Choosing Passive Investing: Why I Don't Pick Stocks
Stock markets are intellectually very stimulating, with some of the brightest minds on the planet competing to make money. Constant price updates on the screen give a rush that is hard to match. A chance to make tons of money in a short period is too tempting to not try.
Like everyone else who has dipped their feet in the markets, I too thought it could not be too hard. I was too naive to know better, and have lost money, and wasted time, as a result.
With age comes wisdom, they say. I have realized that I have a higher chance of accumulating wealth being a passive investor than figuring out the next winning stocks. Passive investing also frees up my time and mind for other things that I care about. Let me walk you through why I no longer try to pick individual stocks.
To make money picking stocks, one needs to get a few things right: valuation, time horizon and bet size.
Valuation
From Finance 101:
A business is worth the present value of its expected future profits, minus its obligations
Owning a share of a company entitles you to its profits in perpetuity, but you need to pay upfront–the share price–for that right. Since one can only make money by buying something for lower than its worth, unless you are playing a Ponzi scheme, the price you pay today must turn out to be lower than the sum of all the profits in perpetuity, adjusted for time value. Otherwise, you would have been better off keeping the money to yourself.
The definition tells us something crucial: Past is irrelevant; the future is all that matters. Past is of consequence only as an indicator of the future, and that too not a particularly reliable one. If the quarterly earnings reveal that the company is performing amazingly well but just not as good as previously thought, the future profits too would likely be lower than believed. This necessitates a price adjustment and is the reason why stocks at times behave seemingly counterintuitively: crash despite the company announcing excellent profits.
Also notice the expected, from the world of probability, in the definition. A company could do unexpectedly well in future or, various risk factors (internal or external) could negatively affect the companies’ growth or margins. Your analysis should not assume the best or worst case but realistic probabilities of these and everything in between. If it portrays a picture drastically different from the current market price, you should double-check. There is usually something that the market, as a collective, knows and has incorporated into the price that individuals tend to miss.
Following are some conversations I have heard from people around me:
- Salman Khan’s upcoming movie will be a blockbuster hit. Few other mega-budget movies are also releasing this quarter. Inox and PVR would make a lot of money.
- I see the latest Maruti car a lot on the road these days. It is an absolute hit. The stock would do great; I am buying.
- Investment in infrastructure is going to be critical for India’s progress. Infrastructure companies would make tons of money. I am accumulating L&T and GMR Infra for the long term.
These seem like reasonable arguments for buying shares of these companies, right? Problem is, this is simplistic, 1st order thinking. There is an age-old saying on Wall Street: “what everyone knows is not worth knowing”. Are you amongst the first ones to have noticed this? Probably not. Pre-bookings for a new car are known before it hits the road. Expected release dates for big-budget movies are often announced years in advance. Every investor tracks government announcements for infrastructure projects in the annual budget. These developments will benefit the companies, but they are not reasons to buy their shares. The market, in all likelihood, has already factored in these events and the price will not increase when they actually happen.
Brokerage firms such as Stockal, Vested, INDWealth do a disservice when they pitch US investments to Indians as a chance to invest in their favourite companies. Favourite companies should not necessarily be favourite investments too – price matters.
The world is dynamic, changing every day, and this affects inputs (margins, growth rate, interest rates, risk factors etc) to the valuation model. You need to revisit your analysis every now and then to make sure that it still indicates the same call-to-action.
Time Horizon
Your analysis concluding a mismatch between a company’s true value and current price may be on the spot, yet you may lose rather than make money. Being right is not enough; the price needs to move in your favour. The price will move when the rest of the market agrees with you, which could take a lot longer than you had budgeted for.
Famous economist John Maynard Keynes said, “markets can stay irrational for longer than you can stay solvent”. Are you willing to put your money to test for 1 year? 3 years? How about 10? Chances are at some point you would become frustrated and sell, often at the worst possible point. In general, shorter the period, lesser are the chances of price reaching your target.
Warren Buffet does not invest in businesses with a predefined time frame, say of 3, 5 or even 10 years. His favourite holding period is “forever”.
Bet Size
Let us consider that you found an undervalued company, and you have a long enough horizon, how much would you make? If you practise sensible risk management, you would not put more than 20% of the total in one investment. If that stock increases by 50%, in say 1 year, your portfolio will be up 10%, which is wonderful. But if you put 5%, even doubling–which is rare–will bump up the total by only 5%. You will need to be right about many more companies to come out ahead. Keep in mind that shares can and do decline 90% or more in value – DHFL, Yes Bank, Zee Media etc being recent examples. Chasing down “value” in one such loser can erase years of gains.
Cherry-picking your winners can lead to a false perception of skill. Returns must be calculated on the entire amount you have earmarked. It should include the money put in loss-making picks as well as the portion that sat idle in your bank or brokerage account awaiting perfect opportunities, which never came.
Even absolute returns do not tell the whole story. Performance should not be measured in isolation but relative to appropriate Total Return Index 1 benchmarks, say Nifty 50 Total Returns Index . If your portfolio is up 12% but markets increased 15% during the same period, that is not a stellar performance.
If your reason for investing in a company is not supported by a detailed analysis justifying a higher valuation or if you do not have a long enough time horizon, you would be gambling rather than investing. Risk should be managed by appropriate allocation amongst various companies. Bet too much on a single company, and even small declines can wipe off gains from the rest of the portfolio. Bet too low, and you may not come out ahead even if you were correct. Also, always measure performance against relevant benchmarks.
Getting all these three correct is hard, even for professionals. Nearly 7 out of 102 of large-cap mutual funds in India failed to beat the markets over the last 10 years. Fund managers running these are smart, educated (from top-tier B-schools, CFA charter-holders etc), and often with decades of experience in markets. They have an army of analysts working for them and have $24,000/seat/year Bloomberg terminals at their disposal. Stock picking is their full time job, and they still failed. What is your edge against the markets?
A Total Return Index assumes that dividends are reinvested, and hence provides a better picture of performance ↩︎