Author: shyam

Embracing Volatility

Market volatility is a feature, not a bug.

In the short run, market is a voting machine; in the long run, it’s a weighing machine. – Benjamin Graham

Price is a measure of Sentiment

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Early last year, when it became clear that the China Virus had spread all over the world and was getting millions sick, overwhelming healthcare systems everywhere, the markets tanked. In USD terms, Indian stocks were down more than 40% and the S&P was down more than 30%.

Then, a miracle cure was discovered and the markets quickly recovered.

Just kidding!

Governments and Central Banks everywhere did whatever they could to lift sentiment. And markets quickly followed.

Sentiment remains one of the least understood but the most important factor in investing. All prices are eventually tied to how optimistic or pessimistic investors are feeling about the future.

While Graham’s weighing machine might arrive in time for tenured investments, like bonds, that have a fixed maturity date, perpetual securities like stocks are always at the mercy of the voting machine, i.e., sentiment.

The Market sets the Price

For stocks, Price = multiple x earnings

For prices to go up, you don’t need earnings to go up. It is enough if multiples do.

The market doesn’t care why you are transacting. Only that you are. It doesn’t matter what your investment horizon is or the type of investor you are, all transactions take place in the market at a price set by it.

As an investor, you can be right about the company (direction of earnings) but wrong about the sentiment (direction of multiple) and can end up with a stock that goes nowhere in price for years and exit with no rewards for your effort.

No such thing as Buy-and-Hold Forever

It is the end of a “long-term” for a subset of investors everyday.

Investors usually save with a specific goal in mind. These goals tend to be time bound: retirement, kid’s education, etc. While their horizons can be “long” at the outset, it gradually shortens as the D-day arrives. Equities (and other high-risk securities) are constantly being sold and rotated into bonds (and other low-risk securities) set by a glide-path.

As much as professionals like to fantasize about long-term investing, the investors in their funds have bounded horizons. This is especially true for open-end funds.

Sentiment + Finite Holding Periods = Volatility

Finite holding periods create the need to transact. This makes it impossible to ignore sentiment. The two combine to create volatility.

It is easy to blame investor greed and fear for bad portfolio outcomes. We have all seen this sketch make the rounds:

Buy High, Sell Low: How To Free Yourself From The Madness

However, even if an investor overcomes the call of greed and fear, it is impossible to ignore time. This makes sentiment the prime determinant of investment outcomes.

If you think investors having longer time-horizons can ignore volatility. Think again. As the chart above illustrates, volatility is an equal opportunity hater.

Embrace and Extinguish

Volatility clusters. You have reasonably long periods of calm, then suddenly a lot of things “go wrong.” Markets gyrate and you feel that all hell has broken lose.

This leads investors to assume that periods of calm are normal and volatility is abnormal. But in markets, the reverse is true. Sudden shocks, volatility and jolts to sentiment are the norm. Calm periods are the anomaly.

Sentiments wax-and-wane. Multiples expand and contract. Markets melt-up and melt-down for no good reason.

The only time-tested way of reducing volatility is asset allocation. Invest in a basket of different assets (make sure that at least a few of them a not financialized) and accept the market for what it is.

Embrace volatility and extinguish it.

Looking for a sensible way to invest? Here’s how to get started.

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Book Review: Where Good Ideas Come From

In Where Good Ideas Come From: The Natural History of Innovation (Amazon,) author Steven Johnson lays out a big-picture of how ideas are formed and how to setup an environment that fosters innovation.

Readers in a hurry can stick to the last chapter of the book. That’s pretty much where the meat of the book is.

Take-aways:

  • It is important to just get started solving a problem. And do it publicly if possible. You may not solve the problem you set out initially but along the way, you will find a solution to something else entirely.
  • Error often creates a path that leads you out of your comfortable assumptions. Being right keeps you in place. Being wrong forces you to explore. Some of the most important innovations in history have taken a long, messy torturous path.
  • Markets allow good ideas to erupt anywhere in the system. The decentralized pricing mechanism of the marketplace allows an entrepreneur to gauge the relative value of his or her innovation. If you come up with an interesting new contraption, you don’t need to persuade a government commission of its value. You just need to get someone to buy it.

Recommendation: Worth flipping through.

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Book Review: Business Adventures

Business Adventures (Amazon,) is a collection of stories written by longtime New Yorker contributor John Brooks that capture the zeitgeist of the late 60’s.

It is dated and most of the stories are quite boring. And the few interesting ones, like the Piggly Wiggly short squeeze or the Ford Edsel disaster, have been discussed ad infinitum.

Quotable:

Most nineteenth-century American fortunes were enlarged by, if they were not actually founded on, the practice of insider trading. Not until 1910 did anyone publicly question the morality of corporate officers, directors, and employees trading in the shares of their own companies, not until the nineteen twenties did it come to be widely thought of as outrageous that such persons should be permitted to play the market game with what amounts to a stacked deck, and not until 1934 did Congress pass legislation intended to restore equity.

Recommendation: Avoid.

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Momo "Rapid-Fire" Momentum

High octane strategies for your portfolio

The biggest advantage that retail investors have is that they don’t have to worry about managing a huge portfolio with different types of investors with differing time-horizons and expectations. And of course, there’s the straightjacket of mandates that bind professional investors.

The problem with bucketing yourself as a “value investor,” “contrarian,” “growth,” or “momentum guy” is that you lose the biggest advantage that you have: flexibility and the ability to adapt to the market. Mandates, or lack thereof

Broadly, at a meta-level, investment strategies can either be Ferraris or busses but not both. They are built with different uses in mind. A Ferrari is not going to be able to seat 40 people or tug a 40 ton rig. And you don’t build a bus to go 0 to 60 mph in 3 seconds.

As a retail investor, your life becomes a lot simpler if you decide upfront if you want to drive a Ferrari or take the bus. But once you get on one, be at peace with your decision. Most investors would be better off taking the bus: DCA/SIP into a mutual fund, don’t chase performance, focus on asset allocation and increase your income and savings over time.

However, just because taking the bus is “right” according to conventional wisdom, doesn’t mean that everybody should be forced to get on one. Just like how you have Ferraris, buses and everything else in-between on the road, there are a wide range of investment strategies outside of the mainstream “at-scale” investment vehicles like mutual funds, PMS, managed accounts, etc.

Momo: The Ferrari Of Investment Strategies

Momentum is a well known Fama-French factor. The problem with momentum portfolios have always been the massive left-tail: when markets are volatile, the drawdowns have been heart-breaking. It doesn’t matter if the portfolio is long-only or long/short, there is no escaping the momentum whiplash.

Then there is the question of rebalancing frequency. To scale a momentum fund, managers need to trade-off transaction and impact costs with being responsive to the market. And that means leaving a fair bit of alpha on the table.

This is the constraint of driving a bus. It can be a fast bus. But it is still a bus.

However, what is true for professional investors and funds is not necessarily true for you, the retail investor.

Do It Often, Do It Better

Most of the early factors were researched at a time when compute power and data were hard to come by. Researchers took the short-cut of using monthly returns to run their analysis because it made the problem more tractable. That set a precedent that is being followed to this day: the monthly rebalance schedule.

The problem with a monthly or a quarterly rebalance schedule is that the market has got a lot faster since the days the papers were written. We live in a world where data is abundant and compute power is a fraction of what it used to be. And trading costs have crashed to a small fraction of what it was 30 years ago.

The world changed.

There is no reason why the market shouldn’t be sampled more frequently.

Some Left-Tails Can Be Docked

A higher frequency approach lends itself to better risk management. It allows for a more responsive position sizing system based on market volatility and the ability to employ “stop-loss” exits on individual positions.

While drawdowns are not entirely avoidable given the nature of the markets, it is quite possible to protect the portfolio against the extremely deep ones. And the deep ones seem to occur at least once every three years, or so.

Avoiding the worst of the drawdowns allows for faster compounding of the portfolio.

Momos are risk-managed, frequently sampled momentum strategies.

Our Experience With Momos

We have been running Momo portfolios for both Indian and US markets for a while and we do it for all three flavors of momentum: Relative, Velocity and Acceleration. We’ll get into the differences between these in later posts but irrespective of the flavor, the “container” within which they run are identical.

The flavors wax and wane depending on the market – there is really no way to quantifiably claim that one is better than the other. In terms of personal preference, I would rank Relative Momentum first, Velocity and then Acceleration. To keep things concise, we show Relative “Momo” Momentum performance below.

US Equities

Indian Equities

Does It Scale?

When we discuss these strategies with professional fund managers, the most common question that comes up is “does it scale?”

And the answer is: No.

It doesn’t scale to professional break-even levels. For eg: for an Indian PMS to break-even, it at least needs Rs. 100 cr in AUM. There is no way the Indian Momos scale up to that level.

But it really doesn’t matter to you, the retail investor. Remember: professional investors are driving a bus, you need not.

Trade-Offs

The market abhors a free lunch. So the next questions is: “What are the trade-offs?”

  1. Risk management is not free. There are always trading costs/taxes that affect the final outcome. But the known-knowns are factored into the performance metrics shown above.

  2. Execution lags. There is always a delay between when the trades are triggered and when the execution takes place. This can be narrowed down by automation to a de minimis.

  3. Compliance. There could be employer, broker or regulator imposed limits on how frequently positions can be churned in certain accounts. Momos would be a poor fit in these circumstances given that any deviation from the model triggered trades can lead to substantial deviation in performance.

Next Steps

If you decide that taking the bus is not for you, then we can help. Have a look at the Momo strategies linked below and let us know if you are interested. We are here to help.

US Momos

Relative Momentum

Velocity

Acceleration

Indian Momos

Relative Momentum

Velocity

Acceleration

Check out our completely automated strategies: stockviz.biz/themes

Investing in the US? We got you covered on us.stockviz.biz/themes

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Book Review: Transaction Man

In Transaction Man: The Rise of the Deal and the Decline of the American Dream (Amazon,) author Nicholas Lemann makes a case for building a plural democracy. Did it have to be a book? Probably not.

The money quote:

Embracing pluralism has to begin with a kind of radical humility. It’s human nature, especially for people who think of themselves as educated, sophisticated, and public-spirited, to believe that what you want the world to look like is a broad, objectively determined meliorist plan that will help everyone.

Pluralism requires accepting a degree of messiness, squabbling, pettiness, and bargaining in the governing of a society: these things are a feature, not a bug. People have a strong and often demonstrated tendency to try to settle their differences through violence. Pluralism means to redirect this tendency into managed, nonviolent conflict. It imagines a system of groups endlessly in vigorous contention. No one group should be able to establish its dominion over the others, either out of selfishness or in the conviction that it represents some inarguably right outcome. There is no such thing as a commonsense solution to a major problem, one that is good for everyone.

Pluralism treats democratic processes, not particular outcomes, as moral absolutes.

The economic system, since the Industrial Revolution, has periodically generated extreme concentrations of power and wealth. Imbalances in economic power always turn into imbalances in political power, unless the political system forcibly corrects them. Concentrations of power always wind up harming people, no matter how benign the holders of power believe themselves to be.

The book meanders between trying to be a history lesson and an NYT human interest piece.

Recommendation: Avoid.

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