Why invest the way you play cricket and not chess! - The 5 Minute WrapUp by Equitymaster
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Why invest the way you play cricket and not chess!

Nov 13, 2014

In this issue:
» The hidden dangers to India Inc's balance sheet
» The US is likely to witness another Great Depression in next 3 years!
» Why are central banks across developed world panicking?
» ...and more!

99.94! That's the average the legendary Sir Don Bradman ended his test career with. For some, this feat simply remains the greatest achievement by any sportsman in any major sport.

Well, lot of water has flown from under the Sydney Bridge since the time the Don hung up his boots. Yet his record has stood the test of time. No one has even come close to it. Not even the likes of the Tendulkars or Laras and the Gavaskars of the world.

While a lot of theories have been floated to explain this, we felt the one coming from a certain Michael Mauboussin is certainly amongst the most interesting. He calls this phenomenon a rather geeky sounding 'Paradox of Skill'.

However, to the layman, what this simply means is that since the time of Bradman, absolute skills have improved no doubt but skills on a relative level have shrunk. In other words, there's not much separating the best and the rest anymore.

And if this is not enough, the bowlers tend to have a lot more resources at their disposal these days. Consequently, the chinks in a batsman's armour are quickly exposed and this poses further challenge to someone who's looking to equal Sir Bradman's feats.

So, will the world never see a Bradman again? Perhaps it will. But for that to happen, the batsman will need to have a huge slice of luck going his way - much larger than what Bradman enjoyed - in addition to his phenomenal skill. May be someone like Tendulkar came up short on the luck part for even the legendary Don believed that in terms of skill, the closest that anyone came to him was Sachin Tendulkar himself.

This example of course is a part of the larger belief of Mauboussin that a large number of human activities lie along what he calls the luck-skill scale.

So imagine a scale where on the left hand side there is 100% luck and 0% skill and on the right hand side 100% skill and 0% luck. All the other values of course lie in between.

Thus, something like a game of chess will lie on extreme right as it is all about skill while a Russian roulette on the extreme left as it is simply all about luck and nearly zero skill. Cricket as we discussed is somewhere in between.

What about investing, where do you think investing lies? If Mauboussin is to be believed and we sort of tend to agree with him, investing lies more on the luck side than skill.

Surprised? Well, Mauboussin believes this is the case because in investing, there are a multitude of factors that are outside the control of an investor. Besides, with information about stocks being much more widely available today, luck has become even more powerful than skill in investing.

Does this effectively shut the doors on investors looking to outperform the indices? Certainly not. The way out of this dilemma is simply to focus more on the process and rely less on short term outcomes.

Yes, there could be times when one is skilful and still have poor results in the short term. But over the long term, the law of averages will catch up with luck and it will be the process that will determine who wins and who loses.

Therefore if you are worried about results not coming your way even though you have a good process, it could be simply because the lady luck is looking the other way for the time being.

But turn she will and will eventually reward you for the hard work you've put into not only developing a good process but also having the character to stick to it.

What do you think? Do you agree that in investing it is the process that matters more than short term outcomes? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Talking about luck, it seems India Inc is taking its luck too far as far as contingent liabilities is concerned. For as today's chart of the day highlights, the slowdown of the last few years has not just impacted earnings, it has also led to the contingent liabilities of the BSE 200 companies swell a whopping 44% over the last four years.

Thus, as compared to Rs 1.8 trillion in FY11, the cumulative contingent liabilities of the BSE-200 index companies have gone up to close to Rs 2.6 trillion. What is more worrying is that for some companies, the extent of these liabilities exceeds not just the net worth but also their market capitalisation. Of course not all of this can turn into real loss of wealth for shareholders but it is better to be safe than sorry we reckon.

The risks that lurk in India Inc's balance sheet

Moving over from Michael Mauboussin to Robert Rodriguez. The latter, a legendary fund manager, has done a Nouriel Roubini. Rodriguez is of the view that the US is likely to face a financial crisis as perilous as The Great Recession within next 3 years! Perhaps, this seems as improbable as Roubini's forecast on the mortgage crisis initially appeared out to be. But later we all know what happened. So, what is Rodriguez's basis for such an antagonistic opinion?

Reckless monetary and fiscal policies of the Fed are primary culprits here. Easy money has led to P/E expansion. In fact, he stated that 60% of investment returns during the last 2 years have come from P/E expansion with earnings growth stagnating!. This speaks about the quantum of artificial inflation in stock prices that loose monetary policies have caused. In fact, he is so worried about valuations that he is sceptical of holding equities altogether at these levels. He reckons a correction of 20-30% is on the cards for 2015.

The bigger irony is that the financial regulators realize it is an endemic problem but have yet chosen to be mum. Probably they should be ready to face repercussions of another massive disaster whose roots were sown by the system itself.

While Robert Rodriguez's views may have created a panic in the mind of investors let us tell you that they are not the only ones in this state currently. Even central banks across the world are in a state of fear. And the reason is that their stated economic policies have failed to revive the economy. Be it the loose monetary policies that Rodriguez mentioned earlier or doses of external liquidity. None are a panacea to sins of the past. And central banks very well know that.

Indirectly low/zero rates compel you to pull out your money from banks as it hardly fetches anything. Such a regime encourages you to invest in other asset classes. However, for the sheer fear that economy is on death bed investment is not happening. As such, central bankers' strategy to revive money velocity via low interest rates has hardly borne any fruits.

Non recovery in growth has created a state of panic amongst central banks as they too know that such a strategy cannot continue for long and should end one day. But if they end it soon growth shall falter. If not, risk shall rise further. As such, they are caught in a vicious cycle. It would be interesting to see when the zero rate bubble bursts.

The Indian stock markets are trading weak today. At the time of writing the BSE-Sensex was trading down by around 90 points, while the NSE-Nifty was down 34 points. Losses were largely seen in oil & gas stocks. Most Asian stock markets were trading in the red. However, European markets have opened the day on a strong note.

 Today's investing mantra
"We enjoy the process far more than the proceeds". - Warren Buffett

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

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1 Responses to "Why invest the way you play cricket and not chess!"

neeradi srinivasulu

Nov 14, 2014

very useful CHESS

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