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.          

Don't Worry about Your Returns. Worry about Playing the Game Well.

Perhaps nothing has caused more harm to stock investors than worrying incessantly about returns. The stock investor is perennially in virtual competition with not only other stock investors but also with mutual funds. The argument goes that if you can't beat the benchmark, you shouldn't be investing yourself but should take the fund route, since many mutual funds have a proven history of beating the benchmark. If you do beat the benchmark but there are funds that have given better returns than what you have generated, again you should go by the fund route, they say. I wonder what if Warren Buffett and other star stock investors had invested in funds. Would they have reached the stature they command now? The answer is a clear no. Can you name a famous “fund investor”? At least I don't know any.

Those who make it big focus on playing the game and conquering it. In the stock market, it is self-defeating to worry about the returns your stocks are generating and then comparing them with whatever. What matters is understanding the game and playing it well. Once you have understood the game, the returns are natural to come. Hence, it's crucial that you don't get swayed by whatever whosoever is doing or saying. Rome wasn't built in a day, and your stock success will also take its fair share of time. Be patient and stand your position.

The biggest cost that you pay when you decide to quit is not learning how it works. Ignorance is not bliss. When you decide to quit, there are people who carry on amidst uncertainty and eventually find the way. Once they get the key, their lives are transformed. That's true in the stock market also. So, don't be embarrassed if you are underperforming the benchmark or some fund is doing better than you. Don't feel diffident if you have been running in losses, while the guy next to you has been making money in a great fund. Just stick to your path; learn, understand, and try again. Once you have cracked the code, the top fund manager may as well want to follow your footsteps.

Beware of Those Entrepreneurship Ads

Quite a few ads leveraging the idea of entrepreneurship are on air these days. One ad shows a girl, who after fighting with her parents, opens a tattoo shop. The other shows a person resigning from his job to start his own business. When his boss asks him to think again about resigning, a “car” fuels confidence in him and he decides to go ahead with his idea.

One should be beware of such shallow ads. While starting your own business does entail some degree of struggle, it doesn't mean you have to pit the world against you to succeed. Indeed, your chances of success are greater if your family and friends are with you. Being rebellious is easy; any idiot can be. What requires skill is how to strike balance between family, society, ambition, and so on. But for some reason, the so-called rebel stories get a lot of attention in the media. Don't be carried away by them.

As to the second ad, you really don't need to quit a well-paying job to “chase your dreams.” Anything you want to do can be done part time, at a small scale. Once you really start to get successful, you can pursue the idea full time. No sweat. For employees, it's always a good idea to start their personal venture part time. In this way, you can reduce the risk.

Mind you, entrepreneurship is no cakewalk. Your chances of failure are much higher than your chances of success. If it's your first shot, most likely you will fail. Failure can really devastate you if you don't have a support system in place. A job, family support, money—all these are support systems. Also, while starting something, avoid committing a lot of resources, especially money. Start small, work hard, and see if it works. If it doesn't, never mind. You can try again.

Like any ad, the only good that ads riding on the entrepreneurship theme do is not for you but for their marketers. You are better off ignoring them.

What Works on the Street (and in Real Life)

There are numerous stock-market success formulas. Those who are successful at stock investing tend to tell us their formulas for success, but not many of us are able to replicate them. Take Warren Buffett for example. Half the world is crazy about his ideas, which is obvious, given the huge fortune he has amassed. But how many can actually boast of accumulating that sort of wealth? I haven't heard of many. Peter Lynch visited companies before investing in them. How many investors can do that? The fact remains that what wins in the stock market (and in real life) is originality. People who get successful are those who have something new to offer and say. Copycats seldom get successful or famous. 

I am not suggesting that you shouldn't take inspiration from the successful. By all means, reading about and learning from the successful is essential. Even when you start, you may like to take the tested path, yet the tested path isn't enough if your goal is to get really successful. You will need to devise something new, something that works for you. It doesn't matter if others can't replicate it or find it altogether crappy. If something works, it works, and that's more than enough. When you get successful, there will be many who get inspired from your formula and follow it. That's exactly what happened with Warren Buffett, and, for that matter, with any other successful personality,

How do you evolve something new? You can't become a star the day you begin. The key is experimenting. Learn, experiment, observe, and try again. Once you spend time doing something, you naturally develop insights that are alien to an outsider. Once you have these insights, you can cast them into a methodology. If the methodology works (for you, of course), you have just developed a success secret and you will eventually know what actually works on the Street. 

   

Why Studying Businesses Is of Limited Use in the Stock Market

The history of stock markets is full of investment wizards who picked wonderful stocks by studying their underlying businesses: what a company makes, what its market is, who its competitors are, where the industry is headed, how solid its financial strength is, and so on. True, such an approach can generate rewards, but what about the link between a real business and its stock? When you buy a company's stock, you are buying a piece in its business, but does the stock really mimic the business?

The unfortunate truth remains that a stock may not always follow its underlying business. Though the correlation between a business's performance and its stock performance is positive, there are a plethora of other factors that impact the stock. Since you buy the stock and not the real business itself, you become vulnerable to the eccentricities of the stock market.

Take for instance the market sentiment. Even if you have picked a good stock, it may not go anywhere (or rather go down) because of the sentiment prevailing in the market, even when the underlying business is doing just fine. Consider this fact: A stock starts racing in sheer optimism even before the underlying business has turned around. Further, talks of a buyback, a stake sale, a merger, etc., all drive stock prices, when the underlying business hasn't shown any improvement. A dilution in equity hits the stock, while the business remains unharmed.

You may want to take comfort in the stock-market adage that over the long term, a stock traces the course of its underlying business. And you are right. But over this “long” term many things will have changed for the business itself—for the worse. So, you can't really rely on the long-term theory. What's the message then? In the stock market, while it pays to keep an eye on the underlying business, that's not the only way to make money. What will work is a well-crafted strategy based on what moves stock prices. The strategy, what I call a model, will clearly tell you what and when to buy, how to track progress, and when to sell and take your profits home. 

Don't Disregard Your Profits

The one aspect of stock investing which surprises me the most is that money loses its significance in the stock market. What I mean by this is that investors behave differently toward money in the stock market than they do in their daily lives. In daily life, many of us have a cautious approach toward money (which is good); we tend to think twice before spending it. And surely we don't want to lose it.

In the stock market, investors frequently show a complete disregard to profits. The other day someone told me that she wasn't selling a stock that was showing a huge gain just because she didn't need the money. Another “fundamental” analyst said he preferred to keep stocks for the long term, even if it meant losing on the profits the market was offering him. Further, one bright fellow stayed invested because he didn't know any other stock to invest in. I bet the same people would behave differently outside the stock market.

I am not saying that just because your stock shows some profit, you should sell out. Selling a stock should follow a strategy, but it must be sold at some point because you make no money unless you sell it. Many times stocks become expensive in terms of valuations and it is prudent to sell them rather than blindly follow “long-term” investing principles. It's indeed wise to take money out of a stock and wait on the sidelines rather than say that you don't need the money or you don't know any other stock to invest in. You can always act later, but your stock-market profits may not always be there. The bear can quickly gobble them, while you preen yourself for being faithful to the investing principles given by your investment icon.

The profit that the market offers is real money. If you spend it, it will work in the same manner as your hard-earned money does. There's no difference. The need is to give your profits the top priority and do anything to protect them, even if it entails breaking any cherished principles of investment science.