Monday, June 23, 2008

Smart Lessons for Smart Investors

Hi, I read this while browsing net, I thought this may be useful to you. Read on......
The other day, two school kids were talking to each other – sharing jokes and having a great time. I happened to be around and overheard the following joke.

One day, a moron decided to swim across the English Channel. He started with a lot of enthusiasm. He had crossed around three fourth of the channel. Tired and exhausted, he thought this was enough and he cannot go any further. So he swam all the way back.

Well, this is a good joke from the perspective of the kids. They enjoy the situation that the moron put him into.

But that set me thinking. Doesn’t this sound familiar – especially for many investors in the stock markets? Why do the markets have to start rising immediately after we have sold or vice versa?

Rational thinking suggests that an investor chooses to invest in the “risky” stock market securities to reap higher rewards. Reality suggests that an investor chooses to invest in the “ever-rising” stock markets after the prices have been rising for some time in the recent past. This past trend is then extrapolated into infinite future to conclude that upward is the only direction in which stock prices can and will go. In such a scenario, one tends to assume that the stock markets can give super normal returns without carrying any risk at all. The investor perceives the risk to be absent from the market and continues to pour in more and more money.

Suddenly, for reasons not known to anyone, the market takes a “U” turn and prices start their southward journey. The initial response from people at large is that of denial. The situation looks like small aberration and one is convinced that the reversal will happen once again. It may or may not happen that way. And when the prices do not start moving up in a hurry, one’s patience gets tested. How long can one control the emotions in such a scenario is a function of the conviction that one has and of course the solvency. But often, more than the solvency, it is the conviction that is more important to survive in the market.

Where does the conviction come from? Conviction comes from supreme confidence in what one knows and understands. What is this knowledge?

“Stock prices are slaves of the profit growth of underlying companies over longer periods.”

This simple line sums up all the knowledge that one needs to have in order to develop the confidence. As Benjamin Graham puts it,

“In the short run, the market is a voting machine - reflecting a voter registration that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine.”

If one understands this and has confidence in the economic growth, staying invested could be highly rewarding. Then comes the question of the short term movements of the prices. Someone has very nicely said that the long term is made up of many short terms. Absolutely correct, but one forgot to mention that many of the short terms cancel one another out and the remaining short terms are a part of the long term trend.

It takes enormous courage to stay calm in the noise of the short term – what with ticker, media, friends, brokers, internet – giving out number of messages. It takes a lot of patience to stay balanced in such a scenario. But patience is a rare virtue.

Look at the everyday life and one can see how impatient we have generally become. One of the funniest examples of impatience is what railway passengers do while nearing their destination – even when that may be the last station on the train’s route. I was once travelling from Ahmedabad to Mumbai in Shatabdi Express and had to get down at Mumbai Central, which is the last station on the route. Shatabdi starts from Ahmedabd in the afternoon and reaches Mumbai late in the evening. Soon after we crossed Borivali, the penultimate station, some of the passengers started to take their luggage off the overhead racks and from below the seats to queue up towards the door. Some left the comfort of air-conditioned cabins to stand near the exit doors. And they stood there for close to 20 minutes.

I was wondering what was happening. Mumbai Central being the final station, the train was not going to go anywhere after that giving ample time to the passengers to get off the train with all the luggage they had. The train, as mentioned earlier, reaches Mumbai late in the evening and hence there is no hurry to rush for a time bound schedule unlike in the morning or during the day time. Inside the train compartment, the environment was very comfortable, thanks to the air-conditioning. Outside was typical Mumbai weather – hot and humid. And still, many gave up the comfort for no apparent benefit.

What was the hurry then? But, that is human nature. And if that is how people behave in such a simple case, stock markets are a much more complicated place. Expecting patience might be asking for too much. But then, that one trait ensures you get out of the market with reasonable profits.

To sum up, let us see what Warren Buffet had to say about patience in stock market investing, “The stock market is a device for transferring money from the impatient to the patient.”

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