Seven principles - mostly about investment

The following 7 principles summarize my personal strategy to address a recent question that I came by: How do you keep a cool head in a hot market?

1. 1. Don’t panic

As stated on the cover of the Hitchhiker’s guide to the galaxy, don’t panic. If you see reason to panic at some point in the market, then your past investment strategies are more than likely flawed.

Another important aspect of this principle, is stated by several great investment gurus over the years (Sit tight and be right – principle of Jesse Livermore, a famous speculator from around 1900, to Bogle, Warren Buffett and other contemporary leaders – who prove that inaction is the best strategy to maximize the power of compounding).

2. 2. Be right, not successful

This is the essence of the bhagavad gita’s most famous quote(karmanyevaadhikaaraste…), and also the essence of many a strategy and investment article. Convince yourself of the right approach to tackle any problem, and follow it. Good results by bad strategy are just pure luck, and can be wiped out in your next attempt. Bad results by good strategy do not require a change of course. As long as your strategy is based on principles you have validated for yourself, you only need to test and see if the principles are changed by any of the new data you have in hand. If you are right, then success will eventually find you.

3. 3. Fish with a line and hook, not a net

When you fish with a line and hook, you know upfront exactly what you are looking for, and choose the precise spot, the precise kind of fish you want, and most importantly return with a few selective catches of your liking. On the other hand, fishing with a net, generally takes anything that falls into your net, and you land up taking a few good catches, along with a lot of mediocre and even outright bad catches.

Information today is like a sea – and unfortunately, most people fish with a net, in the form of surfing on the tv, or on the net, or listening to so called experts, or just plain chatting with people they know , hoping for the next big investment formula. The few anglers, who use the line and hook approach, ignore all the media buzz altogether. They start out with a specific question: what is the past performance of this stock? Who is the manager of this fund, and what is his past track record? And then they use the different media (and not the other way around) to find an answer. The media will sensationalize a soap bubble into the phenomenon of the century. Don’t let the media drive you – you go and pick what you want, and get out when you got what you were looking for.

4. 4. Squint hard

John Bogle, founder and ex-head of Vanguard, and a prominent investment thinker, shows, in his recent book – The little book of common sense investing, that if you look at the average annual stock market returns over the last century, you may land up noticing for instance the market crash of the 1930s. But if you hold the chart a distance away, and squint at it, you will see a more or less clear trend, upward, in this case. Squinting at the information from a distance is a good general strategy to follow. Anything that is a short term trend, or a short term activity will be evened out, and only the larger picture, which is what a good investor should focus on, will emerge. In current terms, all the panic, chaos and confusion around where each market, currency, etc. is headed will be something for us to laugh at twenty years from now.

5. 5. Do what you know

Invest in what you understand – be it the sector, the kind of security, the geography, or any other parameter. Do not invest in Timbuktoo just because 'they' say that it is booming. Some principles that relate to this include:

- Warren Buffett’s – invest as much as you can in a security you have identified. If you are not willing to invest all the money you have, then it only means that you do not understand the security well enough. Learn more about it.

- Bogle, Buffett and others – invest once and hold forever. Do not sell, unless data emerges that counters your premises.

- Lynch’s mall technique – walk around a shopping mall, and invest in the companies of products that you love to buy and people seem to be buying faster than they can be restocked – it means there is something in that business. Of course, learn about it before deciding, but that gives a good starting point.

- Fisher’s scuttlebutt - In ‘Common Stocks and Uncommon Profits’, Philip Fisher mentions a simple principle which he called ‘scuttlebutt’ – to analyze all you can about a security before investing in it.

6. If you love a rule, drop it

If you hear of a rule through the vine, that everyone says is guaranteed to give you millions, then in most cases, you can safely drop it. Unless you are an ‘insider’ with early access to such insights, chances are a lot of people have heard of it, and the market has already factored that formula in pricing the associated securities. This is also known as the efficient market hypothesis, which, in spite of all the controversy around it, makes sense. The only principles that are worth adopting are the ones that transcend any microlevel formula or strategy – (such as, Don’t panic.

7. Diversify

This is the most specific principle that I have and I will elaborate on it quite a bit. It means just that – diversify. Anything that tries to predict Mr Market is doomed to be speculative, and cannot return yields with any predictable certainty, over the long run.

As described in Ben Graham’s Intelligent Investor, how you build your investment strategy depends on how much time and effort you can invest in it. If you are a full time investor, then you would probably invest in good businesses as they become available at good discounts and hold them for life.

If you are a part time investor, then you need to set your portfolio on autopilot. The best way to do this, as per Graham’s ‘defensive investment’ extended by Bogle’s ideas, is to have a diversified portfolio, with minimum churn. Bogle however, is still for the most part biased in his views towards the US market. However, today’s global climate affords further opportunities for diversification.

There is a sum total of money in the market: People will move money between a set of things. When they are skeptical about the stock markets, they will put their money in gold. When they are skeptical about the US economy, they will invest in India, or Brazil, or China. And each of these classes tends to increase its intrinsic value over time.

So, the ideal safe strategy diversifies across all these instruments. Start with a distribution across all the asset classes that you can think of – stocks, bonds, gold, India, brazil, US, China, real estate. You could base the distribution on a simple equitable distribution, or a higher percentage in mature markets, or if you have a lesser appetite for risk, you may want to invest a higher percentage in stable income based securities.

Now apply small corrections to skew it in favor of your own speculative predictions. If you believe as I do, that there is a high chance of the US market going into recession, reduce the percentage in the US market. If you believe that gold is going to continue its upward spiral, then put a higher percentage in it. If you feel that the dollar will continue to drop relative to the Indian rupee, increase the percentage of investments in India to the percentage in the US. However, retain a lower threshold of investment in all the different asset classes, and make sure you never drop below that.

Once this is done, identify securities within those asset classes, and further diversify within those asset classes, but be sure to invest a good percentage in the asset class as a whole. By investing in the asset class as a whole, I mean to invest, ideally, in an index fund (or even better, an ETF) for the entire class, from a reputed fund company, with a low expense ratio. Unfortunately, index funds are not as available in India – in that case, invest in well managed funds with reputed managers with a good track record, in those sectors.

For instance, indian stocks can further be divided by sector – make sure to invest a significant portion in a Sensex and a Nifty index fund , and a smaller amount on each individual sector (after all, sector investment is, at the end of the day, speculative, and subject to market volatility more than the broad asset class as a whole).

Once you have identified the securities, and invested in them, track the news to see if there are any major influencing changes, especially in the more volatile and less understood aspects of your portfolio. For instance, I did not understand the Canadian market initially, but saw rapid gains in it when I initially invested there – I learnt by following the news how oil had a major influence on that growth. Readjust the percentages if (and only if) you learn anything that changes the fundamentals on which you based your initial asset allocations. After a month of initial investment, just leave the portfolio be, watch only the movie and music channels on tv and surf something more useful on the internet, like whether Britney Spears is in or out of rehab. (You may have set up SIPs as well, to invest periodically, but leave them be – don’t change the percentages based on sensational news). Set some alerts for when anything falls drastically, say, to half its value, and check back to see why it happened. More likely than not, it is some market craze doing it, but if you have some money lying around by then, then buy some more of that. Otherwise, just let your money grow. If you have extra money at any time, like an unexpected bonus, just check the percentages of things in your portfolio against your initial percentages, and buy back into those items whose percentages have dropped. For instance, if you had 10 percent in Brazil, and it has dropped to 8%, then buy enough to make it back up to 10%. Check back periodically: every year or so, and readjust the portfolio to the original percentages.

Recommended Reading:

1. Intelligent Investor – Ben Graham

2. More than you know - Michael Mauboussin

3. The little book of common sense investing – John C. Bogle

4. Hitchhiker’s guide to the galaxy – Douglas Adams

5. In an uncertain world – Robert Rubin

6. Buffettology – Mary Buffett

7. Common stocks and Uncommon Profits – Philip Fisher

8. Reminiscences of a Stock Operator – Edwin Lefevre

Disclaimer: I am not an expert or even a seasoned investor in the stock market – I am just an interested layman trying to apply some common sense to the market to sustain the value of my assets. Hence, none of this is intended to be investment advice and I do not take responsibility for any consequences that may arise by investing based on this post. Feel free to use or ignore any thoughts proposed here at your own discretion. Thanks.