Sunday, May 4, 2008

Comfortably Dumb

I want to reach a state of being “Comfortably Dumb” and hence attain my state of nirvana when it comes to stock investing.

The stock markets are made of millions of participants vying with each other to make money. So what options does the average investor have?

Passive Investment Strategy
Buy an index fund, search for the lowest tracking error and the lowest fees and the markets should compound at about 15 % on a long term basis. The Indian equity market has given around that kind of return in the last 20 years. So if we go with Goldmans Sachs forecast on the BRICS story, there is a lot of steam left for the next 25 years. Though I don’t how they manage 25/50 year forecasts when they can’t figure the sub prime crisis hitting them and their brethren a few quarters down the line (That’s for another post). Anyway running with a passive investment strategy will generate markets returns and history tells us that equities would provide better returns than all other asset classes.

This is what I call the “Comfortably Dumb” state.

Active Investment Strategy
This one is the action packed one which all of us follow including me. We get up every morning watch CNBC, read ET , discuss, write blogs etc to come up with brilliant stock picking to ensure that we over perform the market. What does this mean? It means if the markets gives 15 % returns we want to top that and get more than that. I target about 3 – 4 % more than the market but then there are brave hearts that target maybe 50 % above the market return.

So far so good but here lies the catch ….

Every participant who refuses to accept the “ Comfortably Dumb” strategy believes that he is gifted with superior intelligence and insight ( that includes me ) to generate returns above the index. Where do these returns come from – Not from thin air? So let’s assume the index generates 10 % return this year and I make 15 % on my portfolio this year then somebody somewhere has only made 5 % on his portfolio.

It’s a zero sum game. If somebody makes 5 % more somebody has to lose 5%. (Warren Buffett made a lot more at the expense of a lot of people). But then who is losing, since we believe that we are all superior intelligent beings. Assuming all men are equal, (Women are obviously a superior species as they don’t waste time on this :-)) mathematically, we all theoretically have a 50% probability of outperforming the market.

There is an interesting saying in the stock markets that the investor comes walking to a broker’s office and the broker goes home in a car. So the third variable in this zero sum game is the broker (and his brokerage) and various taxes like STT, Service tax, Edu cess etc. Factoring in these costs the mathematical odds of outperforming the index goes below 50 % lets say about 49 %.

So we have a 49% probability of making more returns than the index and 51% probability of lower than it. (Most fund managers underperform the index and of course charge us for that)

But with our testosterone induced ego’s we soldier on believing in our superior intelligence.

“Comfortably Numb” to the odds stacked against our success.


Ganesh said...

Hey nice first blog. I see that you couldn't resist a nod to Floyd. I loved the tone of the post, it makes a very important observation on human behaviour (Do we have a budding behavioral economist in the family?) with a lot of humor thrown in. Keep it up! :) Looking forward to ur future posts.

Inquisitive Stranger said...

Hi ninad,

i have been searching for a blog that talks about opportunity based folio and someone very good refereed me to your blog.

Just wanted to say that i wanted to read the entire thing from beginning and hence starting today and read the first post of yours, and i must say that you have a magnetic language, and the 1st post has made be very positive to complete the entire blog.


Ninad Kunder said...

Hi Inq Stranger

Thanks for dropping on the blog and hope u enjoy it.