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The School Of Hard Knocks

I write at Yahoo: The School Of Hard Knocks

Many of us desire to make money from the stock markets, because it doesn’t seem to take a lot of skill. After all, like a casino, all you need is one good trade. That’s what we read about — the success stories of investing talk about how Warren Buffett bought into Coke, or Rakesh Jhunjhunwala bought Titan, or Paulson shorted sub-prime mortgages or such.

While these investors — and many others — have benefited from the huge success of a few stocks, there are thousands, even millions, of other investors who lost much of their money chasing performance. And not just speculating, but even with deep, well researched analysis. A stock that seemed like a steal three years ago is still a steal; they have higher profits, and a lower stock price. In another ten years, they might still have the same stock price. The “value trap” attracts people who think luck plays no role in investing, that all it takes is good analysis.  Value traps are lessons you don’t learn about in books; real life teaches you instead.

I attend the School of Hard Knocks, and every time I think I’m close to graduating, I fail the next test. Here are four mistakes I’ve made and hopefully, learnt from.

Chasing Highs and Lows

On twitter, when I mention that a stock has fallen 10%, I get a quick response — “Is it time to buy?” Usually, it is not — it’s a warning sign. But what we like is to have “caught the low” — bought it when the stock was at the bottom. This is unlikely to happen — you may catch a bottom once or twice, but it’s like a falling knife that’ll slice through you. When Satyam fell rapidly from over 200 to 80 in December 2008, I had decided to pick up a few shares, assuming that it was just a “margin call” or something. The news about Mr. Raju’s announcement waltzed in a few minutes later, that he had lied about the company’s financials all along. I sold the stock — intra-day — at Rs. 65 or so. It still languishes around those levels three years later. What I thought was a “low” at Rs. 80 went all the way to Rs. 20.

I want to sell the highs too. I held a share called Reliance Petroleum Limited (RPL) which was bought in its IPO at Rs. 60. The stock went to Rs. 240 and I decided to sell. Yet, I felt those pangs of regret as the stock went to Rs. 300. Even with a very good profit — 300% in less than two years — I felt bad that I couldn’t make some more?

For the record, I have picked highs and lows; I have bought at the high and sold at the low more often than the other way around.

The Desire to “know”.

A friend who had $1,000 in currency asked me if it was a good time to convert to rupees. I said I had no idea. He laughed, and asked me why I was in the finance business if I didn’t know. But I honestly didn’t know if:

a)      He should care where the rupee or dollar would go, in a one-off transaction, not being a trader

b)      The dollar would move further up — and therefore my friend could get a few more rupees for his dollars

c)       Any prediction would be to simply assuage my friend’s need for an answer.

We all wish we could know, which is why astrology is so popular. But we don’t.  The markets have asymmetrical information; different participants know different things. An investor may be aware of a problem that you and I don’t — and if he sells heavily, the stock collapses; with the information we have, the stock looks attractive, but is it?

I’ve been trapped enough times thinking that I know more than the market — but more often than not, I’ve been the ignorant one. In the face of the knowledge that one doesn’t really know, what’s the right action? Not invest or trade? That would be pointless, because investing or trading, even with incomplete information, can lead to substantially higher returns.

Now I prefer to act another way. I expect this stock to go up. But if it comes down to X, I’ll sell, assuming something happened that I didn’t know. This is called a “stop loss”, but it’s more of a “stop the pain of not admitting my ignorance”.

The Revenge Trade

And just when I’ve admitted I was wrong, the stock stops falling and goes back up to new highs. This short-circuits my brain, and I feel like the universe has just conspired against me.

The desire for revenge has made me jump back into a stock, only to watch the temporary move reverse and again come back to hurt me. Usually, such a trade has no logic; it’s just a strong feeling that losses in one stock must be recovered from the same stock.

In the school of hard knocks, revenge is an F.

The Perspective: Percentages and Absolutes

Consider the proposal where if you invest Rs. 20,000 in certain (80CCF) bonds, you don’t get taxed on that amount. With all sorts of calculations, you hear that you’re really investing Rs. 14,000 (since you would have paid Rs. 6,000 as tax on that money, in the highest marginal tax bracket) And then, you get back Rs. 26,000 in five years, making your return 13.2%.

While the 13% is attractive, the entire exercise allows you to earn Rs. 12,000 in five years (assuming the 6,000 in tax saving, and 6,000 in interest).That’s Rs. 2,400 per year, or Rs. 200 per month. When you are earning more than Rs. 8 lakhs per year — that’s at the highest tax bracket — the amount saved is significantly lower than the joy you feel by hearing “13%”.

I have bought stock options for Rs. 100, which tripled in one day. I was overjoyed — 200% in one day. Now let’s see: 365 days in a year, 200% a day — that makes me…very stupid. The point here is not just that I can’t find such trades every day (and I’ll lose my shirt on many of them), it’s also that the amount I can invest in options has to necessarily be small, because you can lose 100%. If I invest just 2% of my portfolio on a single trade, and I double my money, the real profit on my total portfolio is just 2%. Nothing to write home about.

Absolutes and percentages both matter; when you get a high percentage return on a single trade, the school of hard knocks tells you to evaluate the overall return on your portfolio instead. You don’t appreciate a car that has a great steering wheel if its engine misfires, its headlamps don’t work and the seat is uncomfortable. You don’t praise one good trade if you have three equal (or worse!) bad ones burning your portfolio.

Perhaps you invested five years ago, when the India story was going strong and they told you, like they told me, that India was the next big thing. Five years have gone, India’s GDP and per capita income have doubled, car sales have quadrupled, and yet, markets have returned a miserable 4% per annum, just about beating the savings deposit rate. India’s stock market behaves very differently from the rest of India, we learn, as we pass through another year in the school of hard knocks.

  • Rajiv says:

    Honest and well-written.
    I also think one needs to find the school that suits them, and then stick with it. There are as many ways of making and losing money as there are investors, but if one is stuck in the wrong school, the hard knocks might amount to nothing. The other school – the non-trading, value-investing school has plenty of hard knocks to give as well – but if one’s temperament fits it maybe its the one to go to. To each their own.

  • saif says:

    What a brilliant writeup.I could relate a lot from my own experience in markets.Thanks for the posts.

  • Rudra Chowdhury says:

    Absolutely brilliant Deepak, and the ones one can identify truly.
    Many a times it happens once you are out of patience holding what you think was a dud stock, it starts rising vigorously just to prove how wrong you were.
    Also another lesson is it takes only 50% fall on downside but the stock needs to make a 100% on the upside just to break even again. Many don’t realize this.
    Often there are anomalies and issues like corporate governance where one loses money otherwise incomprehensible. Welspun Corp, Satyam, LIC Housing, Everonn – a few such cases where I have suffered large losses for those stupid reasons.
    I started investing in August 2007 and in the last five years have hardly made any money on my own, apart from the MF SIPs (which by the way returned something!). However, I do feel experiencing a deadly bear market hones an investor greatly.

  • Ashish says:

    Hello Deepak,
    Informative as always.
    I am not sure if the question is worth your time but I did not understand the 80CCF example completely.
    Why its investing 14000? The amount you paid as tax (and hence never got back) is also yours in this case.
    And how did we reach figure of 26K?
    If you don’t mind explaining a little.

    • bemoneyaware says:

      My two cents in explaining:
      Assuming infrastructure bonds with average rate of 8.0% per annum.
      The tax deduction under 80CCF means an absolute tax saving of Rs. 6,180 for an investor who falls in the highest tax bracket 30.90%; Rs. 4,120 if you pay income-tax at the rate of 20.60%; and Rs. 2,060 if you fall in the last tax bracket of 10.30%
      So effectively you have paid only approximately 14,000.
      After 5 years you gets Rs 26,000.
      So Net gain = 26,000- 14,000 = 12,000
      Calculate CAGR:
      Principal:  14000
      Years:  5
      Rate of Interest:13.2 %
      Amount: 26023.17
      Hope it helped.

      • Thanks! Yes, the interest is actually the yield on the bonds for five years, minus the 30% tax one has to pay on the interest. At about 8.3% you make 6K in total, in interest, plus the 20K principal, for 26K as a return.
        That translates to: investment = 14K, return = 26K, five years, so 13% yield. But you are right, it’s actually 20K invested, not 14K. If you are in the top tax bracket the return is inconsequential, for all the mathematic hoops 🙂

  • bemoneyaware says:

    Very interesting and honest article. I would like to call School of Hard Knocks as Life’s experience. Warren Buffet, Rakesh Jhunjunwala all have made mistakes , Warren Buffet’s buying Berkshire was itself a mistake. Catch is not in falling down but in getting up and learning from mistakes. Similar to learning a bike. I don’t think anyone has learnt bike without falling.
    Sadly our school systems penalizes us for mistakes. I think I am wiser and careful now because of my mistakes I take it not as problems but as opportunities.
    Quoting Colin Powell There are no secrets to success. It is the result of preparation, hard work, and learning from failure.

  • Sanjay Das says:

    I really appreciate this honest article and it reflects my early experience with markets. Sometimes market does appear random after all.
    Over time, I have learnt not to trade very frequently and know that what really matters is “price” than other indicators like PE, BV, EPS etc. Of course these indicators can help you make an educated guess on whether the stock is cheap or not.
    All said, it is not an exact science and you essentially make a gamble. Sometimes it pays and sometimes does not.
    Thanks to the author for confirming my experience.