Key to success in Share Market

Life & Share market are both impossible to forecast. It is inevitable that when a number of variables interact among themselves – to varying degrees – affecting outcomes & getting affected in return – then ‘uncertainty’ is the only certainty. In this state of unstable equilibrium, each change causes stock market to chart a new pattern or at best rhyme with that from the past but may not exactly repeat. In such a scenario, one has to be cognizant of all that is known, not known & cannot be known about the investment. The probabilities of success improve significantly if one sticks to the known & the knowable & risks of the unknown & the unknowable are not exacerbated by guesswork.

Adam Smith once observed, ‘The market will so compose itself as to dispossess the maximum number of people of the maximum amount of money.’ A herd of deer bets its life every time it comes to pond to drink water, feeling safe in presence of so many of its kind. It is a huge risk for small reward. A crocodile, on the other hand, waits for its big meal all alone & patient.  Where there is a herd to be hunted, there will be a predator to hunt. In stock market jungle, speculators & short-term traders are deer to the long-term investor ‘crocodile’. This transfer of wealth happens all the time because real money can only be made in minority.

The ‘transfer of wealth’ truism also implies that maximum wealth gets created or destroyed, when stock market valuations get extreme – on the way up or down. An investment is most profitable when the maximum amount of stock becomes available at the minimum, unbelievable price – at the times of market crash. On the other hand, wealth gets destroyed when markets crash after valuations have reached unsustainable levels. Such market capitulation happens when most participants have bought to the maximum, convinced of further rise ahead. Since it is impossible to exactly forecast the time of boom & bust, the key to making money is to survive the markets, not predict them.

The principle most at work in our markets is the tendency toward long term averages. It is inevitable that competition &/or mass investor behavior would prevent any positive or negative development to go on forever & abnormal profits and valuation would get pushed back to the average. This “regression to the mean” can be a powerful investment tool to select cheap portfolios & avoid expensive ones.

It is best not to ‘try too hard’. Over-thinking proves counter-productive when essentials get sacrificed at the altar of analysis. Odds against forecasting are so great that it may not be the game worth playing. Analysis of data in public domain is unlikely to produce knowledge that the market has not already factored in. Also, wrong assumptions (credit ratings) & weak correlations (between past growth & future growth) would produce results of suspect quality. All such analytical effort for small insights may not be as important to the outcome, as much as we like to think it is.

Simplicity of approach & consistency in execution could be the most under-rated factors responsible for the market success. When too many objectives are aimed for or unknown & unknowable market factors are incorporated in the model, probability of mistakes shoot up. A simple approach naturally limits the downside to the known weaknesses in the model. In addition, asymmetric upside of equity investment does not get sacrificed & is reaped to its full potential. Let riches come to you when winds are blowing in your favor & don’t be so sharp that you cut yourself.

The biggest challenge for investors is that it’s not easy to mitigate risk. Risk is just not the probability of adverse event but also degree of its impact. A low probability event but with possible catastrophic outcome, is as important for investment strategy as a high probability negative event. Don’t depend on averages, trends or historical data to deal with a potentially uncontrollable event. It could have life-changing / life-destroying effect before statistics decide to correct the course.

It is possible for corporates to recover from most mistakes over time, but capital impairments, bankruptcies & fundamental restructurings are mistakes that result in permanent damage. Direct investment in equity demands financial intelligence regarding selection, pricing, valuation & risk assessment of corporate & economic fundamentals. If one is not equipped to manage all these aspects then mutual funds present better prospects for risk-adjusted return, given its resources, structure & flexibility.

Superior returns on account of real economic growth & compounding of such superior return is key to wealth creation as long as one can contain the losses when they come.