Thursday, November 11, 2010

The secret to investment success: Self Awareness?

I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.

In one of my books, Investment Philosophies, I start with a puzzle. There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.

My explanation for the puzzle. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.

Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.

As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt  idek, 

Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes. In the table below, I list the investment philosophy that fits best given your time horizon and views on the market:


Momentum
Contrarian
Opportunisitic
Short term (days to a few weeks)
·      Technical momentum indicators – Buy stocks based upon trend lines and high trading volume.
·      Information trading: Buying after positive news (earnings and dividend announcements, acquisition announcements)
·      Technical contrarian indicators – mutual fund holdings, short interest. These can be for individual stocks or for overall market.

·      Pure arbitrage in derivatives and fixed income markets.
·      Tehnical demand indicators – Patterns in prices such as head and shoulders.
Medium term (few months to a couple of years)
·      Relative strength: Buy stocks that have gone up in the last few months.
·      Information trading: Buy small cap stocks with substantial insider buying.
·      Market timing, based upon normal PE or normal range of interest rates.
·      Information trading: Buying after bad news (buying a week after bad earnings reports and holding for a few months)
·      Near arbitrage opportunities: Buying discounted closed end funds
·      Speculative arbitrage opportunities: Buying paired stocks and merger arbitrage.
Long Term (several years)
·      Passive growth investing: Buying stocks where growth trades at a reasonable price (PEG ratios).
·      Passive value investing: Buy stocks with low PE, PBV or PS ratios.
·      Contrarian value investing: Buying losers or stocks with lots of bad news.
·      Active growth investing: Take stakes in small, growth companies (private equity and venture capital investing)
·      Activist value investing: Buy stocks in poorly managed companies and push for change.

14 comments:

X said...

In your lectures on Valuation, I thought you said that PEG ratios were not necessarily an indicator of value

Aswath Damodaran said...

I used PEG ratio as an example of what passive growth investors may use to find cheap growth stocks. It is not my favorite multiple and I would look for other metrics.

Nofie Iman said...

As a passive investor, I recently use this ratio: (Capitalisation + Liability) to Operating Profit. Assume company A has a ratio of 5, it means that company A requires 5 years in order to pay all of its liabilities and acquire all outstanding shares using its own operating profit. Of course, the lower the ratio, the better the company to invest.

I think this ratio is quite comprehensive and accurate. It's like a simplified version of EV/EBITDA. Indeed, sometimes you need to do some adjustment, particularly for some industries. The only problem is that it can be quite difficult to find a company with ratio lower than 7.

Gaurav Mehta said...

Hi Sir,

Please can you take up the topic of per share calculation in mergers, amalgamations.

Specically, equity share suspense, how treasury shares are created through amalgamation,calculation total outstanding shares post the amalgamation.

In particular i am talking about spice mobility. Bought these shares at Rs 15 last year, currently at Rs150.

There has been an amalgamation in place starting Jan 2010. I am having issues calculation the new equity base. Sept 2010 results have just been released on BSE website and for the first time look at the consolidated company.

Thanks,

Hester said...

This was a good article, but you made a few fundamental mistakes/misassumptions in my opinion.

First, from the article it seems like you assume all strategies produce the same returns for the AVERAGE investor, which of course is false. Nearly every study ever been done shows that buying the stocks with the lower p/e, p/book, p/cash flow, et al outperform their higher ratio cousins over time. This means one should strive to be a value investor over say a growth investor. Of course there are exceptions and every type of investing will produce some successes, but value investing is the best method for the average investor

Which leads me to my second point, that emotions, attitude, and character aren't completely sticky. Some (but admittadly not all)people can become more patient, contrarian, or long term minded with effort over time and should try to over time. You say that success is elusive for Buffett followers, but depending on how you measure success that is wrong. On average, Buffett imitators do A LOT better than Soros or Tudor Jones imatators.

The average long term investor has a giant advantage over the short term trader, simply because of brokerage commissions, spreads, and taxes. A short term trader who makes 10% a year but has to pay short term capital gains at the end of each year has $1.37 at the end of 5 years. A long term investor who makes 10% a year and only has to pay long term capital gains at the end when he sells has $1.488 (roughly). This really adds up over time.

It is true that some people are and aren't hardwired for value investing and other forms of investing. However, your line of thinking that we should just choose the strategy that feels right or fits or current attitude and emotional state offers an awefully good excuse for one to say, "I'm going to day trade and speculate with leverage because, it's just how god made me."
Instead we need to defeat the urge to gamble and retrain ourselves emotionally and psychollogically for success.

Aswath Damodaran said...

The evidence is all on paper. There is no evidence that value mutual funds that invest in these companies do any better than growth oriented funds.

And your part about Buffet imitators doing better that Soros imitators? How do you know? Is this an article of faith or based upon real evidence? I personally find many Buffet imitators to be insufferable snobs, who think they are doing the Lord's (whose first name is Warren) work while investing while mouthing platitudes about value investing, without much understanding of its substance.

Hester said...

Really?
How about every long term study on stocks with the low p/e or p/book outperforming their glamorous high ratio "growth" cousins. Please show me one study that buying growth stocks outperforms value stocks. This was an article about individual investors, not mutual funds. Mutual funds have restrictions, institutional imperitives, and a short term mind set caused by fund flow following hot money. But an individual investor doesn't have to deal with redemptions or legal restrictions and is free to buy the lower 10% of p/e stocks and outperform.

As for the shot at value investors, is that your evidence? Value investors are snobbish. Again, you wrote the article so the burden of proof is on you. Please show me one study that shows short term speculators (soros followers) beat or match long term fundamental investors (buffett). Please show me evidence that momentum beats value. It doesn't.

Until then your article is just a poor excuse to indulge one's herdlike, gambling and greedy instincts that leads so many investors over a cliff. It makes sense you chose academia, you would be terrible at managing money (ooh, was that a shot? I guess I'm snobbish now?)

Gaurav Mehta said...

Hester !!!

You keep taking of value investing ... how many buffets do you have....name me five consistent value investors other than buffet..

About trading and momentum buying..have u heard of the Goldman's, J P Morgans and Morgan Stanleys? These guys have made money almost every single trading day of the last year and a half!!! I am sure the markets haven't gone up every single day...

Growth Investor ....Peter Lynch... have you heard about him?? Also for growth stocks these too can be undervalued given that they have very high growth but at some point trading at low PE's.... Could have bought quite a few during recession in EM's (India) ....

From what i can gather u seem to be a buffet follower and like the value investing form... try making a trader understand what value investing is and he'll talk to you about demand and supply.... actually he too is true ....ever wondered why shares never trade at their percieved actual value??? why a share falls 10 % having been up 5% five minutes back... sure fundamentals couldn't have changed in five minutes... or had they... ??

I am not saying value investing doesn't make you money... it sure does for else how would you have a buffet.... but that doesn't mean traders /arbitraugers don't make money... else there would be no soros...

Remember this... had there would be no traders ... there would be no liquidity ... no price discovery and hence no value for value investor... and had there be no value investors.... the market would definately look like a auction with each day the weather would determine what value would the auction fetch you today...

Market --- its a market place because you have different types of participants... buyers, sellers, traders, investors... and thats precisely why value investors who stayed invested lost a lot of money during the crisis.... while Paulson made a billion through options on sub prime!!

VIKRAM said...

Hi Gaurav,

While I agree with some of your points , I disagree when u say " value investors who stayed invested lost a lot of money during the crisis.... while Paulson made a billion through options on sub prime"

Should we constantly think that there is a crisis around the corner and keep trading in Options ?? Will that work ? I dont think so.

Hester said...

Gaurav,

Sorry for the long time it took for reply.

I agree with many of your points, and I do not disagree that there are successful investors in every type of strategy (although we could debate whether Lynch was a growth or value investor). While probably well over 90% of day traders lose money, there are and always will be a few who are wildly successful. But they are the exception. (I also agree that traders and speculators are vital for a healthy market, but that doesn't mean speculation is the best avenue for success).

Value investing, as measured by the returns of value strategies (low P/e ,P/book, et al) is better in aggregate. And that is what we are talking about, aggregates. The average investor will not be the next Buffett or Lynch or Soros. The average investor will do as well as the average returns of his strategy minus taxes and transactional costs (spreads and commissions). Value investing has the best average returns of any major strategy over long periods of time, and it also has the lowest tax expenses and transactional costs of all the strategies except indexing and perhaps growth investing (depending on how one goes about that).


Our brains evolved during the many years humans lived in a hunter gatherer economy, but now we're in a consumer/trader economy, and our minds aren't well equipped for some things in that economy. This means we have to artificially change our habits, even if it goes against our intuitions. This article suggests we should give in to our natural habits, which don't always (or often) work well in investing for the average investor.

On your other point, I could probably name 100 consistent "Buffetts", although they of course wouldn't be as good as Buffett. Mutual fund manager of the decade, Bruce Berkowitz is an obvious one. Some of the top hedge fund managers are value investors, Baupost and Greenlight are some of the best. Value investors only populate 5-10% of the market, and yet if you objectively study successful investors you'll find that the percentage of great investors who happen to be value guys is MUCH higher than 5-10%. This should tell us something (if we want to listen)

Lastly, your point about the big investment banks being the Momentum successes is odd considering the recent recession. How many value firms had to be bailed out? How many of those trading oriented firms you listed had to be bailed out? Hmmm... Goldman sachs is an example of a good trading firm, Berkshire Hathaway an example of a good value investing firm... Which one of those was begging the other one for money two years ago? The big investment banks were the ones on the other side of the trade of value investors like Michael Burry and John Paulson as they made billions off of these "smart traders." Value investing (while done right) focuses on risks first, which is why you almost never see a value firm in a situation like LTCM got themselves in, or like Lehman, Goldman, et al got themselves into recently.

Sorry for the long reply, but good discussion

Hester said...

Rereading your post Gaurav,
you seem to not think that Paulson is a value investor. Just because he made his money through derivitives, doesn't mean it wasn't a value trade. Value investing is not a stock picking strategy, it's a mental framework that can be applied to nearly every asset class or market type.
In any case, it definitely wasn't a momemtum act.

I'd love to hear the professors thoughts on my last post, if my dissenting opinion didn't scare him and his theories away.

Aswath Damodaran said...

Hester,
The way you phrased your last response was not exactly conducive to a conversation. But here is my response. I am a value investor because it fits my perspective on markets and personal make-up. I am unwilling to take the point of view that this is the only game to play and here is why:

a. The studies that you quote in support of value investing are primarily built around a very simplistic value investing strategy - buy low PE or low PBV stocks - and in the long term, you will make excess returns. Two caveats. The excess returns are relative to risk and return models that we accept have serious skews to the. The other is that most of these studies do not factor in transactions costs.
b. In the last 15 years, the focus for inefficiencies in academic research has shifted from value based strategies to momentum based strategies. There is surprisingly strong evidence that both price and earnings momentum strategies, judiciously used, make money.
c. Though you make take issue with the names that are used as examples, it is undeniable that there have been some very successful growth and momentum investors.
d. Defining a value investor as one who buys assets that are under valued is a cop out. By that definition, most investors are value investors; they just vary in their definition of value. Paulson is more an opportunistic investor than a value one.

Here is my bottom line. I do not have your certitude that my way of investing is the only way that works. In fact, I think I am a better investor by staying open to strategies that I can borrow from others to augment my base value investing philosophy. In effect, I can by stocks that are cheap, based on a value strategy, and time my transactions using a momentum strategy.

Hester said...

"I do not have your certitude that my way of investing is the only way that works."

I certainly made myself very clear multiple times in every comment I've made that I do not believe value investing is the only way that works, as I've said that their are many successful investors/traders of every method. All I have said is that it (value) works best for the masses, for the purely average investor. I stick by my point that your article could be used as an excuse by a beginner who doesn't want to work at developing a disciplined approach, and just saying "This is my natural temperant." This would apply to every strategy, as every strategy requires some discipline through forcing out certain negative habits like impatience

This you cite as an intrinsic trait that one should mold a strategy around, when it is really detrimental to every strategy you mentioned most of the time. I know a day trader who said he failed because he was too impatient. Perhaps flash traders are the only one who can be impatient).

We'll have to agree to disagree. Take care.

R.V.G said...

Hi Sir,

May be its irrelevant here, but I am desperate to know the answers,
There is a bank in India called South Indian Bank, in which management holds hardly 1% stake, but still that’s the one which is managing.
And it’s giving consistently good results. But the problem is last year it diluted the stock by nearly 30% which I think is not good, and the stock seems extremely undervalued, or it’s a value trap, can anybody explain?

Thanks
Ravindra.