May 31, 2011

Ingredients and recipes

The idea for this post came from a question from a reader –

Rohit – you gave us the ingredients in the last two posts on banking (see here and here for various factors on analyzing banks), but these ingredients or factors alone are not sufficient. Where is the recipe? How do i combine the various factors to come up with a final decision or idea?

This is a very interesting question, and I plan to publish a post on how I would combine these factors to arrive at a decision.

The analogy with cooking
Most of us have watched cooking shows or would have seen recipes in a book or a magazine. These cookbooks list out the various ingredients with the precise amounts and then they guide you through the steps of putting these ingredients together to come up with a final dish.

Personally, I am an atrocious cook – I can even burn water :). There have been times when my wife has given the list of ingredients and the exact steps and yet I have managed to mess up the dish completely. Even if you are not as horrible a cook as I am, you must have had the experience that inspite of the following the recipe to the T, the final dish does not come out as good as you thought it would.

There is an art to cooking and after all the instructions and teaching, there is no substitute to practice and experimenting. One tends to get better at it over time and there are subtle nuances that cannot be written in a cookbook (which is why old grannies can cook great food, without any formal training).

If you think of it, there is a lot of similarity with investing. I can tell you all the factors and maybe some kind of recipe , but in the end there is no substitute for actually doing it. You may mess it up once a while, but over time if you are interested in the craft of investing, it will work out for sure.

The case for fund managers or chefs
Now that I have decided to bring in the analogy of cooking, let’s take it a step further. Even if you can cook, you still prefer to go to a restaurant to eat once in a while. The reasons are many – variety, better food, less effort etc.

The case for mutual funds or PMS can be similar too. You may be able to invest well if you worked hard at it, but a lot of times you have other priorities in life and would like to hand over the job of investing to a professional (hopefully a good one) who does this full time.

The same logic applies to almost everything else – otherwise we would be growing our own food, milking our cows and doing most of the other basic work too.

The need for oversight
If you decide to outsource some aspect of life, it does not mean that you should ignore it completely. Do you hire a carpenter or a plumber for some job, pay him cash and ask him to do whatever he wants with no oversight from anyone ?

Why should it be different for a mutual fund or a PMS ?

On the other extreme, do you instruct or monitor every nail that you carpenter hits ? Evaluating weekly or monthly portfolio performance is akin to that.

Irrationality in money
The reason the above points raised by me sound funny or absurd is due to the irrational relationship we have with money. A lot of people either ignore it completely (and hope things will work out) or think it is a form of entertainment to invest money / trade in the market.

I can think of only one rational reason for investing – wealth creation. You invest money so that you are able to build an adequate amount of wealth over time which will help you to realize your goals such as retirement, healthcare or children’s education etc. All of the rest – whether you beat the market by X % or find a hot stock is fluff.

By the way – Although I invest my own money, I will never eat my own cooking unless I want to torture myself :)

5 comments:

Bala said...

Hi Rohit

I thought you will give us the recipe so that we can stat cooking...

Nice analogy, I liked the comparison.

Bala

Sachin Purohit said...

Wow..Sanjeev Kapoor/Tarla Dalal of investments! I was almost visualizing you in the Chef's apron and hat, giving us the recipe of a good investment. You disappointed us with talking everything other than the recipe!! :-)))

But rightly said, if there were to be a formula, there would have been no poor man on the street. Everyone would have been a Warren Buffet.

"I can even burn water" was good one! That rules you out from even making Maggi Noodles or a cup of tea.

Rohit Chauhan said...

hi bala
pretty soon ...lets see if the recipe works :)

rgds
rohit

Rohit Chauhan said...

Hi sachin
i cant visualize myself cooking ever :) ...but can make a little of bit of tea ..maggi too tough for me and everything else outside my circle of competence :)

i can however do the eating part well !

rgds
rohit

AJ said...

Hi Rohit,
You have written excellent posts on fundamentals and valuations.
Although I am a trader and use technical analysis as a basic strategy to trade, I still actively track companies on fundamentals.

There are more than 2 thousand listed companies ( I guess )...tracking and finding the financial ratios is a big issue for me.Can't read every companies balance sheet and compare with peers!. Can you tell me how I can scan for companies based certain financial ratios easily and more efficiently.

Can you please list any free online resource that can be used to narrow down the companies based on certain parameters(for example P/E,P/B,P/S,D/E etc) and then going in for a deeper analysis.

All the best and keep up the good work.
Cheers :)