“Every job looks easy when you’re not the one doing it” -Jeff Immelt, shortly after stepping down as CEO of GE after 17 years
“Obviously you don’t make money if you’re wrong. What most people don’t realize is that you don’t make money if you’re right in consensus. Returns [or alpha] get arbitraged away. The only way you make money is by being right in non-consensus. Which is really hard.”-Former Benchmark Capital Partner Andy Rachleff
When one invests in stocks in the cash market (i.e., when taking delivery of the stocks, and holding them for a long time), the notion of how much capital is involved is straightforward. The total amount invested at any point is your capital, and returns must be calculated accordingly.
When it comes to trading, this is not so clear. This is because of:
Trading involves leverage. Typically, the amount of leverage available is anywhere from 5X to 10X. So, if the money invested for margin is Rs. 1 Crore, the positions created will be anywhere from Rs. 5 Crore to Rs. 10 Crore.
Because of the leverage involved, the amount of drawdown is also magnified. And unlike in investing, the drawdowns (in other words, the mark to market losses) must be made up in cash daily. So, in addition to the margin in a) above, another sum must be kept aside for drawdowns.
How much money should be kept aside for drawdowns?
The answer is not so clear. In practice, I follow the following calculation:
For each strategy I use(Note: I am a purely system trader, I do not use discretion to time my trades, so I can use backtest results. Discretionary traders will not find this post useful), I note the maximum exposure of the strategy (in terms of margin) in the last 10 years. I also note the maximum drawdown on the strategy in the last 10 years. So, if a long mean reversion strategy involves 40 open positions (at a time of a massive fall in the market), and each position involves Rs. 1 lakh as margin, then Rs. 40 lakhs is needed as margin. In addition, if the maximum drawdown in the last 10 years is Rs 40 lakhs, then the total capital to be kept aside is Rs. 80 lakhs. This way I would be able to fund my account in the face of any market condition.
I repeat the above calculation for every strategy I use, and then I total all the strategies up to arrive at the figure of the total capital to be kept aside. So for instance, I would trade two strategies like the one mentioned above, I would have to keep aside 1.6 crores.
This is a somewhat conservative way to go about it. In practice, I would rarely require as much capital, because long and short strategies are rarely likely to both experience a combined drawdown. Also, as long mean reversion strategies kick in, long trend following strategies start getting wound up. So, in real life, I am unlikely to need as much capital. However, it is better to be safe than sorry. I like to have a margin of safety. I therefore keep aside the capital based on the above calculation.
Notice that I am using the phrase “keep aside the capital”, rather than use “invest the capital”. That is because capital can be generated for trading in many ways.
How can trading capital be generated?
Cash in the form of liquid ETFs (i.e., liquid bees) and broker float. One third of the capital required to be kept aside is invested in this manner. Brokers will give 90% margin against liquid bees. Around 80% of the amount is in liquid bees, and the balance in my broking account. (keeping 100% in liquid instruments would involve transaction fees which may exceed any return expected). This cash of course represents investment in the trading business.
Shares as margin. Typically, brokers will give margin between 60% to 80% on widely traded stocks. Again, I keep one third of the capital required to be kept aside in the form of stocks in my demat account.
The last third is probably likely to be used extremely rarely, in the face of a massive market meltdown. I keep this in the form of overdraft accounts against securities (where all I pay is the annual renewal fees) or in the form of inter corporate deposits (ICD’s which I can call at short notice) and in government securities which can be instantly liquidated.
Why this 1/3:1/3:1/3 pattern? In a way, it is completely empirical.
However, in a general sense, the margin against stocks represents the “core” margin required on a daily basis. For instance, if the normal maximum position size is Rs. 10 crores, I require Rs. 2 crore as “core” margin. This can be provided cost-free by taking margin against stocks.
The balance in the brokerage account is usually around 25% of the total cash, and represents normal mark-to market losses for a couple of days. So, if the position size is Rs. 10 Crores, then it is reasonable to assume that two back to back falls of 2% are possible. So to keep Rs. 40 lakhs in the brokerage account is reasonable. The balance in the liquid ETFs is to accomodate large drawdowns, or the occassional spike in position size (I use long mean reversion strategies and long trend following strategies, so in the case of a sharp market downturn, I suffer a sharp drawdown on the trend following strategies, and a sharp increase in the position size of the mean reversion strategies simultaneously).
The balance 1/3 in OD’s, ICD’s and Short term gilts is essentially just margin of safety, in the case of a black swan event, or in the case of a 2008 like market meltdown.
Given the pattern above, how do you calculate the amount of capital invested in trading activity, so as to calculate the return on capital employed?
Calculating the return on trading capital
The cash invested is clearly part of the capital. Liquid ETFs (currently) yield around 6% (pre-tax). Float in a brokerage account does not earn you anything. Hence, the dividend amount received on ETFs should be added to the total trading profit or loss.
When shares are kept aside as margin, then it is not so clear that we should use them as part of the capital involved in trading. The stocks earn capital gains and they also earn dividends. And it is not as if I bought the stocks to invest as margin. I bought the stocks because they are good stocks to invest in. This is just an added utility.
Similarly, when an overdraft account is created using securities as collateral, those securities should not be viewed as capital invested in the trading business. Similarly, ICD’s earn between 11 and 13%, and I might have invested in the ICDs anyway. So, I don’t think those should also be treated as trading capital. However, Government Securities (which earn around 6-7%) should be calculated as part of the capital invested, and the dividends or capitals gains thereon should be added to the total trading profit or loss.
Thus, when you see return on trading capital figures elsewhere in this blog, you should interpret the trading capital in the above manner.
I think Marks’ book is one of the nicest books on investment on the stock markets. More than a book, it is a compilation of a series of letters written by Howard Marks to the investors who invested with his firm, Oaktree Capital. In the particular Kindle Edition I read, there are also a comments on few of his important thoughts by other influential investors. I really got started on thinking off about investment in 2013 after I read this book, and it is only appropriate that this book should be one of the books I start of by reviewing. It is not so a much a review, as a collection of the highlights I did when I read the book. Read the highlights, but better still, read the book. It will open your minds in new ways.
Chapter 1: The Most Important thing is ….. Second Level Thinking
Few people have what it takes to be great investors. Some can be taught, but not everyone … and those who can be taught can’t be taught everything.
Even the best investors don’t get it right every time.
It is essential that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.
definition of successful investing: doing better than the market and other investors. To accomplish that, you need either good luck or superior insight.Counting on luck isn’t much of a plan, so you’d better concentrate on insight.
As with any other art form, some people just understand investing better than others. Only a few investors will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results.
being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others … which by definition means your thinking has to be different.
A second level thinker takes a great many things into account: What is the range of likely future outcomes? • Which outcome do I think will occur? • What’s the probability I’m right? • What does the consensus think? • How does my expectation differ from the consensus? • How does the current price for the asset comport with the consensus view of the future, and with mine? • Is the consensus psychology that’s incorporated in the price too bullish or bearish? • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.
The problem with investing is that extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on.
to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.
Chapter 2: The Most Important Thing is…. Understanding Market Efficiency (and its Limitations)
The efficient market hypothesis states that •
There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed. •
Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.
• Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong. •
Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk. That’s a more or less official summary of the highlights.
Now Marks’ take. When he speaks of this theory, he also uses the word efficient, but he means it in the sense of “speedy, quick to incorporate information,” not “right.”
Because investors work hard to evaluate every new piece of information, asset prices immediately. reflect the consensus view of the information’s significance. Marks’ does not, however, believe the consensus view is necessarily correct.
If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view.
describing a market as inefficient is a high-flown way of saying the market is prone to mistakes that can be taken advantage of.
A market characterized by mistakes and mispricings can be beaten by people with rare insight.
Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes.
If prices can be very wrong, that means it’s possible to find bargains or overpay.
Marks’ wholeheartedly appreciates the opportunities that inefficiency can provide, but he also respects the concept of market efficiency, and he believes strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.
Efficiency is not so universal that we should give up on superior performance. However, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.
For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of. Some assets have to priced too low, or some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter.
Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.
The key turning point in Marks’ investment management career came when he concluded that because the notion of market efficiency has relevance, he should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.
We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. But equally, swallowing theory whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make.
Chapter 3: The Most Important thing is…. Value
The oldest rule in investing is also the simplest: “Buy low; sell high.”
There has to be some objective standard for “high” and “low,” and most usefully that standard is the asset’s intrinsic value.
For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point.
There are two general broad ways of investing (excluding technical analysis, which Marks dismisses with disdain).
The difference between the two principal schools of investing can be boiled down to this:
• Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.
• Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.
To Marks, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.
Compared to value investing, growth investing centers around trying for big winners. If big winners weren’t in the offing, why put up with the uncertainty entailed in guessing at the future? the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Marks describes himself as someone from the Value Investing School.
Is Value Investing Easy? No. For one thing, it depends on an accurate estimate of value. Also, If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away. The most value investors can hope for is to be right about an asset’s value and buy when it’s available for less. But doing so today certainly doesn’t mean you’re going to start making money tomorrow.A firmly held view on value can help you cope with this disconnect.
Many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy. An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.
Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.
Chapter 4: The Most Important Thing Is….The Relationship Between Price and Value
Investment success doesn’t come from “buying good things,” but rather from “buying things well.”
If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.
Remembering that the market eventually gets it right, is one of the most important things to remember when the market acts emotionally over the short term.
It’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.
What should a prospective buyer be looking at to be sure the price is right? Underlying fundamental value, of course, but most of the time a security’s price will be affected at least as much—and its short-term fluctuations determined primarily—by two other factors: psychology and technicals.
Technicals are nonfundamental factors—that is, things unrelated to value—that affect the supply and demand for securities.
The second factor that exerts such a powerful influence on price: psychology.
Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship—and the outlook for it—lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.
The key is who likes the investment now and who doesn’t. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.
The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.
Psychology is an area that is (a) of critical importance and (b) extremely hard to master. First, psychology is elusive. And second, the psychological factors that weigh on other investors’ minds and influence their actions will weigh on yours as well.
It’s essential to understand that fundamental value will be only one of the factors determining a security’s price on the day you buy it. Try to have psychology and technicals on your side as well.
The polar opposite of conscientious value investing is mindlessly chasing bubbles.
All bubbles start with some nugget of truth. A few clever investors figure out (or perhaps even foresee) these truths, invest in the asset, and begin to show profits. Then others catch on to the idea—or just notice that people are making money—and they buy as well, lifting the asset’s price. But as the price rises further and investors become more inflamed by the possibility of easy money, they think less and less about whether the price is fair. People should like something less when its price rises, but in investing they often like it more.
Valuation eventually comes into play, and those who are holding the bag when it does have to face the music. • The positives behind stocks can be genuine and still produce losses if you overpay for them. • Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy. • A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.
“Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time … or become far more so. • Eventually, though, valuation has to matter.
In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway.
Buying at the right price is the hard part of the exercise. Once done correctly, time and other market participants take care of the rest.
One of the most important roles of your strong view of intrinsic value is as a foundation for conviction: to help you hang in until the market comes to agree with you and prices the asset where it should.
There are four possible routes to investment profit
Benefiting from a rise in the asset’s intrinsic value.
Selling for more than your asset’s worth.
Buying something for less than its value.
The most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.
Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn’t sure to work. You can be wrong about the current value. Or events can come along that reduce value. Or deterioration in attitudes or markets can make something sell even further below its value. Or the convergence of price and intrinsic value can take more time than you have;
Trying to buy below value isn’t infallible, but it’s the best chance we have.
Around July August 2014, after the steep “Modi Rally”, I rapidly started running out of ideas on fresh stock picking possibilities. The stocks and the kinds of businesses I liked had become very expensive, and I was finding it difficult to justify to myself the price to acquire positions in stocks.
I also felt at this time, that some of the stocks had run up far ahead of economic fundamentals, and that the government did not have a magic wand to address all the economic difficulties faced by the country.
I also felt like shorting some stocks!!
I never believed in Technical Analysis. I used to try and read Vivek Patil’s technical analysis every week, and it seemed like a huge set of mumbo jumbo to me. I felt that in hindsight, anybody could fit anything to data. It also did not make sense to me that if a stock was going to be bought at multiple times during its rise, it was just better to buy and hold.
Coupled with this was the nonsense dished out on CNBC every day. I never could figure out, for the life of me, how some guy could come every morning, and name a few stocks to buy. What is more, these choices did not seem very appropriate. Having been bred on the virtues of a “buy and sit tight” philosophy, these technical analysts seemed very silly.
Yet, as my interest in stocks built, I could not but help recognize that “strong stocks” often tended to keep becoming stronger, sometimes to the point of irrationality from a normal valuation framework. Similarly, I could not help noticing that prices often fell in advance of news or a change in a commodity cycle. Similarly, a trending market move, like the Modi Rally, often moved all stocks, regardless of financial performance of the company in question.
This is where my interest in technical analysis started. Initially, I was just studying simple charts, and seeing how a stock would neatly rise above its long term moving average for example. Then I got to reading some books. Finally, I mustered the courage to go attend a meeting, Traders Carnival, in August 2014. I frankly did not learn much there, but I did get introduced to the field. I also ponied up some money to invest in software called trader’s cockpit, which allowed some rudimentary back testing and some simple strategy creation.
When I started playing around with Trader’s Cockpit, I clearly got some results on back testing. Trader’s cockpit has the facility of sending SMS’s of trade alerts, and allows you to paper test a strategy. So I started with that too.
I also started reading books. I read a book on Trading Systems on Kindle, which gave me a great introduction to risk, portfolio sizing, portfolio management, limiting risk through stop losses, the limitations of stop losses (no system I have developed so far has a stop loss), parameter optimization, over fitting and the dangers of over fitting.I am so glad I read this book well. It has really prepared me for the future.
Finally, by February-March 2015, I had started realizing the limitations of Trader’s Cockpit as a strategy development and testing tool. So, after some hesitation, I bought Amibroker, and shortly, a data feed. I then downloaded some code from Marketcalls, and decided that using that code, with parameter optimization, optimal position sizing and low brokerage, I could trade the bank nifty profitably. More on my journey in the next post.