This blog is in continuation to my last one. Here we will talk about the behavior gap between what Mutual funds claim to be their CAGR returns Vs the actual return an average investor gets.
The GAP arises due to an unfair and flawed assumption that average retail Investor will continue with his/her investment despite the falling prices.
This assumption is equivalent to our modern day economics assumption of efficient market hypothesis or economists claiming that human beings take rational decisions.
As Dan Ariely and Daniel Kahneman have substantiated in their books, this assumption is far from the truth. Not only are we irrational, we are predictable at that. What that means is that cometh the same situation, we tend to make the same mistake again and again and again.
Lets look at the example. Lets just say for the sake of our example, that you are a bible thumping hardcore Warren Buffet buy and hold priest and you go all in with your Rs 1 lakh and buy Niftybees in the year 2005 and hold it till date.
Your 01 lakh would have become 3 lakhs, 63 thousand, that is a return of 12.15% CAGR. But wait a second, to achieve this respectable CAGR, you had to go through a ditch of 59.67%.
Well, I have come across many a stubborn, dogmatic investors, but to sustain a 60% draw-down you need…
And NOW it makes sense to look at the following statement in the new LIGHT.
80% of investors invest at expensive valuations.
The above mentioned return and drawdown was based on a presumption that our priest is a devout and would hold on or continue his SIP throughout. Now lets PLOT the graph of actual investor who as statistics suggest buy at the peak or close to it.
Presuming our average Joe bought NiftyBees close to the peak in September 2007. This is how the equity curve would look like.
Notice an interesting thing. Even after getting the timing horribly wrong, Joe still got a positive 5%CAGR. This is because of inherent upward bias of equity market in a growing country. You need to be a genius to go bankrupt in stock markets. Its not easy without excessive use of leverage.
Now for those of you who claim to have in possession the balls I referenced above, I would suggest you to read my earlier piece about DRAW DOWN Termite and how it eats into your CAGR.
The rebuttal that I usually get from people in defense of drawdown is a Quote from Charlie Munger
If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”
Charlie Munger said a lot of Other things too which our audience conveniently ignore. They pick up what they want or what suits them and justifies their laziness. Yes taking a drawdown is just that, LAZINESS.
Charlie in the above quote is talking to Intelligent above average investors and not average Joe. Problem with Average Joe is that he thinks he is above average. That is functional equivalent of a poll result where 80% drivers think that they are above average which is a mathematical JOKE.
The above quote is for those few who also follow his other quotes and exhibit traits like
Extreme patience combined with extreme decisiveness.
It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.
One of the saddest cases in investing happens when someone thinks they are active investor but the reality is that they have invested in so many stocks that they have become “closet indexers.
“The idea of excessive diversification is madness.”
“Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results
and then finally, this one takes the cake, on efficient market hypothesis, Munger said
Its true, Markets are fairly efficient, but not entirely efficient, top 3 to 4% of Investment management can beat the market.
Now you see, Charlie in his above quote is talking with above average smart rational investors and if you could throw the veil of over confidence off, you would realize he is not talking to us unfortunately 🙁
So what do we do!!!
Have a look at the chart below.
This is a return of 18.03% CAGR with a maximum drawdown of 29.92% during the same time period of 2005–2016.
What did I do, i created a basket of 03 asset classes, (NiftyBees, GoldBees and N100) N100 is motilal oswal top 100 nasdaq funds which in this backtest we started using after its launch in 2012.
From here on after end of every month, we ran a screener asking the computer which one of them is strongest relatively. which is to say which one has a better ROC. (rate of change)
This simple relative strength system parked our money in gold from Jan 2008 to April 2009 and got us out of the current market on 27th Feb 2015 and put us in Nasdaq 100 and on 29/feb, 2016 it got out of N100 as well and came to gold.
Our results would be a lot stellar, if we remove gold (which has lost its sheen) and put USDINR which has an inherent upward bias just like equity and is inversely related. I have not used USDINR for backtest as I did not want to use a leveraged product (there is no other way to go long the dollar).
Notice that this system is always in the market and never sits on cash since it only accommodates relative strength between asset classes. This can be improved by introducing the concept of Absolute momentum.
So once you have chosen your asset class based on relative strength, you ask the computer again if in last 01 year has this asset class return been above my benchmark FD, lets say 8%. You go long only if the answer is yes. This will further reduce the draw down to very manageable proportions without compromising on returns.
In my own account, I use a more comprehensive and better trend following system than this where I define the overall trend of a market on weekly and monthly time frames. If that system is a sell, I sit on cash, Debt or use that money to write credit spreads. Once that system is a buy, I, instead of buying Nifty, go long on inefficiencies of the market like spinoffs, demergers, turn arounds and other themes.
The idea is simple, I want my cake and eat it too. This system jettisons you out of equity from 2007–2009, from 2011–12 and now out since early 2016.
The system was developed because i realize I am not Warren Buffet. Not in talent and not in resources. You see Warren can keep buying the stock that keeps falling because of 02 reasons a) he has done his homework like no one else can and b) he can buy enough to have influence and if needed change management itself.
While its just a M2M loss for him, it will become very real for us. And therefore I am from Ed seykota school of thought which says, if you cannot measure it, you cannot control it. Your risk need to be defined every time you enter a trade. Period.
Comments are welcome.
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Originally published at www.mysticwealth.in on April 4, 2016.