I was recently talking to a friend and he made an interesting comment after looking at my blog.

‘Why do you target beating the market by 2-5%, when you can make 80-90% per annum by trading? I recently started trading and have been making almost 7-8% per month. You should do that too!’

I have heard this comment from a lot of people in the past. The only common feature is that such people trade for a few months, make good returns and extrapolate it to annual returns. Ofcourse, the very same people after losing money in the market make a hasty retreat and are never heard of again.

The quants
I am currently reading a book – The quants. It is quite an entertaining book, though I doubt there is anything to learn from it. The book is about various kinds of traders who use mathematical models and high power computers to trade in the market. It talks about a few hyper successful traders at various firms such Goldman sachs, Morgan Stanley, deutsche bank and hedge funds such as renaissance technologies and citadel investment group.

Some of these trader/ investors were pioneers in their fields, the best of the best and achieved in excess of 30% annual returns over 10 years or more. The best returns were posted by renaissance technologies, which seems to have posted annual returns of around 40% over 2 decades.

The point of the above commentary is this – If you can make 30-40% annual returns for a few years and prove it, there are people who will be ready to handover millions to you to manage. You will be rich and can retire soon. If you can make 40% or more, then you will be considered a god and there is will be books written about you – think of George soros and others.

If you think you can make 70-80% per annum for the next 10 years, then you are day dreaming. If you think you can make these kinds of returns, as my friend suggested while working in a full time job, you should meet a psychiatrist and get a mental health check done.

I think the chance of 1 crore rupees dropping on someone from the sky while walking on the road is higher than making 70-80% per annum for the next 10 years. A 75% return for ten years will give you 269 times you starting capital and 73000 times your capital in 20 years.

A personal experiment
Let me come back to title of my post. If you are new to the blog, let me say it outright – I am biased against short term trading. I do not believe it is the right approach for me. It may work for others, but not for me.

I have said this more out of a general belief and not based on any specific experience, atleast till now.

So, this time around I tried an experiment. I decided to experiment with trading in the last few months. I bought some stocks for day trading, did some momentum buys and sell and did some news based trading too.

At the end of the experiment, I tabulated my results and found that I had made around 18% on my capital in around 3 months. The maximum loss was around 6% and the highest gain on a single position was 11%. The average holding period ranged from 2-3 days to around 15 days.

A success?
If I annualize, then the returns come to around 72%. Should I declare it a success and start trading actively?

I do not term the experience as a success and do not plan to trade ever again. Let me tell you why.

I typically check my long term positions once in a month or a quarter. My broker is one unhappy guy as I have very few orders in a month and my account is generally a sleepy account.

The above experiment seems to be a success only in terms of the returns. What is not obvious is the effort and the pain behind it. I found myself scouring the internet and bse website for news and tips. In addition, I found myself checking the stock price several times in a day. There was definite change in my thought process as I found myself more anxious, stressed and reacting more and more to daily news.

I realized that my short term approach started infecting my long term though process too. I started looking at my long term holding frequently and started getting more anxious about them. One fine morning, I just plugged the plug and stopped all the trading. Life is good now and back to normal 🙂

A typical experience?
So does it mean long term investors should not trade? No, it only means that I should not trade because I do not have the temperament to do it.

The point of the post it this – One should invest based on one’s own temperament. Some people like fast paced action and the adrenaline rush, so trading may the right approach for them. I prefer a slower and more sedate approach where I will analyze a company for a long time and then slowly build my position. Now if that nets me lower returns, then so be it! Atleast I will sleep well at night and not check stock prices continuously during the day.

One of the least discussed topics on investing is emotions. I have rarely found any discussion on this topic. Behavioral finance does take up this topic and there is a lot of academic analysis on the various pitfalls and mistakes of investors. However there is still a lack of discussion on emotions and how one should handle them while investing.

Are emotions important?

If you are Mr. Spock, then emotions do not matter. For the rest of us, emotions play a very important role in our lives and definitely in investing.

As an investor, one is faced with feelings of joy, confidence, euphoria or despair, frustration, fear and similar other emotions. I can’t speak for others, but I have had all these emotions and more.

Should feelings be ignored?
One school of thought is that one should be a completely rational investor and should take emotions completely out of investing. I find this as the stupidest advice.

Do you think that is possible? Can you invest without ‘feeling anything?

The only time one does not ‘feel’ anything is when one does not care about it. If you are dealing with your hard earned money, how will not feel anything?

Understand and manage feeling
I have found that it is far more important to acknowledge your feelings and then try to think rationally about them. In some instances, you may be able to realize that your feelings are leading you down the wrong path and you will be able to correct yourself. In other instances, your gut or feelings are telling you something and you are better off listening to them

My own experiences
During the start of my investing life, I rarely thought about how I felt and just went with the flow. For example, if I started analyzing a stock and ‘felt’ confident, then my tendency would be to rush through the analysis and just build a position.

Once I had created a position, a confirmation and consistency bias would set in and I would avoid negative information on the stock if it went against my view. If you think you and others are immune to it, think of the time you and your friends have tried to ‘defend’ your stock (as if your stock needs defending!) and have discounted someone who is giving you contrary information. This tendency sometimes gets vicious on public stock forums (which is one reason I avoid criticizing other’s stock picks)

The converse of the above situation occurred when the stock market was down and everyone was bearish. I found myself overly pessimistic like others and would constantly keep questioning myself. As a result I did not build as big a position as I should have – case in point: I bought concor in 2002-2003 at a PE of 5. I should have built a big position, but never did. Same with blue star and several others

My current approach
I did not get hit by lighting or have achieved any enlightenment like Gautama Buddha. I tend to feel the same emotions as earlier. The difference is that I try to acknowledge them when they happen and to understand what they are conveying.

During 2008, I too had feelings of uncertainty and some amount of doubt. However based on past experience and based on the valuations I could see, I decided to ignore them and went ahead with my positions.

Conversely, I have been feeling fairly smug and happy with my positions and optimistic (atleast till last month) in general. This matched with the feeling, others have about the market. I think this itself is a red flag for me. The time when I start feeling confident and on top of the world is the time to start getting worried. In response to this, I have started reducing my fully valued positions and have not really been buying much (though have been tempted several times).

I don’t go against my feelings always. On analyzing my past positions, I have realized that my position size is driven a lot by my feelings. I maintain a few major and some minor positions (see my portfolio here). I have found that the stocks in my minor holding are cheap and at a higher discount to fair value than major positions.

However for some reason which I cannot articulate, my ‘feel’ for the minor positions is not as good as the major ones. For example, I always felt that a grindwell Norton is a better position than a VST. As a result my position size has been larger in the former than the latter. On analyzing my past results I have found the major positions have done far better than the smaller positions (though I did not realize that at the time of making these investments).

I don’t claim to infallible. Far from it ! I have done enough silly things and confident that I will continue to do so (options may be one 🙂 ). However I think listening to your gut is important, even if you do not always follow it.

As an aside – I think if you feel a little bit apprehensive and scared when trying something new, it’s a good thing. It means that you are pushing the boundary of your learning. I feel the same with arbitrage and options and think that it is the right thing to do.