Markets: maddening yet marvellous

A question of time-frame

At family gatherings, I am embarrassed to admit that I work in the stock market. Most people rightly view it as a crazy place. I prefer to call it moody. Individual mood swings get reinforced across herding humans, making it one hell of a roller-coaster. 

Zoomed in, it’s plain mad

This messy world is way more than a mere mob of buggy humans. It has its own set of instigators and arsonists. There’s an entire military-industrial complex worsening and exploiting the mayhem. A partial list would include:

·      Economists whose forecasts imply that evolution is working in reverse

·      Astrologers divining direction of commodities and currencies

·      A chronically over-optimistic sell-side

·      Head poets (strategists)

·      High priests (“I am Warren Buffett of Elbonia”)

·      Quacks (technical analysts)

·      Snake oil salesmen (investment bankers)

·      Those who should be wearing ski masks (wealth managers)

·      Compromised rubber-stamps (rating agencies)

·      Willfully blind (auditors)

·      Fund managers failing conventionally to minimize career risk

·      CNBC with its combination of cheerleaders and hooligans in the stands

·      Day-traders playing Russian roulette

·      Honest management tripped up by their ‘guidance’

·      Dishonest management tripped up by reality

Phew. No wonder the wisest man to ever step in here described Mr Market as not merely moody but manic depressive.

Zoomed out, it’s all good

As we zoom out from this chaotic cacophony, it gets way better. This craziest show on earth metamorphosizes into the greatest (financial) show on earth. Over decades, this is by far the safest and surest path to maximizing long-run savings. This gives people a secure retirement and sends their kids to college. With long-run, post-tax returns of 10-12% a year, a Rupee invested in the stock market for 40-years becomes 50-100 Rupees. In contrast, a Rupee in a fixed deposit over the same period becomes 7 Rupees. Someone entering the workforce will have roughly 10 times more money at retirement by being a part of this seeming madness than by staying away. Equities are ahead of every other investment option on returns. Throw in diversification and liquidity, and equities are way ahead. 

Markets get the best of humanity to work for you

Why is this such a wonderful place over the long run? Three weird coincidences offer a hint. First, long-run returns from markets are same as returns on capital earned by businesses. Second, growth in profits of businesses lines up with nominal GDP growth. Third, while swings are extreme, they are around a level where market value is roughly 15 times business profits. These are neither weird nor coincidental. If you ignore finance professors bearing Greek letters, you’ll remember that a stock is part ownership in a business. Over the long run, an owner in a basket of stocks will do as well or as badly as the underlying businesses do. If you ignore communists, business converts human ingenuity into growing profits for its owners. As weaker businesses get weeded out over time, invested money grows in line with the best businesses. Jeff, Mark, Satya and Sundar are working for you. That is as good as it gets.  

Amateurs have a simple way to get the good without the mad

So, how do you get this goodness without losing your sanity (and savings) to the madness? For the 99.999% of humanity whose day job is outside the stock market, start with an inverted objective: How do I NOT do worse than average? Periodically invest a fixed percentage of your monthly income into the market over your entire adult life. Before doing this, set aside enough money for short-term exigencies. Ignore charlatans and minimize their cut by choosing passive index funds. In India, this translates into a monthly SIP through a direct-plan of a low-cost index-fund. However, there is one important disclaimer. A happy ending doesn’t imply a smooth ride. There will be a few times over forty years when your investments will halve in value. If this seriously affects your health or is likely to compromise your discipline to stay the course, this is not for you. Vipassana or psychiatry may help you here, but I can’t.

Professionals have a way to get from good to better; Most fail

For the 0.001% of humanity whose day job is to make money in the stock market, the objective function flips to: How can I reliably do somewhat better than average? Before answering, I have to mention that odds of achieving this are dismal. In Western markets, over 80% of professionals do worse than market averages. India fares somewhat better, but odds have worsened with time. Professionals have proven more vulnerable to market madness than amateurs.

The same wise man provided the answer: stay sane and occasionally profit from your manic depressive counterparts. Since stocks are parts of businesses, start with businesses that one can reliably understand. That eliminates most businesses. Without getting too technical, these would be categories with labels such as challenged, crooked or complicated. For the short list that is left, conservatively estimate what each business is worth. There are some loose thumb rules around profits and cash-flows that can be derived by studying history. When your nutty counterparty offers to sell at a decent discount to your estimate, (bravely) take him up on the offer. Else, ignore him. Rinse and repeat. In spirit, this is value investing. In practice, this term tends to be used with confusing connotations. So, let’s just call it sensible investing.

[The preceding paragraph is generally correct but grossly oversimplified. I’ll get to nuances in subsequent essays. ]

Physical fitness boils down to healthy eating and exercise. This is simple but not easy. Everyone knows it and no one follows it. It’s the same with financial fitness, for both amateurs and professionals. It is a non-trivial psychological challenge. Here, if you can be a monk, you can buy a Ferrari! 

[This essay is part of the series "Buggy Humans in a Messy World". Views are personal. Ideas are at best unoriginal and at worst plagiarized. For anything sensible, credit goes to people around me. For any nonsense, blame is solely mine.]

PS. I wrote this essay in December-2019 (https://www.linkedin.com/pulse/markets-maddening-yet-marvellous-anand-sridharan/). Perhaps, maddening might have been an understatement.