AA - Abhishek's Attic (place to store stuff to clear my head)!

[basumallick]

I did some basic number crunching to try and find patterns in the previous major market crashes. Below are some initial thoughts. Will see if I can develop on this theme further.

THOUGHTS

• Both the previous big falls have been 50%+.
• The falls were multi-stage. ie. markets fell 30%-ish for 4 times during the dotcom crash and thrice during the GFC.
• During the GFC, the last leg of the fall was the sharpest, falling 45% in 2.6 months. This is when people already knew the extent of the problem.
• Strong pullback rallies punctuated each leg of the fall.
• Going by the last 2 falls, the 50% mark is roughly 6000 and 60% mark is 5000.
• Each phase of the fall and rise comprised of about 2 months. Going by history, we could be looking at a pullback rally for the next 1-2 months.
• During the dotcom crash, the market fell consistently for nearly 20 months, and during the GFC it fell for 10 months (top to bottom).
• The extent and speed of the current fall could mean that we could be heading for a sharp but short cycle of fall which can last less than 1 year.

Post initially put in Market Meltdown, the Virus, and our Actionables - #183. Adding here for future reference and record.

[Caution_Investor]

Excellent insight and thoughts Sir. It is really greatly helpful for new and inexperienced investors like me. I have been hearing that NO one can find a bottom and hence start investing little bit as market falls and you make a great money in long term. Going by this strategy, I may exhaust all my money in the First fall itself!

What you have shared - the market movements - rise and fall and the time frame gives clear view of what can happen in future also. It may not repeat in exact same fashion but I feel this time too we will have similar ups and downs for long time. Thanks.

[basumallick]

ON STOPLOSS

Should you have a stop loss if you are an investor? That is the question I have have been trying to answer for myself. I have been dabbling with various quant systems and obviously stop losses is a part of the thought process in any trading system.

Stop loss is a simple yet extremely powerful concept. It can protect you from major catastrophes that can completely erode your portfolio to protect large part of gains made (when used as protective stops). It is part of the “money management” or “allocation” strategy followed in trading systems.

Money management is perhaps one of the most important things that I learnt while studying quant systems. And I find that not knowing it was stupid. Every investor MUST know about money management and adapt it to their own investing style. More on money management later.

There are only 2 types of stocks - trending and mean-reverting.

Trending stocks are those that follow a trend (it keeps going up or down over time - since we are usually all long-only investors I will talk about price rise trends). The rising price trend is usually but not necessarily improving fundamentals like earnings. Examples are many like Pidilite, Asian Paints, HDFC Bank etc.

Mean reverting stocks are those where the prices keep oscillating about a mean position (which also tends to slant upwards but at a much lower slope). Practically, most stocks belong to this category.

Stop loss should be used differently for the 2 types of stock. If you have bought a trending stock, a stop loss is a must. It helps in preventing massive losses in case your thesis is wrong or there is a major market correction. It also prevents in locking in gains by the use of a trailing stop loss. (A trailing stop loss is one where you keep raising the stop price as the price of the stock keeps going up). If you have bought a trending stock at 100, and it falls to 80, the trend is possibly broken and you need to reevaluate your thesis and hence get out of the position. Exactly, the same situation with a trailing stop. It gets hit when the trend reverses.

On the other hand, if you have bought a mean-reversion stock, where you are expecting a change in fortune, then a stop loss initially is a STUPID idea. This is precisely why Warren Buffett or any other value investor do not use stop losses. Value investing, by definition, is a mean-reversion strategy, where you are expecting the price of the stock to revert back to its mean “value”. IN a mean reverting stock, lets say you have bought it at 100 and expect it to revert to its intrinsic value of 150 in some time period. Now if the price falls to 80, ideally your philosophy should drive you to buy more at the lower price since you are now getting a better bargain and potentially more profits when the stock does mean revert.

How to set stops?

There are many ways stops can be put. Unfortunately, there is no correct way. Different people use different methods based on their trading style, capital at risk, investment horizon etc. Some basic strategies are:

1. Using a fixed percentage stop loss (say 10% or 20% from buy price)
2. Based on technical chart patterns (support levels, breakout levels, gaps etc)
3. Based on statistical indicators (Fibonacci levels, moving averages, ATR etc)
4. Volatility based
5. PE based (exit at x PE)
6. Growth level based (if earnings growth falls below x% for 2 quarters in a row)
7. So on and so forth…

Stop levels need to be in line with your capital and time horizon. If you keep a 5% stop loss and your a long term investor, you will get stopped out 99% of the time. You need to understand the volatility of the particular stock and make sure you do not get stopped out under normal market gyrations. However, if you are a day trader and are trying to make 1% return from the stock, even a 1% stop loss may be way too high.

Portfolio level stop loss vs individual stock stop loss

The next problem is whether to have an individual stop loss for a stock or a stop at the portfolio level. Again, like in nearly everything in life, the answer is “it depends”. Individual stop loss, in my opinion, should be more liberal, if you are a long term investor. Something like 30-40% or even 50%. But if you combine it with a market level stop loss, then it could get triggered at a lower combined level.
For example, say you have bought a stock at 100 and you have a 30% stop loss on it. You expect the stock to double in the next 4-5 years. When you bought it, the Nifty was at 11,000. Now, the markets starts tanking and Nifty falls to 8800, which is a 20% loss on the index. Now, if you have a complex stop loss which takes both individual stock price and the index price, then you could actually be stopped out of the position even without the individual stock not having lost 30%.

Single or Graded Stops

You can use either single stop loss to get out of your entire position or graded stop loss to get out gradually. Example: Sell 50% at a 20% stop, and then 10% every 5% fall.

Does a stop loss reduce drawdowns or lock in losses? What is the impact on profits?

This is the most crucial question that very few people actually ask. I have been dabbling with this for a while now. Stop loss in my studies, nearly always, reduces returns. Obviously there are many assumptions that have gone in the data studying primary amongst which is that you are not a very poor stock picker and you make reasonable profits when the markets are dong well. If you are not sure if you are a good stock picker, then use a stop. It is like a helmet. It will save your life if you crash.
However, if you are a good stock picker and have a good track record, 9 / 10 times your stop will get hit and the stock will recover ground post that. Only in very very rare cases like a DHFL or a Yes Bank would it protect you immensely. But then again, if you were a good stock picker you would have gotten out of those even without a stop loss.

Is a stop loss strategy a behavioural strategy more than a money management strategy?
A stop loss is mostly a behavioural strategy. It is also a strategy for those who do not know the stocks they are buying so in a way it is ignorance insurance. It protects you from the unknown and from making stupid catastrophic mistakes.

BOTTOM LINE: Since the world is dynamic and you can never know everything about everything, having an exit strategy is important for all your investments. Stop losses are part of that exit strategy.

[homemaker]

I kept a dummy portfolio to check on Trailing Stop Loss @ 20%. Seldom checked for last 18-24 months.In this COVID-19 triggered crash, I checked, and found that TSL could have saved a draw-down of 19-20%. TSL allows profits to grow and cuts the losers. Yes, there would have been high transaction cost which is not accounted for in the analysis.

This is not very accurate table, neither I took effort to maintain checks & balance regularly. So one should not treat this as very reliable data. But the broad level benefits are loud & clear.

[basumallick]

You have to look at this table after say 2 years more and then compare it with the current snapshot to understand whether you got stopped out and booked losses or it was just volatility that could have been handled.

As I said, there are no easy answers in this. It has to be tailored based on personal preference, risk appetite, return expectation, time horizon etc.

[gautham1]

@basumallick As usual, yet another great post. Thank you. I have a related question. Lets say you exit a large position or exit the entire portfolio. I think one of the biggest challenges is reinvestment or building a portfolio all over again. Its very difficult construct from scratch. Somehow I fee an equal allocation portfolio may not be a bad idea, although its not very optimal. (As we know, ideally we should have max allocation to highest conviction ideas) . As long as one limits the max no of stocks to <30.
I know there is no right answer for this. Would love to hear your views

[Ratul_Deb]

I have a query on money management and building that may be relevant here. It’s more to do with building a position (and managing it, so even stop loss is a part of it) over a long run.

Say I have taken an initial position in a stock at 100 rs per share. And let’s say I keep a stop loss at 20%. Now imagine the price moves up 50% in 6 months (price now 150). At this point, should I still keep stop loss at 20%? That would mean i should sell it at 120, which is still 20% above my buy price. In this case shouldn’t I be more patient, knowing my capital is preserved? The assumption here is there’s no change in my conviction. Now that brings me to another dilemma - if my conviction is unchanged, and the stock corrects by 20% from 150 (thereby hitting my stop loss btw), shouldn’t I in fact consider adding more if possible?

Another approach here can be keeping the stop-loss dynamic. As the price goes up, I keep revising the stop loss price based on my understanding of the business. No fixed percentage, but a fixed price for each of the stock, and they all to be revised at regular intervals. Would that make more sense? But that would make the decision making susceptible to behavioural biases, isn’t it?

Would really like to know how you deal with these issues. Is there any books/articles on this topic that can help us develop a framework for this?

Thanks so much for your insightful posts, as always.

[malthankar]

Just penning down some thoughts with my experience:

I feel there should be stop loss at individual stock level, it could be preference of someone to put 20% or 33% or may be selling in chunks when it start going more than 20%. I feel it is very rare situation when 20% stop loss hits to good company with less price variance when stock is in good up trend.As long as we have conviction that we can buy back when it start moving up and fundamental story is intact, there should not be any hesitation in selling as we can always buy back or we may find another good stock as long as we are a reasonably good stock picker.

Benefits of selling with my experience:

1. It makes our thinking pure (biggest benefit) when we are out of loosing stock. If we see stock and having loss in that stock, knowing / unknowing we get biased or anchored with that stock price that sometime does allow us to think about other great opportunities lying there. (We need only 15 good stocks kind off where there would be many more good stock picker can find)
2. Protecting profit is also not a bad idea as it makes us more sincere about money when it becomes part of capital (Loosing gain has less pain than capital so human psychology problem)- I was reading a book where it explains how big fund housed deal with this problem
3. In the current dynamic world and cleaver guys, it is very very difficult to know everything about a company, Stock price is super god kind off which start reflecting company fundamental of next 6 months or you can say, Market always discount stock price for known news (May be known only for selective investors)
   (May be very long term investor do not worry about it)

Cons:

1. Missing opportunities
2. Not able to buy back

I can write too many things but would like to know more about other people thoughts and experience.

Regards,
Milind

[basumallick]

@gautham1

reinvestment or building a portfolio all over again.

Building, or rebuilding, a portfolio is a different ball game altogether. Nothing to do with stop loss. Will discuss it some other time at length.

Allocation strategies are very interesting and ideally should be based on how much conviction you have on a stock and its relative potential for outperformance. If you are unsure of both, then an equi-weighted strategy works well. But in that case, you have to also think about what you would do once some stocks go up and some go down. Basically, a comprehensive thought-out strategy is required, and not random buying and selling, which is unfortunately what most investors do.

[basumallick]

@Ratul_Deb

Say I have taken an initial position in a stock at 100 rs per share. And let’s say I keep a stop loss at 20%. Now imagine the price moves up 50% in 6 months (price now 150). At this point, should I still keep stop loss at 20%?

If your strategy is to use a 20% trailing stop then yes, you should continue with it.

@Ratul_Deb

In this case shouldn’t I be more patient, knowing my capital is preserved?

No. This has nothing to do with the price you bought at. You are trapping yourself with price anchoring bias. How on earth does it matter whether you bought the stock at 100 or 120 or 80?

You have to be very clear why you are putting a stop loss (or a trailing stop). If you are unsure, which your question suggests you are, then all sorts of rationalizations will crop up in your mind.

You are putting a stop loss because you do not know the direction of the stock price in the short term. Nothing to do with your conviction in the stock. You are trying to protect your capital or preserve your gains.
As I explained, there are only 2 types of stocks - trending and mean-reverting. You need to know which one is which. You cannot be playing a bouncer and a yorker the same way.

@Ratul_Deb

No fixed percentage, but a fixed price for each of the stock, and they all to be revised at regular intervals. Would that make more sense? But that would make the decision making susceptible to behavioural biases, isn’t it?

Let me try to explain slightly more.

The steps:

1. Be clear what kind of stock you have and whether you want to have a stop loss or not. For mean-reverting stocks, you need NOT have SL. But, a SL is usually a good idea, because we are all fallible and make mistakes while choosing a stock.

2. Decide how to devise the SL. It can be simple with a single factor or complex, composed of multiple factors. Some factors could even be market-related and not related to the stock in question.

3. The stop loss needs to be as far as possible mechanical. That is it should NOT be dependent on investor discretion at the time of execution. You should be able to say that I will get out of this investment if X is hit at any time of the duration of holding. A SL can definitely be dynamic. A lot of strategies include dynamic SL like using moving averages or ATR such simple technical indicators.

Unfortunately, I have not found a good book which covers stop loss well. I have picked up the thoughts from many many trading and money management books and interviews of successful traders. I have distilled whatever there is to know, in my opinion, in the previous post. You are not likely to find anything extra in any book. And if you do, please let me know.

[deevee]

Hi

First of all thanks Dada for sharing so much on this thread. I have my own small rules for money management. Mostly they are a combination of an equity allocation framework, portfolio value which could be trending upwards or downwards, individual stock positions which could be in their own drawdowns or impacting the overall portfolios and last a thesis change in the stocks I hold. Also I am not claiming that these are perfect infact far from that

I tried to write it down as crisply as possible but it is flowing into long pages. So I temporarily put it up on my inactive blog.

Not sure if this would be helpful for folks here.

https://peepalcapital.blogspot.com/p/money-management.html

Thanks & regards
Deepak

[basumallick]

@deevee Excellent system. You seem to have a pretty comprehensive strategy built for yourself. Your asset allocation strategy is based on mean reversion and your stock picking is trend following.

If you are able to follow the system through emotionally difficult periods like what we are going through now, I am sure you will do better than most “great stock pickers” out there. That is what I am increasingly learning. Systems beat people hands down.

[bheeshma]

Very nicely articulated @deevee! Esp the max DD part. I feel DD is a good tool for money management and is also very intuitive. For historical nifty trend - I find looking at p/b of HDFC bank gives a good better sense of overvaluation and undervaluation in the market - since the twins form a large component in the index

[anon34631667]

You need to let go of ego to believe in system investing

Very few investors/traders manage to reach this nirvana , path is hard .

[hack2abi]

Have taken a subset of @deevee bhai’s work and expanded upon it. Hope it will be useful for everyone to form an asset allocation framework. Will expand on this with NIFTY500 data in future.

The last 3 columns represent the win, loss rolling periods where investor earned more or less than 12% threshold return.

Increasing capital allocation to equities when market is under 18 PE is when the odds start to be in your favour across all time frames.

[bharat.jain]

@deevee What are your views on gold in portfolio?

[onlish2014]

Hi Deepak,
Great writeup and thanks for sharing. I have a couple of questions:

1. How exactly to calculate Max DD? Eg. Let’s say stock price on subsequent days is 100, 90, 85, 90, 80, 75,… Now if I look at moving window of 3 days max DD is 15 but if expand to window of 6 days max DD is 25.

2. Going through your very helpful examples at the end of the write up, it appears that thesis change is preceeded by drop in stock price often even if not hitting max DD. Are you using some sort of trailing stop loss model as well?

3. Can you give an example of how you use PVT lever as trigger for exit/maintain?

Thanks!

[hack2abi]

You can use this sheet to calculate Drawdown for any stock.

Abhinav Mehrotra

[basumallick]

On World Book Day, my Top 10 favourite list. This list keeps changing but most has been there for many years on the favourite list. I have read each multiple times over the years. Still love them.

1. Poor Charlie’s Almanac
2. Seeking Wisdom
3. One Up on Wall Street
4. Fooled By Randomness
5. Berkshire Hathaway Letters to Shareholders 1965-2012
6. Rich Dad, Poor Dad
7. Mahabharat
8. All Agatha Christie books
9. All Alistair McLean books
10. All Satyajit Ray books

[basumallick]

Tussle between Bulls and Bears

Currently, there is a boxing match going on between liquidity & low-interest rates on one hand and business and economic uncertainty on the other. In March, round one had gone to uncertainty and in April, in round two, liquidity won. So, right now, round wise we are 1-1 but uncertainty had struck heavier blows and has more points (the market is down more than up)!

Just to understand the liquidity situation, let’s look at what is happening around the world.

• US: $5 trillion stimulus package announced. Roughly, 25% of GDP.
• UK: GBP 500 billion stimulus package announced. Roughly, 25% of GDP.
• Eurozone: Euro 3.2 trillion stimulus package announced. Roughly, 24% of GDP.
• US: Yen 108 trillion stimulus package announced. Roughly, 20% of GDP.

So, both sides are strong and it is not very clear who will win the next few rounds.

The central banks globally are using their 2008 playbook and have jumped in very quickly to the rescue. That is why even Warren Buffett is sitting holding his 130+ billion dollars of cash. But no one is calling to offer him great deals that he got in 2008 because the guys who need the cash have now got it from the central banks in some roundabout way.

Compare this with what the Indian government and RBI has done for the industry – practically nothing. And unless some significant measures come in, India is going to have to pay for the consequences for a long time.

The Way Forward

I am of the opinion after speaking to a large number of business owners over the last few weeks that the next 1-1.5 years will be extremely tough. The level of uncertainty is only going to go down as and when a vaccine is found and is delivered to the masses and is effective in preventing a further outbreak. Till then we are going to be wary of the circumstances. The more the duration of the lockdown goes on and the more social distancing norms gets mainstreamed, the more persistent behaviour changes are likely to be. The scars of this event will be there for a fairly long period in my opinion.

The urban salaried and business class are likely to be badly affected with reduced income from salaries or businesses. This is likely to have a negative impact on discretionary spending. So, sectors like real estate, both residential and commercial; 4 wheelers, luxury items, leisure travel are likely to be hit much longer than people are currently factoring in.

Another area of concern for me is how the startup space will play out. The “thin-air” valuation model is likely to come under severe scrutiny and make way for more profitable and cashflow oriented business models. The concern is that in the last few years, the bulk of incremental jobs in India, especially at the lower end of the spectrum, has come from these “non-profitable” enterprises (the likes of Oyo, Swiggy, Zomato, Ola, Uber, Flipkart, Amazon, Paytm etc). Impact to such businesses would mean a chain reaction and lead to joblessness.

Civil Distress

History tells us that severe economic contractions most of the time lead to social unrest, civil wars and even full-scale wars between countries. I am not suggesting we would have it this time around, but we need to be aware of such an outcome. Already social tensions have started rising and with more duress in daily life, it is likely to escalate. The government does have a significant role to play in this through various social schemes.

Silver Lining

Some areas which give me comfort is that a very large section of Indians depends on agriculture and that has been the least impacted in the crisis. With, hopefully, a good monsoon, we should be able to see rural demand coming back.

Another silver lining is the reset in labour laws that states are now resorting to. Times of crisis such as these are great opportunities for policy reset which is particularly difficult to get done during normal times. Labour and land reforms are the two most critical issues that have been holding back Indian industry and any progress on these should be welcomed.

In times like this, it is better to remain cautious. There are 3 positions an investor can take in the market at any time – i) be a buyer, ii) be a seller and iii) wait outside.

Now seems a good time to be waiting outside.