January 19, 2019

Building an edge


In an earlier note, I wrote about the three factors which contribute to outperformance (doing better than an index). I expanded on the third factor in the most recent update.

Sources of outperformance
Superior performance versus the indices can usually be broken down into three buckets

a.     Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.

b.     Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models

c.     Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is eroding with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. Ultimately it, depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

An enormous advantage

We started the advisory in 2011. At the outset, we made a few decisions which has made our life simpler and saved us a lot of pain.

-    We will not tout the wins on social media, which are often due to luck and can easily get hit by a random event causing a loss for anyone trying to follow them. If it works well, the person taking the tip attributes it to their genius. If it fails, we are responsible. Considering that the best of investors don’t get it right more than 60-70% of the time, what is the upside other than an occasional ego trip?
-    We will focus on the investment process as that is the only repeatable aspect of investing over which we have some control. We cannot control the outcome.
-    We will focus on the long term as short-term results are prone to random events, but the noise cancels out over time
-    We will not indulge in making fun of other investors when we are doing well. It is stupid behavior and extremely petty. There are times when every investor goes through a bad patch – so what goes around comes around

Some of the behavior we see in the media, although loud, petty and promotional is not irrational. It allows the advisor/ fund manager to get visibility and increase their AUM. In the end, managing a fund is a business and one cannot live on high ideals alone.

The problem with this behavior is the type of investors you attract. If you talk about short term performance and multi-baggers, then you will attract people looking for quick gains and easy profits. The downside of having such investors, is that  they get quickly disappointed when the inevitable downturn hits the market.

Looking for quick gains, such investors join at the top and manage to get quick losses.

For the fund manager, there is no downside. If the market keeps going up, they get to make their fees. If the market drops and they lose a few investors, which is part of the normal business cycle. They just need to wait for the next bull market for a new crop of performance chasers.

Both me and Kedar don’t want to play this game. We are not running this advisory for the good of mankind, but do not like this behavior. In addition, we are in a financial position, where we do not depend on the fees we earn to put food on the table.

Why am I sharing this now after so many years?

The reason for sharing is that a person cannot be rational and make decisions for the long term if that results in career risk. Try telling your family that you took a 5-year view which cost you your job. It is never going to happen.


We have taken this element of risk out of the equation for us. As I mentioned earlier – we do not depend on the advisory to put food on our table. In addition, our own money is invested in the same way as the model portfolio. Put the two together and you will realize that we are willing and able to think long term with a focus on risk reduction.

I think this is a very important edge for us compared to most fund managers. We can safely ignore short term fads (such as the bull market in small and mid-caps last year) and panics and rationally manage the portfolio. This allows us to take bets which are unpopular and hold on to them.

In an age of huge computing power and easily available information, one is unlikely to get a durable analytical or information edge over other investors. However, the third edge – behavioral which is durable and cannot be competed away, is available to us due to the reasons I have shared.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

January 2, 2019

The journey matters


Following is from my recent annual update to subscribers

The journey matters
I wrote about bitcoin in the 2017 update and compared it with small caps and midcaps. Since then bitcoin is down 75%, midcaps are down 16% and small caps are down around 30% on average.

A lot of investors believe they have a lot of tolerance for risk. I can tell you from personal experience, that most of us over-estimate our tolerance to risk, me included. There is a lot of difference between intellectually thinking of a 30% loss versus experiencing a real 30% loss in your portfolio.

For a check, think of how you felt during September when the market and individual portfolios dropped around 20%. These drops have gotten worse emotionally in the recent past due to social media and the speed with which rumors and panic spread. The same 20% drop causes far more anguish now than the past when such noise was minimal. In such a climate, it is critical to insulate yourself from the noise. If you don’t do that, it is likely you will panic at the bottom and make an irrational decision.

One way to insulate yourself from this noise is to know your own risk tolerance. If you think, you can bear a 30% loss on your portfolio – ensure that your equity allocation as percentage of your net worth does not exceed 50%. This will ensure that the net impact on your portfolio will not exceed 15%. In effect, ensure that the actual loss of your net worth is less than half your estimate of risk tolerance. This is a sort of margin of safety on your own behavior in case you have over-estimated your ability to withstand financial pain.

Know thyself
You will find a lot of charts on how companies like amazon have given 25%+ CAGR with 60-70% drops along the way. These charts show the 100X returns a hypothetical investor would have made in the last 15 years of holding this stock.

I can tell you that such hypothetical investors are very very rare and even if they hold this stock, it would be a small percentage of their portfolio. There is an infinitely small number of investors who can buy and hold such volatile companies as a large percentage of their portfolio. Try imagining your entire net worth going down by 80% and still holding on to it.

I am definitely not one of those brave investors. I have a much higher tolerance for volatility and risk than an average person, but I am not a risk savant - an outlier in terms of my tolerance. I have developed a level of risk tolerance over time but have always tried to remain within my limits. I see no reason for testing those limits as I don’t want to be miserable even if I get ‘richer’ over time.

There are no defined limits for risk tolerance. Every individual has to answer it for himself/herself. You will have to do same. One of the best test I have found is the sleep and worry test. If some positions or the overall equity allocation is causing you to worry and lose sleep, then it means that you are nearing your risk tolerance. At that point it makes sense to drop the position or reduce allocation before hitting the limit (and panicking at the wrong point).

I started worrying in late 2017 and hence reduced the equity allocation in the model portfolio. This allowed me to sleep better in 2018.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

November 24, 2018

Missing the forest for the trees


I wrote the following note to subscribers, in context of a specific position. I have made edits and additions to the original note for this post.
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I have a different set of expectations from this position. The management of the company is quite conservative (rightfully so) and as a result has always grown at a measured pace without taking on too much debt. As a result, the profit growth has never been too high, but at the same time the company has always been profitable even in the worst of the times.

Due to this cautious approach, we cannot expect this position to be a multi-bagger any time soon. 

Although a lot of subscriber still look at individual positions, I prefer to zoom out and look at the aggregate portfolio level. We are not in multi-bagger business where me and kedar will run around touting our wins on social media.

Our focus is to achieve above average returns at the portfolio level with lower risk over the long run, to achieve our financial goals. 

Mania of the multi-baggers

The last three years have been all about multi-baggers.

The Media is usually fixated on multi-baggers and short term price changes as that grabs attention (which is their sole focus). Unfortunately, a lot of investment advisories and so called gurus are the in same boat. It is not too difficult to see the reason – you need to make big claims to grab attention and clients.

Touting a low risk, steady compounder which doubles every four years is not going to win too many fans and subscribers/investors. As a result, the focus of the industry is to talk about high returns and multi-baggers in the portfolio, ignoring the risk completely. 

On this count, I will not blame the media and financial industry alone for selling dreams to the general public. A vast majority of investors (if you can call them that) are searching for shortcuts to become rich quickly. Media and a lot of professionals are merely satisfying that demand.
One cannot run a business on high principles alone.

Missing the forest for the trees
In selling, what is being demanded, the financial industry ends up ignoring several other key factors which drive returns over the long run.

The key point in investing is how well are you doing at the portfolio level and if the return is commensurate with the risk. The individual wins and losses are a driving factor but not the only criteria. Overall risk driven by position size and diversification plays an equally important role. I find these aspects of investing missing in most discussions.

If you agree with the above point, then you should also consider the lower risk, moderate return ideas. In the past, I have not allocated as much as I should have to these kind of ideas as they do not have the dazzle and fireworks. However, I have slowly changed my thought process on it.

A part of the portfolio should be allocated to such low key, solid performers which act as a ballast to the portfolio and deliver decent returns over the long run (with much lower stress). This is now becoming apparent where some of the past multi-baggers have left investors holding the bag.

Confusing the means (multi-bagger picks) with the end (achieving financial goals via equity investing) had led to investors achieving neither.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.