Day: December 12, 2011

As the investment climate turns more pessimistic by the day – more and more people are turning away from the stock market – and I’m being asked by friends why I continue to remain bullish when there is so much bad news coming in from all directions.

The answer to that is I’m not bullish in the sense that the market will go up next month or next year or in any other ways that people generally think about being bullish. Yes, I’ve bought stocks in the last few months, and will continue to do so in the coming months, but the reason for that is not because I’m bullish in the sense that most people think about it.

I have no idea where the market will be next month or next year or two years down the line, but I do believe that companies will continue to exist and make profits many many years down the line, and as long as I invest in companies that don’t go bankrupt and with money that I won’t need in a hurry I think I will come out fine.

I recently re-read some parts of The Intelligent Investor, which is of course considered the bible of value investing, and I think two excerpts from the book capture how I feel quite nicely.

Here is the first one:

A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.

Except for the first one or two years of investing when I was still in college – I’ve viewed stocks as representatives of companies and that makes it a lot easier to go through all the volatility that exists in the market today, and has always existed.

I think this mindset improves the chances of investing success phenomenally but I have no illusions of never making any mistakes, and I’m pretty sure there will be some mistakes and that’s really not in my control. I can’t be error free but I can diversify in a way such that those errors are not very costly.

Jason Zweig has added commentary to the issue of The Intelligent Investor I currently have, and I think this excerpt captures the essence of what I want to say about errors quite nicely.

The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong. Many “investors” put essentially all of their money into dot-com stocks in 1999; an online survey of 1,338 Americans by Money Magazine in 1999 found that nearly one-tenth of them had at least 85% of their money in Internet stocks. By ignoring Graham’s call for a margin of safety, these people took the wrong side of Pascal’s wager. Certain that they knew the probabilities of being right, they did nothing to protect themselves against the consequences of being wrong

In my opinion – I can be wrong about two things – first about investing in stocks itself – five years down the line I could find that companies aren’t making profits any longer or less than they were five years ago and the macro situation was so bad that stock prices are just a third of what they were a few years ago. And to get away from this risk one could invest in debt instruments, real estate, gold or just keep cash – basically not invest 100% in stocks.

The second risk is stock specific risk and to get away from that you can invest in multiple stocks and especially stocks that have been around for decades, have low debt, high dividends and good fundamentals. This will at least minimize the chances of bankruptcy and if you have ten stocks in different sectors or large cap diversified mutual funds then you are protected from stock specific risk quite easily.

I’m not a market trader and I don’t pretend to understand everything that’s happening in Europe or how it will play out in the future – but I do know what has worked for me in the past and I have high confidence that companies that have been around for decades will continue to exist in the future as well and make profits. At this point, this is enough to make me interested in stocks, and be bullish as they say.

Over the weekend I got an email from a reader who had a question on how to identify under – performing mutual funds, and in what way should one get rid of them.

I think this is a difficult question, and I don’t think there are any straightforward answers to it, but there are certain things that do come to mind.

Before getting to those things though, you need to ensure that you really are comparing the fund to its peers and not being harsh on it.

Remember, that an equity fund will only go up if the stock market has been up, and you can’t punish an equity fund for being down if the whole market is down. Small caps generally fall a lot more than large caps, so in down markets you will find that funds based on small caps are also down a lot more, and that’s not really a sign of under performance. The mutual fund is supposed to own small caps, and if it’s down as a result of that – then that’s really not the problem of the fund.

You need to evaluate the mutual fund against its peer group and if it has been down in that peer group, then that’s a sign of under performance, not otherwise.

Now, let’s look at some things that you can do to sniff out under performance, and let’s start with the obvious things first.

Was the fund sold to you?

I think the first thing you need to look at is why you bought a particular mutual fund, and have the conditions that existed when you bought the fund changed now. Looking at the huge volumes that mutual fund NFOs get, I think there are a lot of people who don’t really buy mutual funds, but they get sold to them.

If you have a fund that got sold to you, then it’s a good idea to evaluate how well it has done compared to its peers, and if there are other options with longer histories, and better performance then it makes sense to switch to those.

New information about the fund manager

If you bought the fund because of the fund manager and you find out some new information about the fund manager that makes you view him in a different light then that’s probably a sign of re-evaluating your decisions.

For example, Sandip Sabharwal is a well known fund manager in India and blogs as well. In going through his blog – I read a post where he discusses financial astrology and that made me view him in a completely different light, and I don’t think I will ever invest in a fund that he manages.

Thin Volumes

It’s always better to be in a fund with good volumes and a decent volume of assets under their management so if you are in a diversified large cap mutual fund which has just a fourth of the assets that another fund of similar type has, then it’s probably better to switch to that fund.

These were some obvious things, but what if the mutual fund has been a consistent performer in the past, but has started doing badly recently?

Is it high cost?

Look at the expense ratio of the peers and compare it with your fund – if it’s too high then that may as well be a reason of why the fund isn’t performing well.

If the fund expense ratio is high then that itself takes a big toll on the fund performance and it’s better to switch to low cost funds.

So, if you had something like HDFC Top 200, which is a good fund and you saw that it started under performing the market – how do you know whether you should give it the benefit of the doubt or should get rid of it?

If such a thing were to happen to one of my holdings, then I would like to see if the fund manager changed or not, and if they didn’t then I’d like to continue holding the funds, and give the fund manager the benefit of the doubt. But for how long? I will probably stick three years or so and in that time start investment with another fund as well, but I think if you have a shorter period then it is likely that you keep chasing one high return fund after the other.

I’d much rather be in a few high performing funds to start with, and that way the chances of all of them turning down at the same time reduces. There is no science behind this number of three years, just a feeling that this number is neither too short nor too long, and is a reasonable time frame.

I think a large part of the gains you get from equity will be because the market itself has done well, and a good fund manager may be able to juice up the return a bit but asset allocation and being in the market itself through decent funds is a more practical and achievable goal than trying to find the best fund within a category.