Why Stock Analysts Should Hire Someone Else to Manage Their Money

Most investors equate stock analysis with making money in the stock market. In reality, these are two different things. Just because you are good at analyzing equities doesn't mean that you can make money off them. On the contrary, the more thoroughly you analyze stocks, the fewer are the chances that you will profit from them. Call it the stock-market paradox, if you will.

This doesn't mean that making money in the market is all about luck and fluke. It's not. But it's not about stock analysis either. The right answer lies somewhere in between. You do need to have some strategy for buying stocks, but analyzing stocks should not become an obsession. Stock-market investing is an art, not a science.

The market doesn't care about your analysis. It doesn't know how accomplished an analyst you are. All it cares about is certain triggers. For instance, companies that turn around see their stock prices racing. If your strategy can spot a turnaround in making, you can make money. Another trigger is rising profits and so on. Aligning yourself with what the market cares about is the secret of making money in the market.

Seeing everything from analytical perspective soon becomes an end in itself. The stock analyst forgets why he is there in the market. He is no longer making money but is getting deeper and deeper into a company's books. Naturally, this leads to analysis paralysis. The analyst can't act now. He just knows too much. Meanwhile, the stock keeps racing. Given that it has now gone up, the analyst enters into a dilemma if he should buy it now. The outcome is that he is left with reams of analysis but no money.

While the stock analyst can still keep analyzing stocks as a part of his job, he would do himself a great favor by leaving the money-making function to someone else.

The Market Is Overvalued. What Should You Do?

In February this year, I wrote the blog “The Bear Is on the Prowl. What Should You Do?” (See http://smi4e.blogspot.in/2016/02/the-bear-is-on-prowl-what-should-you-do.html) Interestingly, just a few months hence, market pundits are talking about an overvalued market. According to them, market indices are trading at all-time highs, and index P/Es have swelled. They feel this is the sign that the market could come down from here, perhaps sharply. The average investor is confused as ever.

One thing that becomes quite clear from the narrative above is that the market can quickly change its course even before you realize what's happening. In the blog post mentioned above, I advised that you should not worry about the market and wherever it's headed. The point still remains the same. Even if the market looks overvalued, that's not your problem. It's futile worrying about bad and good markets. 

As a stock investor, you just need to worry about the company you are going to invest in, not the market. The company should be able to clear your criteria and that’s that. And no matter what kind of market it is, there are always good investments available. Just because the index is trading above some historical average doesn't mean that you give the deserving company a miss.

Market pundits may disagree. They say that if the market falls, your “good” investment may fall as well. And they are right. In bear markets, almost all stocks fall. But no one knows when the market is going to fall or how much your stock will fall vis-a-vis the market (it may even continue going up while the market is falling). It is often seen that all the while experts are worrying about market levels, the market just keeps going up. 

The fear of a market fall is a big impediment to success in the stock market. Fearing a fall in market, many investors remain away from the market and miss the opportunity. Don’t let that happen. The best answer to an “overvalued” market is to do whatever you would have done if it weren't overvalued.      

Why Investors Miss Multi-Baggers

The other day I told a colleague about a little-known company that I hold in my portfolio. His reaction was: “It’s a dodgy company.” I enquired what he knew about the company. He knew nothing. But because he hadn’t heard of the company, that rang alarm bells for him. 

On another occasion, somebody asked me what company he could invest in. I suggested a name that he was not familiar with. He gave me a confused look and asked for another suggestion. I suggested to him a well-known large-cap stock, and he was happy because he “knew” this company.

For both experienced investors and amateurs, the familiarity with a company’s “name” is an important investment criterion, though they won’t confess it. They would prefer a company whose name they have heard of to a company that they don’t know. 

One can’t blame the investor community for this behavior. The reason for the inclination towards what’s familiar is psychological in nature. Familiarity breeds trust. And lack of it engenders caution. Naturally, investors turn cautious of what they haven’t heard of. But due to this psychological instinct, many great companies are skipped. These companies later turn out to be multi-baggers.

How do you overcome this problem? First, “curse” yourself. You don’t know enough, so you must not trust your own knowledge. Just because you haven’t heard of a company doesn’t make it a dodgy one. All it indicates is you have limited exposure and you don’t know. It’s plain ignorance—yours. Second, don’t stop at a company’s name. Study it and then make a judgment. While studying it, don’t begin with a negative impression of it. If you do, you will simply pick evidence that confirms your suspicion of it. That’s another psychological bias, called the confirmation bias.

In investing, psychology plays a more important than finance. Ignoring it and staying buried in finance books won’t get you anywhere. To spot multi-baggers, understand psychology more than IRR or CAGR or whatever. Is the analyst community listening?

Stock Investing Should Be Simple, Not Simplistic

An analyst on a business-news channel was saying this with gleaming eyes and feeling as proud as a peacock: “This housing-finance stock is just going to go up because the demand for new houses is just going to increase with time. This company is a direct beneficiary of the Indian government’s focus on housing for all.” Another bright chap I know bet on an FMCG company because he thought its products would never be out of demand. Yet another person justified his “long-term-investing” mindset saying that the Indian economy is only going to expand, so forget about everything and stay invested.

Most analysts and investors receive heavy doses of the tonic called “Keep It Simple.” It is said that the simpler the investment argument is, the better it becomes. And we all know many investors who have made huge money by just keeping it simple. The problem with being simple is that simple arguments frequently turn into “simplistic” ones.

What’s the difference? Something that’s simple solves complexity and something that’s simplistic disregards complexity. Getting to simple isn’t simple. Those who get to real simplicity are the ones who have dealt with complexity and know how to steer their way through it—just like driving. Driving isn’t simple for someone who is not trained in it. But a skillful driver makes things look so easy and effortless. If an amateur driver looks at a trained driver and thinks that driving is all about moving the steering wheel correctly, you know what fate he is destined to meet.

The simplistic arguments mentioned at the beginning overlook several important aspects. For instance, the first two arguments undermine the impact of competition and the last one overlooks history altogether.

How to get to “simple” then? Devote yourself to the trade in question and experiment. The trial-and-error method is the best way to unravel the puzzle. As you spend more time on something, you will naturally cut through complexity and arrive at simplicity. And those who unwittingly stick to the simplistic will only find that the path to their failure has just got simpler.

Don’t Get Mad about Positive Portfolio Returns

The other day a colleague of mine who has recently started investing directly in stocks asked me if it’s okay to sell out the “losers” in his portfolio so that the aggregate portfolio value looks better. Obviously, I asked him not to. On another occasion, an amateur analyst, who has just acquired an MBA degree, advised me to buy “puts” for my portfolio so that I can hedge it against market downturns. I scratched my head for some time, trying to understand the logic behind his argument, and eventually decided to junk the idea.

Obsession with positive portfolio returns isn’t just an obsession with the analyst community; laypeople are equally affected by it. A positive portfolio return is taken as a barometer of your prudence in stock selection. Those who have poor aggregate returns tend to slip into self-inflicted inferiority complex. They should not.

There are quite a few problems with the obsession with positive portfolio returns. Since you are almost never going to sell the entire portfolio, aggregate returns mean little. Secondly, if you sell out your profitable positions, the portfolio sinks into red, which may artificially make it look ugly. Sometimes it’s because two or three stocks that the aggregate portfolio looks bad, while the others are doing pretty well. That doesn’t mean that you get desperate to sell out the nonperformers. Selling out should always be dictated by your stock strategy and not market movements.

Doing all sorts of acrobatics, such as buying puts, to “save” your portfolio is no sign of investment savvy. On the contrary, I consider it a strong indicator of muddled thinking. Your “savior” strategy can soon turn into a booby trap, and you will be looking for another savior to save you from the first. Complex products, like calls and puts, are not only difficult to understand; they are also difficult to manage.

The best thing you can do when your portfolio goes into negative is do nothing. Fall in stock prices is a fundamental aspect of the stock market, and you must accustom yourself to tolerate it quietly. Eventually, if you are invested in good stocks, you will find them regaining their lost heights. As to the amateur analyst with his pristine MBA degree, God save him from himself.