Skill vs Luck in Trading

Here’s my take on the eternal debate. Let’s indicate the unknown (i.e. what trading is?) by ‘x’. Now, luck and skill seem to be at 90 degrees to each other (i.e. only luck and no skill as well as only skill and no luck will both take you to the cleaners, I guess). Furthermore, since we are talking about successful traders here, it is unlikely that any would be found on the (all skill, no luck) or (no skill, all luck) lines. Which means that every successful trader has to have some modicum of both. Elementary, but I am sure how many of us are humble enough to recognize and appropriately fear the role that luck plays in our fortunes.

Kelly Formula (Part 1)

Most of my smart winners have been small capital bets while the losers have seen larger bets of capital. One of the reasons for this could be that catching a high beta asset at its low point (about to breakout; Lower Bollinger  touch; RSI < 20%, whatever) has given a higher alpha to me since the price move (due to high beta) has been swift and definitive. The low beta stocks, giving the illusion of secure staidness, have killed often by bleeding a part of my portfolio to death. Since these are the blue chip, low beta shares, I have been tempted to invest a larger proportion of my capital as compared to the mid/small cap sprightly upstarts being lured by the illusion of safety. As I look into my trading log, it is the multiple smaller bets that have really been multi baggers for me. So, I spent a good part of the long weekend reading on optimal bet sizes!

It is a common belief that a high amount of beginning traders do better with paper trading than once actually live. The reason being the realization of losing ‘real’ money. Knowing how to deal with profits doesn’t make one a successful trader insomuch as being able to handle losses. Every trade can have five potential outcomes – big profits, small profits, par, small losses and big losses. Taking the big losses out of the picture will logically give any trader less chances of frowning. Big losses can come due to decision paralysis (and waiting in the hope that the price will recover) or large capital outlay. The topic of this post is to ponder on understanding what should be the right size of trades. While its natural to think that the size of trades depends on a) your personal strengths and weaknesses, b) amount of capital, b) trust in an investment thesis, c) degree of diversification etc but like all good things there is a formula for this too! Namely, the Kelly Formula. This was designed by John Kelly who worked for AT&T and devised this for use in long distance communication – signal loss; signal to noise ratio and all those nice things. Since there are two basic components to the formula: win probability and win/loss ratio, this found application in the world of trading as well. The Kelly Formula states that for any given stock, you should invest the probability of winning times the payoff minus the probability of losing divided by the payoff. It is represented by the equation:

 where, P = payoff (i.e. odds offered by the betting syndicate); W = probability of winning and L = probability of losing


So while the debate on chance vs. skill in investing continues, here are some of my investigations and thoughts on whatever I have read and managed to understand so far. At the core of all this line of enquiry is a desire to figure out a personal method to ensure that I statistically end up putting more money on my winning ideas as compared to my duds. If I get to do that I am pretty sure, I would  be all :)s.

So back to the ruminations on the Kelly Formula: If you are worth 1 crore (say) then it’s clearly stupid to be risk averse for small amounts like INR 5,000 (say). You should regard “gaining 5,000” and “losing 5,000” as equal-but-opposite faces of the same coin. But it’s very rational to be risk averse for 50 lakhs. Whatever I have seen and heard from people with modest wealth around me suggests that people in fact behave in a predictably irrational manner when faced with these little choices of chance that their investment process throws at them. Penny wise and pound foolish…

But what if we step out of the frame a bit and focus on the really long term? Personally, if my health (mental as well as physical) stays with me, I very well have a further three decades of investing ahead of me. However, let’s take a hypothetical case – say you inherit a sum of money at a young age and to invest it for a really long time. [if wishes were true…] You always have a choice between a safe investment (treasuries) and a myriad of risky bets whose probabilities of outcomes is also known to you. [this is possible in a casino, but never on Dalal Street, but please lets go ahead with the logic]. Also, lets visualize that you are breaking up your investment time horizon into finite smaller periods (could be years, months or even weeks or days) at the end of which you take stock (i.e. P&L) and start again with whatever you’ve got at that time (i.e. rebalance your portfolio at periodic rests). The Kelly Formula gives you an explicit rule regarding how to divide your investments to maximize long-term growth rate.

There is this book called Fortune’s Formula by William Poundstone which I need to read to understand this better. Part two of this post will come after I have read that book and some more.

Read less, Trade Less

Among the many misconceptions/myths prevalent, one is that you should be an active trader if you want to make money from equity markets. Well, ‘active’ does not mean actively buying or selling – but active in being knowledgeable about the economy/markets etc. Not every ball should be hit – good batsmen realize that some balls outside the off-stump should be left alone.

Traditional finance theory have always recommended that individual investors simply buy and hold the market portfolio, or at least a well diversified portfolio of stocks. The typical retail investor doesn’t hold a well diversified portfolio nor does he desist from churning his portfolio every now and then. The attached paper delves into the subject and concludes that younger and male investors trade more aggressively than older and female investors.

In addition to overconfidence and gender, the more frequently individuals invest in information, the more they trade. To stretch the point further, investor psychology research has also pointed out that trading behaviour is also sensitive to the sources of information used by investors. Overconfident investors trade more frequently when they collect information directly using specialized sources. Investors getting stock related information from banks and/or brokers tend to trade more frequently than those who interact socially and are informed via friends and family or those who use non-specialized media like newspapers, financial magazines etc.

News, ‘hot tips’, brokerage reports et al are like deadly vortexes that can suck in an average investor and sink his portfolio hard. When you play information (budget announcements, RBI will come out with a rate cut, employment figures, economic survey etc) you are playing a game which is dominated by the big boys. Big players use news events to trade. In fact, some of them may even not be above ‘creating’ news if there is no ‘real’ news available. I recollect myself buying a share nearly concomitant to the release of a nice upbeat equity research report on the stock only to realise that it was all downhill from there on. May not happen always and maybe i was just plain unlucky and that things are not so murky in the world of equity research, but it pays to be very, very paranoid if you a small chap. In any case, smart money gets to see the research report first before mainline media catches it and sends it out for the universe to consume. Furthermore, when the big players trade, they trade such large holdings that when they initiate trades, they typically move markets. If you are the sucker who’s caught the other end of the rope, chances are very high that you’re the small fry who has come in attracted by the recent news blurb on the stock and are entering the room just as the party’s ending and the biggies are leaving. Best bet for the little ones – do not rush into acting on every thing that you hear or read.

Worst off are the ones caught in the middle – i.e. ones between the retail rats and the fat cats; the higher net worth individuals who do not consider themselves to be small and ergo turn over their capital to professional wealth managers or bank/broker dealers. Sometimes, unbeknownst to them, their money managers may resort to excessive churning of the portfolio in the lure of commissions. In this regard, the stock turnover ratio has been commonly used to measure and keep tabs on such fleet footedness, but really it is another ratio – the commission to equity ratio which is a better way of measuring the impact of excessive trading in a very direct way, i.e. the cost impact.

The chart above shows how often I have traded over the past 10 years.

Abortive Gold Trade

Of late, the NIFTY has been climbing up while Gold has been dropping. When I looked at the short term technical charts of NIFTY and Benchmark Gold Bees Index (I am long this index on a long term basis), I had an idea – to short the NIFTY and go long on Gold. So I chewed upon this trade set-up idea this weekend and finally perished the thought. Interestingly, my gut-feel (aka intuition or 6th sense) is a biased coin. When I have relied on my inner voice and followed the thought or idea that has sprung to my mind first, I have generally found myself to have chosen wisely. But this is generally related to work related and other decisions. Now, investing is certainly not about which-turn-to-take-from-Masab Tank type of inner voice invocation. So, it is not surprising that for me, when it comes to investing gut-feel, usually my initial gut-feel reaction has always tended to be dead wrong!!! Quite a personal contrarian indicator.

The chart alongside shows the 7.45% return of the NIFTY over the trailing 12 months against the very significant 16.25% returned by the Benchmark BeES index. The first half of the trailing calendar year has generally seen gold prices moving in lock-step with equity prices. From February this year onwards, the correlation has turned mildly negative which is what seems intuitive. So, commodity prices being the primary fuel of the stock indices has ceased to be the case for now as metals and of course, oil contracts. As I read up more on the internet, I figured out logic and reasons for why my initial gut-feel spawned trade idea was bad. On Gold, with Greece passing austerity measures, there is less of a motivation to look at gold as a safe haven in the very short term. So, it is likely that the coming week will be bearish or directionless for the yellow metal. Moreover, the US markets are going to be closed on Monday (4th July) and therefore gold could continue going the “buy the rumour, sell the fact” way down. On Thursday, the ECB and the BoE will have interest rate decisions announced and Friday will see the release of non-farm payroll data in the US. Therefore, it is unlikely that traders will take a strong view before these data points are clear.

So, if you look at the above chart, my hunch is that during the coming week, the gap between the yellow line (proxy for Gold) and the NIFTY will narrow down. Even if it doesn’t, no big deal for I have done the best thing that practise has taught me re investing: ignore my otherwise extremely reliable inner voice when it comes to pulling the trigger on investment decision making. Even if my intuition is proved right, at maximum I would just be guilty of an opportunity loss. Trade idea postponed, if not entirely killed, to next week now!

Structured Equity Products

First things first – daughter gets through the national round of the spelling bee that was held in Kolkata. International round is next.

Yesterday, someone asked me to analyse a structured equity product which the wealth management group of a well known private bank had pushed for his consideration and possible investment. This was a “structured” equity linked debenture with a pay-out in the form of a knock out barrier option. If I have not lost you yet and if you aren’t KO’d, you may want to take a peep at the term sheet here. In a nutshell, what this instrument is saying is that it’ll pay you regardless of the NIFTY tanking down. If on any of the predefined monthly observation dates, the NIFTY breaches a preset barrier, then a knock out event would have happened and investors will get a fixed return of 27.5% for 24 months.  This is equivalent to investing in a fixed income instrument (bond) that gives an annual return of 11.4%. Note that with QE2, and a new wave of cheap US money expected to flood our markets the chances of the barrier getting knocked out in the short term remains extremely high. so then all that this means is that you are holding a pure fixed income instrument. The hastily scribbled payoff diagram above tries to show what I think this gives us.

“Structured” equity notes seems to be an INR 15,000 crore industry having been introduced only 4 years back in the Indian market. These class of products are quite popular in Asia and with increasing volatility expected due to increasing wads of hot money coming down to Asia, the popularity of such instruments should grow. That is really a problem since it does not seem cool to buy these things. Why? Because these are just plain and simple fixed income instruments at heart masquerading as sexy and exotic equity junkets. The annual yield of 11.4% really does not look quite cool when one considers A) the prospect of interest rates rising locally as the RBI grapples to control inflation and B) the management fee of 2 – 2.5% that such structures entail. Just 9% after taking out the fees. Also, this is not risk free for it entails taking on the credit risk of the issuer. There is no liquidity as well so the managers of such structures do not have much of a duration risk to manage – so what for this 2 – 2.5% fee? That fee, really is to justify the enormous amount of finacial acumen and spreadsheet crunching calculations that goes under anything that swishes using guiles like “structured”, “Knock Out”, “Barrier”, “Participation” etc. Investors who put their money behind such ventures must be feeling really hep and smart about themselves. Imagine having protected your capital (ok, not all of it, 97.5% perhaps 🙂 ) and also participating in the run up of NIFTY. Wouldn’t such males love to brag about it to whoever cares to listen – if some female ears patronise their trumpeting, then all the better! I don’t think I’m stretching the issue – do a random survey, I can bet my widgets that the proportion of investing females that pick up this product would be far lesser than the proportion of investing males that do the same.

SEBI made capital protection on such instruments mandatory some time back, so that lends some saving grace for such macho investors. Thankfully, most ticket sizes (i.e. face value of such debentures/notes) are 1 lakh plus so that means that macho men of modest means will not be able to participate here. Which is good, but then there was this CIO of an asset management house making a case for peddling this for an investment level as low as INR 5000! Wow! That makes it a mass market structured kill! That was from an article that was published in early 2008. In fact the more noise about such products more are the chances that we might be nearing really overbought market levels.  The point behind introducing a sexist angle to this barrier is simply to make a strong point in favour of restricting investing to products and asset classes that one understands. I know most of you would agree that there is nothing hep or cool about buying such notes, but I also do know that if some of you did buy it under whatever compomising situations then a part of you would trumpet. Avoid that. The process of amassing wealth through investing is utterly boring and almost emasculated, if I daresay.

The latent desire that such products seek to serve still needs addressing though. You have a section of the HNI/well heeled type of investors who get edgy whenever the benchmarks seem like peaking up and there is an increase in volatility. The psychological weightage that such investors apply to the act of capital preservation becomes higher. Which is again correct. But I kind of disagree in getting blindsided by the hype around these products and only using such notes to achieve that end. 9% return. Investors would be better off buying a high rated bond (of similar maturity)directly. Picking up a balanced mutual fund might require active monitoring of the fund managers’ actions (since a rising market might invoke some managers’ to increase their allocation to equity in a balanced fund making the risk – reward ratio lean towards the risk side). If you must do something whacky, then take a look at the crude payoff diagram of this structure that I have shown above. What base building blocks can be combined to create something similar to this?

An option strategy called the bull call spread, where one buys an at the money call and simltaneously sells an out of money call at a strike that is around the participation rate of the above structure should achieve a similar payoff. The quantity of options should be scaled up depending on the participation rate of the structure. The net premium paid will be one part of your investment. The balance can be put to work by buying a simple fixed income instrument. And you are home – your manliness intact (if that matters to you!). The hitch here could be finding long dated options – most of you would be using common online trading screens of retail brokerages and the max that you’ll get is a quarter’s look forward. This is something I have not explored myself but what I suggest is that next time your banks’ investment planner or relationship manager calls you, instead of finding an excuse and disconnecting ask that person to give you quotes (i.e. premiums) if you were to purchase/sell long dated options of NIFTY. The premiums would be high, no doubt – but I don’t even know how high. So, it’s a line that at least I am waiting to pick up. Will the bank really negotiate hard for me and try to find me a good deal? Will my notional be high enough for anyone to be really interested in? Does my bank have a prop trading arm where they are be a counterparty to my macho designs? I don’t know the answers to any of these questions – but yes, I am interested in long dated index options, if cost effective.

When to Sell – Part Two

In my post titled Portrait of a Portfolio, I had talked about my conscious shift towards a higher frequency of trading since the start of this calendar year. A lot many informed voices were then pointing out to increasing choppiness and therefore the need to be nimble and hit the right spots in terms of stock selection. The standard ham was “India is a growth and domestic consumpition driven story – long term trajectory remains upwards – but there is a lot of pain in the international markets – higher volatility is expected – cannot predict what the market will do by end of 2010 but stock specific action will abound”. Since I personally agreed to this prognosis and also since a relatively high frequency style of trading/investing suits my personality, I applied this mantra not just to that Portfolio I talked about on 7Oct’10, but to the entire block of personal capital that I ‘play’ with.

A natural consequence of the rapid churing out of my positions is a sharp reduction in the average holding period of my trade positions. These days I have been holding my positions for an average of 45 – 60 days only! This is in stark contrast to the 500+ days positions I normally used to have prior to the crash of the previous year. So, as part of the ongoing effort to gather insights on the best method of selling out, I tried to look at the relation between the returns that I have earned and the time I have spent in nurturing my trades. I took all the 306 odd closed trades that I have on me since May’03 and tried to stack up the (weighted) average returns across the corresponding holding period in calendar days. The chart shown on the right is what came about. The picture in inset shows the same chart with the full range of the y-axis (representing % returns) – I could not resist blowing my trumpet on the 18 bagger investment of mine which I held on for a good 978 calendar days. It was not a black swan – though it is an outlier on the chart – there was logic and conviction backing that trade all the way. I really don’t know if it’s just poor me or even other market players are currently feeling that the age of finding such skyscrapers has passed us by. Anyways, the main body of the chart is squeezed into a narrower vertical range to bring out more detail on the other trades.

Some interesting observations and takeaways come about. I guess, some of these might be applicable to you as well since like it or not us amateurs seem to be cut from the same cloth:

  1. There is clearly no optimum holding period, but in the past 7 years or so the longer term holds win. They have the potential to compound much faster than the market. I spent a few minutes trying to isolate the high yielding tenures and checking if some logical pattern applies to the number of these days. Fibonacci Series? Nope. Prime (numbers) days? No. Numerologically significant days? Absolutely not! What is abundantly clear (at least to me) is that longer the hold, better off you will be provided you keep monitoring and assessing the position every now and then. Personally for me that is a challenge. See, when I started investing, a 3 year time horizon represented 11% of my lifetime! For someone like a WB, a 3 year hold represents 3.75% of his lifetime. The concept of time, patience and maturity is different. However, I cannot wait to grow old to hold for longer time periods and therefore compoung well and high. Who’ll have the inclination to purchase a Ferrowatch at age of 80! And as Adam Smith said, “In the long run we are dead”. Therefore, for me another takeaway from this data representation, though oblique, is that invest when young but think like an octogenarian. A smattering of maturity ahead of one’s chronological age might be the most important thing – apart from luck.
  2. Then there is the importance of stop losses. As I mentioned in some of the previous posts, for an average investor like me, with a full day/late evening job it is impossible to pour over balance sheets, interview managements (ha ha), overlay companies’ prospects in the context of larger economy and all that ‘bull’. I am also not the kind of guy who will read a research report from a brokerage house to invest. Not for me the kind of consensus building investing that some kind of people prefer – call up a hundred contacts from your phone’s address book and bounce an investing idea off them – and if most agree, then invest. My phone’s address book is quite impoverished anyways. So I guess what works for me is a ruthless culling off of losing positions – regardless of the long term, hidden value spiel. As long as the general trend of the local economy is expansive I am cool. This inbuilt bias in equity markets to rise tells me that while such an edgy response to volatility/corrections may not result in the most optimal of returns I think I will make enough to take care of the added burden that transaction costs and taxes place on such behaviour. That’s what I am thinking right now – but remain open to change my view as I “mature”.
  3. One last point regaring the sea of red at longer holding periods. This is my personal example of loss avoidance – of ego triumphing over prudence. Of imprudent youth putting false hopes of a turnaround. An example is the “Stupid Mining Company” trade of mine – when price falls, you just don’t care if it falls another 20% – 30% more, right? How does it matter? A loss is a loss. It was at a particular level once, it will surely climb back and beyond, right? Well, try plotting your own personal chart like the one above – then ask yourself these questions again. The fear of booking a loss is something I think I have hopefully gotten over now. And one should know when to call it a day. While my personal data may not be representative, the reds are concerntrated towards the right of the chart. That’s poor management of capital indeed! I guess what I am implying is that a dud can be spotted in a year or two – it does not require more than that (even if you are the oldest, most “mature” value junkie) to pull out one’s precious capital and put it to work elsewhere.


Portrait of a Portfolio – I

I have been managing an equity portfolio for someone since the past 5 – 6 years. While the returns over the past 6 years or so have been just about acceptable (CAGR of 17%), not much advance planning went into it. Of course, I do spend a lot of time in assessing and worrying about the positions (mostly direct equity longs) but there were no targets or goals till the beginning of the current calendar year. I can be quite cavalier about my money and take risks and yet not lose an iota of sleep even if I end up deeply and irrevocably in red. I once remember dunking 50% of one of my annual bonuses on a stock only to see it dropping 80% in value in the months to come. That was some years back and I still flinch whenever I come across that company’s name again. I had done almost everything wrong in that trade. I now always keep a printout of the chart (see the grotesque graphic above) of that trade at hand to serve as a grim reminder. I’ve not repeated that mistake yet. A set of scathing and self berating doodles are annotated on the chart and a bit more mature post mortem occupies its place of pride in my trading journal.

But it was my money and I had no qualms in losing it. With someone else’s money however, the game is completely different. There is a lot of responsibility and fear when you realise that the person has reposed not just his/her funds, but his/her trust in you. I do not know if professional fund managers think like this. They should, in my opinion. Recently there was talk of allowing the National Pension Scheme (NPS) to invest a small portion of its funds in the equity markets. The logic is impeccable – domestic, sticky money can be routed to the ever hungry infrastructure sector and its reliance on Foreign Domestic Investment (FDI) can thus be reduced. Point to note being that the country has not done too well in terms of attracting FDI this year. The Foreign Institution Investments (FII) that have been propping up the local markets to dizzying heights are not the same as FDI. I think everyone agrees that there is a Schwarzenegger sized opportunity in India’s infrastructure sector. I guess obstinacy and arrogance have stalled that move. Or is it could be that a similar sense of heightened anxiety and responsibility over playing with the public’s money is keeping the boring pension funds away from the capital markets? Bull!

Coming back to this portfolio that I manage: the advent of 2010 saw all the stock market experts proclaim the new year to be range bound and choppy. All surprisingly chorused that stock specific action could not be ruled out however. Given the avalanche of such advise, I decided, for the first time to have a calendar year end target for the portfolio. The return expectations being very sensible (15% per annum), my target therefore is to grow the portfolio by 17.65% between the period 1Jan’10 to 31Dec’10. Given the range bound prognosis of the local experts, I realised that frequent trading by booking short term gains and doing this a multiple times over will be key to reaching the target. Since we pay 15% as short term capital gains tax on equity profits, the 15% target was scaled up to 17.65%. This translates to a tiny 1.364% per month. Easy? That’s what you think! Not my experience really. Brokerage charges were not considered – but these would be offset by the fact that there would be some (non taxable) long term gains and that the effective tax outgo would be less than 15% of the net gain since some interim short term losses would certainly be available to set off against a part of the short term gains.

The chart on the right shows how I have fared in managing that chunk of money.  The solid green line scripts the movement of the portfolio value while the red line is the NIFTY. The light green bars climbing up from the x-axis depict the cash position in the portfolio. As you can see, luckily for me, I went all in just at the start of Sep’10 – just before the current climb began! Mostly in frontline counters. The light blue line is the monthly cumulative target line and as you can see I’ve crossed the target (represented by the faint dashed horizontal line at the top of the chart) already. I crossed it on 5Oct’10 with 87 calendar days to spare! So what should I do? Get out of it all, stay in cash and spend the remainder of the year with a big grin plastered on my mug planning and plotting the CY’11 strategy? Hardly. Interesting days lie ahead and much remains to be done. But I’ll feel awful if I dip below the blue line again. Since this time around there would be no FIIs to pull me out. The big mistake for me this time around happened during the onset of May’10. While the NIFTY fell c 8% – 9% during this time, this particular portfolio fell 12% – 13%. The additional delta was on account of a large long call on the NIFTY. And that hurt, I got numbed and I just let theta take control and it was game over very quickly. The only saving grace was that, unlike the earlier blunder of mine (mentioned above; on my own money), a lot of market participants got suckered and lost a lot of money in May this year. So, I had August company.

I’m worried about what will happen to this portfolio for the remainder of the year. A lot of public issues are going to hit the Indian capital market scene very soon and they are expected to suck out money from the ring. The canary is expected to sing loudly in the coal mines this winter. And then a quick round of profit booking by the FIIs cannot be ruled out. The street also looks divided on whether the Reserve Bank of India (RBI) will affect another round of rate hikes. I guess the market will wait for some times for the results to start hitting the newsreels and then whatever will happen will happen. But yes, I will definitely post about how I fared during the first week of next year!

When to Sell – Part One

I’ve been spending some time digging around in my trade journal and trying to understand this. Getting a handle of this very important aspect of investing is one of my birthday resolutions. This study and therefore these series of posts are a set of steps in that direction. I’ve entered into 337 sell transactions till date. The first time I ever booked a profit on a secondary market trade was way back in 05Oct’01 and the latest one was as near as 06Sep’10. To understand more about the when of my selling behaviour I looked at these 337 in conjunction with the market and it’s valuation. I also tried to plot my sales in along time to see if there were clusters of sales happening during particular time periods. I will bother (and write) about the other questions of why, how and what regarding my selling behaviour at a later stage.

For now, I constructed this chart which shows my selling activity during the period spanning Oct’01 to Sep’10. The small green histograms at the bottom show the distribution of my sell trades. Three clusters seem to emerge: Aug’04 to May’05; Jan’07 to Apr’07 and Aug’09 till date. I have started my investing career with a handicap – which might seem like a paradox given the upward ascent of the NIFTY since 2001. What I mean is that my investing thought process has been spawned during a whopper of a bull run. Nearly anything anyone touched during 2001-03 turned to gold. Midases were everywhere, hemlines were getting higher by the minute. Then after that 2008 and the early part of 2009 was such a humbling moment. And a great learning experience. I lost money on a few trades and the flurry of sales that you see during more recent times are my unwinding of those doomed trades as they recouped some of their lost ground. The wicked blue line represents the market – NIFTY in this case. The oscillating orange band represents the value of the market – trailing 12 month NIFTY P/E ratios. If one uses this lens to view the art of getting off the train, then it’s good to be a net seller when the NIFTY’s P/E is above 25. It pays to be a net buyer if the NIFTY P/E is below the first quartile (under or at 15). Currently the NIFTY P/E is around 24 so we are entering hilly terrain – best to tighten up our seat belts. I use the terms “net seller” and “net buyer” since even at exalted heights of market valuation one can find a few lonely bulls rampaging around and likewise the depths of market penury still throw up some bears lying in wait to maul you.

The idea is that statistics and data tell a story about your trading pattern. It is useful to step out of the frame once in a while and see things from a wider time perspective. I guess successful traders need to necessarily have oodles of experience behind them. The best minds in the business have lived through at least a couple of downturns and figured out their behavioural patterns and emotional compass. Also, when you see the picture in cinemascope, a few down months don’t seem all that frightening.

The wise ‘old’ men of investing mysteriously say – buy when you see value and sell when your asset gets expensive. but how the heck does one go about ‘seeing value’? We seem to know/have heard about things like fundamental analysis, discounted cash flows, industry compares, etc. Most of us however, do not have the time to do detailed down-to-the bone analysis of company financials. Some of us don’t even know how to go about doing it. I don’t think that such people should not participate in the markets or run scared of balance sheets and mathematics. I guess what is required for this set (I may fall in this realm) is to develop and consistently use common sensical heuristics with modest return expectations. One such rule is getting in and out depending on the movement of NIFTY P/E as compared to the two control limits as depicted in the chart. You may have a better method – gazing at tea leaves perhaps – whatever it is, I think the key is to stick to it. Economies and therfore the stock markets have a slight inbuilt bias towards expansion and growth. Therefore, the dice is loaded – but only if you stick to the same dice.

I don’t drink tea, BTW.

Urinary Track Investing

Fourteen hour flights can be quite challenging. Faced with the prospect of enduring one such torture during my hop from the JFK international airport, NY to the Dubai airport I tried to prepare as best as I could. I did not sleep much prior to the flight, bought a book (A Million Little Pieces) and decided to lighten myself of some bodily fluids being coaxed out as they were by some good beer that I was gulping down to kill time.

Now, I had a good time in the toilets of JFK! At first I thought I had been incredibly lucky to have been graced by a house fly in the pit of the toilet bowl that I’d chosen. But I had the presence of mind to quickly lean towards my right and peep in the pit of the urinal bowl next to mine. There was a fly there as well! So ignoring the other fly of metal, I stepped back and realised that all gleaming pits of white porcelain had flies sitting in them! What do they eat/drink around here, I thought! I peered into the pot – not quite deep though – to realise that these were stickers of flies! Aha! They looked very real though. So, in this age of financial prudence, I think these innovations play on man’s primordial male instinct best demonstrated by a ceremonial territorial marking ritual accompanied by an emphatic subjugation of any encroachers. Modern male travellers are expected to give in to their natural calls and try to kill the fly when they go about doing their business. This adroit chaperoning of jets (we’re at the airport, you see!) must be delivering twin benefits – A) it keeps the fun centered in or around the intended target thereby minimising the chances of a spillover and B) replacing a worn out sticker of a fly would be cheaper than replaced rapidly eroding cakes of disinfectants and sanitizers. The soccer inspired toilet design on the right also achieves this goal.

I am sure each and every one of my male readers would have experienced and participated in the “avoidance process of natural selection”. But I do have some lady audience and this might interest them as I now talk about some behind the doors stereotypes. The psychology of independence, dear ladies, and a need for marking out a personal territory distinguishes men and is quite well documented in various websites on the internet. If a man comes in to an empty bank of urinals, he will usually choose the one on the extreme end. the next one will pick up the one on the other extreme followed by a middle one getting picked up last. This is not how most men behave when making investing decisions. If you stumble on a urinal along with a Warren Buffett or a Peter Lynch or RJ, I guess its ok to break this rule, but mostly the herding instinct lives itself out in the outside world. Many years ago I used to work in downtown Mumbai and take local trains to get back to my home in the suburbs. If some day I left early (Dalal Street closes at 3:30PM),  i’d invariably come across a gentleman, chewing on chikki and calling up every contact in his phone address book to verfiy the creddentials of a hot tip that he’d received! The need to build consensus before investing/trading is rampant.

Contrarian investing can offer a good edge over conventional consensus based investing. Is today the right time for a contrarian approach? No idea – local Indian markets certainly do not look like that. But the US perhaps, yes. The approach surely works since one operates on assets that are mispriced – both too high and too low. And the good thing is that it lowers the risk in case the investment logic turns out to be wrong.

The second investing lesson which urinals can teach us concerns special situations – mergers, acquisitions, covertible debentures, buy backs, turnarounds, etc. Not many understand, but there is a very high liklihood of discovering money being left on the table in such cases. There are quite a few special situation mutual funds available for purchase in the Indian marketplace currently. Buffett did special situations investing a lot – easy pickings really, if you understood the math and risks involved.  Special situations are highly probabilistic and it’s difficult striking a home run consistently. They end up failing many times – at least for me. South Indian Bank forever remains an attractive takeover target. IFCI’s obtaining of a banking license remains in limbo. Some people talked up the story of PNB Gilts folding up into it’s parent but nothing happened. I feel it’s best to leave special situations to experts. For example, the toilet on the third picture below – built for Spiderman perhaps? The first two seem to be customised for Zohan Dvir and Borat Sagdiyev?

 Following are some examples of special situations. Trust that you will be able to spot, mergers, turnarounds, etc.




Are we done yet?

We are now at a 31 month high for the NIFTY (@ 5590 therabouts)!

And my mood is getting to be optimistically cautious. It surfaces immediately in my latest tweet which in turn was inspired by the recent tweet from Clifford Alvares, an Outlook Money correspondent.

Clifford Alvares Tell-tale signs of the next downturn: Slow-down in daily FII figures; market PE of 24+; unjustified run in small-caps — and free lunches. 5:50 PM Sep 6th via web Retweeted by you

Most of the people tracking and working the markets will be cautiously optimistic now, but I’m a worm. And worms have no spine. It’s getting to be a cacophony of dire predictions and upbeat prophecies. The more one reads and listens and watches, the more confusing it gets. But if you dont read or listen or watch, you might as well invest using your keen sense of smell or touch, maybe. Thats puts a weird thought in the wormy head. I am thinking of taking a leaf out of Curtis Faith‘s “Way of the Turtle“, where two stock market professionals recruited a couple of dozen bright men and women with no prior experience of trading and transformed them into star traders in two weeks flat (or maybe more). The basic premise being that trading is a skill that can be learnt just like any other academic/vocational course and that traders are made not born. So, what I’m going to do is recruit a dozen sharp blind men and women. Then as study material I’m going to give them thousands of historical stock charts converted into 3d, beveling up the stock price movement lines and make them trace their fingers on the line. The charts would run only upto certain arbitrarily chosen past points in time but I would urge my blind charges to carry on the “momentum” of their fingers….the future path which  the fingers take will be compared against actual historical movements and feedback will be provided….. if this experiment of mine ever gets done, then my hypothesis that blind people can make the best technical investors can be tested. Maybe this personal blind worm method of forecasting will work for me. I’ll write a book, become hugely famous and after a hundred years, people will falsely believe that the phrase “momentum investing” was coined off the tips of blind star traders.

The reason for this lunatic ambling within moving average envelopes is that expert opinions are certainly not helping:

The New York Times carries a story telling us all that the cloud of a double dip recession seems to have passed us by while Nouriel Roubini chastises the US economy planners that we are now defenceless against the looming threat of a double dip. A year or so back, if you’d have mentioned double dip to me, I’d have visions of Taj Mahal tea bags and “dip dip dip, and it’s ready to sip. Do you want it stronger, then dip a little longer. Dip, dip, dip..and it’s ready to sip”. But that’s a triple dip – maybe a new challenge worthy for Roubini. But for now, everyone and her pet poodle is talking of double dips:

Double Dip: the pet food of your pet bears. “Dip, dip and it’s ready to slip. For teddy to be stronger, dip a little longer. Dip, dip…and it’s ready to slip”.

I felt that this interview of the equity analyst, Sangeeta Purushottam dispensed some sane advice. It seems to say that there could be money waiting on the sidelines and it could come pouring in taking our local markets to euphoric heights. But the premise operating here is that there is indeed money waiting on the sidelines. Is there? A browse through global investing sites does not indicate a clamour to invest in the much discovered Asian bourses. Indeed, for all that noise about the NIFTY reaching it’s 31 month high, this country performance table by The Bespoke Investment Group is quite educative and humbling. But then the presses in the USA are printing and printing and printing. Strange things can happen.

So I crawled the SEBI website to ferret out FII net flows into Indian equity over time.  I left out derivative data and picked data representing the FIIs’ stock exchange investments and primary market data only. I think the chart speaks for itself. The main question however remains unanswered: is there is more cash coming India’s way via the FII route for the remainder of the year (net inflows)? Since Jan’10, c 60,000 crores of rupees have come into Indian markets via the FII direct participation in equity. Logic dictates that we should definitely get in more for the remainder of the 115 calendar days left in 2010. However, I noticed that typically there are 3 months (modal frequency) that see net FII withdrawals from the equity markets. We have seen two down months this year (January and May) – is a third one coming? So money will definitely be made, euphoria or not, but it calls for nimble trading and investing. That to me is a big problem since I am a worm after all. Any advise will be greatly appreciated.

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