Last Updated : Jul 25, 2018 04:24 PM IST | Source:

Explained: The role of skill vs the role of time in markets

Does it take time or skillset to garner returns in the market? A quite trade-off in itself, the choice depends on the goal of the investor.

CK Narayan

Recently, my good friend Mahesh Bhagwat, wrote an excellent piece on the matter of total returns on an investment using acquisition price, earnings growth and holding periods as variables. It brought out several important points, the major of which were the following

- PE levels (or acquisition price) is largely less relevant when holding periods are long (I.e.10 years and above).

- Both earnings growth and PE levels are important if one is looking at shorter periods of holding.

Using a table of a starting PE of 25 (which is the current level of the Nifty) and ending PE ranging from 15 through 25, and through years of holding (1 through 10), Mahesh demonstrated the impact of changes in the PE and growth through time.

For instance, if the PE remains at 25 and growth is 10% across several years, we can still generate a return of 10% on the portfolio. However, if the PE just drops by 1 (that is to 24), the returns across a 2-year period drops to below 8%.

And if the PE pulls back to 20 then the returns drop to 1.6% only. Note that this occurs despite an earnings growth of 10%. In fact, even with a growth of 20%, if the PE were to drop from the current 26 levels to 20, the returns over a 1 or 2 year period can turn negative!

Now contrast that with an investor who is willing to wait for 10 years, where a big drop of the PE from 25 to 15 (that is 40%), the returns still remain at 4.5% positive! This is the game that mutual funds and the big investors play.

For a large investor, safety and consistency of return is more important than the quantum of return! Mutual funds feed on that sentiment and are therefore able to corner large sums of money that get committed for long lengths of time, allowing them to add some personal skills of the fund manager to bring about additional returns.

But now comes the crux. Most people who play the market are not really long-term investors! While they may agree on principle that one should hold investments for 5 or 10 years, the pressure of being an active market player, watching the market moves frequently, tuning in to financial channels daily, reading websites, interacting with other market players, being inundated with messages to buy or sell on various WhatsApp groups that one belongs to- all these become too much pressure for the normal person to think very far into the future.

Like Daniel Kahneman writes, the personal behavioural characteristics like loss aversion and recency (and other) Bias etc. take their toll on investor psyche and most people are unable to hold on to their investments beyond 3 to 24 months. And here is where it all begins to kick in. If the acquisition cost is not correct, then returns over 1 to 2 year periods become poor to very bad!

Does this mean then, that people should not play the market over terms of 1-2 years if they cannot get the stock relatively cheap? The answer is yes. But what if one does want to have returns over the near term and does not have the ability to wait for 10 years? Well, in that case, such persons will have to garner different skills; ones that help them deal with the producing returns over the short term! There is no choice! It is either that or the long route.

And here is where technical analysis steps in to help people out. Most small investors do not have the luxury or willingness to stay invested for long periods of time. Most small investors do not have to wherewithal to withstand market gyrations. They also have no means of gauging the market flow. Thus they become victims of the market forces and live in this unsatisfactory world, believing that it is really fate and good luck which produces market profits.

It isn’t. Skill has a great role to play and gathering those skills is the responsibility of the individual investor and trader. Shirk that education and market will turn into a very expensive place! Unfortunately, most people believe that education should be cheap or even free- like in YouTube! Among the worst performers in the market are those that learn Technical analysis from free YouTube videos. They are doomed to failure. It is just that they don’t know it yet.

Since so much is available on YouTube, people find themselves reluctant to pay for good education in the markets. Or they feel it is not worth spending so much time in learning. What would you say to your child if he or she said that they couldn’t be bothered with 16 years of school and college education, terming it as being too long and too expensive?

Chances are that you will give the kid a nice whack and send him packing to school! The same thing needs to be done with market schooling. Unfortunately, you have to whack yourself; else the market will keep whacking you with more losses! Like Mark Douglas puts it brilliantly, ‘The amount of losses that you create is an indicator of how much you don’t know yet about the markets’.

There is enough profitability in the shorter leg of the market too but it has to be harnessed through a different approach that does not include earnings, growth and valuations. Until you learn that truth, it is better to remain an investor and not seek to be a trader.

To get trading recommendations from C.K. Narayan, click here.
First Published on Jul 9, 2018 02:40 pm
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