Monday, October 21, 2013

5 Things You Need To Know About Investing

I have always wanted to write something about investing incorporating some well known statistics which I think every investor should know. Only then we can appreciate how the value philosophy will help us win this complicated game. Well, though first we have to define what the definition of winning is:

Winning, in my opinion, is to generate a long term annual return that is higher than the market return. The market is usually defined by an index like the Straits Times Index or the Hang Seng Index. Needless to say, the most famous of them all is the US S&P500 which has generated a 8-10% return per annum since like 1900. Yes, since more than a hundred years ago.

It would be a feat to actually beat this tall order (of 8%pa or 10%pa for that matter) over a long timeframe like 20 to 30 years. Warren Buffett who managed to achieve this feat over the last 50 years have recently admitted that he would probably fail to beat the S&P in the next five years as his fund size has gotten too big.

Why is achieving 8-10% per annum so difficult? This is related to the 5 things that you need to know (all are statistical numbers) which I would like to highlight today.

1. The top 10% takes all. Since the inception of fund management, only 10% of all investors (roughly speaking), or statistically proven, only 20% of all professional fund managers have actually beaten the benchmark that they were supposed to beat. This means that 80-90% of investors actually earn less than 8-10% over a very long periods like 20 to 30 years.

2. 20% of your bets will make 80% of your profits. This is the well-known 80/20 rule and it sure works in investing as well. Later we shall see how this plays out to ensure that most investors are destined to earn mediocre returns.

3. 30% margin of safety. One paramount rule of investing is the margin of safety rule. According to Ben Graham, the father of value investing, if you have to surmise investing into 3 words, it's margin of safety. It is that important. What this means is that we can buy only when there is a significant buffer, or when there is a huge gap between price and value. Again Ben Graham advocated that one should ask for at least 30% margin of safety ie if you determined that a stock is worth $100, you should only pay $70 for it.

4. There is always a 40% chance of getting it wrong. No matter how much analysis you have done and how many expert opinions you have consulted, for every stock that you buy, there is a 60% chance that you will get it right, and a 40% chance that you will lose money. This is a well-known probability statistics in investing that applies to both for investors and traders. Actually it's more like a 55% or 57% winning ratio. But this is already far better than the casinos as the highest winning ratio for any casino game is always less than 50%. (Closest being Blackjack apparently at 49.4%. In casino parlance, it's call the house edge of 0.6%. I haven't confirmed the exact math in converting it to a winning ratio - my own terminology, but the idea is the same.)

5. Invest with at least a 5 year investment horizon. This is something that is almost impossible with today's MTV culture of instant gratification. We don't even want to wait 5 min most of the time, especially not for the MRT at peak hours. The investment horizon has declined to 6 months in a recent study on the holding period for investors of the New York Stock Exchange. But compound interest only works well the time period is long enough. Anything less than 5 years is basically not cutting it. The famous rule of 72 tells us that even with a high 10% return, it will take 7.2 years to double our money. Trying to achieve anything significant in 5 years is just plain illogical in the world of investing. Strangely, Wall Street and most market participants think otherwise.

Summing this all up, what does it mean?

First we should think about Pt 3 and 4. We must understand that 4 out of 10 stocks we buy will not make money. This means that every time we lose, we must ensure that the loss is minimal. This can only happen if you have a good margin of safety for any bet. So a 30% margin of safety and a 40% winning ratio goes hand in hand. Incidentally, trading tactics talk about a similar strategy. One must have a strict cut loss rule. Like maximum 3% loss or 5% loss. This is then offset by a "let your winners run" rule, usually at least a 10-20% profit. That way you can lose 3-4 trades but still make it back with 1-2 winning trades.

Now with Pt 3 and 4 in mind, we then take in Pt 2 which says that 20% of your bets will generate the bulk of your profits. This means that out of the 6 winning bets, only 1 or maybe 2 will make it really big like doubling the initial money or more. But if we have a short term investing mindset we would then take profit in Year 1 or 2, (or sometimes even shorter) which means that we lose all the upside that comes with the compounding effect. Then we are destined for mediocre returns, aren't we?

Let's just do a simple math on all these.

We have a capital base of $100 and we make 10 bets. 4 bets will lose money. But because we diligently adhere to our margin of safety rule, say we lose 10%. So of the $40 invested, we are left with $36. The remaining $60, let's just assume that 4 bets did ok, ie we make 20%. So we have grown our $40 to $48 from these 4 bets. The last 2 bets we make 100%. So from $20 we now have $40.

Adding the numbers up $36 + $48 + $40 = $124. So we managed to make 24% return. But over what time period? If we can do this in 1 year and repeat for the next 50 years, we are on our way to beat Buffett's record. That's very unlikely, so I would say this is probably achievable over 3 to 5 years. Then we would only barely make 8%pa.

Most investors don't think in terms of 5 years, they take profits off their 20% winning bets way too early, they are not interested in adhering to a Herculean 30% margin of safety (which means they will just buy when they are afraid of "losing out", like everyone who bought tech stocks at the height of the tech bubble, or every Singaporean who rushed in to buy Sky Habitat at the peak of Singapore's property bubble) and obviously they also think that they will lose not 40% but 4% of the time.

Is it then a wonder why only 10% of all investors can actually beat 8-10%pa over time?
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