Why being right 10/10 times in investing may not make you rich... - The 5 Minute WrapUp by Equitymaster
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Why being right 10/10 times in investing may not make you rich...

Jan 29, 2015

In this issue:
» Penny stocks tower to exponential rise in 2014
» What does the upcoming mega share sale reveal about markets?
» The dangers of money printing
» ...and more!

Let's assume you are a treasurer at a well known money management firm and are given an assignment to pick the best performing fund manager/s. You are given the following data about the fund managers' performance.

Performance of the fund managers
Name of the manager No of stocks in his portfolio No of stocks that have outperformed the Sensex
Manager A 10 8
Manager B 10 7
Manager C 10 6
Manager D 10 5

Which manager would you pick and why? If you picked manager A, as 8 of his stocks have outperformed Sensex, then let us tell you that like many others you could be wrong. In fact, the data presented in the table is insufficient for anyone to tell which manager is the best. It just tells you the frequency (no of stocks) of outperformance and not the quantum (return). And in judging manager performance frequency does not matter as much as the quantum.

Allow us to explain. Let's say you own 4 stocks in a portfolio. 3 of them go down a bit and underperform markets while the fourth one outperforms significantly. In this case, your success ratio is just 25% (1 out of 4). But when assessed on portfolio basis you could have outperformed markets by the virtue of your return from the 4th stock. As can be seen, the quantum of return here dictated your overall return performance putting frequency of being right on the backburner.

This teaches us a very important lesson. People who find solace in being right frequently are not necessarily best return aggregators. Behaviourally, they may feel happy for being right but that does not necessarily translate into a portfolio that outperforms benchmark.

In fact, as most shrewd investors do, one should evaluate investments on expected value analysis terms. Let us put it across simply. Let's say that the 4th stock that you bought only had a 30% probability of rising. Being relatively undiscovered and operating in a nascent industry the probability was low. But if it materialized a huge upside (assume 2-3x) was for the taking. Buying such low probability high reward stocks can do wonders for an investor's portfolio.

Naturally, coming up with such outcomes and probabilities is not an easy task. More than mathematical skills it requires unusual judgment. And that requires experience. However, if an investor thinks along these lines he would compel himself to analyze the risk reward of stocks. This way he can land on a low probability but high potential multi-bagger.

At Equitymaster, while we do not aptly mimic this approach, we insist on margin of safety even for the best companies because we reckon as long as you take care of the downside risk, the upside is taken care of automatically. While in services like StockSelect and Hidden Treasure our attempt is to ensure that every buy recommendation fetches at least 15% returns per annum, a handful of multi-bagger recommendations each year ensure that we comfortably outperform the benchmark indices.

Do you feel happy when your investment calls go right? If yes, what kind of returns have these calls generated? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
Talking about multi-baggers, not surprisingly the 2014 market rally has seen some of the penny stocks rise exponentially. In fact, as today's chart of the day shows one stock has rallied by almost 10,000% thereby being a 100 bagger in just one year!

The rally in penny stocks during bull markets is nothing new. These stocks typically explode when markets rise. Being low in liquidity it is relatively easy to manipulate their price. And a market rally typically acts as a camouflage for these stocks. However, investors should not get carried away by high returns from such stocks. While some may have rallied on the back of improved fundamentals the rally in others could be misleading. Basically, investors should exercise caution when dealing in penny stocks as the risk is high.

Penny stocks capitalize on market rally
SSA = Shantanu Sheorey Aquakult; SDM = Super Domestic Machines;
KP = Kesar Petro Prod; WLA = White Lion Asia; KFC = Kamalkshi Fin Corp

Rs 425 bn! Well, this is the sum that the Government is planning to raise through stake sale in few PSUs over the next couple of months. Just to put things in perspective, the Indian capital markets have never seen such large offerings in such a short span of time as per a leading daily. And if this is not enough, there are some private companies as well that are looking to raise huge sums through share sale. Consequently, with such a large amount of money looking to change hands, there is a view doing the rounds that investors might sell some of their existing shares in order to subscriber to these issues. As a result, we could see some correction in the markets in the near term.

Honestly speaking we don't subscribe to such views. We are of the opinion that sensible long term investing shouldn't be based on making such assumptions. As long as the stock you are considering is available at a significant discount to intrinsic value, it should be bought irrespective of what markets are going to do in the short term. In investing, it is always sensible to profit from remembering the obvious than from grasping the esoteric.

Until recently, it appeared that the world was divided into two factions as far as view on money was concerned. There was the US led faction who believed that in order to kick start the economy, money printing is necessary and hence there should be quantitative easing. And then there was the faction led by Germany that was strictly opposed to the idea. However, with the European Central Bank, of which Germany is the most important member, agreeing to start its own round of quantitative easing, the last wall of resistance also seems to have crumbled. Honestly speaking, if the economic evidence was any indication, Germany had little chance. So far, quantitative easing has proven to be more of a boon than a bane. It has led to revival in the US economy and has also helped boost employment.

The absence of QE in the Euro zone on the other hand has hurt especially in the case of peripheral nations like Greece and Spain. So, does this mean countries like US and UK were right all along and Germany wrong? Well, we don't think so. It has been our stand for quite some time now that printing money and debasing currency is not how a nation can become more prosperous. It can certainly provide some temporary relief but once the faith in the currency is gone, there will be a huge price to pay. This is why we have always advised readers to have some portion of one's money invested in gold.

The Indian stock markets are trading negative today. At the time of writing the BSE-Sensex was trading down by around 93 points, while the NSE-Nifty was down by 34 points. Losses were largely seen in metal and IT stocks. Most Asian markets were trading in the red at the time of writing. European stock markets, however, opened mixed today.

 Today's investing mantra
"You're looking for a mispriced gamble. That's what investing is. And you have to know enough to know whether the gamble is mispriced. That's value investing." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Rahul Shah and Jinesh Joshi.

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