Wednesday, April 29, 2015

want to pick stock?

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operation not meeting these requirements are speculative”         Benjamin Graham

Many readers have the wrong impression that I discouraged investors investing in Malaysian unit trusts. That isn’t true as on average, unit trusts generally have been providing good long-term risk-adjusted real return (return after adjusted for fees, tax, inflation etc), higher than the fixed income as shown in my appended post below.
I have to qualify here that comparing with EPF and ASB, this may not be true as these instruments have much lower risk and hence the risk-adjusted returns of unit trust may not be superior to EPF and ASB.
However, there is no free lunch in this world. It was shown in the above article that on average, the unit trust funds underperformed the market, at about the cost of upfront fees, annual total management expense etc. This total leakage can amount to 4% a year as described in this article here.
And how do you like putting your money in a fund where the fund manager places a large amount into fixed income and doing nothing for years, extracting large amount of annual fees and expenses, and your fund severely underperformed the market?
So you get fed up and decide to invest your money by yourself! But before that let us see how retail investors have been doing investing on their own.

The performance of individual investor
Below is an email I just received today from a reader here.
[Hi KC,
Been seeing your posts and thoughts on I3Investor, would like to acquire more info on value investing.
I am 28, been in the stock market since 4 years ago, with a total net loss, as i've made many stupid mistakes (margin, contra/intra, sell at loss, etc....), until recently have come across the real meaning of 'investing'. However, it is still very unclear for me to see those financial figures and how to utilize them to help in intrinsic value's calculation.]

This is what I called humility, recognizing that one has made mistakes and taking steps to correct them. Humility in investing can lead you to higher probability of success, unlike arrogance as below. Arrogance in investing is very dangerous.

[Posted by blank > Sep 24, 2013 06:18 PM | Report Abuse http://cdn1.i3investor.com/cm/icon/trans16.gif
Sorry fundamentals not my style haha. I'm more of a trader, using technicals and behavioural finance. I made 700% last year.]

[Posted by blank > Sep 24, 2013 07:15 PM | Report Abuse http://cdn1.i3investor.com/cm/icon/trans16.gif
Haha kcchongz u can say whatever you want. I just know I have all the profits in my bank now :). Btw just to let you know. I'm vested 6 digits in mpcorp at an average price of 0.33. Excluding warrants. Cheers]

MPCorp closed at 20 sen on 24th April 2015, compared with about 55 sen when the above comments were made. By the way, I am here to discuss an issue, and not a personal attack.

Brad M. Barber and Terrance Odean in their paper “The behaviour of individual investors” in the link below shows that collectively individual investors trading on their own under-performed the market. However, this average performance of individual investors masks tremendous variation in performance across individuals. The underperformance was due to information asymmetry, overconfidence, sensation seeking and action chasing, failure to diversify, easily influenced by rumours, tips, media and internet forums etc.
Below shows a chart in JP Morgan’s 1Q 2014 Guide to the markets.

 
Based on their analysis, the average investor had a 2.3% annualized return over the 20 years from 1993 to 2012, way underperformed the market return of 8.4% during the same period. To put that into perspective, an investor invested $100,000 in the S&P500 20 years ago would today have a total portfolio of around $502,000-compared with only $156,000 for the average investor. This return is not even enough to beat inflation and the total money left today can’t buy the things one could buy 20 years ago. It would be worse if one borrowed money to invest and get what an average investor does, his portfolio will shrink to less than $50,000 now and he now owes the bank more than $50000. Of course he will claim that he is not an average investor, but a super investor and this predicament won’t happen to him.

Why do individual investors perform so poorly?
The main reason why individual investors perform poorly is because in the stock market, the odds are leaning heavily against them in an uneven playing field. In Bursa, most retail market players are traders and speculators, rather as investors. If you are a regular reader in public forums on investing, it is hard to dispel that notion. Trading and speculating, unlike investing, is a zero-sum game, no doubt about that. It is not difficult to guess who the winners and the losers are in this type of game. No prize for the correct guess. The problems actually go deeper than that. The herd mentality and psychology of fear and greed, overconfidence, sensation seeking etc also play a very important role in the outcome of investing experience of individual investors.

Market efficiency
As much as one disagrees, the stock market is somewhat efficient, especially in the long-term. There are thousands of well qualified and experienced professionals watching over the market every minute and every hour. As a consequence, any market mispricing generally would have been quickly arbitraged away by eagle-eyed professionals most of the time; low price stocks bidden up, and high price stocks sold down. Hence in an efficient market, it is hard to find bargain stocks and harder for anyone to outperform.  It is not easy even for professional, what else can you say about retail investors. The problem is exaggerated by the inherent problem of the impossibility of forecasting the future as investing is about the future, not the past.

The odds are against retail investors
Bursa is dominated by 60% of fund managers and institutional investors, local and foreign. The investment bankers and fund managers especially have all the financial, human and computer power and all kind of resources at their disposal. Furthermore there are syndicate players, insiders who can easily manipulate the market at the expense of retail investors. They can move the market where retail investors dwell.
If you think charts alone can provide all the information for you to make money, think about it again. Even if a chart can predict human behavior correctly, when there is a “breakout” or going to be one, or something else, who will spot it first? Who have the resources and computer power to do all the charting fast and furious before you see it? Hack, syndicates and insiders can just build the nice charts to deceive you, without blinking their eyes.
It is really a jungle out there for retail investors. They as a whole have little chance, unless he is the “chosen one”. It is a loser’s game for retail investor.

Human Psychology
Retail investors are greatly influenced by emotions when making investment decisions. It is part of who they are as human beings. They tend to exhibit herd’s mentality. You buy, I buy. What business does the company do? Are they making money? I don’t know and I don’t care. They chase hot stocks, tips, hypes and fads from interested parties when their prices have gone up sky high. Well it is ok to buy high as there will be others who will buy higher from us; the greater fool theory and the “me too” lemming investing strategy. You make a lot of money, I want to make more, and so many people run, I run too; why? I don’t know and I don’t care; greed and fear.

When a stock is going up, everyone gets excited and start to join in the party, only to experience the power of mean reverting shortly after that. The cognitive bias of loss aversion prevents them from selling when they realize that they are wrong in their judgment, only to sell close to its bottom when they then need money to chase other hot stocks or suddenly remember this strategy of cut-loss thingy. So the buy high and sell low strategy. This is one of the biggest reasons why so many people lose money when they invest, in spite of the fact that the general trend of the market is up.
Even professional fund managers are not spared of this fear and greed cognitive bias. Most funds are fully invested at market peaks and heavy in cash when market bottoms. See how icap.biz has been with so much cash so many years ago when the broad KLCI was half its value then compared to now.
Overconfidence of individual investors also explain their relatively high turnover rates causing high transaction costs and poor performance. Men, who are more prone to be overconfident than woman, trade more and perform worse than woman. Are you a man?
Many people treats investing as entertainment, like many people like to gamble. This sensation seeking activities lead to high trading activities in hot stocks, hypes and fads with high volume, going in and out for fun, action chasing and ultimately incurring high transaction costs and leading to huge losses and detrimental to their investments outcome.

If the odds are against me investing successfully, what should an investor do?
It should be clear that individual investors are, on average, not good at investing. What are the options available for them?
There is no variety of exchange traded funds in Bursa. Many unit trust underperformed the market the last five years and you don’t like to pay fees for some meager return. So what to do? Want to invest yourself in individual stocks?
Is there any chance that you can earn better return from the unit trust funds without having to spend too much time and effort?
Yes, I believe individual investors have good chance of earning better returns. You don’t need to be a finance and accounting professional. Neither do you need to know complex financial theories. But you do need to learn the basics of the language of business, after all investing in a stock is investing in a small piece of a business, and knowing the language of a business, which is not difficult, is a prerequisite if you want to be successful in investing. It is just logic. The other important thing you will learn is the psychology of investing, having a proper mind set when investing, and some useful philosophies of investing.
With the prerequisite knowledge and experience, a proper mind set, play your own game, and not dancing to the tunes of institutional investors, the syndicated, manipulators and insiders, your chance of success in investing is certainly much higher than other retail investors. This has been convincingly proven so in the past.
Remember what the research of Brad M. Barber and Terrance Odean in their paper “The behaviour of individual investors” above concludes?
“this average (poor) performance of individual investors masks tremendous variation in performance across individuals.”
I will deliberate why this has a higher probability that it will work. After all Charles Munger said,
"When you locate a bargain, you must ask, 'Why me, God? Why am I the only one who could find this bargain?'"
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