In the financial world, there are some dogmas which participants are keen to reinforce every now and then. The stated justifications for these are mostly on the basis of principle, while the real reasons have generally got to do with more parochial interests (Regulatory arbitrage is one that comes to mind). There are many such dogmas around – the concept of a high-water mark, the notion of insuring bonds to get a higher rating, the idea of low-tax offshore havens, etc. In my mind, the one that has caused the most damage is the notion that liquidity is the holy grail of the capital markets (in fact all markets). We have all been led to believe that liquid capital markets are good for participants, regulators, small investors, governments, everyone else. Why, indeed? Because it aids price discovery. It helps the market know exactly what the market clearing price is for any stock at any point of time.
Creating liquidity in every imaginable market has become a guiding principle for participants that we have often created tradable entities where none should have existed. We want to trade carbon, carbon footprint, grades, virginity?, and many other historical non-tradables. I do not want to enter into the debate of moral questions on trading all kinds of stuff. I am not easily outraged, and more importantly, I would prefer debating on this issue without entering the morality domain. The belief that if anything is tradable, the price would be accurate is ubiquitous. I think this is just plain wrong. Some instruments are meant to be illiquid. In our fetish to create liquidity, we create shallow markets and prostrate before the holy god of price discovery. Merely trading over and over again does not aid price discovery. We merely get to a market-clearing price, and not to a relevant discovered-price.
I think there is an interesting analogy in the science of measurement that might help explain what I am getting at here. There are two interesting terms in measurement – accuracy and precision, both of which give an idea about the efficiency of a measurement but with subtle differences. Accuracy is the measure of how close the measurement is to an actual value, while precision is a measure of how close the measurements are to each other. Accuracy depicts how close we are to the actual quantity. So, in layman terms, accuracy is what is important. Very often, we mistake a precise measurement for an accurate one. According to me, market determined share prices are very precise. Quiet often share prices are “discovered” based on orders accumulated around a point. The more orders that are there, more precise the measurement. But markets do not uncover value accurately. If that were the case, then an index would not move from 8K to 21K in 1.5 years and go all the way back in another 8 months.
Market aficionados will retort saying that there is no “actual” value as far as markets are concerned. Perception is reality, “discovered price” is indeed the actual price. This is a credible argument. One that acknowledges the inherent variability in values of assets based on future assumptions about different factors in the world. But, if this is indeed the case, why do we want precisely discovered prices. Why place the burden of precision on an entity that has no notion of accuracy? The idea of having high levels of precision for an measurement that is inherently inaccurate is absurd. This is like a weather report guy telling you that the temperature for the day should be 23.678 degrees Celsius, but with the caveat that the measurement could be off by 15 degrees on either side. If your range if this broad, your precision counts for pish tosh, a concept with financial markets have never come around to understanding.
If valuing assets is a mugs game, if variance is going to be high, if market dynamics are going to influence prices way more than actual changes, if a change in unemployment rate in the US can take the share price of a local pharma company down sharply, then why should we insist on creating liquidity and aiding price discovery. This piece from Paul Wilmott from New York Times discusses the notion of liquidity and price discovery well.
Leaving aside the question of whether or not liquidity is necessarily a great idea (perhaps not being able to get out of a trade might make people think twice before entering it), or whether there is such a thing as a price that must be discovered (just watch the price of unpopular goods fall in your local supermarket — that’s plenty fast enough for me).
I remember a time when real estate prices of places close to the LSE were higher than ones 200 meters further away – merely for the fact that orders entered into systems in these offices could hit the LSE sooner. We are talking nanoseconds here. If this does not make people look at the financial markets and go – Oh my god, what have we created here? I don’t know what will.
Apparently, this madness is finally being debated. Our fetish for liquidity has led to a scenario where High Frequency Traders account for 50% of NYSE volumes. As ever, this article uses myriad high-falutin words like Flash trading, frequency rebate etc. Finance need not and should not be this complex. If it gets to this level, we should be stopping and restarting.
Nicolas Nassim Taleb wrote a book on randomness in markets called “Fooled by randomness”. The fundamental premise in the entire book is that people do not realise the role randomness plays in life, and in financial markets. That randomness is there is undeniable, and perhaps can be managed. What is more difficult to handle is the fact that inevitably (and periodically) people create structures and thought processes that do not acknowledge the inherent randomness in life (and financial markets).
Why should stock prices trade every day? Why should stock prices be given to the final decimal? We could just have a system that says stock A trades between Rs. 50 and Rs. 55. They announce results on the third Thursday after each quarter ends. The stock can be traded for a week after their results are announced – from the Monday after the results are announced to the Friday. Beyond this, there will be a week in the middle of the quarter when stock A will be open to trade. Prices will still be “discovered”, liquidity will still be there, randomness will be acknowledged, there will be little mark-to-market madness, and insider trading will be non-existent. Mutual funds will not be able to publish NAVs. If there NAVs change from when they publish it to when you read it, the NAV publishing is useless anyway. This is a small price to pay, I would argue. There would be fewer people participating in the price discovery game. This may not be a bad thing.
Weather forecasts often go wrong. The financial market is often like weather forecast. Except that instead of having a weatherman give his thoughts, we have about 25 who contribute their data-points for the daily temperature, and we take the average as a benchmark for the day. Can any of these forecasts change the temperature for the day? Can more estimates improve our accuracy of our prediction? If both these answers are no, then we are probably better off with one guy trying to tie all the dots. All people in the country will have to live with the fact that the temperature could be between 28 and 32 degree Celsius. It is far better than them assuming that it is 30 degree Celsius, when in fact it could be anywhere between 14 and 46.
Imagine the number of weather forecasters freed up to do less damage to the world than they were originally doing. Now, multiply that number by a million. That would probably be the number of resources that can be taken away from harm-creating financial jobs, if the world could shed its fetish for price discovery.
Showing posts with label Financial Markets. Show all posts
Showing posts with label Financial Markets. Show all posts
Wednesday, August 5, 2009
Monday, July 27, 2009
Financial Sector participants – II
Bunch II – Guys who work with the markets
This category comprises of two sub-sections, buy-side and sell-side. The buy-side is the one that buys/sells securities. These groups manage funds, invest in equities, debt etc and try to generate returns. Sell-side firms are the ones that work for a commission. Whenever buy-side firms trade anything, they do through a broking firm, paying anywhere between 10-45 bps for this transaction. This commission is the key revenue line for sell-side firms. In other words, buy-side firms generate on fund-based income, sell-side firms generate fee-based income.
Sell-side firms have 3 kinds of participants – analysts, sales guys and traders. Analysts are the ones that sweat over balance sheet, P&Ls and the like, come up with recommendations for stocks and supposedly uncover value in equities. Sales guys propagate these ideas. They call up assorted buy-side firms and ask them to buy stocks which they (analysts and sales) think are undervalued and sell those which they think are overvalued. Traders are the guys who actually put orders through. They understand the mechanisms of the market and can get a sense of which direction the market is headed merely by watching the order book.
Analysts agonise over small details and generally pontificate about specific industries. They are the most pseudo-intellectual of the lot. They generally do not have the courage to put in any trades on their own but take great pride in sharing anecdotes about how they helped a client make lots of money. Particularly bitter analysts have a habit of recalling stories where a client lost money after having not listened to the sage advice from the analyst himself.
Sales guys have the individuality of a log of wood, a particularly uninteresting one at that. They peddle analysts’ views with any market flavour they can pick up. Sales guys spend hours on the phone recalling funny anecdotes from stories they heard while they were spending hours on the phone talking to other clients. Sales guys swear by the flavour of the season and pride themselves on knowing the pulse of the market.
Traders live for/in the moment. If they see a big buy order they conclude markets are indefinitely going up. If they see no activity in a day, they are generally depressed. These guys rarely care about anything beyond the immediate future.
On the buy-side, there are analysts and fund managers. Analysts are generally flunkeys who interact with fellow analysts in sell-side firms, provide internal research to fund managers, and generally do anything that helps them in their eternal quest to impress fund managers. Fund managers are the guys who manage portfolios, the ones who take the decision to buy/sell/not buy any stock. They are paid on the basis of their funds’ performance.
Now, where is the catch? If this is such a well-structured industry, where is the problem?. The problem stems from the fact that everything in the industry is relative or hidden. And every participant is allowed to hide behind some smokescreen. Cover-thy-ass is the underlying theme amongst all participants. Any research report will be littered with the following phrases – “in our view”, “we believe”, “increasing likelihood” etc. Now, equity pricing is an inexact science, so there is nothing wrong in getting things wrong. Except that, the pay packets of the participants hardly acknowledge the fact that this is an inexact science. Markets are random, investors bear the brunt of this, but employees are hardly affected. And, in my view that is wrong.
Imagine going into a hospital and the doctor says – “Look, in my view, you should take these tablets. There is a likelihood that these might help you” and follows up with – “ I must disclose to you that I might or might not have a stake in the pharma company that sells these tablets”. And for good measure, you find out that the doctor himself would never take these tablets. Not because he does not trust them. No siree. But because he wants to diversify his professional and personal risk. As in, if the tablet turns out to be bad, even if his professional reputation is ruined his personal health at least would remain. Remember, doctors generally earn about one-fifth of financial consultants globally.
Both diagnosis and stock-picking are inexact sciences. It is just lamentable that we set two standards for these two. The more crucial between doctors and analysts is set the more onerous set of restrictions, judged harder and has to get by with far lesser pay.
Now, coming to the part where the industry participants hedge their bets. Sell-side guys are in the business of generating commissions, not returns. So, they do enough to create chatter. According to the sell-side, the actual job of picking the right-stocks is with the buy-side. The motto is simple – Ours is not to buy or sell, ours is but to peddle (paraphrasing Alfred Tennyson). Even within this, the structure helps these guys out. The research analysts are slightly reticent; while the sales guy is at liberty to say whatever he wants, because in the end he is just providing market view (albeit with a bias). On the buy-side, the analysts do not take any calls, so it is impossible to blame them. The fund managers, who are the only ones who can be pinned down to something (because they have a clear P&L) have numerous ways of getting away with it. Fund managers are generally measured only relative to the market. So, their play is simple – allocate 85% of portfolio to the standard stocks (market), have 4 companies where you have inside information, park 10% of your portfolio here, and place 5% of funds base on your analysts’ recommendations and blame them if things go wrong. Everyone is happy this way.
This category comprises of two sub-sections, buy-side and sell-side. The buy-side is the one that buys/sells securities. These groups manage funds, invest in equities, debt etc and try to generate returns. Sell-side firms are the ones that work for a commission. Whenever buy-side firms trade anything, they do through a broking firm, paying anywhere between 10-45 bps for this transaction. This commission is the key revenue line for sell-side firms. In other words, buy-side firms generate on fund-based income, sell-side firms generate fee-based income.
Sell-side firms have 3 kinds of participants – analysts, sales guys and traders. Analysts are the ones that sweat over balance sheet, P&Ls and the like, come up with recommendations for stocks and supposedly uncover value in equities. Sales guys propagate these ideas. They call up assorted buy-side firms and ask them to buy stocks which they (analysts and sales) think are undervalued and sell those which they think are overvalued. Traders are the guys who actually put orders through. They understand the mechanisms of the market and can get a sense of which direction the market is headed merely by watching the order book.
Analysts agonise over small details and generally pontificate about specific industries. They are the most pseudo-intellectual of the lot. They generally do not have the courage to put in any trades on their own but take great pride in sharing anecdotes about how they helped a client make lots of money. Particularly bitter analysts have a habit of recalling stories where a client lost money after having not listened to the sage advice from the analyst himself.
Sales guys have the individuality of a log of wood, a particularly uninteresting one at that. They peddle analysts’ views with any market flavour they can pick up. Sales guys spend hours on the phone recalling funny anecdotes from stories they heard while they were spending hours on the phone talking to other clients. Sales guys swear by the flavour of the season and pride themselves on knowing the pulse of the market.
Traders live for/in the moment. If they see a big buy order they conclude markets are indefinitely going up. If they see no activity in a day, they are generally depressed. These guys rarely care about anything beyond the immediate future.
On the buy-side, there are analysts and fund managers. Analysts are generally flunkeys who interact with fellow analysts in sell-side firms, provide internal research to fund managers, and generally do anything that helps them in their eternal quest to impress fund managers. Fund managers are the guys who manage portfolios, the ones who take the decision to buy/sell/not buy any stock. They are paid on the basis of their funds’ performance.
Now, where is the catch? If this is such a well-structured industry, where is the problem?. The problem stems from the fact that everything in the industry is relative or hidden. And every participant is allowed to hide behind some smokescreen. Cover-thy-ass is the underlying theme amongst all participants. Any research report will be littered with the following phrases – “in our view”, “we believe”, “increasing likelihood” etc. Now, equity pricing is an inexact science, so there is nothing wrong in getting things wrong. Except that, the pay packets of the participants hardly acknowledge the fact that this is an inexact science. Markets are random, investors bear the brunt of this, but employees are hardly affected. And, in my view that is wrong.
Imagine going into a hospital and the doctor says – “Look, in my view, you should take these tablets. There is a likelihood that these might help you” and follows up with – “ I must disclose to you that I might or might not have a stake in the pharma company that sells these tablets”. And for good measure, you find out that the doctor himself would never take these tablets. Not because he does not trust them. No siree. But because he wants to diversify his professional and personal risk. As in, if the tablet turns out to be bad, even if his professional reputation is ruined his personal health at least would remain. Remember, doctors generally earn about one-fifth of financial consultants globally.
Both diagnosis and stock-picking are inexact sciences. It is just lamentable that we set two standards for these two. The more crucial between doctors and analysts is set the more onerous set of restrictions, judged harder and has to get by with far lesser pay.
Now, coming to the part where the industry participants hedge their bets. Sell-side guys are in the business of generating commissions, not returns. So, they do enough to create chatter. According to the sell-side, the actual job of picking the right-stocks is with the buy-side. The motto is simple – Ours is not to buy or sell, ours is but to peddle (paraphrasing Alfred Tennyson). Even within this, the structure helps these guys out. The research analysts are slightly reticent; while the sales guy is at liberty to say whatever he wants, because in the end he is just providing market view (albeit with a bias). On the buy-side, the analysts do not take any calls, so it is impossible to blame them. The fund managers, who are the only ones who can be pinned down to something (because they have a clear P&L) have numerous ways of getting away with it. Fund managers are generally measured only relative to the market. So, their play is simple – allocate 85% of portfolio to the standard stocks (market), have 4 companies where you have inside information, park 10% of your portfolio here, and place 5% of funds base on your analysts’ recommendations and blame them if things go wrong. Everyone is happy this way.
Monday, June 22, 2009
Financial sector participants - I
Financial services is one of more opaque industries around. The structure of the industry and the reporting lines are fairly muddled. It took me quite a while to understand how the industry is structured and so I thought it would be a good idea to give a broad map of the industry. All in an effort to lower my own guilt at earning a living out of a fundamentally unscrupulous industry (perhaps all industries are like this, but I have only ever been exposed to this one).
Broadly, the industry can be divided into three parts – one bunch of people working with companies, one bunch of people working with markets and a third bunch who we will charitably describe as other jokers (mostly because I do not understand what they do). By industry, I do not include the guys who actually do banking in the true sense of the word. The guys who actually lend you money to buy house, car, or an education. These guys are probably only slightly less clueless, but what makes them far more tolerable is the fact that they generally don’t have huge egos. Also, there are more women in this part of banking. J
Bunch 1 – Guys who work with companies.
The guys who work with companies are the ones that advise companies to issue corporate paper (to “borrow” in English), to “optimise” their balance sheet (there is no English-word equivalent for this) and to buy other companies. This industry is structured in three layers, one big shot guy who has a “board-level” relationship with 4-5 companies in an industry. He has 2-3 guys reporting to him (rising stars) who do the market analysis and are generally sold the dream of being tomorrow’s big shot. This structure is propped up by flunkeys who make the presentations. Now, you might wonder why these guys would be best-suited to give gyaan to CEOs on what companies to buy. How in the wide world would a 28-year-old who has spent all his career (all of 4-5 years) in the financial sector be capable of “advising” on a transaction where one telecom company buys another, you might wonder. But this is how the industry works. Most big deals are done for the sake of one underlying theme, and generally that is not financial. Top management either develops a fetish for a competitor’s product, or develops an ego that demands a bigger company to run, or in most cases is under pressure to “better-utilise” the cash on its balance sheet.
The “board-level” guy plants the idea in the minds of top management, gets his flunkeys to flip a bunch of the presentations, has one of his stars run through this and makes a pitch to the management with a shortlist of 3 targets. Some financials are thrown in for good measure. The flunkeys literally do a match-the-following of “buyers” and “sellers” in the industry and create a laundry-list of possibilities. When some companies fall under the category of potential “buyers” and “sellers”, flunkeys self-actualise. I have heard questions from flunkeys like – Can Atos Origin buy Satyam in order to acquire offshore capacity?. I would reply that Atos has cartloads of debt, and Satyam’s market cap is actually higher than Atos’s. Oh, then can Infosys buy Atos Origin then?, would be the next question. Imagine you going to a vegetable vendor and asking for potatoes and him replying, I don’t have potatoes today, but can I buy your pen instead?
The stars know a lot more about the industries. They would know that Atos hadn’t a chance in hell of acquiring anything and Infosys would rather de-list before they bought Atos. They would shorten the list created by flunkeys, add their “expertise” and bond with the board-guy to discuss possibilities for the sector. They would patiently “crack” new boardrooms, build a potential-deal “pipeline” and wait for one ego to get big enough to cloud judgement. That is pretty much the description of your average M&A house. Till I completed by MBA, I did not even know that companies bought other companies so frequently. I just could not see the reason for this type of transaction. They probably wouldn’t do this if not for this industry.
The other divisions which raise debt, help with rights issues etc, work similarly. There is one bunch that does financial engineering to help companies manage their balance sheet. In India, generally this work is done by assorted auditing firms. Mostly, what these guys do pushes the ethical boundaries; in some cases it is downright fraud. The auditing firm will help you “optimise” your balance sheet. In essence, the company will help you massage your ratios if you want to borrow on favourable terms. Your inventory will be placed with your biggest customer to count it as receivable, your key shareholders will be paid cash dividends, your big lenders will be told they will receive interest, only it will be called dividend from now on. This is called financial engineering. It sullies the good name of engineering.
Will give a few bits on bunch II and III later on.
Broadly, the industry can be divided into three parts – one bunch of people working with companies, one bunch of people working with markets and a third bunch who we will charitably describe as other jokers (mostly because I do not understand what they do). By industry, I do not include the guys who actually do banking in the true sense of the word. The guys who actually lend you money to buy house, car, or an education. These guys are probably only slightly less clueless, but what makes them far more tolerable is the fact that they generally don’t have huge egos. Also, there are more women in this part of banking. J
Bunch 1 – Guys who work with companies.
The guys who work with companies are the ones that advise companies to issue corporate paper (to “borrow” in English), to “optimise” their balance sheet (there is no English-word equivalent for this) and to buy other companies. This industry is structured in three layers, one big shot guy who has a “board-level” relationship with 4-5 companies in an industry. He has 2-3 guys reporting to him (rising stars) who do the market analysis and are generally sold the dream of being tomorrow’s big shot. This structure is propped up by flunkeys who make the presentations. Now, you might wonder why these guys would be best-suited to give gyaan to CEOs on what companies to buy. How in the wide world would a 28-year-old who has spent all his career (all of 4-5 years) in the financial sector be capable of “advising” on a transaction where one telecom company buys another, you might wonder. But this is how the industry works. Most big deals are done for the sake of one underlying theme, and generally that is not financial. Top management either develops a fetish for a competitor’s product, or develops an ego that demands a bigger company to run, or in most cases is under pressure to “better-utilise” the cash on its balance sheet.
The “board-level” guy plants the idea in the minds of top management, gets his flunkeys to flip a bunch of the presentations, has one of his stars run through this and makes a pitch to the management with a shortlist of 3 targets. Some financials are thrown in for good measure. The flunkeys literally do a match-the-following of “buyers” and “sellers” in the industry and create a laundry-list of possibilities. When some companies fall under the category of potential “buyers” and “sellers”, flunkeys self-actualise. I have heard questions from flunkeys like – Can Atos Origin buy Satyam in order to acquire offshore capacity?. I would reply that Atos has cartloads of debt, and Satyam’s market cap is actually higher than Atos’s. Oh, then can Infosys buy Atos Origin then?, would be the next question. Imagine you going to a vegetable vendor and asking for potatoes and him replying, I don’t have potatoes today, but can I buy your pen instead?
The stars know a lot more about the industries. They would know that Atos hadn’t a chance in hell of acquiring anything and Infosys would rather de-list before they bought Atos. They would shorten the list created by flunkeys, add their “expertise” and bond with the board-guy to discuss possibilities for the sector. They would patiently “crack” new boardrooms, build a potential-deal “pipeline” and wait for one ego to get big enough to cloud judgement. That is pretty much the description of your average M&A house. Till I completed by MBA, I did not even know that companies bought other companies so frequently. I just could not see the reason for this type of transaction. They probably wouldn’t do this if not for this industry.
The other divisions which raise debt, help with rights issues etc, work similarly. There is one bunch that does financial engineering to help companies manage their balance sheet. In India, generally this work is done by assorted auditing firms. Mostly, what these guys do pushes the ethical boundaries; in some cases it is downright fraud. The auditing firm will help you “optimise” your balance sheet. In essence, the company will help you massage your ratios if you want to borrow on favourable terms. Your inventory will be placed with your biggest customer to count it as receivable, your key shareholders will be paid cash dividends, your big lenders will be told they will receive interest, only it will be called dividend from now on. This is called financial engineering. It sullies the good name of engineering.
Will give a few bits on bunch II and III later on.
Thursday, June 4, 2009
Markets and the small investor
A lot many Indian families have been sold the idea of taking part in the great Indian bull-market game. Quite a few have tried this and met with some success as well, and now think that this is a no-brainer. I work in the financial services sector and I can state with reasonable conviction that it is not easy to generate solid returns year after year. There have been a lot of myths sold to retail investors in order to make them cough up. As a kind of guilt-reduction exercise, I want to explode a few of them.
1. Equities may be a riskier asset, but if you are investing for a long time, they will definitely generate better returns: This is pish tosh. Most long-term calculations are biased by the starting date, and therefore most statistics presented are wrong. Let me explain this with an example. If as a small investor, one had entered the market in 2006, the long-term argument will hold good, but anyone who entered when the sensex was anywhere between 18-21K might not see this argument bearing good even if we stretch the definition of long-term to 50 years. If over any stretch of long-term, equities generated better returns, then this is not a riskier asset class, it is the juicier asset class.
2. Small investors are not at a disadvantage: Think about this. The industry has 3 kinds of participants, domestic institutions, foreign institutions and small investors. The first two move the market, and the third is a price-taker, and this is a zero sum game. This is how market mechanism works – Company of reasonable size keeps peddling its own investment story, Fund managers hear the story and build positions; one of the sell-side research firms picks up on this and writes research, some more fund managers like story and buy stock; some retail brokers follow suit and write about the investment idea, the small investors also get in and the stock price keeps going up. Who do you think is selling? In the first 2 phases it is some promoter, in the third phase it is the fund manager. The key to an investment idea is not whether or not you understand the story, it is whether you are amongst the ones who are early to the story. A fortnight after the elections, the buzz word among retail investors was how infra would be a major theme for this government. At least 4 fund houses held conference calls with psephologists before election results were out. Infra stocks were up 50% in the first 2 weeks after election results. By the time the retail investors get into the theme, it is already done and dusted.
3. The guys on TV are really smart, and therefore get things right: I worked for a large sell-side firm. Journalists from Bloomberg or Dow Jones would call our offices once a month to have a chat about this and that. I would give him/her the most sanitised dope possible, sans name/organisation. (The stated internal rationale for this was that our clients pay for our research, they would be angry if we gave it away for free; the real reason is that in most cases, we are really not sure what is going to happen and wouldn’t want to get sued). These journalists would spin a story out of this which would then get picked on by the TV guys. As a sell-side analyst, I was generally late to the game as the buy side guys had more at stake, more resources and were generally better than me. The best buy-side guys got may be 60% of their calls right. TV analysis is at the fag end of the investment analysis-chain. They still sound smart because they are good at packaging and are perhaps at the beginning of the retail investment analysis chain. In a reasonable market, a major insight uncovered by good analysis lasts perhaps a week. This is roughly about the time the insight takes to find itself on TV screens. So, if you invest based on TV analysis, be prepared for some rude shocks.
4. A lot of small investors make very good money: Remember this is a zero sum game. Most small investors get s*ckered into this because someone they know has struck it rich by just randomly punting it on the market. All investors like to talk about their investments that worked beautifully. This is true of mutual fund managers, hedge-fund guys and small investors. When things go well because the market is going up, people give themselves credit for picking the right stocks. When things go wrong, they go quiet. So, anyone hearing these jokers will assume that they are rockstars of the investment world. They are not. (Nobody is, the market is a great leveller. More on that in another post). Rising tide takes all boats up, the oarsmen take credit for this; and when the tide recedes, they go quiet. You will hear the odd story that someone has gone bust because of stock investing, but this is not all. Most guys enjoy trading in bull markets, lose a lot of money in bear markets and keep their trap shut about this. Chatter is directly proportional to return levels.
5. Blue-chip names are generally safe bets: Again, think about this. Blue-chip names are among the most researched in the market (There are perhaps 40 sell-side analysts covering Infosys, there will be another 50 buy-side analysts covering the same name). There are guys who have spent 10 years in just studying the 25 names that are so-called blue-chips. So, even if they are stable and solid, you will get beaten to the best returns by the guy who goes to the same club as the CFO. So, you are likely to generate better returns by placing money on the index. There is a huge difference between a good company and a good stock.
6. The financial markets are very ethical and take care of the small investor: Hahahaha. This is a whole new can of worms. One can write an entire book on ethical standards in the financial sector. Let me at least set this aside for another post.
So, what does a retail investor do? Generally, market return is classified into two types – alpha and beta. Beta is just what the market returns, while alpha is what the “skill” level of the money-manager returns. By definition, the cumulative alpha of all market participants has to be zero. According to me, the best strategy for retail investors is to go for beta, and build portfolios where they won’t get smacked by huge negative alpha. In essence, time your overall market entry, don’t get s*ckered into the absolute lemons, and for the love of god do not fall for the temptation of trading more when the going is good. The simpler version of this is to just punt on the overall market and not get into specific names. If you want to trade on khabar, do not use your brains to verify whether khabar is likely to be right, rack your brains to figure out if you are the first to the khabar. Baseless khabar can generate returns if you are the first to hear it; and vice versa. And develop a temperament to handle volatility in returns without letting it affect your health. If you cannot do any of these, place your money in FD’s and pray that this bull-market madness comes to pass.
1. Equities may be a riskier asset, but if you are investing for a long time, they will definitely generate better returns: This is pish tosh. Most long-term calculations are biased by the starting date, and therefore most statistics presented are wrong. Let me explain this with an example. If as a small investor, one had entered the market in 2006, the long-term argument will hold good, but anyone who entered when the sensex was anywhere between 18-21K might not see this argument bearing good even if we stretch the definition of long-term to 50 years. If over any stretch of long-term, equities generated better returns, then this is not a riskier asset class, it is the juicier asset class.
2. Small investors are not at a disadvantage: Think about this. The industry has 3 kinds of participants, domestic institutions, foreign institutions and small investors. The first two move the market, and the third is a price-taker, and this is a zero sum game. This is how market mechanism works – Company of reasonable size keeps peddling its own investment story, Fund managers hear the story and build positions; one of the sell-side research firms picks up on this and writes research, some more fund managers like story and buy stock; some retail brokers follow suit and write about the investment idea, the small investors also get in and the stock price keeps going up. Who do you think is selling? In the first 2 phases it is some promoter, in the third phase it is the fund manager. The key to an investment idea is not whether or not you understand the story, it is whether you are amongst the ones who are early to the story. A fortnight after the elections, the buzz word among retail investors was how infra would be a major theme for this government. At least 4 fund houses held conference calls with psephologists before election results were out. Infra stocks were up 50% in the first 2 weeks after election results. By the time the retail investors get into the theme, it is already done and dusted.
3. The guys on TV are really smart, and therefore get things right: I worked for a large sell-side firm. Journalists from Bloomberg or Dow Jones would call our offices once a month to have a chat about this and that. I would give him/her the most sanitised dope possible, sans name/organisation. (The stated internal rationale for this was that our clients pay for our research, they would be angry if we gave it away for free; the real reason is that in most cases, we are really not sure what is going to happen and wouldn’t want to get sued). These journalists would spin a story out of this which would then get picked on by the TV guys. As a sell-side analyst, I was generally late to the game as the buy side guys had more at stake, more resources and were generally better than me. The best buy-side guys got may be 60% of their calls right. TV analysis is at the fag end of the investment analysis-chain. They still sound smart because they are good at packaging and are perhaps at the beginning of the retail investment analysis chain. In a reasonable market, a major insight uncovered by good analysis lasts perhaps a week. This is roughly about the time the insight takes to find itself on TV screens. So, if you invest based on TV analysis, be prepared for some rude shocks.
4. A lot of small investors make very good money: Remember this is a zero sum game. Most small investors get s*ckered into this because someone they know has struck it rich by just randomly punting it on the market. All investors like to talk about their investments that worked beautifully. This is true of mutual fund managers, hedge-fund guys and small investors. When things go well because the market is going up, people give themselves credit for picking the right stocks. When things go wrong, they go quiet. So, anyone hearing these jokers will assume that they are rockstars of the investment world. They are not. (Nobody is, the market is a great leveller. More on that in another post). Rising tide takes all boats up, the oarsmen take credit for this; and when the tide recedes, they go quiet. You will hear the odd story that someone has gone bust because of stock investing, but this is not all. Most guys enjoy trading in bull markets, lose a lot of money in bear markets and keep their trap shut about this. Chatter is directly proportional to return levels.
5. Blue-chip names are generally safe bets: Again, think about this. Blue-chip names are among the most researched in the market (There are perhaps 40 sell-side analysts covering Infosys, there will be another 50 buy-side analysts covering the same name). There are guys who have spent 10 years in just studying the 25 names that are so-called blue-chips. So, even if they are stable and solid, you will get beaten to the best returns by the guy who goes to the same club as the CFO. So, you are likely to generate better returns by placing money on the index. There is a huge difference between a good company and a good stock.
6. The financial markets are very ethical and take care of the small investor: Hahahaha. This is a whole new can of worms. One can write an entire book on ethical standards in the financial sector. Let me at least set this aside for another post.
So, what does a retail investor do? Generally, market return is classified into two types – alpha and beta. Beta is just what the market returns, while alpha is what the “skill” level of the money-manager returns. By definition, the cumulative alpha of all market participants has to be zero. According to me, the best strategy for retail investors is to go for beta, and build portfolios where they won’t get smacked by huge negative alpha. In essence, time your overall market entry, don’t get s*ckered into the absolute lemons, and for the love of god do not fall for the temptation of trading more when the going is good. The simpler version of this is to just punt on the overall market and not get into specific names. If you want to trade on khabar, do not use your brains to verify whether khabar is likely to be right, rack your brains to figure out if you are the first to the khabar. Baseless khabar can generate returns if you are the first to hear it; and vice versa. And develop a temperament to handle volatility in returns without letting it affect your health. If you cannot do any of these, place your money in FD’s and pray that this bull-market madness comes to pass.
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