When we have success in our lives, we tend to attribute that success to skill or hard work. When we fail, we attribute it to bad luck. Sounds familiar?
I know I do this all the time. It is easier than admitting that there was some luck involved in our wins and a lack of skill in our losses, says Michael Mauboussin.
A key differentiator for long-term success in investing is understanding outcomes based on the role of skill versus luck. Investing is more of science combined with art, where the end outcome is a function of luck and skill. In the short term, though, luck plays a crucial role due to market timing.
During the eight months ended November, as an economy, we added, roughly, a record 76 lakh demat accounts. And all those investors experienced tremendous tailwinds in terms of market performance in the last nine months, during which the Nifty’s return stood at about 62%. More than 148 stocks in the BSE 500 delivered more than 100% returns during the period.
Since the success ratio is materially higher than the historical average, the investor will be wise enough to spend time to understand it better from the perspective of skill and luck.
Skill versus luck
The first test of checking investment success is to see whether the returns are generated due to fundamentals, which is skill, or, due to re-rating at least in the short term, that is more of luck than skill.
Divide the stock’s returns by growth in fundamentals — proxy is PAT growth — and see what percentage is from fundamentals. The balance is from rerating, which is not a sustainable factor in the long term. For example, if the stock price moved from 100 to 200 in the last nine months, where the actual growth in PAT was only 20%, then the balance 80% was due to valuation rerating. Since we had a huge drop in the market in March following COVID-19 and a subsequent rise, it’s best to remember that multiples expansion has its limits.
Understanding base rate
The new investor experience in the last nine months is nothing short of a dream market where any stock you purchased, irrespective of the fundamentals, actually did exceedingly well.
Out of the BSE 500, 400-plus stocks delivered more than 35% in terms of absolute returns in the nine-month period versus the average long-term Nifty index return of about 10-11% CAGR and 6% annual fixed-deposit return.
Investors are best advised to tone down the return expectation as historically, the median nine-month rolling return is about 8%, the highest about 112% and the lowest, a negative 51%.
On a nine-month rolling return basis, approximately a third of the time, the Nifty return has been negative in the last 20 years. The latest return is clearly an outlier and not normal.
Risk tolerance
As the market is very buoyant, it is an extremely good time to check your risk tolerance for how much downside risk you will be able to withstand. This helps you to understand your market-risk appetite better and you will be able to handle the volatility better as you are prepared. Look for stocks in your portfolio that are fundamentally good but price action has been very buoyant and it has been a very volatile stock in the past. Earmark them so that when the tide turns, you will be able to quickly take appropriate action in a timely manner to keep your profit that you have made in last nine months
Risks to avoid
Risk 1: Poor governance or balance sheet. Check for companies with weak balance sheets or governance structures and try to sell them.
Avoid buying them, even though the stock might look cheap as prices implode during market panic, creating huge volatility. During March 2020 correction, we had seen how prices of companies with weak balance sheet structure imploded versus the broader index.
Risk 2: High expectation risk. The future performance of a stock is a function of execution of the business versus expectation which is already priced into the stock . Higher the expectation, higher the bar for the firm to perform and deliver decent returns.
Between FY02-07, HUL had delivered negative return and underperformed the Nifty by 280%. The difference in expectation and execution of business led to poor performance of the stock. Similarly, Reliance Industries underperformed Nifty for a five-year period ending 2014. Reduce exposure to stocks in a systematic way where you believe the expectation is running ahead of fundamentals.
Risk 3: When the initial thesis of buying a stock is not playing out as expected, then re-evaluate the thesis and check if there is still merit in holding the stock. Unless you are comfortable with your thesis based on execution, it becomes very difficult to hold on to stocks when the market drops as you are internally not convinced about the investment thesis. To end, it’s time to control risk at stock and portfolio level and view opportunity through a risk-adjusted return lens to enjoy sustainable and profitable investing.
(The author is head of research and co-fund manager at ithought Financial Consulting)
