It’s that time of the year again!
End of the year is a good time to reflect on the year and take stock of what worked, what didn’t and focus areas for next year. I do this exercise annually and occasionally it has brought some profound changes to how I look at investing. 2018 could very well be one such year.
So what worked and what didn’t in 2018? this year its the same items that worked and didn’t work. Exactly a year ago, just after a big year for small & mid caps, I decided to adopt a strategy to preserve those gains rather than going after even more gains. Did that work? Partially. That means I managed to keep some gains but managed to give up some others. So the next question is, why? In retrospect, preserving gains is turning out to be much harder than earning those gains. This isn’t the first time I have given up gains after a huge year and after every such year I plan on focusing on preserving those gains only to forget it by the time next bull run is about to end. At least by end of 2017 I didn’t forget this rule but implementation of it in 2018 is only partially successful. So why is it so difficult? After some soul searching, I realized that I need to work on 3 qualities:
- Discipline to sell when price is high
- Patience to wait until price begins to correct
- Courage to buy when price has fallen
If these 3 rules are so logical why is it so difficult to implement them? I guess towards the end of a bull run, making money looks easy and who wants to give up those easy gains? Finding winners is hard and when we do find one, it looks foolish to give it up too early. If you did sell something and sit on cash, market can keep going up and fear of missing out will test your patience. Lack of alternatives will also make you hold on to expensive investments. In the past I even invented new reasons to hold to to expensive stocks only to laugh at those reasons when price fell. If you don’t sell at the top, you wont have funds to deploy at the bottom. Moreover, when you feel like having made mistake in selling (or not selling) or not being patient enough, you will not have courage to buy when price has fallen because you will feel like making another mistake. You will have courage when price has recovered but that will come at the cost of returns.
One thing that is common in all these qualities is that a strong sense of intrinsic value is required for implementation . No one can accurately calculate intrinsic value but you can have a confidence interval around it so that you will know when price is too high or too low and that will automatically lead to discipline in selling and courage in buying. It will also help in being patient until price drifts outside of the confidence interval. 2018 has turned out to one such year when decisions driven by valuation calls turned out to be correct and those driven by sentiments turned out be wrong including decisions to do nothing. That leads to focus area for 2019, to strengthen valuation models and drive decisions based on it.
Another common factor in discipline to sell at the top and courage to buy at the bottom is that these actions are decidedly contrarian. It is the exact opposite of what crowd is doing (or appears to be doing because that’s what produces those high and low prices) which leads to another profound question of the year:
Am I a contrarian investor or just a trend follower?
Thinking about investing strategies, I came to a conclusion that broadly investors can be classified as either trend followers or contrarians. Most investors (including me) start as trend followers because it is intuitive and it is a low risk strategy. Its like driving on the right side of the road, follow the conventional wisdom and do what everyone else is doing because that’s what we learn growing up. Trend followers don’t need to do a lot of analysis because they benefit from the wisdom of the masses. If something is going up it must be good and if something is going down it must be bad. Often, this is true, but not always. That distinction makes all the difference between trend followers and contrarians. While trend followers benefit when it is true, contrarians benefit when it is not (provided they spot the distinction correctly). Occasionally trend followers are subject to madness of the crowd but it is less painful because everyone is in pain too. Moreover, we know that the whole market is not going to zero so sooner or later it will bottom out. There is always a light at the end of the tunnel. There is nothing wrong in being a trend follower as long as you realize that it is low risk - low return strategy with some chances of wild rides.
Contrarians are those that drive in the opposite direction because they know that market has overshoot its trajectory and they need to reverse the gear to get back on track. They feel comfortable in doing what makes trend followers uncomfortable. Conventional wisdom sounds like an oxymoron to contrarians. When contrarians are right, they become the trend setters, when they are wrong, they go broke. That’s what make this a risky strategy as going in the opposite direction can take you further away from your destination unless you are confident that doing so would put you back on track. To a trend follower, contrarians appear to be heading deeper in to a tunnel with a dead end whereas a contrarians looks at trend followers like lemmings heading towards a cliff. Contrarians need to do a lot of fundamental analysis to determine intrinsic value because a strong notion of intrinsic value is needed to confidently determine if market value is too high or too low.
Contrarians can get an edge by mastering fundamental analysis as it can spot gaps in intrinsic value and market value while trend followers can get and edge using technical analysis as it can spot trend reversals much better than fundamental analysis. My observation is, too many trend followers analyze fundamentals either to confirm a trend or to spot a reversal. To me that’s a flawed strategy (which I also followed for years) because by the time trend reversals appear in fundamentals, price has already reflected that. Only an expert in the industry or an investor with an edge in an industry can spot a trend earlier than others. However such investors will benefit much more by being a contrarian and wait for market to given them an opportunity to profit from the edge they have.
Ten years ago when the world was in the middle of the worst crisis since great depression and my portfolio had lost 2/3rd of its value, I asked myself a similarly profound question. Am I an investor or just a gambler? The reason that question must have flashed my mind because at least some of my actions leading up to the crisis must have fallen in the realm of gambling rather than investing. Today that question does not cross my mind because I know I am not a gambler. So why am I asking myself if I am a trend follower or a contrarian? It’s because some of my recent actions look like that of a trend follower while I am focusing on fundamental analysis like a contrarian. Which means I am still in a transition stage from a trend follower to a contrarian. When the push comes to shove, my subconscious mind is listening to my trend following instincts even though the push itself comes from the contrarian side.
Focus area for 2019 is to take this further and analyze if a decision (including decision to do nothing) is coming from my trend follower side or contrarian side and take more and more contrarian decisions to execution. I think 2019 should provide plenty of opportunity for contrarians.