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Approximate vs Precise: Which Is Better in Investing?

May 20, 2017

In this issue:
» Always Mr Approximate over Mr Precise
» The Magic of Altering Cash Levels in Microcap Milionaires
» Weekly Round up
» ....and more!
00:00
Rahul Shah, Co-Head of Research

There are two ways to know the speed of your car during an entire journey. The first method involves simple division. Distance divided by duration and voila, you have your answer.

This method, however, is limited. It gives you the average speed and not your actual speed at different points in the journey. If you want to know your speed at fixed points or legs of your trip, you'll need calculus or some other high-level math. If there is a method to your driving, we could even derive a formula that could tell us your future speed.

But if you just want to plan your trip from point A to point B, simple division will do. It's not as precise or comprehensive as the second method, but it's approximate enough for your purpose. In fact, try telling someone their speed in the language of a parabola and you'll be laughed at. Why bring out the howitzer to kill a spider?

Change the context to rocket science, however, and approximate will no longer suffice. You simply can't calculate the distance from here to the moon and design a vehicle that will travel at an average speed of say 500 kms per hour. That would be a recipe for disaster. Too many elements are at play. More complex calculations will be required. This is the world of precision. And the more precise you can get, the better.

We hope you get the point. Certain situations call for an approximate calculation or a broad thumb rule. And sometimes, you need to be as precise as possible and employ complex problem-solving techniques.

How about in the context of investing? Does the highway to long-term wealth creation pass through the tunnels of precision? Or the bridges of approximation?

Hark your minds back to the 2008 crisis and you may get your answer. 'Quants' and other experts were building all sorts of mathematical models to cover all sorts of risk. These people thought they had everything figured out. Their systems were said to be so robust that nothing could put their corporations at risk.

Well, we know how that all ended. When the crisis struck, these so-called fortresses collapsed like a pack of cards, leaving huge destruction in its wake. The situation became so dire that the government had to bail out almost the entire financial sector.

So much for precision.

Contrast that with the approach Warren Buffett took. Forget complicated spreadsheets; Buffett doesn't use so much as a calculator. How did he fare? He was virtually unscathed. In fact, he used the crisis to his advantage to scoop up fantastic assets on the cheap.

Precision works best when the possibilities are limited and the probabilities are known. This information can then be put into an equation to arrive at an optimal solution.

However, the world of investing is uncertain. Not only are the possibilities unlimited but even the probabilities are unknown. The day you think you have it all figured out could be the beginning of your end.

Buffett emerged stronger from the crisis because he knew it's better to be approximately right than precisely wrong. He was humble enough to admit an unknown future. He knew he needed to build a large buffer and not leave anything to chance. The 'quants', on the other hand, were fine with taking risks as long as the model allowed it. But the models, as we know, had a deeply flawed view of reality.

Simplicity and humility are the keys to successful investing.

Buffett, incidentally, is not the only successful proponent of this approach. His mentor, Benjamin Graham, held a similar view. In fact, it can't get simpler than Graham's formula for beating the stock markets.

He insisted on having an approximate view of both the valuations of the broader markets as well as individual companies. And he absolutely abhorred precise models.

The formula works. Our Microcap Millionaires service - based on Graham's formula - is up an impressive 150% since inception in February 2014. That's three times the 50% returns from the Sensex for the same period. And of the 28 positions we've closed, only four were at a loss.

In investing, approximate beats precise.

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03:00 Chart of the Day

Today's chart of the day highlights how we have recommended subscribers to alter their cash levels in our Microcap Millionaires based on the valuations of the broader market. So when the markets turned expensive from a historical perspective, we recommended to increase cash levels and when they turned cheap, we recommended to lower them and put more into stocks in order to take advantage of the cheap valuations.

And this discipline has served us remarkably well. It allowed us to get into the 2014 bull market with minimum cash levels as the valuations were attractive. And the same rule allowed us to get into cash in the subsequent year when the markets turned expensive and lost around 20% in one year. Our service however, was flat as we had more than 50% of the corpus in cash.

Yet another example of how not trying to be precise but approximate helps in the long run.

We Dumped Precision for Approximation in Microcap Millionaires

03:45

Global financial markets ended the week on a mixed note. It has been one of the most eventful weeks in the recent times, with leading world equity markets scaling record highs and then plunging in one of the sharpest cross-asset routs in years.

Brazil's stock market, Bovespa, plunged more than 10% immediately after opening Thursday, wiping out almost all of its gains for the year. Brazil's currency, the real, also tanked 7% against the dollar, its worst day since the global financial crisis in 2008. The selloff came after new bribery allegations surfaced against Brazil's president, Michel Temer. The index and real tumbled as fresh accusations against Temer dampened the outlook for his structural reform plans. The Brazilian market closed the week down by 8.2%.

The US market remained choppy and closed in the negative territory. This was on the back of Trump's firing of FBI director James Comey and allegations he pressed Comey to stop investigating his former national security chief and other officials' alleged ties with Russia. Investors have been concerned the allegations could delay tax cuts and increased spending, pro-growth efforts touted by Trump during his election campaign. The US market closed the week down 0.4%.

Meanwhile, European indices closed on a weaker note. Germany's DAX was down by 1%, while France's CAC was down by 1.4%. The UK indices closed the week up by 0.5%,

In Asia, Japan's benchmark Nikkei 225 was down by 1.5%. Hong Kong's Hang Seng rose marginally by 0.1%.

Back home, the BSE Sensex and the Nifty recorded their second straight weekly gains. The key Indian equity indices touched new intra-day highs during the week. FMCG counters buzzed following finalisation of GST rates for the bulk of the items. However, global volatility arising out of political developments in the US and emerging markets like Brazil held back the gains. The BSE-Sensex ended in green and was up 0.9%.

Performance During the Week Ended 20th May, 2017

04:45 Weekend Investment Mantra

"Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from. Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment." - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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2 Responses to "Approximate vs Precise: Which Is Better in Investing?"

Arun

May 24, 2017

9717873111 loved it

Like 

Anish Shah

May 20, 2017

Loved the way you wrote the article Rahul..

Like (1)
  
Equitymaster requests your view! Post a comment on "Approximate vs Precise: Which Is Better in Investing?". Click here!