4 investment lessons to hold you in good stead

By Larissa Fernand |  17-07-17 | 
No Image
About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

The Collaborative Fund wrote an excellent post titled “The Reasonable Formation of Unreasonable Things”. The essence was to explain market bubbles without blaming greed or incompetence. While my best advice would be to read all eight pages, I would like to ponder on some nuggets of wisdom found across the copy.

Lesson I: Few things have as much impact on your lifetime investment returns as the decisions you make during bubbles.

Imagine yourself in the middle of a galloping bull run. You decide to rebalance your portfolio by offloading your profitable equity holdings. Or, you decide to throw caution to the wind and keep buying at stretched valuations fully convinced that the market will keep rising.

In the first instance you would rake in big bucks. In the second scenario, you are treading very precariously and letting greed egg you on. Your decision could do severe damage to your portfolio.

Let’s extend this to a bear market. Instead of panicking and fleeing to fixed deposits, you look for solid companies whose stocks are available at great bargains. You buy stocks trading way below their intrinsic worth. Then you sit tight, probably for many years. Not easy. As billionaire hedge fund manager David Tepper observes: “Sometimes the hardest thing to do is to do nothing.”

But markets move in cycles. The inevitable rise will take place. If you bought wisely, you make a killing.

Lesson II: There is no one rational price to a stock. Investors have different goals and time horizons.

The writer throws an interesting question to the reader: How much should you have paid for Yahoo! stock in 1999?

Why Yahoo!? There is a background to this.

It was an iconic brand that ruled the internet in its early days and was the most popular starting point for web users. On April 12, 1996, Yahoo! traded publicly for the first time. At the end of its first day of trading, its stock closed at a (split-adjusted) price of $1.38. On January 3, 2000, it closed at an all-time high of $118.75. Between these two dates, Yahoo!’s stock price increased by 8,505%. That is less than 4 years!!! (Source: FT Guide to Understanding Finance: A no-nonsense companion to financial tools and techniques).

Back to the question: How much should you have paid for Yahoo! stock in 1999? The answer depends on who “you” are.

If you have a 30-year time horizon, the smart price to pay was a sober analysis of Yahoo!’s discounted cash flows over the subsequent 30-years.

If you have a 10-year time horizon, it’s some analysis about the industry’s potential over the next decade and whether management could execute on its vision.

If you have a 1-year time horizon, it’s an analysis of current product sales cycles and whether we’ll have a bear market.

If you’re a day trader, the smart price to pay is “who the hell cares?,” because you’re just trying to squeeze a few basis points out of whatever happens between now and lunchtime, which can be accomplished at any price.

In other words, prices that look ridiculous for one person make sense to another. Because, each one is paying attention to different factors and parameters, and want something different from the stock.

People can look at Yahoo! stock in 1999 and say “This is crazy! A zillion times revenue! This valuation makes no sense!” But many investors who owned the stock in 1999 had time horizons so short that it made sense for them to pay a ridiculous price. A day trader could accomplish what they need whether Yahoo! was at $5 a share or $500 a share, as long as it moved in the right direction.

Lesson III: As an investor, understand and act upon your own time horizon. Other people’s goals, motives and time horizons are different from yours. And it’s ok.

A long-term investor should never take his cues from a short-term trader.

A highly overvalued stock may be trading at Rs 430. A day trader will have no qualms buying it because he probably anticipates the stock going to Rs 431 or Rs 432 by closing, when he’d sell.

But a middle-class, salaried individual buying this stock for retirement a decade down the road could mess up substantially by picking it up at such a stretched valuation.

When momentum entices short-term investors, and short-term investors dominate market pricing and activity, the long-term investor is at risk of seeing rising prices as a signal of long-term worth.

Few things matter more in investing than understanding your own time horizon and not being persuaded by the price actions caused by people with different time horizons.

Lesson IV: Investing is 7 parts emotional, 3 parts analytical.

The emotional rollercoaster of bubbles will always be something investors struggle with.

Just remember two things. One is that that volatility has to happen for any asset to have decent long-term returns. Secondly, volatility gets out of hand when people with short-time horizons become the dominant investors, pricing assets in ways that make no sense to long-term investors.

One of the hardest things you as an investor can do is maintain conviction on a long-term strategy despite the short-term movements. It is also the smartest. It will help you ride the roller coaster with no damage to your portfolio.

This post initially appeared in Moneycontrol.com 

Add a Comment
Please login or register to post a comment.
Aravind Sankeerth
Jul 17 2017 04:09 PM
Wow, awesome read. Brings prudence back to anyone who might just be swinging in the trend. I was always a believer that we need more articles and writers like this. The last part of the essay where its mentioned that 'volatility gets out of hand in the short term' is the mist crucial to me. I feel most people loose it there, where they should exit, they add and feel vindicated later on.

I also feel that at this point of time considering that we all will be here to see a few more cycles, this particular bull market swing is slightly over done and in the sub-cycle we may be at a high already. Here I refer to the Index in India.

Caution is always a good word
Mutual Fund Tools