Why you should learn how to lose money in stocks? - The 5 Minute WrapUp by Equitymaster
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Why you should learn how to lose money in stocks?

Jul 25, 2015

In this issue:
» The unimagined wealth destruction in Chinese stocks
» Government's tall claims in the power sector
» Weekly market round up
» ...and more!

Two, two, two, I muttered under my breath as I got ready to roll a dice. Alas, it turned out to be a 5 to my dismay! The thing is I had just won but was feeling bad about it.

Feeling bad about winning? Yes. Actually, I was playing snakes and ladders with my nephew and niece and wanted any one of them to win. I wanted to see a big smile covering their faces. The kind that must have come on the face of David as he felled the mighty Goliath.

But that was not to be. It was I who ended up the winner. Then, even as I saw their puffed up cheeks from the side of my eye, I started wondering. How could this be? I was playing a game and just as someone can win a game, one can also lose deliberately if one wants to. It then hit me like a ton of bricks that it all depends on the kind of game you are playing. In fact, to go a step further, it depends on whether the game is skill based or luck based or part skill and part luck.

It was quite obvious to me that a game involving a simple roll of dice has luck written all over it. And therefore, I cannot win it or deliberately lose in it if the person at the other end does not have the rub of the green on his side. Turns out the kids weren't particularly lucky that day and therefore they lost.

I then realised that I had stumbled upon a great method to know whether an activity you are indulging in is more skill based or luck based. And it comes from a famous finance thinker of our times, Michael Mauboussin.

Mauboussin believes that there's a very reliable way to know the location of an activity along the luck-skill meter. Just ask yourself whether it is possible for you to lose deliberately while performing the underlying activity?

If the answer is yes, then that particular activity is more skill based than luck. This is indeed true for things like golf or chess. Here, a player can indeed lose if he deliberately makes an attempt to do so.

However, if an activity can't be lost deliberately, then luck certainly plays a role in the outcome.

Now, coming back to investing, can you lose deliberately in investing? I don't think so. You see, individual investing is all about beating the markets.

In other words, if you need to beat the indices, you need to pick mostly winning stocks. This is certainly difficult. Similarly, what is equally difficult is picking stocks that are consistent losers. For if it would have been easy, short sellers would have never got a call wrong. Therefore, losing deliberately in stock investing is also not that easy.

Now, what if I tell you there's a strategy out there that comes pretty close to losing deliberately in stocks? Well, as per a website called investorfieldguide.com, this strategy answers to the name of consistently buying the most expensive stocks. As per an article on the site, the strategy of buying the most expensive stocks from an EV/EBITDA perspective is a very bad idea. This strategy has underperformed the rest of the market 87% of the time when a period of 5 year is considered. And if one considers a 10-year period, it has underperformed 95% of the time.

The reason is not hard to find. Expensive stocks have a lot of growth expectations built into them. And therefore are ripe for a correction even if there's a slight change in those expectations. Of course the odd high multiple stocks will certainly do well over the long term. But to expect a large percentage of them to do well consistently year after year is certainly highly improbable according to us.

You would wonder as to why we are talking about losing money in investing. Well, we are trying to turn investing upside down a bit. You see, most people invest with the intention of finding the next winners. However, what is equally effective if not more is to avoid investing in losers.

Therefore if you know what kind of stocks could put you at high risk of losing money or severely underperforming the market, you can simply avoid those kinds of stocks. In other words, knowing how to lose deliberately is also important as you can then try and stay away from this strategy as much as possible.

What other kinds of stocks apart from the most expensive ones you think could cause you to severely underperform? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Today's edition of the Business Standard has thrown up some interesting points related to the power sector and the current government's claim of playing a strong role towards achieving the same. The Modi government has made various claims about how the sector has prospered well under its rule as compared to the previous year; and that some of the ‘all time highs' feats were achieved after it came into power.

One of which is highlighted in today's chart of the day. According to the power ministry, 22,566 MW of power was added in FY15 and was termed as the "highest ever growth in a single year". However, as the business daily has mentioned, the highest ever "growth" was in fact achieved in FY12, when over 8.3 GW of capacity was added. In comparison, only over 4.7 GW was added in FY15.

What however is strange here that these aspects should not be something to be very proud about considering that India has hardly ever achieved the original targets that were set out over longer periods in the first place.

Also, we find it funny that the government is taking the credit for power capacity addition in the current year. Fact of the matter is that power projects generally take anywhere between three to five years to construct and commission. How can the current government have anything to do with the projects being commissioned in the year gone by when it was not in power three to five years ago.

On an overall basis, one should not pay too much heed to such claims by governments. Broader look at the regulatory factors and the trends would be a better way to gauge the prospects (such as the fact that India has very low per capita power consumption as compared to other emerging markets) and opportunity in the sector.

Should one give heed to the government's claims?

The hedge fund guys are not amongst the nicest people to get advice from, on investing. However, when they set the alarm ringing on risks, one would only be too foolish to not listen. Hence, when one of the largest hedge funds, Bridgewater Associates, sent a warning note on China to its clients, we were all ears. The note published by Business Insider, reveals some startling and unknown facts about the recent Chinese market crash. There is no doubt about the fact that the retail investors are typically the biggest losers in any market crash. But in this case, the amount lost was gargantuan. The retail speculators lost as much as 1.3% of the country's GDP by gambling in stocks.

To put things in perspective, they lost more than their American counterparts did during the meltdowns of 2000 and 2008, combined! It is not hard to find why...67% of retail investors had less than a high school education and were borrowing money to trade. So they were literally gambling for the sake of gambling. And they may not be done yet. As per the note, the Chinese government will do its best to keep propping up stocks. It has already spent renminbi 380 billion doing so. And has renminbi 3.5 trillion at its disposal. So while the retail investors keep trying to make good their loss, the government will keep stoking their hopes. In the midst of this, the hedge fund managers have advised the smart investors to stay away from Chinese markets. Well, there is little more than we need to say about the Chinese bubble in the making.

Barring stock market in China (up 2.8%), major global markets ended the week on a negative note.The stock markets in Brazil (down 7.2%) and UK (3.1%) were the major losers in the week gone by. The stock markets in US witnessed intense selling, resulting in biggest weekly losses since March. The talks of Greece bailout continued to get delayed. Major European stocks too closed weak. However China stock markets were able to register third weekly gain in a row.

Concerns over economic growth remain the key driver for the poor performance in the global markets. Further, sharp correction in various commodity prices impacted various stocks in such sector. Over and above, corporate earnings so far have not been very encouraging for most of the countries. In the commodity basket, the yellow metal had a tough week. A combination of a strong US dollar and alarming interest rate rises prompted a 'flash crash' in the gold price in the beginning of the week. Gold prices were down by 5.4% in the week gone by.

Back home, the global pessimism gripped the stock markets. The BSE Sensex was down by 1.2% for the week gone by. Even the results have been a mixed bag so far for the Indian corporates. The first week of parliament proceedings has been quite disappointing. The continued logjam in parliament also impacted the Indian indices. Among the sectoral indices, the stocks from IT sector were maximum in demand. The Pharma and Realty stocks were under pressure and witnessed maximum selling. However, the stocks from small cap and mid cap were in demand during the week gone by.

Performance during the week ended 24 July, 2015
Data source: Yahoo Finance

 Weekend investing mantra
"If we avoid the losers, the winners will take care of themselves" - Howard Marks

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

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