AuthorRohit Chauhan

Weekend Thoughts

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I am have been mulling a few things over the last few weeks. Thought of sharing it with all of you. I may probably do this again in the future on other topics

Cut and run

In the last few months, we have seen stocks nose dive when the market learnt that, management was doing something unethical or working against the shareholders. The examples are quite well known and need not repeated.

The reaction is swift and brutal. I have learnt this painful lesson personally in the past, on a few investments. In the first case – SSI tech, which occurred in early 2001, I kept holding the stock waiting for some miracle to happen. In the end, I lost around 90% of my investment in 2 years. The same occurred with Zylog in 2012-13, but as this was a tiny speculative position, the loss was very small.

We have been lucky to have avoided such a situation till date. However, it does not mean I am exempt from it. Inspite of my best efforts, I may end up trusting a management who could turn out to be a fraud.

To be clear, I don’t think we have any such position where I think the management is cheating us.

I want to make it clear that if such a situation were to occur and it becomes apparent that the management is either fudging the accounts or cheating the minority shareholders, i will not hesitate to exit even if it means a financial loss and me looking like a dumb fool.

I have learnt that exiting such a position and salvaging whatever you can is always the best option. Case in point: I sold zylog for a 30% loss at around 30-35/ share. It now sells for 0.8 (yes that’s not a typo)

Pick and choose

I am aware that some of you use the model portfolio as a starting point and pick and choose some positions out of it. I have no problems with it personally and you are free to make your decisions.

That said, I am would not do that if I were in your place. The reason has nothing to do with my ego or that I am some awesome investor whose every word is gospel.

The true reason is actually the opposite. Even the best of investors do not get more than 70% of their picks right (in our case its around 60-65%). This means that around 1 in 3 picks are wrong and will lose money.

When you pick and choose from the model portfolio, you are making an implicit bet that you have the skills to know which one of my three picks, will fail. I cannot judge that for anyone – that is for you to answer for yourself.

My own process acknowledges the above failure rate and hence most of the new positions start small and at a lower priority in the model portfolio. As the company/ management performs, I raise the position size (often after a long time). If on the other hand, I make a mistake, I simply take the loss and move on.

The key point in this process is that my focus is on the portfolio, which should do well and not on individual positions alone. Doing a pick & choose means, that you are ignoring the portfolio approach (or handling it yourself)

Building an edge

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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

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

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

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.

The Journey matters

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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.



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.

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