Higher stock returns: How to improve the odds

Take any high-volume stock. The chance of correctly guessing the direction of movement in the next five minutes is 50-50. The chances of guessing the direction of net movement in the next day is perhaps, slightly better than 50-50.

But if a stock is held for an extended period, the volatility is reduced. Over a longer time-period, the fundamentals count in that a stock with a decent perspective is likely to see the price move up. Technical factors also count over the longer term in that price trends have some persistence. However, even the best analysts - fundamental or technical - cannot really be certain of the price direction within a given time period.

In that sense, trading a stock is like betting on the toss of a coin. There are ways to improve the odds. One is to hold a diversified portfolio. If one stock doesn't move in the direction the way desired, another might over-compensate. Apart from complicated mathematical justifications, there is a simple logical reason why diversification often works. Different industries are at different stages of the business cycle at any time. Therefore, a diversified portfolio should have some performers at any given time.

A diversified index which is held for an extended period of time fulfils both criteria. The long time period cuts down on the volatility of return while the inherent diversification helps ensure that some proportion of the portfolio is performing at any given time. We can see some interesting results if we compare directional trends over various time frames for the Nifty. Between April 1, 2004 and now (June 20), the Nifty has moved from 1,820 (April 1, 2004) to 7,511 (June 20, 2014). That is a compounded annualised return of about 11.8 per cent across slightly over 10 years. This is the buy and hold return (B+H) for a passive non-systematic investor. Eight of those 10 years have seen positive returns.

Now, assume a day-trader buys the Nifty every day at the opening price and sells out at the closing price. Then, over 2,548 sessions (from April 1, 2004 to June 20, 2014), this 'day-trader' makes an annualised compounded return of about 6.8 per cent. This is much less than the B+H return and it would be even lower taking brokerage into account. However, the futures trader gets the benefit of leverage of course, which is approximately 6x. The low return is due to the great volatility - 1,313 sessions are positive, and 1,235 are negative.

A trader who does a 'monthly ticket', being long on the near-term future on the opening monthly settlement day and settling it on the last session, collects a compounded annualised return of 17.5 per cent. This is higher than the B+H and it is further multiplied 6x by leverage. The monthly trader also risks disastrous losses - in this period of 123 months, as many as 47 saw negative returns and each of those losses is magnified by leverage as well. These numbers are only indicative of course. The long-term investor would be systematic in reality. The day-trader would set stop losses and so would the monthly trader. But the odds clearly improve as the time period increases.

The author is a technical and equity analyst