A prominent research house gave a bearish call on the market at the end of February. Despite the Index climbing over 16% in the past 2 months, the firm stuck to its guns. However, last week, the firm reversed their bearish call, and suggested their base case now was a market 10% higher by March 2017.
The change in forecast resulted in searing criticism from investors who feel they have been taken for a ride “by experts”. But is the research house to blame or are investors themselves responsible for not knowing the rules of the game they are playing?
Investors are bombarded with non-stop commentary and contrary opinions (sometimes from experts within the same firm) on what’s best for investors. Top 5 trades of the day, top picks of the week etc. etc. It is critical for each one of us as investors to define what will be our investing “North Star” or guiding principles and then act to shut out the noise. Defining your guiding principles is too critical a decision to be left to advisors.
The following questions may help define your North Star
• Are you playing for a short term move or a long term gains?
• Can you trade short term and invest long term at the same time?
• What is the pain you are willing to bear?
Are you playing for a short term move or long term gains? The chart below shows the Indexed value of the Sensex and Sensex EPS over the last 21 years. It shows clearly that stock prices follow earnings growth over the long term, even as in the short term the market seems to have a mind of its own, running above or below fair price. Note, this time period includes the Kargil war, the 2000 dot com market meltdown, the 2008 financial crisis, multiple Govt. at the centre and time periods of significant political uncertainty.
Forecasting short term movements within this larger picture is a mug’s game. Why so?
• There are too many variables which influence short term direction; each day new ones get created, and others lose relevance. We do not have the wisdom to comprehend the tail winds or head winds of unknown variables.
• We do not have models that predict the interplay of these variables and what influence they have on stock prices in the short term
• The trader has a false implicit assumption that markets will behave rationally in the short term.
In this video, Mr. Udayan Mukherjee, former high profile anchor of CNBC-TV18, is quite candid that experts and anchors trying to forecast market levels, actually harm the common investor. He also states that it is impossible to forecast short term market direction
Can one trade short term and invest long term at the same time? In an investment career spanning over 10 years, I have met very few people who have been able to demonstrate both the above skills, simultaneously. Those who do, maintain separate trading and investment portfolios. Successful investment requires a deep conviction, often against the tide. Successful trading is price dependent, not opinion dependent as you have to cut losses to conserve capital. Moreover, frequent trading activity results in not only high transaction costs and taxes, but also reinvestment risk. In the example above, those following the research firm advice will perhaps enter the market 16% higher than when they exited
“What is the pain I am willing to bear”? Long term investing is tied to the hip with the frequent pain of “notional losses”. But most participants are unwilling to accept the pain of seeing your Capital below the initial invested price. Unfortunately, it is impossible to earn the long term returns without suffering this pain. Hence, it’s critical to define your pain threshold and invest accordingly. (Technical jargon, get your “Asset Allocation” right)
In conclusion, we recommend one not mix trading with investing. We recommend your investment principles be “spending time in the market by investing in companies which have longevity of earnings growth, and are available at reasonable valuations”. As markets could deviate significantly below fair value, money needed over the next 24 months should not be invested in Equity markets. If you can stick with the above resolve, and ignore market corrections, the compounding power of earnings should give you a great result. You will then not need to succumb to the lure of short term gains obtained through trading.