Commentary | Portfolio Yoga

Investing in Markets – Ways and Means

We have hundreds if not more number of studies that has shown that over the long term, the best growth is delivered only by equities. While in India, Real Estate has also proven to be a bonafide wealth generator, I strongly believe that growth over the next decade or two will more likely come in Equity with Real Estate more or less providing sub-optimal returns.

So, how does one go about in investing into the markets. For a lay man, there lies there options of investing his savings into the markets

1. Investing via a Mutual Fund

Theoretically speaking, this is the easiest way to gain exposure to the markets. But then again, not all Mutual Funds are the same and hence some amount of research is necessary to ensure that we invest in the funds that have showcased long term growth vs chasing funds that have made a mark in the very near past.

While most mutual funds in United States haven’t been able to beat the benchmark consistently, in India, we have hordes of fund managers who have beaten the benchmark returns year after year. Whether this is due to they being Genuis or whether its because of the fact that the benchmarks are not really that good a criteria to compare against is a story for another time.

But having said that, its a fact that top funds keep changing over time. Prashant Jain is a much acclaimed fund manager, but lets face the facts – his top fund, HDFC Top 200 has generated a CAGR return of 13.36% DSP BlackRock Micro Cap Fund which over the same period has seen a CAGR return of 24.5%.

What I have done above is known as Selection bias. I have selected the DSP fund not by foresight but by using current returns. In 2008 and 2009, the best large cap fund (5 year returns) was Reliance Growth Fund. Over the last 5 years, this fund has provided a CAGR return of 12.8%.

Over a similar period Nifty Total Return Index has shown a CAGR growth of 11.68%. While one can still argue about there being a alpha out there in funds such as HDFC Top 200 and Reliance Growth, we need to also consider the fact that they hold stocks outside of Nifty constituents and in essence, comparing the performance to Nifty is erroneous.

Personally my family is invested into multiple funds across the spectrum and overall, returns have been decent enough. As Warren Buffet once said, diversification is the only free lunch and this applies to Mutual funds as well.

A step above Mutual Funds comes a more personalized investment vehicle.

Portfolio Management Scheme (PMS for short):

Those who follow me on Twitter know that I am a very strong skeptic of PMS as a investment vehicle. My main objection comes from the fact that for most brokerage led PMS, this is not something where the objective is to generate above market returns for the client but is a nice way to churn the portfolio as much as possible in an attempt to garner as much brokerage as can be culled from the account.

In fact, it is a surprise that Assets under Management of PMS has growth substantially over the years despite most of them not even providing decent returns (let alone market beating) and worse of all, hiding the facts from the potential investors.

I do not have the break-down as which firm manages what amount, but just as a simple exercise, lets review the performances of top names in this business

Coming up first would be Sharekhan (Link)

AUM: Around 32 Crores

What surprises me is not the under-performance but the fact that NSE Nifty returns are shown as having given different returns when compared with different products.

India Infoline (Link)

AUM: 4600 Crores

India Infoline runs a multitude of funds

IIFL-1

Motilal Oswal (Link)

AUM: 1400 Crores

One of the few which has beaten their benchmarks. But then again, these are 1. Weighted Returns (and not everyone would get the same) and 2. Am not sure if these are after fees or before fees (Fees are substantial in nature, refer to page 14 of the document).

There are at least another 25 – 30 firms offering PMS, but I do hope you get the idea. PMS is not a ideal vehicle to ride the markets. In fact, one PMS firm actually managed to lose money when the markets were going up and lost money when the markets were coming down. The fund manager is now a star investment advisor 🙂

Last but not the least

Direct Investments into Equity:

Directly investing into equities is one of the most risky ways to put savings to work if you are neither willing to work hard nor have a clue about how markets work. Too many folks have burnt their hands in equity investing to swear off anything related to equity (Direct or not). But having said that, the only way to beat the returns generated elsewhere can be found here.

But if you are willing to put in the hours required to learn and understand the various way to analyze the markets, its a effort that can provide for worthwhile returns with total control in your hand.

But a caveat first – International evidence has shown that the average equity investor under-performs the markets very badly. In fact, many would have been better off just putting the cash under their pillow than investing into markets

While the above data comes from Mutual Fund investments and redemption by individual investors, with human psyche being the same, direct returns by investors would not be too different.

Investing (no matter how large or small your investments is) is a full time endeavor. Unless you are willing to devote a substantial amount of time, this is definitely not a area to dabble in since not only would the returns be below par, but the time spent could have been better utilized elsewhere.

To fill this gap, we have many a person offering to advise (Newsletter based generally) for a small fee. But with the vast majority of them being pure snake oil sellers, I would generally avoid all such stuff unless they have proof of their pudding (Audited returns of their own funds which in turn should be substantial portion of their net worth)

To conclude, while its true that some funds have shown ability to beat the markets, I recommend novice investors to distribute between a few select funds and a few ETF’s that track the index (Index funds). Invest regularly and you would turn out fine regardless of the gyrations we see in markets.

Of Helmets & Stop Losses

Bangalore (like many other cities) has had a rule for compulsory wearing of helmets by those riding a two wheeler. But what I observe is that many a helmet are worn to protect not the head but the risk of getting caught by the police constable. At the first instance of a risk to the head, the helmet would be sure to bail itself out leaving the head to take care of the mess by itself. And since the wearer of the helmet in a way thinks that his head is protected, he may actually take more risks than what he would have when he was not wearing one (before it was made compulsory).

So, what is the relationship between the helmet and the stop loss you may ask. Well, there is one. A wrong stop loss like a wrong helmet may cause more grief to the user than to a trader who trades without one.

A stop loss is said to protect one from the loss while allowing the winners to remain in the system. But the thing about stops is that if not placed right, it has a ability to cause more damage than one where it was not used in the first instance.

So, what is the ideal stop you may wonder. Is placing a stop above a resistance / below a support a good idea? Or should one just stick to one’s risk profile and say that if a stock loses more than X% of my capital, I am out?

With the increase in algorithmic trading, stops below support / resistance are the easiest to take out since everyone sees more or less the same chart and comes more or less to the the same conclusions.

As to those using X% of risk per trade, the problem comes by the way of the fact that the stock may not necessarily fit that profile. Some stocks have very high volatility while some remain bland for most of the time but then spurt up in one swing what would be a multi X deviation from the mean.

So, when is that one should sell or buy (based on one’s existing long or short position). To me, the best way is the way described by Jesse Livermore (which I shall paraphrase) where he says that if a stock is good enough to sell, it should be good enough to short as well. So, if you are placing a stop at level X, not only should you be happy to sell your longs there, but also be willing to go short.

That does not mean that one has to go short every time one wants to exit a long, but its the conviction that matters.

On the other hand, if you are using a portfolio / ranking based model, the above assumption may not be required since you will be exiting one stock in favor of other which your model is showcasing as one with a better opportunity.

Traders biggest Worry

What is the biggest worry for a systematic trader?

If you said, Loss, you are wrong. Yes, a loss does hurt a trader, but unless he has no clue as to what he is doing, he knows that losses are inevitable, even big losses. What he worries more is the risk of his system going into a losing steak.

Lets assume your system is doing fine and you suddenly find markets moving against you and by the time your system comes with its signal, you are on a non leveraged basis looking at a loss of 8%. A loss that big hurts and for some one who is leveraged say 3 times, he would have just seen 24% of his capital vanish into thin air.

But what if the same trader sees a draw-down of say 4.75% but not in one big swoop but one that comes as a streak of 9 consecutive losses and one that lasts over 44 calendar days. Which one do you think shall be more painful?

In case of the 1 big negative trade, While the pain will be immense, it will quickly pass as the trader moves to his next trade (with a much lower position size) and hopes that he can at some point of time recover from the hole he has fallen into.

In case of the 9 small but consecutive trades, the pain is much more dragged on as the trader spends nearly 1.5 months with every trade he has taken going for a toss. Its very tough for even those with strong hearts (not to mention a nice bank balance) losing their sanity and deciding that pulling the plug from the system may be the only way out.

But losing streaks are fairly common and as I shall showcase later, something that you shall have unless your system has a win rate of 100%. When you run a back-test, most reports do provide you with the number of losses that have come in a streak.

But what if your system is more mechanical driven and hence cannot get such a number. The easy way out is to just measure the win or loss % of trades and then check the following table.

The above table lists the probability of you seeing a draw-down of X number of trades based upon your systems winning / losing percentage.

Most trend following systems have a win percentage that ranges between 35 and 45 and if you can check out the same in the above table, you can see that there is a very strong probability that your system at some point of time shall witness a streak of losses ranging from 6 – 9 and that can be said with near 100% confidence.

So, what can be done about that you may like to ask. Unfortunately, there is nothing much you can do other than to keep trading while reducing your position size at every drop of equity. This way, by the time you hit your 8th or 9th losing trade, your position size will be considerably smaller and hence the account will still be able to trade without having to witness fresh capital deployment from outside.

What is interesting though is the fact that even if you have a streak of 9 losing trades, the loss in money terms is generally lower than the biggest losing trade. For example, I was just testing the same for a simple Moving Average Cross over system (3 by 5).

The biggest loss (period being 1st June 2009 to today with trades taken on Close) was a loss of 346 points (8.07%) which took just one day (Entry on 30-07-2009 & exit on 31-07-2009). On the other hand, the streak of 9 losses (loss in point terms being – -40, -9.4, -39.95, -22.45, -44.55, -39, -65.6, -13.2, -20) stretched from 20-07-2010 to 02-09-2010).

While the system may still be positive, that 45 days of bleeding is something that will not pass off in a hurry and like a deep wound would remind the trader every time he encounters a loss.

What is also noteworthy is that a longer streak may not actually be the most painful (in terms of loss). While the 9 trades in total lost around 4.75%, the same back-test data provides evidence of smaller streaks having a bigger impact (in terms of losses).

While there is no escape from such streaks, having a good position sizing algorithm would ensure that the pain in terms of loss of capital would be lower than what it would be if a single position size was maintained throughout.

Use a position size that is neither too aggressive or one that is too meek. In case of the former, you risk blowing up your account while in terms of the later, you never can take advantage of the good runs. But whatever you do, remember that unless the system is faulty, streaks do not stretch to infinity and hence one needs to keep his cool and take all the trades as and when they are signaled.

Getting carried away

Way back in 2007, a good friend of mine called me to ask me to check out a company by name Jindal SouthWest Holdings Ltd. He said that he had heard from some one that it had quite a nice value and was currently trading at pretty discounted rates.

Checking on what I could, I saw that the Intrinsic value of the company (based purely on what it held) came to around 2500 – 3000 per share and the company was trading around 500 bucks (though a couple of years ago, one could have had it much cheaper). While in US, most holding companies are valued at pretty low discount rates, in India due to the fact that most of these holdings will never be sold, holding company valuations have never been aggressive to begin with.

Yet, the deep discount did entice me to invest into the same. The timing of my entry in hindsight proved to be one of great acumen as the stock straight away started to move substantially higher. At 2000, I decided to get rid of half my quantity but the stock showed no signs of weakness. At 3000, I got rid of the rest of it as well (to fund some other idea which ultimately ended up eating both my capital & profits :P).

But before I sold, I did a revaluation of the holdings and voila, instead of the 2500-3000 which was there before this rally started, the valuation had now changed to 5000-6000 🙂

This is not a story to boast my stock picking ability (which I have none anyways) but to remind one not to get carried away with the momentum. Some months back, I got into another stock – a very small quantity but one that has been moving pretty strongly on the back of a report of a small cap fund manager initiating a position in the said stock. While there has been no change in the fundamentals of the stock, the hype given the story and the person who picked it up has meant that the stock is now 300% above my purchase price.

But this cannot really last unless there is really a pot of gold at the end. I do not know when this will end, but the ending generally is not good either. A stock that moves up in Buying freeze generally comes back in selling freeze making it tough if not impossible to exit such stocks.

While not everyone can have a deep understanding of the DCF / SOTP), as a investor, its essential that you know what you are paying for. There is no point in paying 5 times the price just because of some hidden quality which may or may not materialize in the future.

Even in this bull market, there are plenty of stocks that are moving down and hence its always pays to be cautious and fearful than let the greed of easy money carry us away. I am a guy who can be called a perma-bull, but just because the long term is good and the road ahead is a path of roses, there will always be thorns that can cause significant damage to those who are unprepared.

Stick to what we know best

Many a time, On my way to Office and on my way to Home, I come across daredevils who ride their vehicles as if they are in a Moto-GP race. While most onlookers either shake their heads or just ignore them, there are a few young guns who get influenced and attempt to compete with them, either straightaway or when riding with their friends.

More often than not, most speeding drivers finally end up in a hospital or get fined by the police and in worse case end up in Mortuary. Even the rider knows the risks he is getting into, but as they say, Speed Trills (as long as it does not Kill).

So, what is the relationship with markets you may ask. Sitting in a Air Conditioned cabin, one feels that there is a very low risk of getting physically hurt let alone die because of acts of omission and commission. But financial destruction is also a form of death, a slow death by a thousand cuts perhaps, but death for sure if one continues to tread on the wrong line regardless of the hundreds of pointers showing one is on the wrong side of the road.

Yesterday I was talking with a friend of mine about the legendary trader, Jesse Livermore. No matter what his greatness lie, the true fact is that he died a broken man. Broken both in terms of his mind and financially. While its nice to see the positives on one’s life, I wonder how many have given a thought that even the best trader (perhaps) finally ended up broke. He blew his capital not once or twice but four times (and officially declared Bankruptcy twice).

A wonderful quote from Jesse goes as thus

The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.

While we do not floor the accelerator just because we see some one race past us, why is that we do not think before acting on some one else’s thought. Yesterday I read a article which claimed that Anonymous Analysts were wreaking havoc in a few stocks by giving Sell calls without there being much of data to back them up.

When some one cries Fire in a crowded theater, the instant reaction is to rush to the exits without bothering to check whether the fire is real or not. The reason for the rush is that one is ill prepared to know whether there is a fire or not and would rather be found foolish to rush with the crowd than face the ignominy of being unable to escape just because of not acting fast (if there was really a fire).

In markets though, its a fact that Herds are both right and wrong. Right most of the time but wrong at the extremes. But if you are part of the herd, the end result will be one of failure since you cannot judge when they are right and when they are wrong.

Most Analysts (and you can include me as well 🙂 ) do not have a clue. While many of us work on probability, some just throw spaghetti on the wall and hope that some thing sticks. And then there are those who cry wolf every time the market dips a bit – the perma bears whose only hope is to claim that they in fact managed to catch the top.

Markets are a great vehicle for building long term wealth. If you were to Analyze the 140+ years of data (200+ from some sources) that is available for the US markets, you shall see that even those who were unfortunate to enter at the height of the market were able to generate more returns over time than what investing into safer assets (such as Bonds) at the same time would have returned.

But the key to building long term wealth is having a plan and having the balls to stick with it through thick and thin. If you are riding a Hero Splendor, do you worry about trying to compete with the Honda Hayabusa? If no, why worry about the noise generated by others who at best can misguide you on your journey and at worst derail your long term growth.

If you were patient enough to read through my long rant, I am sure that you can stick to your plan.

au revoir

What does one want from the markets

Win or lose, everybody gets what they want out of the market. Some people seem to like to lose, so they win by losing money – Ed Seykota

A very simple statement yet so deep is the philosophy behind it. Its amazing that I did not understand the depth of the statement when I went about showcasing why certain strategies / methods were not worth pursuing since the cost out weighed the benefits it supposedly came up with.

Then again, I failed to understand that not everyone is out here in the markets to make the maximum out of it. A large majority is here for the fun and if some money is made in the interim, all the better. But a very small percentage is ever going to wonder if I made a better CAGR return out here compared to the opportunities available elsewhere in markets (read Passive Investing).

Day trading is a very risky business with the probability of long term success reaching pretty close to the Zero level. But that does not stop the troops of young and old speculators who want to dabble in it. Many are not even here for the money since they have money in plenty, all they are looking for is the excitement of being able to beat the markets at its own game.

I know friends who are pretty happy with getting returns that have been achieved by many a fund and more or less achieved by passive investing as well. But, if you were to invest passively and reap the benefits, how the hell are you supposed to look like the King Kong of markets at parties where you want to be the Rock Star. After all, its only a dumb guy who would invest in Mutual Funds / ETF’s and reap the small benefits when the same is also available by trading day in and day out in the markets.

A lot of traders / investors have lost big money in markets and yet go about their life pretty happy with the sincere belief that it was Greece or Cyprus or Japan (or any other news) that was the reason for their loss this day / month / year and its just a matter of time before they not only recover their losses but thrive in the limelight of being the true master of the universe.

Markets are all about give and take. If you are here for building wealth, think deeply about what you are doing and whether some things can be done better. If you are here for the fun, Enjoy as long as your Bank Account is able to support. But whatever you do, do not mix the fun part with the wealth building part. It will only end badly and you would not even had the fun in the interim

Capital Requirement for a trader

When one starts any business, one has a pretty clear idea as to what would be the cost of starting the business. This may go from a few thousands (if you are starting a web based company) to a few crores (say to get a start in the construction business). But when it comes to trading, there is not much of clarity on what capital is required. This post is a attempt to calculate what you will need if you want to get into the business of trading for a living.

The biggest negative of trading for a living is the fact that the number of failures are humongous in number. I have been in the Industry for nearly 17 years now and I do not know of a single trader who was active when I started off and is still active as a trader now. Of course, there will always be folks who have been active for even more a period of time, but the numbers will be pretty small in nature.

One of the key reason why many a trader cannot sustain this venture is due to lack of a viable strategy. It does not matter how big a capital you start with, if you are chasing the wrong end of the stick, you will end up suffering total capital loss.

A second reason for many a trader to be unable to sustain this business is due to them starting with insufficient capital and then hoping to make a living of it. Markets are not a cow that will provide milk every day or a tenant who shall provide the landlord with a monthly income. Even the best of traders go without having a income (or even worse, having a loss) for months together.

Stress for the trader is guaranteed regardless of the methodology he follows if he has a payment to make and markets are not providing him with the moolah. Many a advise I have heard is to keep 3 years of expenses in a separate account so that you are not troubled by the lack of ability to buy milk the next day because you are having a streak of loses and cannot afford to withdraw capital at this juncture.

I constantly keep meeting traders and the one thing that is constant among many is that they are very well capitalized. This with a decent strategy assures that one will be able to survive the thrills and spills that accompany a traders life.

So, what would be the ideal capital for a trader?

The answer actually is dependent on a lot of factors including the style of trading. For example, capital requirements of a intra-day trader is very small compared to a positional non leveraged trader.

I did a small exercise as to what is the optimal capital requirement for a trader and the results are as shown in the pic underneath.

The above expenses sheet are based on my assumptions on what would be the cost that one needs to account for.

While the costliest data feed would be having a Bloomberg Terminal, I have assumed that not many a trader would actually go for that and instead based it on eSignal. I personally use Global Data Feeds and the amount I pay comes closer to the Average.

So, considering the above expenses, what is the capital requirement if one assumes that the system will over time generate X% / year (not consistently, but on a long enough time frame).

Most simple strategies do not beat the markets and this means that while its nice to be optimistic and think of generating 4 – 5% per month (48 – 60% per annum), in reality you shall find the returns somewhere between 1 – 2% per month (12 – 24%).

Assuming that you are a Average spender, that would mean that you would need a minimum capital of 2 Million to start with. And since we cannot be pulling out money month on month, you would need to store away half a million so that you do not have to worry about your expenses for a year at least. Totaling that up, you will need around 2.5 Million Rupees for one to get started.

The biggest disadvantage for a trader who needs to dip into the capital for expenses (removal even every year) is that he literally misses out on the Eight wonder of the World – Compounding.

Without compounding of capital, there is really very little of wealth generated over time and while you may feel confident that you can continue to do this till the end of your life, it does put a pressure on one to be correct as far as possible.

The biggest advantage of a trader is the ability to lead a life without having to stick to one place. You can travel around the world and yet continue to make a living. In fact, a guy whose website I recently stumbled upon seems to do the same thing and has claimed to have traveled more than 80 countries even as he day trades for a living. (Link)

At the same time, I have first hand witnessed financial destruction and even death of traders who were not able to sustain themselves. As I wrote in my previous post, the probability of survival for a trader (if this is his only source of Income) is pretty low. Just like not everyone can make it to the IIT, so is the ability to earn a living just through trading.

But if you can succeed, there is nothing more satisfying out there. No clients to argue with, no payments overdue, no employees to worry about. Hell, one is truly one’s own boss and driver of his destiny 🙂

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