Mean Reversion and Capital protection are two concepts from your presentation that resonate very strongly with me and are two topics that I am working hard in recent times to come to incorporate them into my investing behavior. Both these ideas influence the Sell action.
Naseem Taleb touches upon this topic of Ergodicity in stock prices and is something that he discusses in the context of trading. I am not quite sure if this is a concept that can be extended to investing as opposed to trading. Naseem argues that the path of a stock price is but one possible “route” or outcome path and the higher and larger is the deviation from the mean, higher is the probability of it reverting to mean.
So the question now is, how is the reversion considered? Is it with respect to the overall market mean of 18%, or is it with respect to an sectorial mean ( for example IT industry mean was about 25-30% a few years back). If one onsiders an investment in a company like SUN pharma, or Lupin, the returns have been in excess of 30% CAGR for over 15 years! When does one decide that the run has gone too long and it’s time to Preserve the capital, i.e. take the profit off the table?
Assuming that one had started out equal weighted portfolio 15 years back and also assuming that the rest of the stocks grew at market rate of 18%, then by 7th year, the single stock of Lupin which started out with 1/10th weighting would be now 25% of the portfolio value, and thus as per the Investment Thumb rules would trigger the sell. This would miss the next 8 years of growth in Sun. But as you say, you’re ready to forgo gains for sake of risk aversion.
Question: What is the “mean” around which you expect stock to revert? Overall market, or sectorial? How is the length of the run decided before you decide it would start the reversion?