Pragmatic rules of investment

Develop a special familiarity with an investment play you are comfortable with

Stock market transactions are zero-sum games, if we ignore brokerage and taxes. Suppose the price of a share rises after a given transaction. The buyer profits, the seller loses. The seller may have a "real" profit if he or she had acquired the stock at a lower price. But there is a "notional loss". In practice, a stock will be traded many times, at different prices. Both parties in many trades will make real profits, though one of them must always suffer notional losses. Extending this logic, consider the following. There is a transaction. The seller deploys the proceeds in another asset. The stock goes up in price after sale. But the other asset gives even better returns. The seller's real gains more than offset his notional losses. Has the buyer suffered notional losses, even if he has scored real gains? He, too, could have deployed money in the alternate, higher-scoring asset.

Also, consider volatility and personal needs. Stock prices are continuously volatile. A share could swing above and below a given transaction price at different times. It always remains a zero-sum game. So, the winner and loser might change places many times with a volatile share.

Now think of a standard life-cycle situation. A 30-year-old may want to hold a volatile asset for a long period and, thus, reap good long-term returns. But a 75-year-old who wants a stable income stream should cash in on volatile stocks and convert them into less volatile assets like debt.

These mental experiments need not be carried too far. But we do need to benchmark returns by comparing these to inflation, and to risk-free assets. In practice, if an equity return exceeds the risk-free rate, and beats inflation, it should be satisfactory. A pragmatic investor will not kill himself trying to maximise theoretical returns. If he or she is an active investor, he will at best try to beat the indices.

There is no golden stock-picking rule or formula, guaranteed to beat market indices. However, following some rules makes it more likely that an investor will succeed in beating the market. There are a few things successful investors seem to have in common.

One is that their money is more or less continually deployed in equity, without over-trading or high churn. Trading frequently incurs brokerage and also makes profits liable to short-term capital gains tax. A great trader can win by frequent trading. But he or she has to outperform by enough to compensate for excess brokerages and higher taxes.

Most successful investors seem to have a basic or core portfolio, permanently held. Those core stocks are bought whenever prices seem attractive and will not be sold even at exaggeratedly high valuations. A third common factor seems to be a specialisation in some "type" of stock, which the investor is really comfortable with. This could be an industry he or she knows very well. Or it could be one type of investment play. Some investors look for dividend yields. Some look for extraordinary growth. Some seek cyclical turnarounds.

By and large, investors who focus only on companies with clean reputations and transparent accounting tend to score higher. A recent study by Ambit Capital asserted the cleanest decile (that is, the 50 most honest companies) in the BSE-500 Index had returned a 26 per cent higher compound annual rate of growth over the long run. That is a huge premium for relative honesty.

These common factors all have downsides. Buy and hold means surviving serious drawdowns in bear markets. There will also be periods when bubbles push up the prices of companies that have dicey accounting standards while honest companies languish. A "speciality" sector, or a speciality type of play, such as high dividend yields, may underperform.

But these principles are pragmatic. They will not maximise returns but will give the investor a good chance of beating the indices over a long run. A sensible investor who is always invested will get high returns over the long term. An honest company will tend to outperform over a long period.

Speciality industry plays are based on specialised knowledge. A civil engineer who looks at construction companies and a banker who looks at financial stocks are both using specialised knowledge and judgement. A "turnaround expert" or a dividend yield player will also have developed good judgement about those specific situations. Most of these common factors are about maintaining investment discipline. Along with that, investors should try and develop a special familiarity with some investment play they are comfortable with. This can drive their style.