This is the last post there under this thread, next I write will use both forum. Also I feel Guru Mantra series focus on value investing, it may help us a good discussion. It’s almost 30/40 posts under that thread, pasting all of them at one go will result obsessive content. Let me think how to do that.
Money and Risk Management- Honey, it’s all about money
Stock market is just a business
Whether you hold the stock as an asset or inventory it does not allow us to afford one carelessness and that is handle with care just like a business. This is another thing I learnt a great deal from speculators, once they buy a stock they become more vigilant, more watchful not lax.
Loss is A function of gain
Whether asset or inventory loss cannot be avoided by any businessman. As I had very little losses faced in life, perhaps one of most difficult beliefs to ingrain within me. We never saw salary going down, you can get lower marks but fail is almost a taboo for majority of guys. Unless there is a loss there will not be gain, it depends how we manage it.
When a vegetable vendor closes her day out, she throws away those unsold items which cannot be further sold say like smashed potatoes, rotten tomatoes etc. She does not fret, oh my god I should have checked everything in morning, how can it be rotten? Over a period, she realises she is likely to lose 5% say of purchase as normal loss i.e. being thrown at end of day. The price she sells includes losses. How do we manage in investing world?
First, we need to assume we will have losses, unavoidable. In fact, we are in a more complex and uncertain business than vegetables, we will have more losses than many other businesses.
Second, if we allow losses more than profits we achieved year after year, month after month we have to close down our business. Imagine same vegetable vendor is not able to factor the normal loss in selling price, she has to take a cut overall loss only. After some point shut the business.
Third, if there are good days don’t complain and don’t be greedy. Immediately make a plan for partial profit booking or watch closely so that you don’t lose everything. And also, don’t throw up mental models in air to justify price rise with your brilliance. When it rains and there are few vegetable vendors they just sell and close the day. Our problem is market is not a onetime event, battle goes till the time we want.
Fourth, gain and loss depends on external factors as well. If there is an economic depression no matter how much heroics you have your gains are going to come down. Tighten your losses, this is you have to do; unlike gains it won’t adjust automatically.
Fifth be bold when in profit, be fearful when in loss. This has nothing to do overall market conditions. If you are sitting in loss in a huge bull market, others may be bursting crackers for you it’s about soul searching not euphoria. Similarly, when you are sitting in profits, make it work harder for something in first place which worked for you.
Please note I am not asking here you take loss frequently, small or anything that short of things. These are attributes of mathematics which will impact results. One need to customise carefully before building a plan.
Be fearful when others are greedy, be greedy when others are fearful. I agree with this statement with a caveat. I don’t have a problem with what people thinks but problem with what people acts. Because I belong to people!
Compounding- eighth wonder of world
The most celebrated scientist of our time was absolutely right. But like all wise men he didn’t tell us how to use, because he knew he would get into a meaningless discussion on a subject which can only be implemented customised. Anything customised we are talking about 5-6 billion case studies on earth, equal to number of humans!
Compounding works much faster with a variable time
Waiting for a long long period can some time works against you. The compounding short spells provide far superior returns than long period. Don’t want to believe?
Situation One
I invest in stock A at 100 Rs, stock goes up to 100% for year 1 and I exit. That means I get 200 Rupees. I invest that 200 Rupees into Stock B and get another 100% by year 2. My value will be 400. Right? Look at this now:
Situation two
I invest in stock A at 100 rs, goes up by 50% by six months. At end of six months my value will be 150 rs. I invest in Stock B for balance six months. My value becomes 225 Rs by end of year 1. I rotate 225 rs to Stock A for next six months at 50% gain. By end of 18 months my value becomes 337. Last six months I came back to Stock B for last assault. With a 50% gain I move to 505 rs as final value.
Two stocks, we compounded twice at 100% and compounded 50% four times in same time bandwidth. Difference in first case 300% absolute return, second case 400% return!
**Warning: not advising you to adapt these methods, just letting you know how beliefs needs to broke for proper usage. **
In a non-linear place with volatility acceleration compounding is a miracle if one can manage. One of major secret of John Maynard Keynes to Paul Tudor Jones.
Magic of expectancy
I owe this to Dr Van Tharp classes, of course I had to grind multiple times before it fits into my DNA. Imagine you are building an asset, and I come and tell you great young boy! We are so happy you are building a marvel but let me tell your chance of making profit is zero. You would get shattered, right? Welcome to mathematics my friend, I owe my father for his valuable coaching when he was not looking for my career.
Situation 1: you tried 10 stocks, win 5 and lose 5. Capital allocated at individual stock 1 lac for simplicity.
Situation 2: you tried 10 stocks, win 4 and lose 6. Capital allocated at individual stock 1 lac for simplicity.
Situation 3: you tried 10 stocks, win 3 and lose 7. Capital allocated at individual stock 1 lac for simplicity.
Now watch this, your average gain in situation 1 is 50000 and loss is 40000. Situation 2 we replace 40000 losses with 20000. For situation 3 we change 20000 losses to 8000.
Profit and loss now: Situation 1: INR 50000
Situation 2: INR 80000
Situation 3: INR 94000
Despite of winning 30% of stocks still you delivered almost 100% return more than situation 1 where you won 50%. Why this happen, probability is at play.
In stock market where we live with uncertainty probability becomes most important tool for us to manage. Never play a game with negative expectancy.
How to calculate expectancy?
Average Gain for Situation 1 to 3: 50%
Average loss for Situation 1: 40%, Situation 2: 20%, Situation 3: 8%
Hit rate of win: Situation 1: 50%, Situation 2: 40%, Situation 3: 30%
Expectancy is equal to (Probability of win* Average Win)- (Probability of loss* average loss)
So, expectancy for Situation 1 is (0.550000-0.540000) or 5000. Mathematical expectancy is MINUS 0.775.
Situation 2 is (0.450000-0.6 20000) or 8000. Mathematical expectancy is PLUS 0.4.
Situation 3 is (0.350000-0.78000) or 9400. Mathematical expectancy is PLUS 1.175.
See how powerful is situation 3 is. Now replace loss 40000 with 80000 in situation 1 (familiar with catastrophic losses?), expectancy becomes MINUS 15000 (0.550000- 0.580000). Your game is over, never go to a war by knowing you will lose from day 1. That’s what Gambling are, organiser always wins! Because before every hand is played expectancy is calculated, same goes for lottery.
ALWAYS ATTEMPT A PROJECT WITH POSITIVE MATHEMATICAL EXPECTANCY.
Please do read more about mathematical expectancy.
Multi bagger with multi looser is dooms day
We all love multi baggers, they are great to change balance sheet. Even one can change your aspiration, I been there one stock is responsible for today what I am doing largely. But now imagine multi baggers with multi losers, what will happen? Results may be shocking than you think!
Now let’s simulate: 10 stocks, capital invested in each stock 10000 INR. Total capital 1 lac
Situation 1: our average gain is 700%, loss is 90%. Probability of winning 10%. Net result MINUS 11000.
Situation 2: our average gain is 100%, loss is 50%. Probability of winning 30%. Net result MINUS 5000.
Situation 3: our average gain is 20%, loss is 10%. Probability of winning 40%. Net result PLUS 2000.
Even a 7 bagger when you lose 90% on 90% of stocks it cannot protect you. But a small 20% profit with small 10% loss and just with 40% winning stocks you are back in positive territory.
If I make 7 baggers in situation with 10 bagger I am back in 81000 Profit.
Don’t get carried away by theoretical numbers, maintain your own metrics to know where do you stand. But please do note:
Both short and long-term investing works as long as mathematics work for you. How did I survive? I lost 60% of stocks once with one 200 bagger which wiped out all loss. But having 200 baggers is difficult than we think.
When you allow loss to creep in your portfolio do not forget these numbers. Calculate once at least to know where do you stand.
A lot of message missing now, not able to pack them at one go. For example, like adding to profit line, in equal position size can create more havoc etc. Let’s discuss next time!
I leave with you my next unconventional thought- ‘Average price of a stock is one of biggest lie told to me’. Give me a chance to put my workings next time, of course comes with caveat!
But trust me unless you maintain record and metrics you won’t even know where you are, by just calculating net worth number one can jump like jackal that I cracked 40% CAGR, ahoy!