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Rediff.com  » Business » How to beat the market blues

How to beat the market blues

By Devangshu Datta in New Delhi
September 24, 2007 13:34 IST
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Before you become an active investor, remember that the odds are stacked against you.

Quite often, in conversations about investing, one talks at cross purposes. Words like 'risk', 'return' and 'style' crop up. Most people have muddled ideas about these concepts. 

In the broadest sense, style can be classified as either 'investment' or 'trading'. A trader will go both long or short. An investor will not short. Investors can be further subdivided into 'active' or 'passive'. A passive investor is somebody who buys index or diversified equity funds or blue-chip stocks and sits tight rather than doing independent research.

An active investor does independent research, seeks opportunities and buys as often as he finds such opportunities. This could be very often. Or not. Warren Buffett followers are active investors. But they don't buy often and they hold through very long periods.

There are other equally valid ways to invest actively. Another active style is to pick a stock and hold until it hits a set valuation target. If this happens in six months, sell. If it takes two years, so be it.

Then again, those who track cyclicals will try to pick up at the bottom of the cycle and sell at the top. One investor I know is an engineer who focuses on auto and auto-ancillaries. Another cycle-tracker of my acquaintance is a sugar mill-owner who follows the related industries of sugar, alcohol
and paper. Neither holds for more than a maximum of  two to three years.

Which style is most risky -- active or passive, long-term or medium-term? The usual answer is that the active, medium-term player is taking the most risk and the active long-term investor is taking the least. Actually, that's not true.

In terms of costs, the passive long-term investor pays the least if he picks no-load index funds. The ALT pays a little more but he doesn't trade often so brokerages are not too high. The AMT pays the most brokerages because he trades the most.

But cost is not the same thing as risk. The PLT is taking the lowest risk. His returns will always be fairly close to that of the market. The ALT is taking the largest risk. The AMT is somewhere in-between in terms of risk-profile. The 'strike-rate' with the ALT style has to be very high. Implicitly, this involves picking up few companies, all trading below the investor's valuation. Again implicitly, the ALT will hold such an investment or increase commitments if the price falls more. 

The quality of research, the judgment and the confidence levels must be good enough for the investor to back his own judgment against the entire market-trend. His returns will rarely be in line with the market. If he's good, he will beat the street by a big margin. If not, he will take large losses over very long periods.

The AMT's potential returns are lower but so is the risk. Losses on a bad call are relatively lower. Since he's trading more often, he can also live with lower 'strike rates'. Since he can live with lower strike-rates, the quality of research and confidence levels need not be quite so high as an ALT.

'Quality of research' brings us to yet another undefined concept, that of research itself. Somebody who buys every recommendation on TV is researching but the quality isn't high! It's one step better than buying trading room rumours. But it's far removed from the in-depth study of an ALT or even the more cursory methods of an AMT.

Since risks are lower for PLTs, one might assume that the returns would also be less. The amazing thing is, this is not true. Very few ALTs, AMTs, or fund managers for that matter, consistently beat the market. Some of those who do are plain lucky. Or their quality of research and judgment is truly extraordinary.

The 27-year (since inception) Sensex return is around 21 per cent per annum. The 15-year-return is about 11 per cent. The five-year-return is 38 per cent. Even the lowest number is pretty impressive. Do you really need to beat the market to get rich and, do you back yourself to possess the judgment and research abilities required to do so consistently?

Fund managers are by definition, smart investors. They work full-time to find good investments and they control vast resources, including smart underlings. Yet most of them cannot beat the market regularly. If you insist on trying, you should start with the knowledge that the odds are stacked against you.

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Devangshu Datta in New Delhi
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