I recently tweeted the following

No one has a logical objection to saving and starting as early as possible in life. If you understand the power of compounding, you will not argue against this point.

The most common objection is against investing in index funds. A lot of people think its an admission of defeat if you go the route of index funds, especially when it so easy to do better than the market

Is it so easy to beat the index?

A lot of people look at the recent experience and conclude that beating the market will be easy going forward. In reaching this conclusion, they are ignoring some obvious points

• Indian markets similar to global markets continue to get more transparent and hence more efficient. The more efficient a market, the harder it is to beat the index
• At the height of the bull market in 2017, a lot of people thought anything less than a 40% CAGR was for losers. That expectation has a lot of arrogance built into it. If the overall market is going to deliver around 14-15% over a long period of time, then the only way an individual can achieve such high returns is by being a far superior investor. A few people may turnout to be exceptional. However, the ex-ante probability of that is usually low
• Most investors ignore the aspect of luck. A lot of new investors started investing in the 2010-2013 period when small and mid cap valuations were at a decade low. We will get the same tailwind in the future.

We are already seeing the level of excess returns over the index compress in several markets such as the US due to rising competition. I think the same is happening in India. This is also called the red queen effect and we are seeing this in other competitive fields such as sports, business, marketing etc too.

Is it worth the effort?

Let’s assume that you work hard and do manage to beat the index. At this point, I would like to reference this post I wrote on the ROI of such an effort. Anyone who decides to become an active investor has to divert time from either full time work or from some other personal activities to make this extra return.

I have laid the math in the table below and you can play with the numbers in terms of your opportunity cost (salary, time with family or any other metric). There is no standard formulae to evaluate the ROI – this is something personal and only you can answer it. However, if you are in this only for the money, then a valid metric for comparison is your current hourly rate in terms of a full time job.

The question to answer is – When will the per hour wage from ‘active investing’ exceed the wage from doing a full time job?

A tough way to make easy money

As can be seen from the table above, the break even usually happens after 8-10 years of active investing. Even if you are great investor – compounding at 20%+ rate which very few investors or mutual funds achieve, the returns are back ended and come much later in life.

Now some folks will point to Rakesh Jhunjhunwala or warren Buffett or some such investor who have become famous and very rich through investing. This is the equivalent of someone pointing out one of the superstars in any field (cricket, Movies etc) and justifying their decision.

They are completely oblivious to the hidden evidence – for every Kohli, Aamir khan or any other hugely successful individual, there is large group of people who never made it big. The earnings per hour through active investing clearly show that making money via this route is not an easy way to get rich

Am I being a hypocrite?

One of the thoughts in your mind must be – This guy has been investing actively and is turning around and recommending others not do it. He is being a hypocrite as he wants to reduce his own competition.

I can assure you that the number of professional and individual investors getting attracted to market is very high and this post will make no difference to that. The rewards of success (or the allure) in this field is high enough to keep attracting new entrants.

As I have shared in the past, if I look back at the 20 years of my investing career, the economic (key word) ROI of the time spent on investing and writing this blog would be far less than a full time job. The only reason I have done this is because I have always loved the process and would do it even if I was not being paid for it (Which is true for this blog anyway).

Active investing is an irrational decision

If you agree with my argument that from an economic standpoint a career of investing actively in the market does not make sense, then saving early and investing via other instruments (mutual funds, ETF etc) is the way to go.

The above point does not mean that you don’t become financially literate. I think that is a must and should be made mandatory in schools. We should all have the minimum knowledge of personal finance to make sensible decisions. This would require only couple of hours a month. Once you have done that, you can use the rest of your time on other pursuits. That was the key point behind the above tweet

Unless you invest for a living (in financial services industry), I think investing directly in the market is not a rational decision. A lot of people do for the entertainment or bragging rights and in the end hurt themselves financially. People who are truly successful in it are those who love the process and don’t care only about the returns. If you are one of those folks, then welcome to my world and please ignore this post.

For others who are in it only for the money – find an area you truly love and get good at it. You will make a very good living at it and enjoy the process. The surplus income you make should then be invested in index funds. That’s what I am going to advise my kids.

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)