Timing the Markets (vs) Time in the Market

The ability of Mr. Market to contradict perception held by market participants, who themselves constitute it, continues to be a great mystery. Ever since the emergence of financial markets, this elusive trait of Mr. Market has continuously caught investors on the wrong foot and, in the process, cost them billions.

This has been made possible by the fact that crowd, which is much influenced by fear and greed, continues to make the same mistake again and again. Also, the fact that the brunt dealt by such blows to one generation is lost on the younger generation, does not help the cause.

As an investor, our goal is to try to ensure that we do not end up committing the same mistake. Following the advice of Santayana, who observed, ‘those who do not learn history are condemned to repeat it,’ let us reflect on what successful investors have done to deal with this problem.

Benjamin Graham answered it best when he said, ‘in the short run, stock market is a voting machines and in the long run, it is a weighing machine.’ There is much wisdom in this one stanza than in many a book on the subject of investing.

It is like you concede defeat to Mr. Market in the short run, yet emerge as a surprise winner in the long run. It requires a sound temperament to accomplish this task but it is well rewarded.

A natural consequence of this lesson is to not succumb to ‘timing the market’ syndrome and follow the ‘time in the market’ rule towards investing.

In a nutshell, ‘time in the market’ rule says that if you appreciate the fact that predicting market movements is not a rational course of action then it becomes much easier to stay invested for longer periods of time, which is the cornerstone on which wealth is created in the stock markets.

Any investor following this rule would have reaped the benefits of this rule immensely during the last few months as Mr. Market caught the investor community on the wrong foot once again. It will happen again but you need not worry much, if you can remain equanimous.

Let me end the write-up with Rothschild’s Law. The legend goes like this:

‘When asked if there was a technique for making money in the stock exchange, Nathan Rothschild said, ‘there certainly is. I never try to buy at the bottom and sell at the top.’

Great Expectations

Children like stories and so do investors. The latest story, which has captured the imagination of investor community, is, ‘a stable government will unlock the growth potential of India.’

This story has, in part, restored investors’ faith, which was thrashed, when the ‘decoupled from developed nations’ story failed to stand up to their expectations.

What investor community doesn’t realize, however, is that just as children stories are fictitious; these stories can be fictitious, inspite of them sounding realistic. And, as a famous philosopher, once observed, ‘“we’re never so vulnerable than when we trust someone,’ investors’ end up being a vulnerable lot.

The behavior of investors, at large, can be likened to a balloon. The more inflated it is with optimism, the more vulnerable it is to blow up in the face of slightest trouble.

The historic rally, which we have witnessed during this week, highlights the tendency of investors to take a good story too far. Of course, it is a relief, more than anything else that we have a stable government after numerous elections resulting in hung parliament halting economic reforms.

But, as Benjamin Franklin observed, ‘he who pays in advance gets a penny worth for a nickel paid,’ investors, in their optimism, always seem to end up paying in advance (think, forward earnings estimate to justify the high valuations of stocks) and end up disappointed (as earnings fail to catch up with expectations and PE multiples collapse).

The SENSEX closed at 13,887 on May 22nd, 2009. This discounts the earnings at19x. Given the cloud of uncertainty prevailing world over and dipping industrial production levels, such an earnings multiple seem to contain elements of irrational exuberance.

At PPFAS, we are not in the business of making market predictions and neither is this a prediction that markets are ripe for correction or over-valued. After all, there is a lot of wisdom in John Maynard Keynes’ advice, ‘markets can remain irrational for longer than you can remain solvent.’

The purpose of this article is to highlight the manic depressive behavior that market displays every now and then and how susceptible, in the process, it becomes to disappointment. And in markets, disappointments mean losing not only one’s hard-earned savings but also losing one’s sleep.

Let me end the article with an excellent quote from Benjamin Graham, which sums up the essence of the whole article succinctly and is, to some extent a reply to the ‘unlocking of growth potential of India’ story,

Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

Filtering the Noise…

Everything has its pros and cons. Our task is to amplify the benefits of the pros, while mitigating the drawbacks of the cons. But it is easier said than done.

The age of computers and information technology is no different. The amount and the speed at which the data can be collected and shared have gone up exponentially over the last few decades. But so has the need to separate noise from information, which is easier said than done, especially, given the fact that our ability to process information is limited.

And as Warren Buffett observed, ‘when a good management tackles a business with bad economics, it is the bad economics of the business which prevails,’ when human beings with their limited processing ability tackle the vast amount of data, it results in confusion in making sense out of the data that prevails.

However, confusion might be an impediment to reach a rational decision but it is still possible to mistake noise for information, which provides an illusion of control, leading to irrational decisions. It reminds me of the following observation made by Charlie Munger, ‘to a man with a hammer, everything looks like a nail.’

Misconception: Stock Market = Gambling

Stock market is considered as a playground for creating massive windfalls of wealth over a short term by many. And in a society, where wealth is considered as a means to achieve happiness, it is not surprising that many a people hang onto this belief lest they miss out on the benefits that wealth is expected to provide.

Also, in a capitalist society anything that can be capitalized will be capitalized and numerous many would be victimized in the process. So, it is not surprising that numerous parties (brokers, analyst, media) exist to feed this belief for their own sake.

Rationalization Trap:

The eagerness to foresee the short term trend of the market and come out victorious, which is so deeply ingrained in the mindset of investor/speculator community at large, is a by-product of the misconceptions discussed above.

As Benjamin Franklin observed, ‘So convenient a thing it is to be human, for he can make a reason for anything he sets himself upon.’ In effect, faith becomes a short cut to knowledge. Ignoring dis-confirming evidence and seeking confirmatory evidence, which is a basic human tendency, makes it possible and sustainable in spite of its inherent weakness.

So, It is not surprising to see huge amount of money and brain power spent by media, brokers and analyst towards fulfilling their needs. Whether it is possible is not something that the target segment is worried about and the servicing agents have incentive to let them continue to live under this mentality.

Catch Yourself Sleeping…

…and you are no more asleep. The same is the case with many of our mistakes/biases.

Just as sooth-sayers considered the possibility of economic slowdown impossible about a year ago, they are now facing great difficulty in foreseeing economic upheaval. But nothing is permanent. Good times, as impossible as they may seem, will present themselves sometime in the future.

Just as ups and downs are part and parcel in life, it is for businesses and stock markets as well. The magnitude and frequency of the economic cycle, its ups and downs, are not easy to predict because reflexivity plays a huge part in how things shape up as things proceed.

Afraid of catching the falling knife?

It is well known fact that market discounts future because the value resides in future earnings that are expected from the businesses and the present volatility indicates the immense uncertainty about the future and, rightly so, given the spill over effects seen across various industries and nations.

However, the volatility/uncertainty also provides one with an opportunity to benefit greatly by betting against the expectations built in the stock prices. What Benjamin Franklin observed for marriages – that it always pays to marry somebody with low expectations – also applies for stocks.

This is no rocket science. Moreover, if everybody thinks this way, the proposition loses its value. But the good news is that the fixation on near term outlook, which continues to be bleak, offers investors with long term outlook an opportunity to benefit immensely.

For all those who are simply afraid of catching a falling knife and want to pick it up from the ground (i.e. when the outlook is better), let me quote Mr. Buffett from his Op-ed piece titled, ‘Buy America. I am’ in NYT on Oct 16, 2008:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over. [Emphasis mine]

‘Independent Directors,’ not so independent. Why?

In today’s Business Line, the columnist, Ashoak Updahyay, observes:

‘When Satyam imploded, most board members responded like ordinary investors – with shock and dismay at having been, well, cheated. A distinguished body of people with great skills and competence was as unable as the ordinary investor to discover, or prevent, for twenty quarters a promoter and his close confidantes from treating a publicly listed company like their personal fiefdom. In hindsight, they fell prey to the most common and ancient human trait – the need to conform.’

After having been fed with numerous write-ups on this big issue highlighting only the immediate cause behind the Satyam saga – the failure of the various bodies that are meant to safeguard every stakeholder’s interest – it is interesting to see somebody point towards the root cause – the perverse incentives, which discourage the individual participants from perceiving the status quo differently and pointing it out, especially, given that organizations/groups, generally speaking, subscribe to the act of killing the messenger, who brings the bad news.

Various parties involved are held responsible for not blowing the whistle, when the irony of the situation is that nobody was allowed to carry the whistles with them, let alone blow them…

An important implication that we can take away from this episode is to ensure that every organization puts in place a structure which seeks out dis-confirming evidence and brings them to fore. Because as human beings are driven by incentives, they will perceive things differently and act as devil’s advocate only when they are encouraged to do so and feel assured that they will not be subjected to the fate of Persian messengers, who were invariably killed, when they brought bad news.

It could be very taxing in the short run with no visible benefits but as somebody once observed, ‘it is easier to resist at the beginning than at the end.’ May be creating a system that encouraged diverse viewpoints could have prevented Mr. Raju from getting onto a tiger not knowing how to get down…

Creative Destruction (or) Destruction of Creativity?

What is Creative Destruction? And what has creative destruction got to do with investing?

As the name suggests, Creative Destruction is a principle which is used to denote the process of something new bringing about a revolutionary change resulting in the destruction of something old. It can be observed that much of human progress has been the result of one long chain of creative destruction, where innovation has resulted in the death of old.

A great example of creative destruction is the invention of wireless telephone technology, which in spite of its countless advantages, has rendered uneconomical the huge investments made in laying out the landline telephone networks around the nation. From the perspective of landline network owners, this invention has been tragic but for the civilization as a whole this has been an event which marks human progress in its grandeur. It must be noted, however, that someday some new invention will bring about a destruction of this technology, which seems invincible at present, and it will be a change for the better.

Killing Old Ideas:

At the heart of creative destruction lies the ability to kill old ideas and establish innovative ways to accomplish better results. And if you notice, all the new transformational innovations are separated by generations. The reason behind it is that we, as individuals or peer group, are not good at killing ideas to which we get used to. It takes fresh dose of imagination and lack of historical conditioning to think out of the box and question the existing notions.

As an investor, the question that I am interested in is – are we good at killing our own investment ideas and replacing them with better ones as they present themselves from time to time?

Experience of an Investor – Destruction of Creativity:

Consider the following hypothetical situation:

If you expect Rs. 10,000 invested today in the stock of NEW Ltd to grow to Rs 20,000 by the end of one year as compared to the same amount growing to Rs 15,000 in the stock of OLD Ltd., then is it not foolish to still invest in the stock of OLD Ltd.? Who would do something like this?

The answer is – all of us are susceptible to do something like this, especially, when we are already holding the stock of OLD Ltd. and have to book a loss to replace it with the stock of NEW Ltd.

Rationally speaking, that is, we would rather wait a year to recover the quotational loss in OLD Ltd. than book the loss today even if it increases our chances of recuperating the losses and making more money on the capital risked.

Just the other day as I was looking at the constituents of my portfolio it struck me that something that looked cheap (and was cheap), when the Sensex was at an all time high, did not look attractive enough as compared to other opportunities that have surfaced as the stock markets corrected. And I noticed that I should have replaced this with another stock with better risk-reward ratio but simply did not do it as it meant booking a loss of 20% in the old investment.

The end result – we often stay invested in the stock of OLD Ltd. and at the end of one year end up having Rs 15,000 instead of Rs 20,000. As Warren Buffett rightly observed when he said that the worst mistakes are those which do not show up anywhere because we simply keep on repeating them.

Why? Loss Aversion:

The reason behind this irrational response lies in loss aversion, which says that we feel uncomfortable booking losses as it causes regret, even when booking losses might be a rational thing to do.

Error of judgement is not that big an impediment to human progress as is his inability to judge his errors reasonably.

I am sure you would relate to the following and see what I am trying to say. How often have we come across people who are still holding onto the share certificates of the stocks from their IPO allotments from the early 1990s or the favourite IT stock from the IT bubble at the turn of the century, simply because they are still selling well below their purchase price? It is like that they have given up on those investments. It is as if, thinking about those investments results in pain. So, we end up doing the next best thing, which is, do not acknowledge the mistake by holding onto them and waiting for losses to be recovered.

Rationalization Trap:

Benjamin Franklin once famously observed, ‘So convenient a thing it is to be a reasonable creature, since it enables one to find or make a reason for everything one has a mind to do.’

The inability to be good at judging our own errors stems from the need to justify ourselves to others and self. Accepting a mistake makes one feel vulnerable. So, we pay the price in the form of covering up our past mistakes.

The defining ability, however, of any super-achiever, in any area of work, is his ability to accept his failures with as much humility as he does his successes. Moreover, sometimes it is not even a case of mistake just that something that seemed (and might have been) right at one point in time ceases to be so as things evolve.

It is easier said than done. In fact, it was my inability to act in the way recommended above to start with that led to this revelation and not the other way around. But as Benjamin Franklin observed a few centuries ago, “Would you live with ease, do what you ought, and not what you please.”

It just happened that I realized one of the things that, as an investor, I ought to learn to do is reshuffle the portfolio on a regular basis even if it means killing my own best loved ideas and booking losses…