thoughts | Portfolio Yoga

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

Travails of a Trader

Trading is not just a risky business to be in with a survivor rate of less than 5% but a expensive one as well. Most traders are engaged with the markets on a full time basis which means that they cannot earn a living elsewhere. Of course, a lot of guys do trade from their office, but most of them are there for the thrill rather than engaging in the act of earning substantial returns from the investment they make. Of course, like any other field there will always be outlier’s who are not only able to trade successfully but also hold a good paying job elsewhere.

The whole playing field is actually loaded against the trader. Take taxes for example. A investor who holds a share for more than 1 year can enjoy the gains without paying a cent in taxes, traders pay taxes at multiple levels.

Whenever a trader transacts, not only does he pay the brokerage charges but also pays Service Tax on it and Security Transaction Charges. While a investor may deal very few times, a trader by nature is active on most days (depending on the strategy he follows) and hence ends up paying a pretty packet under these accounts.

While earlier, it was essential for a trader to sit at a brokers place, with the advent of internet trading, this is no longer necessary though even today, you shall find clients sitting behind the dealer and placing their trades at may a broker’s office. But if one were to trade outside the broker’s office, it requires a place where you can sit and trade without being disturbed.

While many a trader works from home, professionals generally prefer a quieter place since unless the house is empty during the day (trading time), its tough to avoid disturbances from family members no matter how much one tries to avoid. Add to that, trading not being recognized as a activity in itself, a person at home is generally seen as unemployed rather than self employed.

Once you have a place of your own, the next in line is the investment one needs to do to ensure access to a trading terminal through the day. This means a UPS to ensure that power failure does not affect one’s trading as well as Internet connection to be able to connect to the brokers server.

While a single laptop + a broadband connection may be good enough, most traders prefer to have some redundancy build in for that rainy day when one suddenly finds that not only is his system switching on, but a damaged cable has meant that he has no access (virtual)
to the outside world.

Building redundancy is expensive but can save one’s butt when things go awry right from the world go. Just to recount a personal experience I had recently, my main system suddenly crashed and my system guy informed me that I will need to reformat and re-set up the whole thing right in the middle of a trading session.

Since I have a secondary system, I did not bother much at that time and continued working from the other system. A hour into that, the SMPS of the back-up system literally went up in smoke. Talk about coincidence.

Most traders use Technical Analysis as their trading tool and this means investment in Charting Software + Live Data Feeds. Of course, you do have internet based charting data providers as also free live data providers, but if you really want to test ideas, you would need to invest in them. And even there, one may need some redundancy. Today for example, right when the market was crashing, Global Data Feeds server crashed. If I were to have had a big long position during that time, I would have had no way to know whether to hold the position or exit and short the market.

While most traders I know trade with only one broker, bigger trading friends of mine actually trade at multiple places to ensure that in case a broker’s server goes down (for any umpteen reason), they are able to hedge themselves somewhere else. After all, if you were holding 10000 Nifty (400 contracts), you cannot wait for the brokers server to be reset even as the market starts to move against your position.

Trading as a hobby (which is what its for many) is a pretty expensive sport to be in. Above are some of the issues that needs to be thought into before you jump into a trade. And even after doing that, you may end up having the worst luck and getting killed because you could not get out of your positions fast enough.

Most traders get killed not just because they lack a strategy worth trading but also because they are highly under-capitalized while at the same time trying to earn a full time living out of it. In a future post, I shall detail what I think is the minimum capital a trader needs to start off with if he wants to survive for a period longer than the average trader.

Not a Clue!

Trend following is a methodology with a simple concept. Keeps (Buy) stocks that are going up, Exit (Sell) stocks that are going down. The tendency to sell winners too early and ride losers too long is referred to as the ‘disposition effect’.

But, why despite tons of evidence do we continue to do the same mistake? The reason I feel that we do what we do is because of pure Hope and Fear.

When a stock where we are long goes down, we “Hope” that it will come back to where we bought and hence it makes sense to wait. Those with a extra appetite for risk go on to average in the hope of getting their average price down and hence profit earlier itself.

When a stock goes up, we are more times than ever riddled with fear. We fear that the profit we are seeing may soon be washed away when market trends higher. After all, having seen that markets are cyclic, we tend to fear that a upcoming fall may wipe away all our profits. As the idiom goes, “1 bird in the hand is worth 2 in the bush”. Its nice to know that there maybe even more profit going forward, but since there is also a risk of losing the current profit, better to exit than wait is the thought.

The key reason for the above attitude by most investors is that they do not have a clue as to why they have bought the stock in the first place. Most of the time, it was based on a recommendation by some friend / television pundit or the broker. So, when it goes up, one is willing to take a profit as early as possible let the profit slip out of hand.

But the same attitude is not followed in loss since it pains once to take a loss. While its one thing to see a notional loss, once its booked, its becomes permanent. Hence, the best way to avoid the pain is by hoping that it will come back some day and wait it out.

In many of my blog posts, I have emphasized on having a plan, a strategy, a thought process before one enters into a investment / trade. Without it, you will never be able to judge whether the carbon your holding in your hand is Coal or Diamond.

Concentrated or Diversified Portfolio.

Depending on how you use it, Twitter can be Good / Bad or Ugly. For me, it has been an interesting minefield of information on a variety of subjects that hold my interest. One of things I keep stumbling about is when a guy says, ABC share has returned 5X returns in Y years. A secondary thing I keep hearing is that equities have given great returns – this is generally calculated by using 1979 as the base and calculating the CAGR returns from that point of time.

Both in a way are bandied about as to why Equity is the best place to invest. While I agree, one should invest in equities, there are several issues with the above statements which I want to explore more via this post.

There are two ways of building a portfolio

1. A Concentrated Portfolio of a few select stocks (or more stocks but with one or two having unequally high weight).

2. A well diversified portfolio of a large number of stocks

Both come with its advantages and disadvantages. Lets first deal with the Pro’s and Con’s of a Concentrated Portfolio

Lets start with this cheesy quote by the Oracle of Omaha

If you have a harem of 40 women, you never get to know any of them very well – Warren Buffett

The advantage of holding a concentrated portfolio is that you have a very low number of stocks / industries you need to understand. We all have our limitations, both in terms of time and knowledge and its impossible for any one person to know everything that is needed to know about every industry / sector / company that is listed.

The second advantage of having a concentrated portfolio is that even if 1 or 2 stocks click big, the out-sized position size means that the net affect on the overall portfolio will be pretty huge.

Peter Lynch made his name managing the Fidelity Magellan Fund. Over the 13 years he managed, he grew (both in terms of AUM & Net Returns) exponentially. The number of stocks he had when he exited the fund as the manager – 1400+ (Yep, One thousand Four Hundred) (Source: http://bit.ly/169mypw ).

The biggest advantage of having a large portfolio – no one or two stocks can damage the portfolio badly .But on the other hand, even if a stock goes 5x from your purchase price, the net impact on the portfolio may be very negligible.

The larger the portfolio, lower is the volatility of returns. A large enough diversified portfolio more or less starts to mimic the Indices both in terms of returns and risk.

So, what is better?

I believe that the final call on what approach is best is dependent on how much of confidence you have in your ability to pick stocks as well as your ability to absorb the pain that comes in with it.

But if you believe that you do not posses the skill set to identify stocks and bet big on it (Concentrated), you may actually be better off investing into a diversified Mutual fund while concentrating your efforts on understanding the larger picture so that you know when you should be Sipping (in other words, following a Systematic Investment Plan) and when you should be Whipping (Systematic Withdrawal Plan).

And before I conclude, just remember that there is no Free lunch in markets. Its all about give and take. Knowing what you are willing to give will also give you a idea on what you can take 🙂

Process vs Outcome

A lot of things in life are based on the concept of following the right process which ensures or is said to ensure the right outcome. Study hard parents say so that you can get into the best college – a direct relationship being there between marks scored and the fact that a high score shall get one into a top notch college.

A employee works hard hoping to claim his spot when a higher position opens up or to be able to claim a higher bonus. Again a direct relationship.

In the financial markets though, such a direct relationship is always difficult to establish. Buying a good company may decrease the probability of total loss of capital but never can guarantee a good return especially when its damm difficult to really say what is a good company and what is not. In 2007, I doubt if any Analyst openly said that Bear Stearns or Lehman were bad companies. After all, Lehman was a 150+ year old company that had survived through every crash and cycle that came about in those years. Bear Stearns was a 80+ year old company.

The thought for this blog came by this article – How we made nearly $1 million on Apple stock (Link).

The story is about how a couple bet (and not a big sum) on Apple and since they have sat on it for the last 16 years have now made a fortune (or sort of depending on what you call a fortune). Nice pleasing story especially since it deals with immigrants, their emphasis on buying a good company, etc, etc.

But is it a good lesson to learn for a ordinary investor? I guess not for not only does this story has its heuristic bias faults – Survivor Bias to start with but also the investors here did break major rules relating to investing. The fact that they came out good does not make the path something others should consider to the the path of the successful.

Lets start with the fact that even after overlooking things like Taxes, the guys have not made a Million (Realized + Un-realized). But since a Million bucks sounds nice, the copy editor maybe decided, this is how I attract more eyeballs.

Coming to the faults of the investment itself. The success is the outcome of breaking two golden rules of investment.

1. Never place all your eggs in a single basket. While the report does not detail whether they had invested in other shares as well, the gist seems to be that this is their only investment – Zero Diversification. In other words, they bet their money on a single stock and it turned out to be a great investment. If it had failed (as it has for hundreds of thousands of investors), they would have lost a small sum of money (that maybe not have been even significant enough to materially change their lives).

2. Not cutting one’s losses (Stop Loss). In the aftermath of the burst of the tech bubble in 2000, the stock of Apple fell by 65% and what did our savvy investors do? Nothing. The stock fell by 61% in 2008 / 09 and once again, our investors stayed put.

This also reminds me of a the following conversation between Barry Ritholtz and James O’Shaughnessy in Bloomberg Radio’s “Masters In Business” programme.

“O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was…”

Ritholtz: “They were dead.”

O’Shaughnessy: “…No, that’s close though! They were the accounts people who forgot they had an account at Fidelity.”

So, is the moral of the story being not to act and hope that the stock will eventually bounce back? I say, lack of exit strategy is one of the biggest reasons that dud shares have only retail investors as their majority investors (even the promoters bail out after a certain period of time).

Is then Buying and Forgetting the right way to deal with the volatility that comes with investments? My limited experience in markets tells me that, this cannot be true. Yes, there will be occasional stories of such success, but then again, who would want to write a story about a guy who was disciplined enough to stay with a great company that just managed to go under when the economy tumbled.

Similar stories can be read about Entrepreneurs as well. The story generally starts with how the guy started out in a Garage and now has build his company to the current multi million / billion level. What is left unsaid that 9 out of 10 ventures fail.

Luck plays a great deal in a lot of our ventures including investments in the market. The following picture by Michael Mauboussin shows the same pretty nicely.

Hind-sight is always 20/20. While much of the world looks at the results, to me, the process is as much important too.

In the field of investment, if you do not have a process, the outcome will generally be one of failure unless you are that 1 in a Million who got Lucky 🙂

One in 10,000

Impact of Social Media on Investing

The arrival of Social Media (Groups / Forums / Twitter / FB / Whatsapp among others) have proved to be a boon to the ordinary investor / trader. The impact it has on my own career is pretty significant and something that I cherish especially since I started my career before the advent (in the way it is today) of Internet.

Back in those days, information was scratchy and the only people one interacted with were those who you knew personally. And unless you were in Mumbai or a major city where investing in the markets were not looked into as a crime (comparable to any other gambling avenues), the percentage of people who knew much was rather limited (personal experience) and you had to be really lucky to be able to have them as friends.

Internet has changed those things quite a bit. Now, you can talk, question and discuss the pro’s and con’s of any company that seems to catch your fancy. Crowd-sourcing is the new mantra with one needing to just start to get others to put up their views as to what is right and what is wrong about a particular investment or strategy. In other words, one can get a peer review done literally for free and all that without having to move an inch from the computer

While the advantages of using such crowd-sourced networks for information is pretty useful, the fact also remains that its not honey and ghee all the way. The ability of such discussions to cloud our judgement is pretty huge.

Take for example the fact that most investors under-perform the indices on the long run (academic research, mostly done in US). But spend a little time and you can barely see many anything lesser than what the best fund manager has done in his best year. And most are then humble enough to point out that they are just a small – part time investor / trader.

The above scenario is true regardless of whether the writer is using his real name or writing using a Anon ID (not that either makes much difference since unless the guy really wants to meet, even with a real name, he can be as much Anon as a ID which hides the name as well). What really pisses me off is the ability of these guys to influence those who are easily swayed by opinions of others. While they themselves are barely invested (using say % of networth invested), they cause disproportionate damage to the psychology of smaller investors who are generally more scared of the markets. Of course, Darwin theory holds good here, the strongest survive while the weak shall get annihilated.

Way back in the 2000, when the IT bull run was in full fury, we had a client – a Chartered Accountant no less who was investing through our brokerage firm for quite some time. He had over time accumulated a good portfolio of stocks, most of them either in cyclic business or the general Hindustan lever / Ponds India / Broke Bond kind of MNC shares.

For much of the bull run, he was able to keep his head light on how stocks outside his portfolio (specifically IT stocks) were going like there was no tomorrow. While I do not remember the conversations I used to have with this gentleman with much clarity (its been 14 long years now), I do know that some where down the line, pressure of seeing other investors doing much better than him (heck, we had a client who could not sign his own name make a bundle in a stock called Octagon Technologies) finally broke him down. So, one fine day, he decided to swap much of his portfolio as well as invest fresh funds into a portfolio of IT stocks. While he did not enter right at the peak, he entered too close to make anything on the upside (even temporary happiness) and when the blade finally came down, his portfolio was just shattered.

While I am no longer in the brokerage business to observe things as closely as I could way back then, I do wonder how much of the crowd-sourced information can lead to investors getting out of good shares and investing into small cap stocks that are going up each day more than what many a big share does in a good month.

The FOMO risk (Fear of Missing out) has a much bigger impact on us than we consider. If everyone around you is claiming to have won in a casino and while you having the knowledge that the house always wins have so far kept afar from getting into that trap, its just a matter of time before you finally decide to take a dive. This is how most Multi Level Marketing works too and best of all when every one finds out they were suckers, they always have their friends to comfort them with stories of their own losses and that some how makes one’s losses more tolerable.

Truth be told, a lot of investors do not have the skill set to Analyse the markets and for them, the best way to participate would be via ETF’s and Mutual Funds. But even those who have some skill set, do remember that markets and life itself being cyclic, it will and never shall be a case of one strategy being the winner all the time.

A lot of investors remind me of Abhimanyu (MahaBharat). They some how know how to get in, getting out is something they sincerely think will happen as easily. If only life was so easy.

If you want to be in this field, do remember that you will need a Edge to survive, a domain expertise of some kind that enables you to distinguish between the good and the bad, the ability to know when is the time to risk more and when is the time to close out the cards. Because unless you know something, you are a sheep that is slaughtered at the end of the line. As much as following some one else’s advise may get you through for some time, when the time is up, the guy who you followed will have escaped while you will be left wondering what the hell hit you.

In Defense of Technical Analysis

One of the ways to beat down a strategy is to apply it wrongly and claim since the results does not match expectations, the strategy has to be wrong. Technical Analysis has its faults and there is no denying that. But claiming that those who use technical analysis as the tool of choice tend to have their performances drag down is doing it a bit too far.

That thought is based on a survey which has been done by Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University (Link). The key reasons they come up for the under-performance are:

Investors using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective.

Investors tend to hold more concentrated portfolios which they turn over at a higher rate

Investors are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of non-systematic risk to total risk

Investors engage in more options trading, and earn lower returns.

The biggest problem area for me in terms of Technical Analysis is the confusion whether it’s a science or an art. While it’s nice to say that it’s both a science and an art, it’s plainly illogical that something can be both. Think about Modern Art being said to be an Art (which is true) as also a Science. I am not sure if there is any other field where both Art and Science are seen to be acting in tango.

Now, let’s go back to the four points which the researchers say are the key reasons for the underperformance of investors who use Technical Analysis for their decision making.

The time frame of a trader / investor using technical analysis is way too short compared to an investor who uses fundamental analysis as his tool. While a fundamental investor gets 4 data points in any given year (4 Quarterly Results), guy who uses Technical analysis has a lot more data points based on what kind of time frame he operates in. A investors who looks at Daily chart would have around 240 data points to consider in any given year while a Investor who looks at a weekly chart will have 52 data points to consider in a year. No matter what time frame one chooses, the data points generally exceed the data points available to a fundamental investor

Having more data points is both a advantage and a disadvantage. Let’s take a example where more data points would have worked in the favour of the Technical Analyst – Satyam Computers. Long before the shit hit the fan, most guys using Technical Analysis as their tool would have seen that it made no sense to trade the stock with bullish bias. For a Value /Fundamental Investor on the other hand, Satyam was a strong case of a stock available for cheap.

It is interesting that the survey finds that Investors hold concentrated portfolio’s / bets compared to investors using other methods who may be holding diversified portfolios. A lot of water has flown down the bridge as to whether it’s better to hold concentrated bets or diversify as much as possible. Both have their advantages and disadvantages and I doubt that it can be proven that either concentrated or diversified portfolio is the best bet.

Personally I believe in concentrated bets since the more number of stocks one is exposed to, the closer we get to ordinary performance. The same was proved when I did the test of random portfolio strategy as well. But I strongly doubt that a concentrated portfolio is the key to under-performance since I know of many value / fundamental investors too who use the same approach and have been able to beat market averages by a mile.

This point interestingly goes against the point number 1. If investors using technical analysis as their trading tool are trading more, it goes on to prove that they are betting on reversal s to the existing trend at multiple points and in turn can miss the big rally when it comes.

Option trading as such has nothing to do with Technical Analysis but since Option traders are short term traders and are betting on charts to decide on what stock and what strike to buy, it’s easy to get clubbed with Technical Analysis even though one can search the entire technical analysis vocabulary and find not a single instance of a tool devoted to options.

In an earlier blog post, I had written about how people buying cheap options is not the path to riches and instead will result in ruin of capital in the long run. But then again, options are pretty enticing since unlike stocks, they can double / triple in no time at all.

But Technical Analysis as such has no role in how investors / traders risk their capital in the markets. Option trading is similar to buying lottery tickets (though the odds here are much better) and hence not something that is bound by any strategy other than human greed.

To me the biggest negative is the fact that Technical Analysis as a tool is far from refined and adapted to the world where it’s important that it’s scientifically proved beyond doubts. If I were to buy stocks based on PE, that would not make me a Value / Fundamental Investor but if I were to draw a line on a chart, I am seen as a Technical Analyst. End of the day, it’s the perceptions that seem to matter more than reality.

Over period of time, I myself have debunked multiple strategies that are associated with Technical Analysis and showed how they fail the traders / investors who use those tools. But to claim Technical Analysis as a whole is quack is akin to throwing the baby with the bathwater.

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