwise would have been over looked.

Investing in Equity (Direct or via Mutual Funds / PMS / Hedge Funds) is not the only solution. Every person has his own reasons which make him invest the way he does. With Interest rates pretty high and being risk free, it will take a long time before investors appreciate the advantages of equity. No point trying to push them when they aren’t mentally or financially ready to take the risks that come associated with investing in the stock markets.

Benchmarking it right

Wikipedia defines Benchmarking as the process of comparing one’s business processes and performance metrics to industry bests or best practices from other companies. Unless one compares and contrasts, one never knows where one is placed relatively speaking.

But the key point to note is that Benchmark works only if done correctly. As a joke / moral goes (Cartoon below), if you were to select a bunch of animals and benchmark them against a single target, you aren’t benchmarking it right.

When it comes to investing, Benchmarking is important since it enables you to get a much better perspective on whether you are getting it right or wrong. If your returns on investments over a period of time cannot even match returns generated by the Index, does it really make sense to keep trying by spending valuable time or whether will you be better off by just buying a cheap ETF that tracks the Index and be done with that?

Mutual Fund managers / PMS fund managers and even Robo Advisors love to tell you how good their picks were and how they have beaten the Index by a comfortable margin. But given the fact that there is plenty of evidence on the other side of the Atlantic about how very few fund managers are able to beat the Index, it makes one question what is missing out here.

The question we need to ask is, Are our fund managers way better in ability to invest than their counterparts in say the United States? After all, if fund manager after fund manager cannot beat the Index on a sustained and continuous basis (heck, even Warren Buffett changed how he measured performance of BRK vs the S&P 500), how is that our fund managers are able to do with such ease.

One reason could be that our Indices are still evolving and hence a lot of quality stuff are left out while including a lot of low quality stocks which end up ensuing that if you replace all the bad apples in the Index and add a few good apples, probability of your returns exceeding the Index is pretty high.

Lets take the broadest index out there, the Nifty 500 and review its list of stocks. Here is a list of 10 of them,

GTL Infrastructure Ltd.
Alok Industries Ltd.
Gammon Infrastructure Projects Ltd.
Unitech Ltd.
Jaiprakash Power Ventures Ltd.
Lanco Infratech Ltd.
GVK Power & Infrastructures Ltd.
IVRCL Ltd.
Usha Martin Ltd.
Jaiprakash Associates Ltd.

What is common in every one of them? Other than that they are all embroiled in debt of the nature that they cannot possibly repay in full, literally everyone has gone through Corporate Debt Restructuring and unless one has been under a rock, the probability is that they shall all fail. Yet, these gems form part of the largest index, stocks that theoretically are penny stocks and have no business getting traded, let alone being part of a index.

Of course, the weight of these are small, but do note that if you can identify stocks that like above and make no allocation, you will beat if you buy the rest in the proportion they are weighted. Its as simple as that. You don’t even have to go out and try and identify stocks out side that are way better than these junks and you shall still be a winner.

A secondary way to beat / or showcase beating the Index is by comparing with the wrong set. Literally everyone loves to compare himself with Nifty 50, but is Nifty 50 really the correct benchmark if you are investing in all kinds of small cap and have a large turnover ratio?

The thing with static indices is that they are always Long – no matter what and even if you can reduce exposure a bit and if those days are bad, you can turn out to be a winner. You will argue of course that how the hell does one know about bad days in advance and for that, I shall post this tweet from a twitter friend who posted it recently.

80% of the worst daily return days happened when Nifty was < 200 MA..same if we exclude 2008 pic.twitter.com/kfGSrpT6mv

— karanb (@karanb_k) January 26, 2016

80% of those bad days had a single independent factor that is known before the bad day has taken place. Now, lets go back the question, How difficult to reduce allocation when Nifty is below the 200 day average? We aren’t talking about shorts or even selling in full. All I am talking about is reducing exposure of equity to 80% and keeping the 20% in cash. What probability do you think you have when it comes to beating Nifty. Remember, we are not even adding stocks from outside, its all a question of allocation.

I am not sure how many are aware of a Index NSE has (and in recent past, NSE has started way more indices than your fingers can count) that goes by the name Nifty Alpha 50. To read more about that Index, please do download this document (Nifty Alpha 50).

To me, the biggest disappointment is that while NSE keeps introducing Index after Index, we really have no way to invest / trade in the same. One hopes that someone with the powers that be shall take notice of this and do something to remove the anomaly. But first, lets compare the performance of the Index vs our Nifty 50

In all years when Nifty was +ve, save for 2013, Nifty Alpha 50 has beaten it. While 2008 showcased how wrong thing can go, 2015 was a case of Alpha trumping even as Nifty closed the year with -ve returns.

If you feel that I am comparing wrong and should be comparing against the Nifty 500, let me show you those numbers as well

Not too different, ain’t it? So, how many funds / advisers have you found bechmarking themselves to the Alpha Index?

Another way to beat benchmarks is to select the period that works best to showcase better returns. A famous fund manager plastered the town with 100% returns over the period of 1 year. But this wasn’t a financial year, it was just from the date he accomplished that number to 1 year prior. The financial year number was 35% (IIRC) below the 100% mark, but he had achieved infamy by then and why bother with these small details.

Advisers (who just provide advise for a fee) who beat the Indices generally do no even bother with small things such as slippage / market limits (as to how many stocks you could have possibly bought at that price) among others. Why let data interfere with the selling they would say.

Benchmarking is a important process and regardless of how others do, its important that you understand the biases and fallacies that can accompany one. After all, its your money everyone is after.

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