Now that we have talked about investments in passive index funds for the hands-off investor, as equity in listed businesses, and their returns.
What if one is a hands-on investor?
Investing in the stock market can be a daunting task to keep improving on returns with less risk, especially for those who want to take a hands-on approach.
But before becoming a hands-on investor, it is important to be intellectually honest with ourselves and assess one's strengths and weaknesses.
Do I have the knowledge and experience to analyse businesses and understand market trends?
Do I have the time and resources to devote to research and monitor investments?
Am I comfortable taking on the risk and potential losses that come with active investing?
I guess like all hands-on investors, I also chose to follow my heart with not so sharp edge and started to find out what’s in the game and how to sharpen the edge, no matter what the results.
The difference between hands-off and hands-on investors is the opportunity cost and I believe one can’t be half pregnant, either one is an active investor or not.
Like Arthur Ashe said,
"Start from where you are, use what you have and do what you can."
We know from the earlier write-up, why passive index funds outperform active funds, now let’s use inversion, and find out why active funds don’t do better than passive index funds.
Or simply
What not to do in active funds to do better than the passive index fund?
First, passive index funds are a great option for hands-off investors who do not have the knowledge, experience, or time to actively invest in the market.
An index fund represents the performance and valuations of constituent businesses. It is an average of many companies, some performing better than others. This means that an index fund's returns will be the average returns of all businesses in the fund.
On the other hand, active funds benchmark the stated index with little aggression and withdraw fees annually, which is designed to underperform and not look bad in the long run.
In active investing, one doesn’t know a business's unpredictable and uncertain future; and in humility, one can’t know for sure.
However, hands-on investors can still have some insight and understanding of a business's potential and probability of doing well in the future.
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Remember there are only two rules in investing,
the first is to never lose money and the second is to never forget this rule.
So initially I started by investing in two index funds where I could understand the downside and potential upside,
One, the Nifty50 index fund which represents India’s top 50 companies market-weighted index and
Two, the Nifty Next50 index fund which represents India’s top 51-100 companies market-weighted index.
I bought and accumulated these index funds when the P/E, which is the price multiple of the index fund’s earnings, was lower than the historical average of 17 times (mostly between 12X to 17X depending on prevailing interest rates).
Before we move on, let’s be clear on what’s price multiple P/E.
Price multiples are ratios of a stock's price to some measure of value per share, which in this case is the average earnings per share of all constituent businesses in the index.
Even if I didn’t know or understand all the top 100 businesses in these two index funds, buying index funds at a historically lower price multiple ensures that they are bought undervalued, which meant there is a lower downside and more upside to investments.
Moving on, to make better returns with compressed risk, it's important to understand how sectors within an economy move in cycles, which can be interrelated and overlapping.
Just to put it simply
Sectors in an economy can be from different industries such as FMCG, Pharma, IT, Banking, Auto, Infrastructure, Commodities, Energy, and more.
Some of the sectors are always in and out of favour in the market as the economic cycle progresses, and their price multiples may vary from time to time.
For example in an economic cycle, FMCG and Pharma are always in reasonable demand, regardless of the state of the economy. As we can’t do without essentials and health.
However, when the economy slows down, companies need technology to be more efficient and competitive in their processes, need IT, and if things are moving fast then to stay ahead and disrupt their own industry with products & services, needs ER&D.
And all the time, companies need to transform and get data onto the cloud and AI/ML for actionable insights on business & consumer.
Next with lowered interest rates to boost the economy, Banking, Auto, and Consumer durables pick up, and home mortgages become popular.
Next for the above industries to sustain the growth momentum and expansion, we need more Capital Goods for plant & machinery.
And to keep up, next need more real Infrastructure like roads, railways, ports and airports and digital infrastructure like 5G, payments gateway, and tech platforms.
To sustain all this momentum further need more Energy and Commodities.
Investing in sectors when they are out of favour can lead to good returns, as and when they eventually become popular again.
It's important to keep in mind that humanity can't do without products and services from any of these sectors, and they are back in favour all the time, sometimes with performance and sometimes before time on expectations of performance.
To get a little idea of how sectors move, for the 10-year-old in us, let’s just glance at the graph below on economic and market cycles.
Don’t worry if don’t get the above cycle and sectors, just know that sectors are a more concentrated set of individual businesses from the same industry and are either cheap when not performing (and out of favour) or expensive when performing (and in favour).
Some more glance at a similar graph.
Good, so far we have graduated from indexes to sectors and also know how to possibly improve on returns with sector rotation as a hands-on investor.
Note, investing with sector rotation can lead us to good returns, but this activity also can cost us transaction fees, ask-bid spreads and taxes, and we can err in our judgment. It is essential to be well-informed and cautious when investing in sectors.
Now still further on how can we get even better returns, as so far, we are still in an average return of sector businesses, where some businesses are getting better, some the same and others not so.
To get out of average returns, we need to get into and stay on with our best ideas at a good price.
Actually, the game starts now for hands-on investors where one needs to know how to find and select businesses and also how to buy and hold positions or sell and reduce positions.
One needs to select and add first on an absolute basis and then on a relative basis.
Or simply
Buy only if it’s a great business and also better than the best there are, and to what we already own.
Buy only at a good price.
To make these investments we need to do the groundwork and get answers in three major areas
Business
Markets
Let’s now bust the most common myth
Investing is simply buying and selling stocks on the ticker app.
Markets are perpetually volatile, if we don’t understand the downside risk involved in underlying businesses and just know their name and price action then the probability of success is reduced in the long run and becomes more like the probability of a coin toss, every time, that is 50:50.
As things are really down in markets and most likely to be from time to time, without conviction one can be humbled by the market.
Peter Lynch says, “Know what you own, and know why you own it.”
Let’s keep fishing where the fishes are and do the needful to concentrate with confidence and diversify in humility.
I believe rather than waiting to be lucky and be left waiting without knowing, it’s better to do the work and stick to a business which has more potential and probability of doing well in the long run.
Both in absolute and relative to others and relative to what we already own. And better to buy them well and get lucky.
Finally remember, by assessing one's strengths and weaknesses, concentrating on researched investments, diversifying, and understanding how sectors within an economy move in cycles, hands-on investing can be a fruitful and rewarding endeavour.
Time out, I’ll share next time what’s important for hands-off investors going ahead and why they should still read more of these writeups.
More insights next time, one at a time.
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