Sunday, July 13, 2008


In a book, I recently read, the author gives the example of a person who turned this life savings of $ 2,000 into $ 1 Million by following a simple strategy. When the dividend yield of the Dow Jones Industrial average went up to 6 %, he put all this money into stocks. When it went below 3 %, he got out of stocks and put the realised amount into a savings bank account. It took him 30 years to achieve the above result, but still it is no mean feat. Though I am in no way advocating that investors follow this method, the fact remains that the techniques that make you the most money are often the most simple to execute.


If making money is the ultimate objective, why do we then follow exotic strategies in our hope of beating the markets in the short term? Could it be that the more we try to outwit the markets, the more we fail? I have tried to examine the reasons behind why people (including myself) go for complicated strategies in trying to outperform. One of the reasons is that we like to have our profits on a regular basis, rather like the coupon payout on a bond. We seek the regularity of bonds with the high returns of stocks. We hate the lumpiness of stock market returns as a result of which the maximum profits occur in short intervals with the markets either going down or sideways in the intervening periods. The fact that the profits made in the good years more than make up for the losses or opportunity cost of down years, tends to be neglected by us.

Another reason could be that we seek a sense of control. We feel the need for activity in the markets, thinking that if we do nothing, we are simply watching while opportunities pass us by and this creates a pressure on us to act. Comparisons with profits made by neighbours and acquaintances make us feel that we are being left behind, while others are raking it in. This psychology was at work in the bull ramp up till January, where most investors got carried away by stupendous returns made by active market players and were attracted to invest in stocks. To compound matters, most investment analysts were predicting still higher levels.

For some investors, outperforming markets is a matter of intellectual satisfaction. Everyone gets an ego boost when their trades turn out right. When we get things right a few times, we tend to feel that we have found Alladin's lamp. Only in retrospect do we realise that in the short term, markets are far smarter than us. I have seen a few experts claim that they can manage to outperform markets on a consistent basis, whatever the time horizon. I do not have the data to judge their claims, but I feel that for the average investor, the simpler the investment strategy, the higher will be the returns.




Uma said...

Good one - at present Nifty divident yield is well below 2%, according to nse website. Let's get out of this market! lol

Uma said...

I have a question for you, had posted it on my blog but then thought I'd ask you here: how do bank valuations work? According to business standard, Axis Bank trades below 3times book value, but PE is over
20x, which makes it not-so-attractive for long term (I think). What's this whole chakkar of book value vs earnings? What is book value and is it a reliable benchmark for bank valuations?

Mahendra Naik said...

Hi Uma,

Probably the private banks look fairly priced, I feel that the undervaluation is in PSU banks. To put it simply book value represents the net assets held by the bank behind each share. It is not the only valuation parameter to be looked at, but if a stock is valued near or below its B.V. it superficially appears undervalued. Now we need to look at market perceptions to see why exactly the market is pricing it so low. I have tried to examine some of these reasons in my post "PSU Bank Stocks". I feel that all the reasons for trashing these stocks are temporary in nature and the stocks would revert to their fundamentals as things sort out. But in waiting for matters to level out, an investor might miss the boat if he tries to time it too finely. Particularly because markets would react far before the fundamentals assert themselves in a tangible fashion. As far as earnings are concerned it is a P&L item and reflects how well (or badly) the company has done in that year or quarter, whereas B.V is a balance sheet component and indicates the value of the asset you are buying. In a way earnings (and its growth) would reflect the potential of the stock for future profits while B.V would represent what assets a company owns behind each share. If I am not very clear, the fault is entirely mine and would be glad to explain further.

Mahendra Naik said...

I would'nt take it too seriously in the Indian context because typically Indian Cos are in a growth phase and reinvest bulk of their profits back in the business rather than pay them out in form of dividends.


Oh yes simplicity in investing sounds really good.