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The psychology of stoploss

By Rohit Chauhan
In Advisory letter
2 months ago
4 Min read
T

I wrote this to our subscribers recently. Hope you find it useful

Why be cautious

It is easy to swing for the fences. If we had been fully invested and had higher allocation to some positions, our returns would be higher. However, I have been a proponent of the principle – The number one goal of investing is survival.

This does not mean we won’t lose money at the position or portfolio level from time to time. Our goal is to have losses from which we can recover financially and psychologically. Most investors underestimate damage to the psyche after a huge drawdown. All high return strategies appear great in hindsight, but usually have 50%+ draw downs in them. It is easy to see such drawdowns on paper and completely different to experience it.

I am certain that less than 1% of investors can tolerate a 50%+ drawdown and continue to invest in the same manner as before. Most throw in the towel, never to return to the markets. There is no point in following an approach you cannot stick with, especially when the going gets tough

The psychology of stoploss

This is another change we introduced in the last few years to manage risk. I never used a stop loss for 20 years and found the idea contrary to buy and hold. If you plan to hold a position for the long term and it drops in price, then it surely is cheaper, and one should add more?

We have done that in the past, before we got hit by a few failures in 2018 and 2020

As I mulled over this issue, I realized that buy & hold works only as a special case – my analysis is correct and there is no change in the underlying thesis. In these failures, I got the analysis wrong, or the thesis changed. Holding onto such positions is financial suicide

We review a host of fundamental and technical factors to arrive at a stop loss number, which also depends on the type of setup. A long term buy and hold position has a much wider stop loss compared to a momentum stock

More than the number though, a stop loss acts as a line in the sand. It allows us to exit the position and look at it at a later point without any baggage.

The most important benefit for us is psychological. It has allowed me to be more aggressive with new ideas as I know that our downside is capped. In absence of a stop loss, the downside risk would have me worried, and we would often miss the idea. In other words, the idea of stop loss has been mentally liberating

Disclaimer

  • This report is published by RC Capital Management – SEBI Registered Investment Advisor (INA000004088).
  • This report is for educational purposes only and should not be construed as an Investment Advice.
  • RC Capital Management may have recommended the above stocks to our clients in the past. However, this is not a recommendation to buy / hold / sell the stock at the time of publishing this report.
  • The securities quoted are for illustration purpose only and are not recommendatory
  • RC Capital Management may hold position in any of the companies mentioned in the report at the time of publishing the same. Its partners may hold a position in this company in their individual capacity at the time of publishing.
  • Neither RC Capital Management nor its partners have received any compensation from any company mentioned in this report for the preparation of this report.
  • There is no conflict of interest for RC Capital Management / it’s partners due to publishing this report
Read on

Winning the battle, losing the war

By Rohit Chauhan
In Investment process
5 months ago
3 Min read
W

I have tweaked my approach in the last few years. An outcome is higher number of transactions and re-entering the same position even though it did not work the first time. This is not about being proven right, but buying a stock if the probabilities are favorable, even if it did not work the first time

This gives an impression of flip flopping to my subscribers. I wrote the following note in response to that.

Winning the battle, losing the war

I have been fixated on the success of each position for a long time. This is a very common mindset among all investors. Although, everyone knows that it’s the portfolio returns that count, we get hung up on each holding

My guess is that some of this comes from our schooling, where we were graded on each question and the final score was a total of individual marks. It does not work that way in life and Investing

For example, if you hold 10 stocks in your portfolio and one stock goes up 10X and the rest drop by 50% before you liquidate your entire portfolio, you have made 45% on your portfolio

Is this hypothetical? Not in the venture capital world where one position can go up 100X and the rest can go to 0. Public market portfolios behave in the same manner.

Most of our alpha have come from a handful of positions

If this is the reality, it leads to a few logical actions

  1. We should not chase a high hit rate. A less than 50% success rate is fine as long as we manage the downside risk. Portfolio management is not an entrance exam
  2. The key is to get a few positions right and make the most of it. If that means, re-entering the same positions several times, so be it. Did it matter we lost 20% on Neuland labs before making 150% on it. The other downside of this approach is higher number of transactions
  3. We will appear to flip flop and regularly change our mind. We will hold our position only if the company gives us reasons to do so. Each position has to earn its place

Disclaimer

  • This report is published by RC Capital Management – SEBI Registered Investment Advisor (INA000004088).
  • This report is for educational purposes only and should not be construed as an Investment Advice.
  • RC Capital Management may have recommended the above stocks to our clients in the past. However, this is not a recommendation to buy / hold / sell the stock at the time of publishing this report.
  • The securities quoted are for illustration purpose only and are not recommendatory
  • RC Capital Management may hold position in any of the companies mentioned in the report at the time of publishing the same. Its partners may hold a position in this company in their individual capacity at the time of publishing.
  • Neither RC Capital Management nor its partners have received any compensation from any company mentioned in this report for the preparation of this report.
  • There is no conflict of interest for RC Capital Management / it’s partners due to publishing this report
Read on

Brain damage Stocks

By Rohit Chauhan
In General thoughts
5 months ago
3 Min read
B

There are some stocks which have a high risk reward equation for investors, but the equation does not work for the investment manager

Let me explain –  There are some stocks a fund manager can buy and even if he loses money, his investors will not be upset. Think of HDFC bank or Reliance industries

And then there are stocks which if you lose money, you will be questioned (to put it mildly). There have been such positions in our portfolio in the past. The prime example was Shemaroo. I still have some of those emails with me as a reminder

We try to ignore the noise and act as rationally as possible. That said, I am human and experience the same emotions. We are far tolerant of such positions in our own portfolio compared to what we recommend for all of you. Neuland labs was not entirely in that bucket, but had elements to it when we re-initiated the position

To begin with, we lost money on it in our first try. We were cautious in restarting the position and did not want to impact the portfolio if it failed again.

High returns are not free

There are some positions which have worked very well in our personal portfolio, but we will not add to the model portfolio. These are small cap, turnaround companies which have a higher risk reward ratio. Also if things go wrong, exit is not easy.

There is no free lunch in the stock market. We are not going to find a 20% compounder with 25% ROC valued at 10 times earnings. There was a time when such stocks were available and I was lucky to invest in some, but those days are long gone

We some time buy these higher risk/reward, ugly looking stocks for our personal account, but the downside for the model portfolio is too high.

We are thinking of how we can develop a different product for such stocks for investors who are tolerant of much higher risk. We will keep you posted as we get ready for the launch

Disclaimer

  • This report is published by RC Capital Management – SEBI Registered Investment Advisor (INA000004088).
  • This report is for educational purposes only and should not be construed as an Investment Advice.
  • RC Capital Management may have recommended the above stocks to our clients in the past. However, this is not a recommendation to buy / hold / sell the stock at the time of publishing this report.
  • The securities quoted are for illustration purpose only and are not recommendatory
  • RC Capital Management may hold position in any of the companies mentioned in the report at the time of publishing the same. Its partners may hold a position in this company in their individual capacity at the time of publishing.
  • Neither RC Capital Management nor its partners have received any compensation from any company mentioned in this report for the preparation of this report.
  • There is no conflict of interest for RC Capital Management / it’s partners due to publishing this report
Read on

Financial planning is 80% Psychology

By Rohit Chauhan
In behavioral finance, General thoughts
6 months ago
5 Min read
F

First a disclaimer: We don’t provide financial planning services, so this is not a sales pitch

I recently met with my extended family and went through a financial planning exercise for some of them. It was a learning experience for all involved

The no.1 element of such exercise is behavioral, or psychology of the individuals involved. An advisor who misses this point and focuses on numbers alone will never be effective. This is like a doctor who prescribes a medicine but does not understand the motivation and fears of the patient. Patient compliance is low in such cases

I focused on the psychology and life situation of each individual and tailored my advice accordingly. I also tried to simplify as much as possible so that it would be easy for them to follow my advice. I used a 3 bucket analogy for savings and investing

Bucket 1: Liquid assets for emergency expenses

Bucket 2: Savings for children’s education (medium term)

Bucket 3: Savings for a long term goal – Retirement

Let me share three case studies and hopefully you can see some value in them even if your personal circumstance may not fit it

  1. Young single mom

A single mom and sole earning member of the family. She is making a reasonable income and is saving a small portion of her income. Most of the savings are in cash or fixed deposits due to lack of knowledge.

I explained the three bucket approach to investing. As she has enough asset in cash/FD, we decided to move some of this capital to broadly diversified mutual funds. The idea was to get started with a small amount initially and then add via SIP over time (to reduce the timing risk)

I took time to re-assure them that her financial situation was fine, and she was doing a good job of saving. She had to focus on creating long term assets to fund her children’s education and her retirement.

  1. Married couple with young children

Typical married middle class couple with home loan and other expenses. They are making reasonable income and saving some portion of it. Most savings are in cash or FD earning low rates of return

I followed the same three bucket approach to investing. The recommendation was the same as the prior case, but as they are making a good salary, we decided to move faster into mutual funds compared to the single mom

Also, they could fund some of their children’s education through regular earnings and could focus on saving for their own retirement. Finally, any bonus or windfall was to be used to pay down debt after ensuring that there was enough in the emergency fund

  1. Married couple with children and volatile income

Very similar to the second case, but the income is very volatile due to business instead of salary income. My template for financial planning was the same as the previous cases but I have asked them to build a 12 month cash reserve.

The surplus capital will move into diversified mutual funds for funding their kid’s education and their own retirement

Some observations from the exercise

The online / Twitter world is completely disconnected from the reality of 90%+ people in the outside world. On Fintwit, a lot of people are jumping around talking of their multi-bagger picks and beating the market

The rest of the world is busy with making a living and saving the best they can. There is a high level of ignorance in terms of financial planning and investment options such as mutual funds. A lot of people are good in terms of savings (though this is reducing), but have no idea on how to invest

As a result, they are invested in low yielding assets. These people also face the risk of mis selling by unscrupulous people. Frustrated with low returns, these people are sold high risk products which does not suit their financial situation or goals.

If like me, you are proficient in financial planning, I think its our moral duty to advise such people – provided they are open to listening. A lot of people will ignore your advice, but a few will listen and that is enough.

If you can help someone secure their financial future, then you have done a big service to them.

Selecting a few mutual funds

I provided a few names to my relatives which I cannot share for obvious regulatory reasons. My criteria for selecting these funds was very simple.

  • Ignore all high risk funds such as Quant, thematic, sector etc. Their returns may be good, but they are not suitable for the people I was advising
  • Select a broadly diversified flexicap fund
  • Short list funds with above average 5 – 10 years of returns
  • Recommend two or three funds. There is no need to go beyond that

The key is to get started and not split hairs on which fund has given the highest return. As I mentioned earlier, the online world is fixated on alpha, whereas in the real world just getting started and making more than an FD will make all the difference

Read on

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