The Simplest Investment Strategy

Over the past few weeks, I've tried to give an insight into the market. Received with severe criticism from a few and some greater expectations about the so-called efficient investment strategies, I think it will be nice for me to put up something on the investment side, much before I'd planned.

Some individuals have left comments that they are following principles led by Warren Buffet. Others proudly claim that they can take risk and are ready to loose money in the market following “No Pain, No Gain”. Fair enough.

It’s easy for anyone to look on Warren Buffet on internet and get his principles. It’s exciting to read that “Warren Buffet bought his 1st stock at the age of 11, and still he feels he was too late to begin stock trading”. OR we watch movies like GURU, where Abhishek Bacchan delivers the dialogues “Mein ek BANIYA hoon aur baniya dhandha hi karta hain” meaning “I am a Businessman, and a businessman is there to make business”. It’s easy to get carried away when you read/hear such things. Rest environment is created by the peer pressure, so called smart traders who are our office colleagues trading online. We are ready to take the risk, claiming that we will NOT regret the losses, if any. Unfortunately, the more we loose, the more we get a tendency to gamble, attempting to recover our losses. Once again, markets go up, everyone makes money and feels happy and pours in more money. Market go down, we loose, and invest more by trying to “Average out” our holdings and trying long term strategies. It’s an addiction. What we fail to discover is that Warren Buffet has ALSO advised youths not to ever use a credit card, and never to take a loan. If a loan is taken, he suggests better to pay-it off first, before getting into the equity market. Another interesting fact that is NOT very well known about Warren Buffet is that he has NEVER invested in a technology company or so called IT firms. India’s heart and soul is the IT workforce.

The reason for me consistently talking about the way the market and the market participants work, the comparison with the Market Index and the failures of MF managers was not just by chance. I was planning to approach the topic in a much more structured way. Though it is too early for me to express and detail the investment scenario, looking at the way the readers are fighting on the comments, I'll go ahead with it to give an introduction about investments.

I've always compared the individuals profit with the market index returns. The reason - Markets are efficient, and so are the market indices. People end up doing all kinds of research to hone their STOCK PICKING skills. Frankly speaking, there is no need for anyone to pickup the stocks. The market index itself is a very good selection of the top rated stocks. Be it NSE Nifty (top 50), BSE Sensex (top 30) or Nifty 100 (top 100), Nifty Junior (top 51 to 100), all these indices carry the top rated companies, in terms of the market valuation. The stocks contained in these indices are reviewed from time to time by the exchanges and the relatively non-performing stocks are kicked out from the index, while new ones are included to replace them.

What constitutes the index? Basically a fixed no. of stocks – 50 for Nifty, 30 for Sensex. Why are the indices always kept upto the mark by the exchanges? Exchanges like BSE and NSE are organizations. They compete with each other, and other regional exchanges as well, so as to get maximum transaction business. When you place your order with your broker, he forwards it to the exchange. Broker needs exchange membership to place you orders on the exchange and have to pay the transaction fee to the exchange. To get the exchange membership, he also needs to pay fee. Ultimately, the more transactions happen at a particular exchange, the more business it generates. The more brokers are subscribed to an exchange, the better its order capturing business. It’s also a requirement for an exchange that more and more companies get listed on it. For e.g. IQMS Software is listed only on BSE, not NSE. Anyone wanting to trade on this stock can do it only on BSE, that too with a broker having BSE membership. It becomes a requirement for exchanges to list the best companies (BEST atleast in the way the exchange measure them). At the same time, they also need to give market indicators like different indices, which give how the markets are moving. These indicators are tracked by market participants, to know how the markets are moving. Hence, exchanges need to keep themselves upto the mark, with the best companies constituting the major indices. They have to review the constituent stocks at regular intervals, so that they can get the best market picture at any given point of time.

What happens when you begin trading/investing? You begin trading/investing by purchasing 1 stock.
If you make profits, you can do 2 things:
1. You may sell the stock and get the profit. But what do you do with that money? You tend to buy another stock.
2. You may not sell the stock, but get excited about the unrealized profits you made on your first investment. You tend to buy another stock or more quantity of the same stock by putting in more money.

If you make loss:
1. You tend to average out by buying more stocks
2. You buy another stock and start talking about diversification

The fact is, ultimately you start to increase your holdings constituting a portfolio. You start talking about diversification, stock-picking, sector-wise allocation, and so on. Ultimately, you never come out of the market. If you make profits on your portfolio, you keep the stocks as it is and keep buying more stocks OR you book profits and use that money to buy another stock. If you suffer losses, you end averaging out, or in a tendency to recover your losses, you pump in more money. The BUSINESSMAN inside us never allows us to completely exit from the market, whether we make huge profits or suffer losses.

However, instead of going through all this headache process of stock-picking, diversification phenomenon, isn’t it a good idea just to invest in the market index like Sensex or Nifty? The exchanges are always upgrading the constituents of the index. They do the stock-picking for you for free. The index has all the constituents that are well-diversified across different sectors. That is the reason the index (Nifty or Sensex) only goes a maximum of 1% up or down on a daily basis, while individual stocks fluctuate with a much higher value. Investing in these indices provides us with a much less risk, as they are already diversified and have the so-called BEST companies as their constituents.

You may now say that I’m contradicting my previous 3rd article Good Company v/s Bad Company. Well, I’m not. The case with index is different. If a Good Company listed in the Index turns out to be a Bad company, it is kicked out of the index. The index value hardly suffers 0.1% to 0.5%, sometimes it even rises, as the new incoming company may be well appreciated by the market. The another so-called GOOD company is brought into the index. Hence, without you actually having to worry about good and bad companies, you can easily get the implicit benefit of stock picking.

In my first article Are you really making money in the stock market, I started with comparing the returns with respect to the market index (Sensex or Nifty). If you had invested in indices instead of individual stocks, you would have earned a whooping 600++ % returns, without having to worry about stock-picking and all kinds of crapy non-sense.

In my second article, Do equities give good return in the long run, I tried to refute the 2 commonly believed myths about bonds and equities. One thing that I want to stress here is that I’m not against equities or bonds. I’m for systematic investments which may include both. The World Equity market is estimated to be at 45 Trillion $, while the exchange traded bond market is about 51 Trillion $. Approximately 60 Trillion $ is the Over-the-counter bond market, that makes the bond market more than double the size of equities market. It shows the importance of bonds. If equities had been the only way to beat inflation and give better returns, bond market would have collapsed by now. The fact is that it is more than double the size of the equity market.

In my 4th article, Should you trust you fund manager, I questioned whether it is worth paying the commission to someone else to manage your money in the name of professional management and diversification and can you be better off in doing it yourself if you know the problems and have alternate investment mediums? The problem with MF managers is that they have to buy and sell stocks, to try and make returns. They end up paying transaction costs which comes from your pocket and eats up the profits made on your investments. Another problem is that a fund like Reliance MF, which managed to gather 5820 crores of Rs. recently, has to invest this big money somewhere. They cannot limit themselves just by buying 30 stocks of Sensex or 50 stocks of Nifty, as the amount of money they have is huge. So they end up buying loads of other stocks, which eat away the profits in transaction costs or loss making stock selection.

In my 5th article Equity research analysis and recommendations, I tried to highlight how our investment decisions are manipulated, and whether it is worth paying for advisory services to your broker or using free advice available online.

In my 6th article Stock Trading Markets, I tried to publish the picture of the market for intraday traders and news based trading and how it fails miserable for we salaried professionals.

Now all the above articles were supposed to be the foundation stones for one of the investment strategies that I have presented in this article. My focus was to highlight all the problems and drawbacks with all the available modes of investments, products and sources and then present the investment technique which atleast partially eliminates the problems that I’ve been discussing in the previous articles. Probably, it’s the human nature; the businessman inside me does NOT have the patience to understand the problems, and then approach the solution. It only needs the solutions straightaway, and want immediate results, irrespective of knowing how and why the solution is better than the rest. Not sure how many of you will still agree with me, but I believe that atleast for people who agree with me, this will be a good start to continue further.

You will definitely have questions about the risk involved, transaction costs and other problems that are there with Index investments.
How to invest in Indices or Funds replicating the indices, and also info about the risk associated with these, please wait for further continuation on this article, which will be published shortly. This one was an attempt to stop the COMMENTS WAR that is going on among the readers of this blog :-)

Here is the article with example and historical data for ETF