Spent 7 years in the market
Here are five things I wish I knew back in 2016
I was 18 when I purchased my first stock. Seven years later, I'd like to believe I am not as naive and have picked up a thing or two. Here are five things I wish I had known when I started my investing journey.
Disclaimer: The following list outlines five personal lessons learned from my own experience in the stock market. These insights are shared for educational purposes only and should not be construed as investment advice.
1. Finding an edge?
I found out while working as a buy-side analyst that most well-run asset management companies (AMC) have incredible access to data, financial models, and management. Having the ability to discuss a business with the person who runs it almost seems like a cheat code.
It will be hard to compete against an AMC if you think you can get better data, models, or access to management. What we can compete on though, is time.
Mutual funds, PMS, and other products usually earn money through their expense ratio which is a function of their AUM. The more money they get to handle, the more they earn. So the question becomes what makes someone pick a particular MF?
The answer seems to be historical returns and alpha. If for 3 years you see an MF deliver 15% annualized whereas another delivers 17% annualized, you think the latter looks better. This simple mindset leads most MFs to think in the short run. They simply cannot sit and take calls for 5-10 years. After all, if they take a 5-year call and underperform for the first 3 years, they aren't really looking good to the public. Also, it’s hard to sit through that underperformance when others are doing well. Again, they are not wrong. It’s just that everyone is obsessed with short-term returns!
Fortunately, this presents an opportunity for retail investors. Assuming we are armed with knowledge and conviction, we can take those 5-10-year calls and endure short-term underperformance. Unlike asset managers, we're not pressured to raise funds. While it demands unwavering conviction, it's a strategy within our reach.
Time is an ally.
2. Process
I love Michael Mauboussin's book, "The Success Equation." Especially the idea that -
Outcome = Skill + Luck
If you focus solely on the outcome, you are disregarding the fact that luck could have played a role in that outcome. Therefore, you need to separate luck from the outcome and then determine if the "right" decision was made. You need to focus on your investment process rather than the investment outcome!
The process could include having a checklist, running DCFs, talking to people who oppose your view, etc. For instance, one addition I have made to my investment process is jotting down the exact reason "Why I bought a particular stock." It could be just 3-4 lines, but I write it down.
It could be something this simple! The point is to come back to this and not judge myself solely by the stock price.
3. Fighting biases
We are biased. So so biased and so so stupid. Fortunately, we are blessed with the awareness of our stupidity and hence can tackle some of it by refining our investment process.
Worried about Hindsight bias - Have a journal
Worried about our illusion of attention - Have a checklist
Worried about the anchoring effect - Don’t stick to relative valuation only
Just the idea that while we might not be able to control the market, we can control our actions to the market is powerful. Again, not saying everything can be eliminated through process. However, being more aware of our stupidity should help. (I mean I hope so!)
For more on biases, consider reading Thinking Fast and Slow by Daniel Kahneman.
4. Reverse DCFs
When I started investing I took Aswath Damodaran’s course and I absolutely fell in love with the concept of discounted cash flow analysis (DCF). Still love them. However, over time it’s obvious to see some of their limitations. (Or rather our limitations in predicting the future)
When do I assume the company begins growing at the terminal growth rate?
What should terminal growth be? If it’s linked to the risk-free rate, then it could move quite a bit, given how the risk-free rates have been moving.
What do I even take for the cost of equity? Does that change in the terminal period?
Again, not saying there are no answers to these questions. However, my faith in those answers has waned over time. And for all those reasons, I like the idea of reverse DCFs now. Matching our model to the current price gives us some idea of what the market is expecting. Knowing this allows us to take a call on whether we expect something other than the market!
Again, it’s far from perfect, but I think I can live with it.
5. Base Rates
Predicted that the market would fall in 2020? Predicted the virus? Predicted the recovery? Predicted oil prices going negative? What about the Ukraine crisis? NFT craze? I could go on, but I suppose spending active time in the market has made me realize that prediction is a sucker’s game. Or at least it’s not my cup of tea.
More power to you, if you can! What I do focus on though are base rates. Base rates are historical data that provide insights into how specific market metrics or conditions have influenced past outcomes. While the past never plays out exactly like the present, having some base rate numbers, especially in times of uncertainty can be incredibly beneficial.
For instance, the Sensex, over any 5-year period from 1986 to 2023 has delivered a positive return close to 90% of the time. (Rolling returns. Calculated using Google Finance data)
Just knowing this provides some level of comfort, especially when the markets are tanking like they did in March 2020. It helps in potentially being a little more braver to take a contrarian bet. The trouble in Indian markets is that we don’t have enough historical data to cover various economic scenarios of the past. Nevertheless, we use what we have!
Base rates extend beyond just market valuations and returns. They can also apply to various fundamental metrics. For instance, 10 years ago the Indian market had 385 companies above the market cap of 1000. (Screener.in) Of those only 34 were able to grow their sales over the past 10 years by a median of greater than 15%. That’s just 8.9% of the companies. So if I am running a DCF where I am assuming 15% growth for the next 10 years, I should be aware, that this is a very rare instance so much so that historically in the past 10 years only 8% of companies have delivered on it.
(The actual number may be lower due to survivorship bias)
For more on base rates I highly recommend you check this out by Mauboussin.
That’s it for now. If you made it so far, thank you! Consider subscribing if you haven’t yet.
Superb piece!