The Hazards of Investing in Stocks
Updated: Jul 31, 2021
The founder of Zerodha, India's largest broking house tweeted that "less than 1% of active traders earn more money than a bank fixed deposit over a 3 year period. But 100% traders remain under the illusion that they belong to that 1% category". A pretty powerful statement from someone who holds the country's largest investor database. As wealth managers who look into several direct equity portfolios (trader or investor), we couldn't agree more.
Equity is an asset class capable of building serious wealth. However, it's knowledge intensive and inherently risky for someone who doesn't know what they're doing; riskier for someone who thinks they know what they're doing. There's two ways to invest in equity:
On your own - open up a demat account and purchase stocks yourself. The implicit assumption here is that you're an expert in analyzing and valuing businesses. Plus, you have a great degree of control over your cognitive biases i.e. you're a rational person.
Through professional management - Choose a professional to manage your money in equities for a fee e.g. mutual funds, PMS, etc. Here you acknowledge that you neither have the time nor expertise to understand the markets.
In our opinion, most people should fully opt for option no. 2. In fact they're probably better off without a demat account altogether. One of the first exercises we conduct when a client shares their direct equity portfolio is compare it to its professionally managed counterparts, say a basket of mutual funds over several time frames. Almost always, the direct equity portfolio underperforms by a substantial margin. Why does this happen? Why do most people fail at equity investing?
An unclear understanding of equity as an asset class - A majority of 'investors' think of equity markets as an opportunity to make quick money. They seek to profit off of imminent events, solicited information or opinions (tips); leaving their money to chance. Successful investors will tell you this is a callous approach. Purchasing an equity share is taking ownership in a business. Needless to say, businesses don't grow or collapse over night. Neither is their fate dependent on one event or opinions.
Unwillingness or inability to put in the work - Most people grossly underestimate the kind of work and detail that goes into truly understanding a business. Identifying 30-40 businesses out of 5,000 listed companies (that's just India!) is no easy feat. It's a full time job. A average analyst will go through years of financial statements, track relevant regulation, meet management/promoters, conduct routine dealer/site checks, create forecasting models, and so much more. A good fund management team knows its investee companies inside out, sometimes more than the promoter! Expecting to beat them by doing quarter of the work with half the knowledge is wishful thinking.
Lack access to information and resources - The fundamental risk in India is corporate governance & accounting manipulation. You can be a wizard at reading annual reports and still get nowhere if the numbers are unreliable. If you're unable to navigate this risk, it's very unlikely you'll compound your money over the long term. Thus, in addition to being an expert in understanding and valuing businesses, an investor needs to be able to access the right information at the right time. Now, who is more likely the get timely information regarding a company; an individual or a resourceful fund management team with 10,000 crores?
Inability to measure return - Most investors are unaware of their stock portfolio's annual return (IRR). Therefore, they remain under the illusion that they're doing better than the market. This illusion is amplified by recency bias and selective memory of winning trades. Calculating the annual return on the ENTIRE portfolio is not easy, it requires specialized knowledge; particularly when multiple (sometimes hundreds) buy/sell transactions are involved throughout the year in several different stocks. Put brokerage and taxes in the mix and the complications increase. It's imperative that an investor knows exactly what the portfolio has generated in the last 1/3/5 years. It can be eye opening.
Poor control on cognitive biases - Cognitive biases are decisions that deviate from rationality and logic. One example is herd mentality i.e. investing in something just because others are. While professional fund managers are not immune to these, their experience and expertise makes them less vulnerable. Research shows that the incremental return on most superior portfolios is attributable to out-behaving and not out-analyzing or out-knowing. For those who are serious about investing, I strongly recommend getting your hands on as much behavioral finance literature as you can.
Accountability - A mutual fund, PMS, or any other professionally managed equity fund is a business. Their fate is driven by client satisfaction. They're competing for investor money by striving to give performance at a low cost. Their livelihoods depend on it. The relationship of service provider/client brings immense accountability to the equation, often more than you place on yourself when managing your own money.
This post may not make much sense at a time like this, especially to novice investors who've made a killing in almost every stock they purchased in recent times! Personally, I've been through three periods in my career where direct equity portfolios did just as well as if not outperformed the broader markets; one was the 2014 rally when Narendra Modi was elected PM and the other is the mid/small cap rally of 2018. However, the carnage that followed afterward permanently separated the wheat from the chaff. It's better to understand this message while the tidings are good, rather then wait for an unpleasant experience that drives you away from the magic of equity markets altogether.