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Saturday, April 12, 2008

Dodging a Bullet

I am posting the performance till March ending 2008 in this downloadable pdf.

If you had invested in Nifty ETFs on Mar 30th 2007 (last trading day in 2007) and stayed invested till 31 Mar 08, the Nifty portfolio would have earned 23.89%, not including dividends. As against this, my portfolio earned, 29.85% (not including dividends), an over performance of 6%. This has been achieved without the use of margin and derivatives.

A word of caution on the posted performance, though. A special situation investment involving a demerger is in the holdings. This particular investment ceased trading end of December and is expected to list soon with the subsidiaries. Until such time as it lists, it will be valued in the portfolio along with the subsidiaries at the last traded price.

The question this time for me has been, how do you measure a dodged bullet? (It would be the present value of future cashflows from the time you dodged to the time you finally meet the maker, no? - comments anybody?) For my investments, I will be attempting to plot the course of the performance as it would have appeared if I hadn't sold the ones I did early Jan. This would be a hard measure to keep track of, with the data I have, for a longer time frame. This is an attempt to compare actual performance against another simulated portfolio if I had held on to shares early Jan 08 with portfolio unchanged. I am expecting to post this graph in the coming months.

Two alternate views I had heard during the time I was coming to a compelling conclusion that market was over-valued were:-

One, in favor of buy and hold, and

Two, use of derivates (the financial weapons of mass destruction, as Buffett terms them in his 2002 letter (Page 14 in the pdf view))

The adherence to principles as against process is detrimental to investing. The comparison between the simulated portfolio and the attained actual performance disproves that adherence to buy and hold for over-performance. Something that works most of the time will not work all the time. As I had written earlier, goal number one is preservation of capital. As long as I am moving towards this goal, I am willing to question and disregard other principles where compelling evidence exists.

Arguably, in the simulated portfolio, I only lost what the market gave. This line of thinking is a slippery slope. I would have to start thinking that when I was born, I was born with no money. As a result arguably, losses of any kind should not make any difference. Even from this particular philosophical angle, I should see myself as a trustee of the wealth entrusted to me. I should measure my overall performance in what I end up with and what I transfer to others (though I am too young to consider such a transfer in the ordinary course of events). As Guy Fraser-Sampson talks about in his book "Multi Asset Class Investing", investing must be seen as a journey.

Here's another intuitive block to overcome when making such a decision. If you are going to be in cash, how is it investing? I am reminded of an old story I had heard in college. The scene is a big factory. A machine has stopped working and as a result, the whole production has stopped. All the top operations management is at the scene worried about potential loss of customers and goodwill. They call in the maintenance guy (outsourced, of course), who comes in, looks under the hood, takes a hammer and gives a gentle knock on a part. The machine comes back to life and the whole production is back on track. When the guy sends the invoice, the operations guys are appalled to see the huge bill for Rs.1 lakh (10 lakhs is one million) (this was a time when a lakh meant something). They ask him why should they pay a lakh to just hit the machine with a Rs.100 hammer. The guy explains that the Rs.100 is for the hammer, and the rest is for knowing where to hit with it. Such is the case with investing. Most of the time is spent on doing the background work, accumulating knowledge. Then you take the decision to go cash.

This interesting study published in New York Times talks about the frame of mind among decision makers also applies to investing.

The quote from 2002 letter must seem as a bias against use of derivatives to the reader. The revelation that I have used derivatives in other portfolios in this context must seem contradictory.

The problem with plain options like put or call on shares is that they have a decay factor to it. I am always against "owning" an asset that loses value by day. Anything with a decay on time should be treated as consumable. Cash Currency, by its inherent nature of inflation, has time decay to it and investing in stocks is a way to get around it. The view that you escape an 4-8% per annum decay in purchasing power (depending on your home currency) and end up with a higher decay (inflation plus risk premium) by "investing" in options doesn't seem to make sense.
Let us take the case of my view in early Jan that markets are over-valued. My alternative to selling shares was to have bought put options. So far good. The next step is trickier - what should be the term? I would go for longer term option that is deep out of the money to minimize time decay. At that point of time, there were only 3 month options available in India. If (a big if at that) I were able to time the market right, the pay-off was good, however, the risk of decay as well as the illiquidity risk due to lack of depth in the options market was high. As against this, was the alternative of selling and going in cash.

The two guidelines for me to "invest" in options, therefore are:

1. Minimize Decay by investing in longest-term and deep out of the money, and

2. Invest in markets with depth.

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