April 25, 2011

You don’t have to be smart often

Lets say you have a portfolio of around 15 stocks, which I think is sufficient diversification for most of us. Now let’s say, you are one of those odd guys who for some inexplicable reason, believes in long term investing – that is buying high quality companies at decent prices and then holding the stock for the long term.

Let’s assume, for argument sake that the average holding period is around 3 years. In such a scenario, you are buying/ selling 5 stocks per year. Now let’s say, you are able to spend around 5-6 hrs each week on searching for decent ideas and are able to analyze 1-2 companies each week. At this rate, you can analyze 50-60 companies each year.

If you look at the above math, you need to smart or lucky around 10% of the time. I don’t consider that as a high threshold.

What wrong with the above logic?
For starters, the above reasoning assumes that you will be able to find attractive ideas on a regular basis – one every 2-3 months. As most of us who have been investing in the market for sometime know that, these things don’t work on such a smooth schedule. Investing ideas tend to come in clusters and in short periods of time – especially when the short term outlook is clouded.

The other assumption is that one will spend a 5-6 hours a week, diligently looking for stock ideas. Unfortunately, I don’t know of any shortcut to make money in the market. A lot of cheats claim to know ‘techniques’ to make money with minimal effort and are able to find enough fools to sell their techniques.

The logic actually works even better
The above logic works even better than what i claim in the post. Let’s say you are able to indentify some high quality companies such as a titan or crisil and make a purchase at decent valuations. Once you purchase such a company, I don’t see any reason to sell the stock unless the valuations go beyond all reason. In such a case, the portfolio turnover drops still further and the number of new ideas required each year is even lesser.

A 60-70% success rate of your ideas, where 3-4 ideas will either make no money or lose a bit for you is quite reasonable. At this success rate, one will still do well on an aggregate portfolio basis.

If you put it all together, I think one needs to pick a successful idea 5-10% of the time or around 1 in 10 ideas evaluated.

The only downside in the above approach is that you cannot share any exciting stories of your stock market coups with your buddies over a drink.

The comparison with trading
I genuinely believe that trading is much tougher game than long term investing. Even if one leaves aside what is required to be a successful trader, the basic math tends to work against you.

Even if you are a moderately active trader and buy/sell 10-15 stocks a year (1-2 per month), the success rate (no. of ideas invested/no. of ideas looked at) required is much higher than a long term investor. I think one has to be much smarter to be a successful trader than a successful long term investor.

Is that what you do?
Short answer to this question is – Yes. I typically evaluate 2-3 ideas each week in some depth and may end up picking just one idea every few months. In most of the cases, it is either some fundamental issue which turns me off or it may just be that the valuation is not attractive enough.

If the idea is good, but the price is not right, then it goes into my tracking list. I tend to review the tracking list once a month to see if Mr Market is offering some bargain on a decent idea.

17 comments:

Vic said...

Thanks Rohit, you summed up your investing philosophy pretty well.

I like how you compare Trading Vs Long term investing from time to time. Nice to see it from different angles.

I hope this effort of yours eventually convinces some folks on the advantages of long term investing.

Also the "temperament" is the key here. Many like the thrill and bragging rights of Trading..:-) Let them have that..hopefully someday they'll learn..:-)

Vikas

JP said...

Nice article. I follow your blog regularly. Keep posting. :)

Jaipal

John said...

Wow, investigating 2-3 ideas in depth per week is very high turnover. I think I spend 2-3 weeks per idea when I'm seriously thinking of establishing a meaningful position.

Ad said...

To me even 2-3 weeks per idea seems pretty aggressive investment. This would mean that one would end up investing in upto18-20 ideas per annum and if your outlook is 2-3 yrs, one would have a pretty long portfolio. Also to me, investing in any company would also mean closely following activities/results of that company, weigh significant developments with assumptions taken at the time of investing and continue tracking. So until, one is really doing this for a living, a portfolio of 10-12 companies is large enough.

Rohit Chauhan said...

Hi vic
thanks for the comment

Rohit Chauhan said...

Hi jp
thanks for the comment

John - my definition of evaluating 2-3 ideas in some depth means having a look at the financials for the last 5-6 years and reading 1-2 annual report. this should generally take 2-3 hrs. so one can have a look at 2-3 companies a week.

this is not enough to make a decision and it takes me a few weeks to do that ..but this much time definitely enough to reject an idea

rgds
rohit

Rohit Chauhan said...

Hi ad
your logic makes sense. in my case, i may look at 2-3 ideas a week and analyse one in depth for a longer period. however i dont always create a position after analysis. sometimes i analyse the stock and file it away till the price is right.
One needs to keep building the knowledge base in advance, so that one can pull the trigger when the time is right

rgds
rohit

Anonymous said...

I am reminded of the proverbial story of the blind men talking about the elephant reading the post and the follow up comments.

It's a matter of what one means by 'idea'. I guess the word idea should be given within quotes. If 'idea' is defined as one only when something is bought or sold, it's a very different thing from an 'idea' which forms part of a knowledge base on which action may or may not be taken, depending on other 'ideas' in the future. The former talks about the whole and the latter about the parts.

The discussion I think should proceed after the above is clear. Once clear, the styles may vary. Like Buffett talks about different investors in 'The Superinvestors of Graham and Doddsville' who with the same approach at bottom, had different styles. For example, Munger held few stocks which Schloss was widely diversified.

The number need not matter, in my opinion, if adequate margin of safety is ensured for the portfolio as a whole.

On trading I think it involves more activity than investment but easier per se, so it looks tougher but in fact much safer if the knowledge of the person doing it isn't much. The following quote by Keynes made me think this way: "It is safer to be a speculator than an investor in the sense that a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware."

Ad said...

Anonymous: Think you made sense in the first half and then really meandered in the remaining. While I would agree that one needs to have full clarity on what he/she is talking about - comparing with blindmen and the elephant is fairly harsh.
Let me clarify, an 'idea' (let me put this in quotes) here means an 'Investment Idea' - which in turn means a clear investment game-plan by an investor who has understood the risk/rewards of this investment, measured it against his/her own benchmarked reward expectations and risk apetite. {As you can see, I differ with the Keynes quote on investor being unaware of the risks.} This could be acted upon immediately or kept in the knowledge base for future actions

Anonymous said...

I apologize if the comparison sounded harsh :(

I request you to not take the connotations that might come up with a comparison. Since it's an offhand reply I didn't take much time to make sure it sounds good.

John said that 2-3 ideas in depth per week is high turnover. You said that it seemed pretty aggressive. It looks like you and John are talking about buying or selling something (a transaction involved). But Rohit clarified that it isn't so and that he meant reading financial statement and annual reports. That's the reason for me saying you guys were referring to the 'whole' and Rohit to the 'part'.

Your recent post is contradictory to what you posted earlier or rather wide enough to include many things. You say 'idea' is the game-plan. This takes 'idea' to a higher abstraction than the two I mentioned. That's fine. I guess game-plan should be the strategy one has (investing long term understanding risks involved), the 'whole' should be buying or selling (a transaction involved) or the 'part', where you analyse information on companies (mkt cap is below book value, below working capital, less than cash held, etc).

How should we interpret your initial comment 'even 2-3 weeks per idea seems pretty aggressive'? Should it be 'even 2-3 weeks per game-plan seems pretty aggressive'? Obviously not, but am saying this to show the haziness of what's spoken about. Or 'even 2-3 weeks for a transaction seems pretty aggressive'? I think this is what you and John initially meant. Or 'even 2-3 weeks for a financial statement analysis seems pretty aggressive’? This is what Rohit meant.

If it was clear for all that an 'idea' was what you have defined it to be, would there be comments and follow up comments in the first place?

You are welcome to disagree with what Keynes says. I gave my opinion. I do agree with him.

Abhishek Nagpal said...

Mr. Rohit, I must say that it is a nice post of yours. Being a Technical Analyst, I luv trading rather than investing. There is every kind of player in the market and it all depends on the objective one has in the mind. I like the patience u have in you for investing. Normally I have seen people jumping in the markets and quite often loose the money.

Well with a final note that you are doing a good job.

Abhishek Nagpal,
http:\\yourstockquery.blogspot.com

Anonymous said...

rohit,

What you think about Gujarat state fertilizers & chemicals ltd.?

Look like a decent conservative company to me.
Regards,
Gian

Sachin Purohit said...

Hey Rohit,
15 days without a post from you! That's a long time. Are you out on a summer vacation?!

Rohit Chauhan said...

Hi anon/ Ad
i thought i mentioned in my post that i look at 2-3 ideas in a week..reason i call them ideas is because if the company is good but not cheap enough, then it goes into the watch list. so even if i dont purchase it ...i consider it as a potential idea which can be picked at the right time.

anyway, i think the confusion was due to the fact that i was not clear enough. anyway will keep that in mind in future posts

rgds
rohit

Rohit Chauhan said...

Hi abhishek
i am really ignorant about technical analysis ..but good to see you here :)

rgds
rohit

Rohit Chauhan said...

Hi gian
i had a look at GSFC in the past. there was profit drop in 2010 ...also a bit concerned about the loans and advances. anyway the valuation appears low ..though i am not a big fan of fertilizer companies due to the pricing control by government. anyway will relook at the company soon

rgds
rohit

Rohit Chauhan said...

Hi sachin
tied up in analysing companies :) just got delayed in the writing up a post

rgds
rohit