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23/06/2012 17:40

Why Most Investors are Mostly Wrong Most of The Time

Last week I offered the readers of Intelligent Investor a reason for the dismal performance of Indian mutual funds. My reason was that portfolio managers don't have the right incentives to make intelligent but unconventional investment decisions with the result that the portfolios of most funds are very much alike and heavily concentrated towards conventional, popular stocks ("the Reliances, the Tiscos and the ITCs.") In this week's column, I will try to address another issue in investing: why do most investors lose money in the stock market? A Loser's Game Charles D. Ellis, a respected investment author, once likened investing to a loser's game. To understand this concept, it is vital to distinguish between a winner's game and a loser's game. In a winner's game, the outcome is determined by the winning actions of the winner. In a loser's game, the outcome is determined by the losing behaviour of the loser. Let's draw an analogy from the game of tennis. Simon Ramo, an eminent scientist, in his book, "Extraordinary Tennis for the Ordinary Tennis Player", identified the crucial difference between a winner's game and a loser's game. Over a period of several years, Dr Ramo observed that tennis was not one game but two - one played by professionals and a very few gifted amateurs; the other played by all the rest of us. Although players in both games use the same equipment, dress, rules and scoring, the basic natures of the games are quite different. After extensive scientific and statistical analysis, Dr Ramo summed it up this way: Professionals win points; amateurs lose points. In expert tennis, the ultimate outcome is determined by the actions of the winner. Professional tennis players stroke the ball with strong, well-aimed shots, through long and often exciting rallies, until one player is able to force an error by his opponent or drive the ball just out of reach. These splendid players seldom make mistakes. Amateur tennis, Dr Ramo found, is almost entirely different. Brilliant shots, long and exciting rallies, and seemingly miraculous recoveries are few and far between. On the other hand, the ball is fairly often hit into the nets or out of the boundary, and double faults at service are not uncommon. The amateur duffer seldom beats his opponent, but he beats himself all the time. When two amateurs are playing each other, the victor in the game of tennis gets a higher score because his opponent is losing even more points. Dr Ramo gathered data to test his hypothesis in a clever way. Instead of keeping conventional game scores - love, 15 all, 30-15, and so on - Dr Ramo simply counted points won versus points lost. He found that in expert tennis about 80 per cent of the points are won, i.e. in 80 percent of the points there are no double faults or netted services or other silly mistakes. But in amateur tennis about 80 per cent of the points are lost due to foolish mistakes of the loser. Like tennis, investing is a loser's game. The winners in the game come out with superior long-term results by simply making fewer mistakes. The losers end up with losses because they make mistakes over and over again.
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I have classified these mistakes into four categories - mistakes in asset allocation, mistakes in market timing, mistakes in security selection and temperamental mistakes. Mistakes in Asset Allocation Most investors make the fatal mistake of buying stocks just when bonds are more appropriate and vice versa. We are seeing that happening in India right now when investors are rushing to buy bonds even though simple common sense tells us that the expected total returns from stocks over the next five years are likely to be well in excess of the returns being offered by bonds. Investors, however, paralysed by the unrealised losses in their equity portfolios and enticed by high short-term bond yields are flocking to buy bonds. Mistakes in Market Timing Most investors try to "time" the market, i.e. they attempt to buy stocks when they think the market is going to go up and attempt to sell stocks when they expect the market to fall. Obviously, to work successfully, this approach requires either accurate predictive abilities or access to someone who possesses those abilities. That's why we have a whole industry whose only work is to make short-term stock market predictions. Virtually everyone involved in the stock market has an opinion of where the market is headed in the next few weeks or months. Chartists and others try to find trends in stock prices. Many investors buy or sell stocks on the basis of tips received from their brokers, friends or even strangers. There is an element of naivet involved here and that is this: if anyone possessed the ability to accurately predict stock market movements consistently, he would become a very very rich man so quickly that he would not find it necessary to sell his forecasts to the general public. Most investors, however, choose to ignore this basic fact and continue to make their investment decisions on the basis of tips. These attempts to time the market are bound to fail for most people because everyone cannot possible buy at the bottom and sell at the top. Most of those who attempt it, sell too late or buy too late, and do both too often. The result is frequent and unnecessary trading. Such actions make investors poorer but brokers richer. There is another side effect of market timing which is this: Market timing involves lots of investment decisions and common sense tells us that the more the number of investment decisions an investor has to make the more the chance that he will make a major mistake. And the avoidance of mistakes is, or should be, the chief objective of any investor. There is a logical reason as to why active investors who trade frequently will always under-perform their passive peers. Here is a two sentence proof of this mathematical truism: One, since all investors collectively own the entire stock market, if passive investors - those holding all stocks, forever - can match the gross return of the stock market, then active investors, as a group, can do no better. They too must match the gross return of the stock market. And two, since the management fees and transaction costs incurred by passive investors are substantially lower than those incurred by active investors, and both provide equal gross returns, then active investors must earn lower net returns as compared to passive investors. Mistakes in Security Selection Most investors simply buy overpriced stocks that are hyped up by sellers of stocks i.e. promoters and intermediaries such as brokers and merchant bankers. They end up chasing fashions and fads and eventually suffer heavy losses.
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A great deal of investors focus on factors that are completely irrelevant in evaluating the worth of the stock and fail to look at simple but vital things before committing money to stocks - things that they would have checked out if they were buying the entire business. Moreover, stockmarket investors display impatience that they do not display in their real-estate transactions. If an investor buys a sound stock and nothing happens for a couple of years he is likely to get impatient and switch to something that is likely to "move". He will show no such impatience in a property transaction where the average holding period is well in excess of five years. That's why the very same people who make money in the property market lose in the stock market. Temperamental Mistakes The biggest mistakes most investors make are temperamental in nature. For example, after having made a mistake, most investors compound it by refusing to sell at a loss thus blocking their capital in a lousy stock when other fantastic investments can be bought at bargain prices. Another temperamental mistake most investors make is their promptness in taking profits. This type of mistake alone keeps millions of investors from getting rich. If you doubt me, just ask any investor who bought Bajaj Auto, Colgate or Castrol shares in 1980 and sold at a profit in 1985. Another common mistake is investors' inability to ignore market fluctuations. Most investors get irrationally euphoric when stock prices rise and depressed when they fall. They forget that the market can get very irrational in the short-term but in the long term stocks of wealth creating companies always go up. The market may ignore business success for a while but will eventually confirm it. Conclusion The typical stockmarket investor makes many such mistakes and after having burnt his fingers over a few years is likely to get deeply disillusioned just as millions of Indian investors currently are. Ironically, he is likely to blame the government, the economy, the promoters, the merchant bankers, the politicians or simply the market for his misery. That is, anyone but himself. He forgets that the stockmarket is a loser's game and to win he must follow two lessons advocated by the world's most successful investor, Warren Buffett. Lesson number 1: don't make mistakes. Lesson number 2: don't forget lesson number 1. Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1996.

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