Investing- Size does matter

Investor who wants to beat market must have EDGE and view on how much money to invest on that stock. i.e optimum amt of money to maximize the geometric mean.

One important thing I have disclose by my own learnt lesson that “ you are unlikely to get an edge out of what you see in news/tv.” . The stock market more effient than the many small investor think. The way to achieve edge is path shown by Charlie Munger, Multidisciplinary thinking which I had discussed earlier.

Today we will discuss about How much to invest (Bet Size) when you  have EDGE.

Always Geometric Mean (GM) less the arithmetic mean (AM) so geometric mean is conservative way of valuing the risky proposition.

Warren Buffet repeatedly stressed the importance of  patience as the most important trait investor has to posses in investing , which means that you should invest only when you have edge and Jhon Kelly tell how much to bet .

Kelly criterion maximizes the median wealth and The Kelly system leads to a distribution of wealth (among scenarios or parallel universes) also shuns the tiniest risk of losing everything, for unlikely contingencies must come to pass in the long run. The Kelly criterion has, “automatically built in… air-tight survival motive.”

Kelly  formula  gives fraction ( f ) bank roll to invest.

f =Edge/odds                       where: edge: Amt you will win

                                                                           odds : profit if you will win

=(P*W-q)/W                   P= probability of winning ,   q= 1-p = probability of losing

                                                  W=winning amt per Rs invested

                                                                                                                                                                       

Example:  In coin tossing on one Rs bet, Heads u get Rs 2, tails you loose. So fraction of your bankroll  to bet for maximise  GM is (p=1/2,q=1/2,W=2)  25%.                                                                                                     

f=( ½*2-1/2)/2=25%

Same can be applied to buying stocks to maximise your portfolio return.

No other money management system has a higher geometric mean than the Kelly system does.Another good feature of the Kelly criterion is that it maximizes the median wealth.

Kelly system cannot do is engineer luck. It is possible to be unlucky when using the Kelly system, to end up with less than the median. When you do, you may be worse off than you would have been with another system.

The ever-expanding web of possibilities is like that interpretation of quantum theory where every chance event splits the world into parallel universes. By the fourth toss, there are 16 distinct parallel universes, corresponding to every possible sequence of heads and tails

In an infinite series of serial Kelly bets, the chance of your bankroll ever dipping down to half its original size is…½. A similar rule holds for any fraction 1/n. The chance of ever dipping to 1/3 your original bankroll is 1/3. The chance of being reduced to 1 percent of your bankroll is 1 percent.

The good news is that the chance of ever being reduced to zero is zero. Because you never go broke, you can always recover from losses.

The bad news is that no matter how rich you get, you run the risk of serious dips. The 1/n rule applies at any stage in the betting.

A fractional Kelly bet doesn’t sacrifice much return. In case of error, it is less likely to push the bettor into insane territory.

For true long-term investors, the Kelly criterion is the boundary between aggressive and insane risk-taking. Like most boundaries, it is an invisible line

Trading and investing –Tax implications

Trading and investing –Tax implications

power of compounding applies to expenses as well as profits.

. You buy a stock for Rs1. It doubles every year for eleven years (100 percent annual return!) and then you sell it for Rs2,048. That triggers capital gains tax on the Rs 2,048 profit. At a 20 percent tax rate, you’d owe the government Rs409. This leaves you Rs1,639. That is the same as getting a 96 percent return, tax-free, for eleven years. The tax knocks only 4 percentage points off the pretax compound return rate.

Suppose instead that you run the same Rs into Rs 2,048 through a lot of trading. You

realize profit each year, so you have to pay capital taxes each year. The first year, you

go from Rs1 to Rs2 and owe tax on the Rs1 profit. For simplicity, pretend that the short term

tax rate is also 20 percent (it’s generally higher). Then you pay the government 20

Paisa and end the first year with Rs1.80 rather than Rs2.00.

This means that you are not doubling your money but increasing it by a factor of 1.8—

after taxes. At the end of eleven years you will have not 2 ^11 but 1.8^11 . That comes to about Rs683. That’s less than half what the  buy-and-hold investor is left with after taxes.

Ecology - Finance and Economics

  There is no reason why finance and economics should be different. It is routinely observed that some of the biggest ideas in one particular field are often borrowed from an entirely unrelated field And if there is one discipline that could do more than any other in bettering our understanding of financial markets, it has to be ecology we believe. At the heart of ecology, lies a very important principle. If an ecosystem grows way too much, a destruction of the excess growth follows, laying the groundwork for a stronger system to evolve. This then leaves the ecosystem in a much better shape than before. And what happens if this process is interfered with.

A real life example can be had from the famous Yellowstone National Park fire in the US in the 1980s and which was 30 times bigger than any previous fires recorded there. It occurred mainly because the forest officers there had decided to stop the earlier fires at the very first blaze. In other words, they had interfered with the nature's mechanism of destroying the most fire-susceptible vegetation which eventually grew bigger and bigger in size and thus increased manifold, the intensity of the final fire.

That's it. The Governments and central banks around the world need no more than this simple lesson to understand the implications of their actions. By repeatedly bailing out sick institutions and by throwing money at the most inefficient businesses, they are interfering with the natural process of capitalism i.e. survival of the fittest. It does not take more than perhaps a sixth grader to realise that every such action is increasing the possibility of a much bigger inferno further down the road, which will have devastating consequences on the wealth of the global economy. Not to forget that just like fire susceptible vegetation, continuous support of bad businesses is also causing unemployment to remain high and growth to remain low. Thus, while the forest officers at the Yellowstone Park seemed to have learnt their lessons, the policymakers seem far from doing it. They should realise that there is hardly any other solution in sight. They will have to let the fires run their course. This is the only way to create a new groundwork for stable, sustainable growth and higher employment. We hope the New Year will drill some sanity into them. Or else the market's way of making them realise this will be far too costly and devastating as per us.

Seven Traits of good Investor

#1 – Ability to buy and sell stocks against the market

Everyone thinks they can do this…[when] the market is crashing all around you, almost no one has the stomach to buy.

#2 – Obsession

The second character trait of a great investor is that he is obsessive about playing the game and wanting to win.

#3 – Willingness to learn from past mistakes

What sets some investors apart is an intense desire to learn from their own mistakes so they can avoid repeating them.

#4 – Inherent sense of risk based on common sense

I believe the greatest risk control is common sense, but people fall into the habit of sleeping well at night because the computer says they should. The thing about common sense is that it isn’t very common.

 #5 – Confidence and Conviction

Great investors have confidence in their own convictions and stick with them, even when facing criticism

.

#6 – Get both sides of your brain working

If you don’t think clearly, you’re in trouble. There are a lot of people who have genius IQs who can’t think clearly.

#7 – Ability to live through volatility

Number 7 is the most important, and rarest, investor trait of all.

To make money, you have to cope with volatility. Volatility is not risk.

Good luck during this difficult period. I hope to see you on the other end victorious

Thought provoking for entrepreneur

Vinod Khosla's Co-founder of sun micro system thought on entrepreneur at MIT

http://www.youtube.com/watch?v=YxYVOMj6F2U&feature=youtube_gdata_player

Value Investing and Investment Psychology - By Mahesh Hamne: Thinking About Thinking

Value Investing and Investment Psychology - By Mahesh Hamne: Thinking About Thinking

Risk V/S Uncerainty

In our day-to-day language, and even in finance, people tend to use the terms risk and uncertainty interchangeably. But in the 1920s economist Frank Knight made a distinction that I find quite useful. He argued that risk describes a system where we don’t know the outcome, but we do know what the underlying probability distribution of outcomes looks like. So think of a roulette wheel—when the croupier spins the wheel, you don’t know where the ball will land, but you do know all the possibilities and their associated probabilities. Risk also incorporates the notion of harm—that is, you can lose.

In contrast, uncertainty reflects a situation where you don’t know the outcome, but you also don’t know what the distribution of the underlying systems looks like.  Uncertainty also doesn’t necessarily imply harm, although it often does. So it’s not hard to see that most systems we deal with in the real world are really uncertain, not risky. Uncertainty better describes issues like terrorism or the avian flu, or even markets. Here’s why I’m stressing this distinction: we can model risk using probability calculus. In fact, the statistics of risk are relatively straightforward. In contrast, we can’t model uncertainty easily. And real trouble arises when we model uncertain systems using the mathematical tools of risk. Yet this is precisely what many people do in financial markets and in other domains as well. We’ll come back to this issue of risk or uncertainty quantification in a moment.

Psychologists have demonstrated that  events that are not vivid in our minds get assigned very low probabilities—much lower than the facts warrantI suspect for us to mobilize, as a society, to address risks like global warming or energy constraints we will need one or more 9/11-type events—a tragic incident that reveals what’s really going on.

To summarise, we humans are still not very good at dealing with risk or uncertainty. We are still linear thinkers, we have a nearly-insatiable need to link cause and effect, and we assess probabilities poorly.  However, we do now better understand some of the mechanisms that underlie complex systems, and that  knowledge can be very helpful in preparation for future catastrophic events.

Being Value Investor means

• Under 5% of all assets are run under value investors, a real minority in the investment world.

• The stock market is created for the other 95% of people, that is where your opportunity and challenge is..
• Biggest challenge: understand whether you are the 5% or the 95%
• It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
• 5% have a spectacular return, but 95% of money probably always resides to somewhere else.
• Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
• If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
• You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
The more you know, the better you are as an investor.
• Politics, science, technology, literature, poetry, everything can affect businesses and help you.
• Occasionally you can find insights that will give you tremendous insights that other people don’t have.
• Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?

To summarize value investing not natural habit, most often you will alone/in minority, so your rational thinking is only the only friend in the process.
To fight and succeed against the majority you need to have edge that comes from patience , patience and patience and independent rational thinking and  virocious reading.

Smart Investors traits

What sets the smartest investors apart from the rest? More often than not it comes down to consistently superior decision making in ‘uncertain’ conditions.

Any effort in coping with uncertainty must define, recognise and understand its different dimensions. McKinsey & Co. have developed a four-level format to identify the spectrum of possibilities.

At Stage 1, the future is relatively clear and dealing effectively with a single uncertain variable is adequate.

Stage 2 needs the ability to cope with several different views of the future but the alternatives are limited, discrete and fairly easily defined.

 Stage 3 is where the level of uncertainty is complicated by the fact that a large number of dynamic interrelated variables come into play.

 Finally, Stage 4 is about a truly ambiguous environment that requires constant learning and great agility, as investors can never adequately anticipate enough of the future in advance.

While dealing with a Stage 1 situation, it is vital to make an accurate assessment of just how much you really know. Once you get to terms with the limits of what’s known, the best way forward is to estimate a range for the unknown outcome and identify the level of confidence one has with the given range as opposed to the false comfort of a single-point forecast. The knowledge that there is a 75 percent chance of Sensex EPS in FY12 being in a range of 1,170-1,280, is far more useful than a number such as 1,240 which has a 10 percent chance of being right.

Stage 2 demands that one generates multiple views of the future by recognising the inherent uncertainty rather than seek a single ‘most certain’ outcome. The time tested technique of ‘pro versus con’ reasoning is effective since it typically leads to a balanced view. Equally interesting is ‘back to the future’ reasoning. In effect, you need to harness your ability to explain events in hindsight to enhance your skill in anticipating what lies ahead — or oxymorons being permitted, prospective hindsight. The impact of such intellectual time travel is usually greatest in coping with decisions involving large stakes!

Stage 3 events are difficult to tackle given the incredible complexity at work. Scenario planning — a disciplined method for envisioning a range of plausible future outcomes — is by far the most widely used analytical technique. It is a mistaken belief that more information will always lead to better decisions. In fact, additional information inputs are of value only to the extent that they help to ‘see’ the jigsaw with greater clarity. Beware of the genuine risk that increased information will lead to a misplaced rise in confidence with no corresponding impact on the accuracy of the decision.

So where does that leave us given the nuclear fallout possible in Japan, the turmoil in the Middle East, the debt mess in Europe,  a raw material related margin squeeze about to hit corporate profit margins, high domestic inflation .

Maybe Samuel Butler had a profound take on investing when saying: “Life is the art of drawing sufficient conclusions from insufficient premises”.

Value Investors and different types Risks

Risk management is the essence of a value investing approach. Creating a margin of safety at each stage is really nothing but a form of protection against errors of judgment and bad luck

My  belief in behavioural economics and the importance of “fundamentals”, risk seems to be probably the most misunderstood concept in modern finance. Clearly, risk is not defined numerically by measuring the standard deviation of historic returns. Rather, it is a concept that helps an investor to focus on the factors that might lead to “a permanent loss of capital”.

The Dean of value investing, Benjamin Graham, identified three primary sources of danger: Valuation risk, business risk and balance sheet/financial risk.

Valuation risk- Most of us know that the stock-market performance of a company is driven more by changes in expectations rather than actual corporate results. This is further compounded by the basic math that determines investment results: If you suffer a 50 percent decline, you must double the current value to just get back to where you started out from.

The second source of danger — business risk — is really to assess the lasting damage that can be caused to earning power as a result of negative changes in the environment. Quite often we assume that current margins can be extrapolated indefinitely into the future rather than contemplate the prospect of mean reversion caused by cyclicality and a deterioration in the business outlook. Indian IT services companies find themselves at an important turn in the road — greater long-term strength for the rupee, an inability to move up the value chain, increasing competition as well as a more hostile political environment in the US. The habit of comparing current earning power to long-term averages can help you keep out of trouble — at least one will receive early warning signs of a “value trap”.

The final element of this unholy trinity is balance sheet risk. In essence, this translates into a compulsive focus on cash flow. Rising debtors or inventories, relentless capital expenditure leading to greater financial leverage or constant equity dilution, declining operating efficiency, an inability to improve or maintain productivity, eccentric capital allocation, all lead to fragile cash flows and deteriorating financial health.

Interestingly, investors are pre-occupied with “reported earnings” and growth at the height of booms, oblivious to the seeds of destruction being sowed for the long haul!

Over-reaction and investment decisions

The  majority of investors tend to formulate investment strategy by naively extrapolating recent trends. Second, they tend to be overconfident in their ability to predict the immediate future accurately. Finally, their confidence intervals are skewed, which means their best guesses are not evenly spaced between their high and low estimates. Why does this happen? In effect, individuals are most influenced or tend to ‘anchor’ their predictions on just how salient they believe recent history is. Nobel Prize winner Daniel Kahneman suggested that we tend to judge the probability of an event by the ease with which we can call it to mind. The more vivid our memory of something similar in the past, the more probable it will seem to happen again. Remember 2008 — AIG, Lehman Brothers, Bear Stearns.

Paul Slovic, psychologist has an explanation that is based on our intuitive sense of risk being driven by two factors — dread and knowability. His conclusion: These two factors ‘infuse risk with feelings’. Dread is really a function of how dramatic, controllable or potentially catastrophic a risk appears to be. The knowability of a risk depends on how immediate, specific or certain the consequences appear to be.

Therefore, our perceptions are distorted such that we underestimate the probability and severity of common risks such as inflation. On the flip side, less comprehensible risks that we have never personally experienced seem potentially lethal. As Jason Zweig put it, “We see the world through warped binoculars that not only magnify whatever is remote, but shrink whatever is near.” So, blinking in the face of risk might well be natural, yet the over-reaction is incredibly dangerous in arriving at investment decisions.
 
The financial media seems to revel in highlighting the current woes of the stock market with laser-like precision — the interminably long list of new 52 week lows, faltering corporate earnings, the soaring price of gold and the incredibly muddled response of policymakers around the globe. So, does financial holocaust beckon just round the corner or are there signs that the deathly pall of gloom might lift within the next two or three quarters?