1. Stocks or Mutual Funds?
A lot of AP investors have invested in both stocks and funds. But often they are confused whether they should stay invested in both. New investors too often face this dilemma. How should you decide? Here are some thoughts that may help.
While both stocks and equity mutual funds (which buy stocks) help you create wealth over the long-term if bought judiciously, as investors we react to them differently in the short-term. There is an important difference between investing in stocks and investing in equity funds. The key difference is that you will never know the specific mistakes a fund manager makes in buying and selling individual stocks and it will not affect you. You will only know of the net result (NAV).
On the other hand, if you buy stocks, you will be aware of the gains and losses in every single stock. This plays on our minds. Gains will lift your mood and losses will depress you. But not to the same extent. There is a difference in the way our mind reacts to gains and losses. It is well-established that we feel worse about losses than we feel good about our gains. We are biologically hardwired that way. No wonder one of our AP subscribers was worried about the short-term loss in one stock and but was not asking us about the handsome gains he was sitting on in almost all the other stocks we recommended.
This problem will not arise if you invest in an equity fund. Do you check what kind of returns a fund has made in each of the stocks it has put your money in? You don’t because you cannot even find that out, even if you wanted to. This is simply because funds don’t report when they have bought a stock and when they have sold it and whether they have made a profit or loss and how much. But you will know that about every stock you buy and sell.
Also, funds often buy and sell a small amount of stock within their overall larger holding in it. That makes it even more difficult to calculate returns. So, you don’t see the losses and gains from individual stocks. All you see is the progress of the overall portfolio – in the form of change in NAV. The lesson is, if you buy stocks you should ignore losses and gains from individual stocks and be focused on the change in portfolio -– just like you do for funds – and that too over the long-term. This will help you deal with the volatility of individual stocks. If you agree with this approach, we would recommend you to invest in stocks.
2. Stocks: How to ignore volatility but not ignore risk
There is a strong misconception that stocks are risky because they are volatile, being traded assets. But volatility is not always risk. Volatility can certainly inflict a short-term loss. But the same stock that goes down sharply in the short-term can go up a lot more in the long-term. (In such cases volatility is an opportunity.) However, in some cases, a stock may not go up even over the long-term. You will then have a permanent loss of capital. That is the real risk of stocks. How to reduce this risk -- of long-term or permanent loss? By buying quality stocks for the long-term. If you compromise on quality you will risk a permanent loss of capital. If you buy for the short-term, again you risk a permanent loss of capital.
3. What we buy
Our strategy is not ‘buy and hold’ a large number of high quality stocks for the long-term. We follow a simple process of 1. Prelisting high quality stocks 2. Recommending them when they are on an uptrend. We identify quality companies (which are generating strong cash flows or on the verge of it) and then suggest a buy when they are rising. Both these conditions have to be present for a stock to be recommended. We have arrived at this process after more than a decade of research of what works in investing. There is nothing more we can share about our stock selections. We wish to be judged by our results. We will benchmark our performance with the best mutual funds and popular indices like Nifty 50 and Nifty 500.
On occasions, depending on market situations, we will have high sector concentrations.
While identifying which stocks to buy we are not tempted by turnarounds, glamorous names, mega themes or stories and narratives that may or may not come true. They usually don’t come true and / or have no correlation with what happens to stock prices. We prefer to look for a company’s annual and quarterly financial data, which will normally tell you all you need to know.
4. When we sell
We usually have a predefined formula that determines the price of our exits. That targeted exit price keeps changing. If the stock goes below that level, we pull the trigger. The only time we may not pull the trigger is a sudden sharp decline caused by external shocks, which may impulsively push the price of a stock. Good quality stocks usually bounce back from such impulsive selling.
5. Executing trades:
When should you buy and sell? Act immediately because it is impossible to fine tune the actual buying and selling. Usually you should be the best buyer after the market settles down in about 30 minutes from the start. Don’t try to scale your buying on declines or wait to sell on rallies unless you have a tested formula that works for you.
6. Periods of holding cash:
Since the core of our strategy is to buy good quality stocks but only when they are trending higher,
, it could well be that in a market downturn, we may recommend more exits and very few stocks to buy. In those periods, which can last for 2-6 months, we would suggest you stay in cash. This is a normal situation every year and you need not feel perturbed that we have gone silent. We would be monitoring our shortlist closely and the moment we find stocks in an uptrend we would recommend a buy.
7. Market / stocks are too expensive:
8. Losses/fall in individual stocks:
- “Expensive” markets are not correlated to returns from individual stocks over the medium to long term. Even in an expensive market, many stocks will continue to do well. It is a common fallacy to confuse between market valuation and valuation of individual stocks.
- “Expensive” markets and stocks are known only with hindsight. Also, after a shock decline, stocks and overall market will always look expensive because they are based on recent low earnings.
- High quality stocks decline along with the market only in severe bear markets. In normal market declines of 10-20%, many high quality stocks may fall a bit, move sideways and go up again. We shortlist high quality stocks available at reasonable valuation. Having said that stocks may go down any time after your purchase, whether they have already run up or not. That is the nature of stocks.
- Nobody knows in advance, the kind of returns a stock will fetch. But a company which keeps growing its revenues and profits, is an exceptional opportunity. Its stock will be a buy at all levels. To stay away from such a stock based on conventional notions of valuation will be mistake. This is why we don’t have target prices for stocks. Nor do we let valuation dictate our exits.
As mentioned above, even in an otherwise bull market, many high quality stocks may fall by 10-20%, move sideways and go up again. Do not get perturbed by such temporary declines. The performance of your portfolio has to be seen as a whole and over 1-2 years. Not one stock that is falling over the short-term. We are tracking each stock and when you need to sell a specific stock, we will inform you.
9. Risk profiling:
We do risk profiling but in a broad way, not in a narrow way. Risk profiling is not a very scientific process. Science is about establishing objective truth. But your risk profile is determined by you subjectively by answering a financial quiz. Read what Jason Zweig, one of the finest writers on Personal Finance, writes in his book, The Little Book of Safe Money
. One of the chapters is titled ‘Financial Planning Fakery’ subtitled, ‘What Is Your Risk Tolerance? No One Knows!’ where Zweig writes: “Its a conventional wisdom among financial planners that every investor has a distinctive appetite for risk. Most financial advisers will subject you to a risk-tolerance questionnaire, a series of between a half-dozen and a hundred questions supposedly designed to determine whether you are a spineless wimp or a wild-eyed thrill seeker…”
“If you get a high score, you are a master of Wall Street minutiae. But that doesn't mean you have a high tolerance for taking financial risk; it means only that you could go to a cocktail party and bore everyone to death… Some of the questions simply make no sense: If the stock market fell 20 percent, you would: (a) buy, (b) sell, (c) do nothing. But if you knew the answer to that kind of question, then you would already understand your own risk tolerance! And in that case, there would be no point in sitting through such a cockamamie quiz.”
Zweig goes on to expose the truth about risk profile, risk appetite or risk tolerance. ‘Risk tolerance’ is a myth, says Zweig.
No one has a fixed attitude toward investing risk. Your willingness to take chances with your money will depend on a large number of factors,
which keep changing. At MAS we believe risk profiling is an American idea to push decision-making onto investors and absolve market
intermediaries of their responsibility. We believe advisors must take responsibility to guard investors against long-term risks, not
save themselves by pointing to a risk score that the investor was forced to arrived at. After all a doctor does not prescribe different
medicines for different patients depending on their risk profiles. Because patients, like investors, are not supposed to know the risks.
It is the doctors, and investment advisors, who are supposed to know and be responsible for what they advise. That is our