Month: April 2011

How should I select which stocks to invest in?

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In the area of finance and investing, like many other fields, the questions you ask are perhaps more important than the answers to them. But again in this area, even the simplest of questions can have a variety of complex answers. So something as basic as how should I decide which stocks to invest in – can have multitude of answers. In my view, this kind of question will, perhaps, have at least 3-4 questions as its answer to start with, when asked to an expert. When individual investors ask this question (or of a similar kind) to a financial planner or an advisor or an expert, the investor is most likely to get either unclear answers with a number of riders; or a set of additional questions like how long can you hold, what is your risk appetite, etc. And do not get me wrong. These are perfectly valid questions from the point of view of the advisor, as the expert is trying to assess the investor before giving a customized answer. But it will still leave the investor confused – specially the next time he wants to take a similar decision on selection on stocks. So, I am going to try and attempt simple answers to this question in this note.

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My first answer is – if you can help it, do not invest in stocks directly at all. Invest in an index fund instead (or if you like a fund manager – invest in an actively managed well performing fund). Despite that, if you still want to invest directly in stocks, my second answer would be restrict yourself to the Index stocks or the top 50 stocks by market capitalization, and simply construct a portfolio by buying companies that have high return on equity, low or no debt compared to equity, high profit margins over time and consistent dividend paying history; and buy them when their valuations as measured by Price to Earnings or Price to Book are lower or reasonable compared to long term averages. And better still, buy them regularly over time to build a portfolio.

Beyond this, if you still want to expand your universe of stocks, then the only reason you need to go outside the top stocks by market capitalization is if you can beat the index. And for that, you will need hard work, continuous research, adoption of an investing approach that is not followed commonly and lots of patience. Once you decide that you are prepared to do that, I think the parameters you look for in stocks for investment change. You then enter a territory where there is lack of credible historical performance, unpredictability, unproven business models and perhaps low liquidity. You are then buying a promise for the future, and your interests are then best served if you strictly buy value. In such a scenario, you should then look for stocks that are cheap in relation to assets and/or earnings. And cheap would mean different benchmarks depending on margins, growth expectations and debt – but essentially the focus should be on buying cheap.

So in a nutshell, the simple answer to this question of ‘how do I select which stocks to invest in?’ is firstly this – do not do that selection at all, leave it to the index or a fund manager who is smarter than you and the index. If you think you are smart, go ahead and buy index stocks over a period of time – you are then buying into good businesses at reasonable prices. If you think you are even smarter, go ahead and buy stocks outside of the top stocks family, when they are cheap by earnings and asset measures – you are then buying into reasonable businesses, so be sure you get them at a good price.

Using this simple framework, you will perhaps be in a position to answer this question on ‘how should I select which stocks to invest in?’ Though not precise, but at least, I hope, it provides a decent guideline to arrive at a stock selection decision.

Why age based asset allocation is mostly wrong

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I have often heard a lot of financial planners advise an asset allocation strategy based on the age of the investor – something on the lines of invest 100 less your age into equity or similar. While the broad logic of this strategy is that with increasing age, the capacity of an individual to earn himself out of a market crash reduces, purely age based asset allocation might, like many other things in finance and investing, be the right answer to the wrong question.

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A student who has taken an education loan or a young married person saving for the down payment of a house can hardly justify investing 80% of his savings into equity, while a middle aged double income couple with their mortgage paid off or a retired millionaire with 20 more years of life would be foolish to invest majority of their net worth in fixed income. In fact, it would be risky for the youngster to put 80% of his savings into equity if he gets caught in a market crash when he needs the money for his house; and equally risky for the retired old man to depend on his fixed deposits to face 20 years of inflation.

I have found that asset allocation percentages need to be an output determined by life circumstances, net worth, current income, overall risk tolerance and age. Age can be a good determinant of some of the above, but it is too simplistic to assume that it is the only one. In many cases, it is not – and hence, it turns out that portfolios are more conservative or riskier than they should be. Historical data suggests that the possibility of losing money in equities over a 10 year period is quite low. Hence the equity percentage of the portfolio must largely depend on the ability of the individual to, more or less, forget his money and ride out a period of 10 years with no need for the money put in equity (and perhaps, put more into equity, if required during crashes). Now this ability is something that depends on factors like risk tolerance, current income, net worth, temperament and life circumstances, of which age is just one determinant.

The more you have of this ability, the more should your asset allocation be comfortably tilted towards equity. And age has, perhaps, little but not much to do with it.

Is Financial Independence an End in itself?

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I have often wondered, specially when I read a lot of financial planning related articles, whether financial independence is an end in itself. A lot of financial planning is geared towards basically creating a corpus for a goal like retirement which can replace your current income stream in inflation adjusted terms. And it is all good when they profess getting out of debt, preach high rates of savings that are put in a manner across asset types to provide returns that enable oneself to reach that goal.

But I sometimes wonder whether financial independence can really be defined? And while the pursuit of that has been one of the key motivators of my life, I have sometimes wondered whether that pursuit of a financially free tomorrow has left me in chains today.money-vs-happiness

That’s where I realized that, perhaps, the goal of achieving financial freedom is not an end in itself. And while it is good to have a financial plan and work towards it (in fact, highly recommended for most individuals), a blind following of the same, specially without purpose, may be closer to slavery than to freedom. Also, I think the point of financial freedom can, perhaps, be defined to be the one where the marginal utility of having more money diminishes in the eyes of the individual. And this point is likely to be different for different individuals. Basically, from that point, 5 times more money will not make one 5 times happier. You may still continue to chase money beyond that, but in non-financial terms, you are already free from that point. I guess if an individual can carefully assess what that point is for himself, it would serve him well to make financial independence a good journey rather than a destination in itself.

So by all means, the pursuit of financial independence is a very worthy goal, but if one adds to it, a purpose as to why one wants to be financially free, and determines a point at which the marginal utility of money keep diminishing – the journey can be truly fulfilling and make life itself much more rewarding.

The Financial and Psychological Benefits of Rebalancing

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I have always felt that individual investors (or perhaps any investor to some extent for that matter) have never got a complete handle of the decision on when to sell. Traders or speculators mostly have a fixed target for profit or stop-loss, but investors never seem to enter a stock with a clear exit goal.

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Rebalancing as a strategy might provide answers to solve this quandary – more than anything else for the individual investor. At a portfolio level, it provides you with a clear answer on when to sell, and, if required, it can be translated and implemented at an individual stock level also by more mature individual investors. Setting asset allocation limits at various levels in a portfolio can provide you with clear triggers on when to sell. So then, you stop asking yourself questions like – should I sell stock A at this price or wait for some time – questions which have no clear answers anyway. On the other hand, that answer is provided at an overall portfolio level, based on allocation limits.

For example, to provide a complex set of rebalancing rules, consider the following: If you determine that equity will account for 60% of my portfolio, and within that, large cap stocks will account for 50% of the holdings, and then no industry will account for more than 25% and no stock more than 10%, then it becomes easier to take decisions on what and how much to sell when these allocation percentages go out of whack. And if you are not a direct stock investor, but take your exposure through mutual funds, it gets much easier than the above scenario, assuming that your fund manager is dealing with the rest. Therefore, ‘I bought stock A at X, should I sell it now at this price Y’ becomes a wrong and somewhat irrelevant question, and thankfully so.

Of course, rebalancing is not a strategy that guarantees the highest returns. In certain cases, you may end up selling your winners, which in hindsight may not feel great. But for individual investors, who may have no particular reason to feel a sense of conviction about a specific stock, it provides a good way to reduce or manage risk. I do not think at a mathematical level, rebalancing has a very high impact on returns, but it sure reduces risk of excessive falls and locks in some of the profits. And if done correctly, it will also ensure that you buy equity at a time when every one is running away from it – in which case rebalancing affects your long term returns too.

An important effect of this strategy might well also be at a mental or psychological level – because an individual investor feels he is in control and has been smart to book profits when his portfolio grows and to buy stocks when they were low in price.

Therefore, less for returns, more for managing risk, and most importantly for the psychological advantage of getting emotion out of buy/sell decisions, rebalancing is a crucial strategy for portfolio management for individual investors.

How to use Diversification to reduce 3 types of risks

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The core objective of diversification is to reduce risk – the idea being that peaks and troughs in a specific investment does not affect overall portfolio return objectives.

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If one defines risk less as volatility, and more as a either a complete or partial, but permanent loss of capital, then an individual investor would be well-advised to consider diversification to reduce risk of a few primary types:

1. Asset Market or Systematic Risk: What if I am invested in the wrong asset class or market? This is best reduced by a prudent asset allocation decision. Investors should identify different types of asset classes that they want to be invested in along with ideal target percentages in each asset class. This will minimize the impact of being invested in the wrong asset class.

2. Unsystematic Risk: What if I choose the wrong stock or bond or property? This is best reduced by investing in a pool of candidates within the same asset class. So if it is equities, it is best to be invested in a bucket of unrelated good businesses, or in commodities or real estate, again try and be invested in unrelated asset candidates. This will minimize the impact of being invested in the wrong securities.

3. Timing risk: What if I invest at the wrong time? Well – you may have a well-diversified pool of securities in a well adjusted portfolio of asset types, but what if you invest at the peak of the markets? This is best reduced by making periodic investments in the assets of your choice, so that timing risk is reduced. This will minimize the impact of being invested in any asset at purely the wrong time.

For individual investors, more than chasing returns, if prudence is exercised in constructing a portfolio with the objective of reducing risk of the above three types, there are good chances that the returns will take care of themselves.

Is direct stock investing worth it or should mutual funds do?

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Assuming that I want to “invest” in the stock market, and not “trade” or “speculate”, getting average market returns is a no-brainer. I just need to buy an open-ended index fund or an exchange traded index fund, and I am done. At the lowest cost, I am guaranteed returns that the market index will give – day on day, month on month, year on year.

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Why, then, should I be even interested in investing in actively managed mutual funds? There can be only a few reasons for that. First – they give returns better than the index after deducing costs.  Second – I want an exposure to companies outside the index in a specific market cap or sector or style that I am bullish about. So it may make sense to supplement my index fund holdings by some actively managed funds that suit these requirements.

After that, why should I directly invest in stocks? Is it really worth the time and effort? There are few reasons when it may make sense. First – I am a better investor and can beat markets consistently. Easier said than done, but if that is the case, there is no reason I need to invest through the fund route. It is likely to take sufficient time and effort, but if indeed one can beat the index, why depend on mutual funds? Second – I want to invest in some businesses that are either small or in under-researched sectors that funds are not allowed to, or not able to invest in. There is a section of the market that institutions are not interested in. An individual investor who understands those businesses and has conviction on a particular company, has an advantage by investing directly. Third – this is perhaps due to the structural constraints of mutual funds. Due to the inherent requirement of funds to keep beating the index, some great businesses cannot be held by funds for long periods of time. For example, a mid-cap fund has identified a great mid-cap company, but once it becomes successful and actually becomes large-cap, the fund has to sell it. Or, during a market crash, a fund has to sell some companies to honor redemptions – so a buy and hold is not possible, even in case of great businesses.

In such scenarios, it may be worth it for individual investors to invest directly in stocks instead of the mutual fund route. But as index returns are easy to get, one has to be sure that these additional investments will actually help better portfolio returns rather than dilute them. Therefore, overall – allotting majority of your equity allocation to mutual funds (index or active based on performance) might be a prudent strategy for individual investors. Investments through direct stock holding can be a small part of your equity allocation – only in situations where there are valid reasons for the same.

5 Steps to Simplifying Portfolio Strategy using Asset Allocation

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A lot of individual investors are so interested in getting answers to questions like which stocks to buy, at what price and when to sell – that they do not realize that these are the least important questions to get answered when it comes to building long term wealth.

Perhaps the single most important decision that influences long term returns has got to do with allocation ratio of asset types. That is – how much of my income after expenses – i.e. savings – do I put in various types of assets across stocks, fixed income, real estate, gold and cash? This is broadly referred to as portfolio asset allocation in financial parlance – and is the single most decision that impacts long term returns.

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For simplifying portfolio strategy, all the opinions and advice can be essentially reduced to, in my view, a set of few simple steps:

1. Decide your asset allocation based on your life circumstances: For an individual who does not intend to do investments full time (i.e. has a job or business for his regular income), an allocation of up to 60% in equity, 10% in gold and the remaining 30% in cash and fixed income might be the optimal allocation. It may not give best returns, but is likely to be something that is practically followed over the long term.

2. Select your core and peripheral assets within the allocation: For most individual investors, index funds or select actively managed mutual funds are the best vehicles for equity participation.

3. Review once a year, and Rebalance when allocation ratios go out of whack: i.e. if equities have grown and now account for 70% of assets, shift 10% into others by selling; similarly if cash/fixed income or gold value has increased, shift proportionately into equity.

4. Set up a system for this: both contributions and rebalancing, so that you do not have to take decisions frequently.

5. Keep increasing absolute amounts or relative asset allocation, as your income levels increase or decrease, life circumstances change or ability to take risk alters.

This can be a framework for deducing a simple investment portfolio strategy for most individual investors. Once this is set up, the investor is likely to realize how unimportant the question of which stock to buy and when to sell really is.

How to handle volatility: Creating a mindset

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I have often  found that for an individual investor, the toughest thing to deal with in stock markets is volatility. And by volatility – though it means fluctuations on both sides, what is tough to deal with is basically crashing stock prices. Financial theories have often equated risk to volatility – which may have some sense when you have a need to regularly evaluate the value of your portfolio, but is perhaps otherwise meaningless for an individual investor.

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The all encompassing mindset of an individual investor has to be that of preparation for crashes. While investing in the stock markets, be it through mutual funds or directly, the dominant mindset needs to be that of being prepared for at least a 30% cut at any point in time. That mindset prepares you better to deal with it when it comes.

The advantage of such a mindset is to ensure some degree of rational thinking when the crash happens, even though there may be butterflies in the stomach. Inevitably that happens. In such a scenario, I have found the Ben Graham corollary of thinking of the stock market as an emotional guy called Mr Market whose moods keep fluctuating to be most valuable. This moody guy comes up everyday and offers you a price for your businesses. You are free to buy from him, or sell to him at that price whenever you want; and best of all, you are free to ignore him if you choose to. He will still come back tomorrow. Getting these two things into your mindset – that of expecting crashes, and thinking of stock markets as an emotional guy Mr Market – are the basic starting points in your battle against volatility.

Let’s say you manage to do that – the toughest task of all. After that, deciding what to do when stocks crash becomes easier. And that depends on largely whether you have a plan on why you are in the markets in the first place. If you have, then you are likely to do whatever makes sense according to that plan. If you do not, then this crash could be a good opportunity to do so. In both cases, you are likely to be in a better position to then decide whether to buy from Mr Market, sell to him or simply ignore him.

Buffett: Penny stocks and day trading are my real key to wealth

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Interesting article that I read yesterday on sfgate.com.

In an interview that is sure to shake the pillars of Wall Street, billionaire investor Warren Buffett revealed to our crack reporter Kent Baleevit that he actually made his wealth from risky penny stocks and day trading. “C’mon, Kent … long term value investing? Who has time for that crap? I’m an old man … I need to make my money quick and get to the casino before the lines at the early-bird buffet get too long.”

Read the entire interview at: http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/04/01/investopedia51599.DTL

Happy Belated April Fools Day!

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