Sell half and play with the profit ?

Scenario: I bought a stock for Rs 50. My intrinsic value estimate was Rs 100. The stock quickly doubled and then some more. It quotes at Rs 125 now. What should I do?

The most common response I read and have also heard from friends is this – Sell half your holding and recover your investment. What you leave behind is your profit. Let it be in the market as can afford to play around with it.

I have myself engaged in the above logic. However I find this logic completely faulty. My ‘investment’ now is not Rs 50. It is Rs 125. That is the money I have now with me. I can sell the stock completely and choose to invest the money in another security or maybe just buy a Flat screen TV or whatever I fancy :)

The above is a case of anchoring bias. We tend to anchor our thinking to the purchase price of the stock. The purchase price is history. The current price is what matters

Lets take another case

I buy a stock for Rs 50. My intrinsic value estimate is Rs 100. The stock drops to 40. I investigate and realise that I have made an error and the intrinsic value is actually 35 only. What should I do?

The price of 50 now has no meaning. The stock has dropped and is still quoting above the intrinsic value. A rational response would be to take a loss and move on. Before I sound any more preachy, let me tell you I have been guilty of the same thought process. I bought SSI at Rs 1900 and rode it right to Rs 100.

Personally, I think the most rational approach is to constantly evaluate the stock price with your conservative estimate of intrinsic value. If the stock sells for more than intrinsic value , sell or else hold. Nothing else matters! not the price paid for the stock or the current level of the market.

Sell half and play with the profit ?

Scenario: I bought a stock for Rs 50. My intrinsic value estimate was Rs 100. The stock quickly doubled and then some more. It quotes at Rs 125 now. What should I do?

The most common response I read and have also heard from friends is this – Sell half your holding and recover your investment. What you leave behind is your profit. Let it be in the market as can afford to play around with it.

I have myself engaged in the above logic. However I find this logic completely faulty. My ‘investment’ now is not Rs 50. It is Rs 125. That is the money I have now with me. I can sell the stock completely and choose to invest the money in another security or maybe just buy a Flat screen TV or whatever I fancy :)

The above is a case of anchoring bias. We tend to anchor our thinking to the purchase price of the stock. The purchase price is history. The current price is what matters

Lets take another case

I buy a stock for Rs 50. My intrinsic value estimate is Rs 100. The stock drops to 40. I investigate and realise that I have made an error and the intrinsic value is actually 35 only. What should I do?

The price of 50 now has no meaning. The stock has dropped and is still quoting above the intrinsic value. A rational response would be to take a loss and move on. Before I sound any more preachy, let me tell you I have been guilty of the same thought process. I bought SSI at Rs 1900 and rode it right to Rs 100.

Personally, I think the most rational approach is to constantly evaluate the stock price with your conservative estimate of intrinsic value. If the stock sells for more than intrinsic value , sell or else hold. Nothing else matters! not the price paid for the stock or the current level of the market.

Gujarat gas – Recent review

I invested in Gujarat gas back in 2003 and exited my position by 2006. I recently read the following post on ranjit’s blog. As Gujarat gas is one of his top 5 holdings, I decided to re-look at the company to see what I am missing out as I had exited my position sometime back and did not feel that the company is under-valued.

I found the following positives

- Gujarat gas now sources almost 95% of its gas requirements at market prices now and has been able to maintain the operating margins. In 2003, a substantial portion of gas was procured at subsidized rates and hence there was a risk of margin reduction. The company has been able to manage the transition very well.
- There has been a substantial reduction in the transmission income. The company has managed this well by expanding the other lines of revenue
- There is substantial expansion in progress at Vapi and Jaghadia. Vapi will contribute to revenue in 2007
- Gas volumes, no. of retail customers and bulk customers are all increasing at a heatlhy rate. This should provide good growth over the next few years
- The CNG business is now in growth phase and should provide for healthy growth of revenue and profits.

Overall the company is firing on all cylinders. It also has expansion plans in place and is investing heavily. I have updated my company analysis (valuation template-gujgasaug2007) and uploaded the same. The earlier analysis of the company from 2003-04 is also uploaded in the valueinvestorindia google groups.

Disclaimer: I am not recommending this stock. I do not hold the stock as of now and may or may not have a position in the future.

Gujarat gas – Recent review

I invested in Gujarat gas back in 2003 and exited my position by 2006. I recently read the following post on ranjit’s blog. As Gujarat gas is one of his top 5 holdings, I decided to re-look at the company to see what I am missing out as I had exited my position sometime back and did not feel that the company is under-valued.

I found the following positives

- Gujarat gas now sources almost 95% of its gas requirements at market prices now and has been able to maintain the operating margins. In 2003, a substantial portion of gas was procured at subsidized rates and hence there was a risk of margin reduction. The company has been able to manage the transition very well.
- There has been a substantial reduction in the transmission income. The company has managed this well by expanding the other lines of revenue
- There is substantial expansion in progress at Vapi and Jaghadia. Vapi will contribute to revenue in 2007
- Gas volumes, no. of retail customers and bulk customers are all increasing at a heatlhy rate. This should provide good growth over the next few years
- The CNG business is now in growth phase and should provide for healthy growth of revenue and profits.

Overall the company is firing on all cylinders. It also has expansion plans in place and is investing heavily. I have updated my company analysis (valuation template-gujgasaug2007) and uploaded the same. The earlier analysis of the company from 2003-04 is also uploaded in the valueinvestorindia google groups.

Disclaimer: I am not recommending this stock. I do not hold the stock as of now and may or may not have a position in the future.

Feeling smart …like the duck

In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond. - Warren bufett - Letter to Berkshire Hathaway shareholders, 1997.

I generally check my portfolio performance once a month and with a runaway stock market (YTD +18% ) , it is diffcult to do badly. So I felt smart - like the duck :) . You have to just throw darts on a stock list to make money these days. Lets see what happens after the music stops !

So are you feeling like the duck?

Feeling smart …like the duck

In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond. - Warren bufett - Letter to Berkshire Hathaway shareholders, 1997.

I generally check my portfolio performance once a month and with a runaway stock market (YTD +18% ) , it is diffcult to do badly. So I felt smart - like the duck :) . You have to just throw darts on a stock list to make money these days. Lets see what happens after the music stops !

So are you feeling like the duck?

Hidden value – Kirloskar oil engines – Report card

I posted on Kirloskar oil engines in oct 2006. I had noted that the company has investment holding in other group companies and JV’s of around Rs 95/ share. My own intrinsic value calculations were in the range of 320-350 Rs/ share. So how did the stock fare?

My personal history with the stock is below. I started investing in the June-july time frame and had an average cost of around 182 Rs/share. I sold at an average price of around 315/ share resulting in an annualized gain of around 75%.

So was it a smart pick ? more of that later. First I bought in june at an average price of around Rs 182/ share and price shot to around 300 by Nov time frame. Had I liquidated then, my annualized gain would be around 125%. Is this hindsight bias? I don’t think so. Let me explain – My approach has generally been buy and hold. The original thesis for this stock was that the company was selling below intrinsic value due to investment holdings and once it approached intrinsic value, I would sell it around 90-100% of the intrinsic value. However old habit die hard. I continued to hold on to the stock due to my muddled thinking.

I later read mohnish pabrai’s book – Dhando investor and also read some lectures by professor bakshi and have expanded my investment approach to buy and hold and to graham type stocks (which I sell once they reach 90-95% of intrinsic value). So the next time around when the stock approached my estimates of intrinsic value, I offloaded it completely this time.

Coming back to the issue of whether it was smart pick. The company is trading around intrinsic value, so it is tempting to claim that I was right. Frankly I am not sure. I also agree with prof bakshi’s comment in his interview that if the corporate structure is flawed, wherein the hidden value will not be unlocked, then such ideas are value traps. I have seen several such stocks where the investments in group companies makes them look undervalued. However I am wary of investing heavily in such stocks.

Final note: I did my personal analysis in june-july and posted it in oct 2006. So please do not blindly follow my suggestions when I publish them. I would suggest that you should do as I do on such stock analysis by bloggers. There are a number of like minded bloggers I read regularly. Whenever they discuss a stock, I make it a point to analyse it myself. I may not agree with the analysis eventually, but I know for sure that blogger has done some analysis and if it has passed his screens, it is definitely worth looking at closely.

Hidden value – Kirloskar oil engines – Report card

I posted on Kirloskar oil engines in oct 2006. I had noted that the company has investment holding in other group companies and JV’s of around Rs 95/ share. My own intrinsic value calculations were in the range of 320-350 Rs/ share. So how did the stock fare?

My personal history with the stock is below. I started investing in the June-july time frame and had an average cost of around 182 Rs/share. I sold at an average price of around 315/ share resulting in an annualized gain of around 75%.

So was it a smart pick ? more of that later. First I bought in june at an average price of around Rs 182/ share and price shot to around 300 by Nov time frame. Had I liquidated then, my annualized gain would be around 125%. Is this hindsight bias? I don’t think so. Let me explain – My approach has generally been buy and hold. The original thesis for this stock was that the company was selling below intrinsic value due to investment holdings and once it approached intrinsic value, I would sell it around 90-100% of the intrinsic value. However old habit die hard. I continued to hold on to the stock due to my muddled thinking.

I later read mohnish pabrai’s book – Dhando investor and also read some lectures by professor bakshi and have expanded my investment approach to buy and hold and to graham type stocks (which I sell once they reach 90-95% of intrinsic value). So the next time around when the stock approached my estimates of intrinsic value, I offloaded it completely this time.

Coming back to the issue of whether it was smart pick. The company is trading around intrinsic value, so it is tempting to claim that I was right. Frankly I am not sure. I also agree with prof bakshi’s comment in his interview that if the corporate structure is flawed, wherein the hidden value will not be unlocked, then such ideas are value traps. I have seen several such stocks where the investments in group companies makes them look undervalued. However I am wary of investing heavily in such stocks.

Final note: I did my personal analysis in june-july and posted it in oct 2006. So please do not blindly follow my suggestions when I publish them. I would suggest that you should do as I do on such stock analysis by bloggers. There are a number of like minded bloggers I read regularly. Whenever they discuss a stock, I make it a point to analyse it myself. I may not agree with the analysis eventually, but I know for sure that blogger has done some analysis and if it has passed his screens, it is definitely worth looking at closely.

Book notes – Way of the Turtle - Final post

Final post on my notes with my comments in italics

Earlier posts on the same book here,here, here and here

The thirteenth chapter discusses how robust systems can be developed. Systems which work in varying market situations are robust. The author gives an example from biological systems. He refers to the concept of simplicity and diversity. Simpler organisms are most resilient than complex ones which are adapted to specific environments. Also nature develops diverse organisms so that the ecosystem is shielded from the effects of a radical change in the environment. So systems or approaches built on these two concepts are more robust.

An investor following a simple and diverse approach will be more successful than others. For example, a value investor (simple approach) following a graham style approach, aribtrage and DCF based approach (diversity) can be fairly successful in varying market circumstances.

The fourteenth chapter discusses about the role of ego in investing. The simple rules discussed in the book are effective and profitable. However these simple rules do not feed the ego. When beginning traders use descretionary trading and use their own judgement, any win feeds the ego and feels good. You can now brag to your friends on how smart you are. The author mentions that this behavior is prevalent on online trading forums.

The same is applicable for value investors too. Value investing is a very effective and simple approach. However very few have the discipline to follow it consistently.

The author makes a very valid point for traders (and investors) that one should not wrap his ego around every trading win or loss. A failed trade or investment does not mean that you are an idiot or that a winning trade or investment does not mean that you are a genius. One should view failure and success in the market in the right perspective and not take it too personally (although it is easier said than done)

The last chapter discusses the Turtle trading rules in detail. It is however difficult for me to discuss them in detail here.

Book notes – Way of the Turtle - Final post

Final post on my notes with my comments in italics

Earlier posts on the same book here,here, here and here

The thirteenth chapter discusses how robust systems can be developed. Systems which work in varying market situations are robust. The author gives an example from biological systems. He refers to the concept of simplicity and diversity. Simpler organisms are most resilient than complex ones which are adapted to specific environments. Also nature develops diverse organisms so that the ecosystem is shielded from the effects of a radical change in the environment. So systems or approaches built on these two concepts are more robust.

An investor following a simple and diverse approach will be more successful than others. For example, a value investor (simple approach) following a graham style approach, aribtrage and DCF based approach (diversity) can be fairly successful in varying market circumstances.

The fourteenth chapter discusses about the role of ego in investing. The simple rules discussed in the book are effective and profitable. However these simple rules do not feed the ego. When beginning traders use descretionary trading and use their own judgement, any win feeds the ego and feels good. You can now brag to your friends on how smart you are. The author mentions that this behavior is prevalent on online trading forums.

The same is applicable for value investors too. Value investing is a very effective and simple approach. However very few have the discipline to follow it consistently.

The author makes a very valid point for traders (and investors) that one should not wrap his ego around every trading win or loss. A failed trade or investment does not mean that you are an idiot or that a winning trade or investment does not mean that you are a genius. One should view failure and success in the market in the right perspective and not take it too personally (although it is easier said than done)

The last chapter discusses the Turtle trading rules in detail. It is however difficult for me to discuss them in detail here.

Negative review - Way of the Turtle

I received the following comment from senthil. He pointed out to a negative review on the book (see link in the comment) – Way of the turtle on which I have been posting for the past few days.

I found some review comments to be valid. However at the same time the reviewer has choosen to highlight only the negatives and not comment on the positives of the book. I think most of the books have a mix of both. I would say good books are the ones where the positives outwiegh the negatives. Ofcourse there are books which take a germ of an idea and use 250 pages to beat it to death. On the other hand there are very few books or classics which are worth reading multiple times. ‘Security analysis’ and ‘The intelligent investor’ by Benjamin graham, Common stock and uncommon profits by Phil fisher are a few which come to my mind.

The book (inspite of the title) is not a ‘how to’ book for trading. If, like me, you do not know much about trading, this book will at best give you a basic feel of what trading is all about. I have had a mental block against trading. The block was more on the lines that it is impossible to make money via trading. I am more inclined now to believe otherwise. I am more open to the idea that traders can and do make money. Does that mean that I am interested in trading? No .. I am not. I find long term buy and hold and other forms of value investing more appealing and easier to make money. I do not have the stomach to bear a drop of 40% in my portfolio.

I am planning to read a good book on real estate investing sometime next year to see what it is all about. Better to understand various forms of investing and then reject the ones which do not fit with my temprament than to have a closed mind against it.

Other books I am reading (not related to investing)

The four hour workweek – Interesting book and quite a few good ideas by the author, but goes overboard a lot of times.
Einstein: His Life and Universe – I seen a lot of good reviews on the book and wanted to read about Einstein. Also I think charlie munger has recommended this book (not sure though)

Negative review - Way of the Turtle

I received the following comment from senthil. He pointed out to a negative review on the book (see link in the comment) – Way of the turtle on which I have been posting for the past few days.

I found some review comments to be valid. However at the same time the reviewer has choosen to highlight only the negatives and not comment on the positives of the book. I think most of the books have a mix of both. I would say good books are the ones where the positives outwiegh the negatives. Ofcourse there are books which take a germ of an idea and use 250 pages to beat it to death. On the other hand there are very few books or classics which are worth reading multiple times. ‘Security analysis’ and ‘The intelligent investor’ by Benjamin graham, Common stock and uncommon profits by Phil fisher are a few which come to my mind.

The book (inspite of the title) is not a ‘how to’ book for trading. If, like me, you do not know much about trading, this book will at best give you a basic feel of what trading is all about. I have had a mental block against trading. The block was more on the lines that it is impossible to make money via trading. I am more inclined now to believe otherwise. I am more open to the idea that traders can and do make money. Does that mean that I am interested in trading? No .. I am not. I find long term buy and hold and other forms of value investing more appealing and easier to make money. I do not have the stomach to bear a drop of 40% in my portfolio.

I am planning to read a good book on real estate investing sometime next year to see what it is all about. Better to understand various forms of investing and then reject the ones which do not fit with my temprament than to have a closed mind against it.

Other books I am reading (not related to investing)

The four hour workweek – Interesting book and quite a few good ideas by the author, but goes overboard a lot of times.
Einstein: His Life and Universe – I seen a lot of good reviews on the book and wanted to read about Einstein. Also I think charlie munger has recommended this book (not sure though)

Book notes – Way of the Turtle - IV

My notes on the previous chapters of the book here, here and here.

The ninth chapter discusses about the building blocks of trading such as breakouts, moving averages, volatility channels, time based exits and simple look backs in detail. The next chapter follows with a detailed discussion on various systems such as the ATR channel breakout, Bollinger breakout and Donchian trend etc. This chapter also gives the performance data for all these systems based on the historical data. For ex: donchian trend has a 10 year return of 30% p.a with a max drawdown of 38.7%.

The important point in this chapter is the author’s emphasis on backtesting. Backtesting means that every system should be evaluated with respect historical data for returns and maximum drawdown. Backtesting may not help predict the future or ensure that the system will always work, but it would help to determine which system could be profitable in the future and what conditions are needed for the success of the system.

My comment: The same approach should be applied by investors too. For ex: value investing has almost a 50 year history of performance over varying periods and business conditions. So this approach to investing has proven its ‘fitness’ over a long period of time and in varying conditions. I would say that any other approach such as momentum investing should also be evaluated in a similar manner.

The next chapter discusses in detail the pitfalls of backtesting. The key reasons why the historical test results differ from actual trading are as follows
- trader effects : As more traders use the system, the effectiveness of the system is lost
- Random effects
- Overoptimization paradox:
- Curve fitting: Fitting the system to data

The chapter then discusses how these distortions can be resolved and backtesting results improved.

The next chapter discusses how one can get better results from backtesting. One approach is by using better measures such as RAR (regressed annual return), R-cubed and a robust sharpe ratio. In addition a representative sample and appropriate sample size can help to get better results. The author also discusses about monte-carlo simulations to analyse the various systems based on historical data.

Book notes – Way of the Turtle - IV

My notes on the previous chapters of the book here, here and here.

The ninth chapter discusses about the building blocks of trading such as breakouts, moving averages, volatility channels, time based exits and simple look backs in detail. The next chapter follows with a detailed discussion on various systems such as the ATR channel breakout, Bollinger breakout and Donchian trend etc. This chapter also gives the performance data for all these systems based on the historical data. For ex: donchian trend has a 10 year return of 30% p.a with a max drawdown of 38.7%.

The important point in this chapter is the author’s emphasis on backtesting. Backtesting means that every system should be evaluated with respect historical data for returns and maximum drawdown. Backtesting may not help predict the future or ensure that the system will always work, but it would help to determine which system could be profitable in the future and what conditions are needed for the success of the system.

My comment: The same approach should be applied by investors too. For ex: value investing has almost a 50 year history of performance over varying periods and business conditions. So this approach to investing has proven its ‘fitness’ over a long period of time and in varying conditions. I would say that any other approach such as momentum investing should also be evaluated in a similar manner.

The next chapter discusses in detail the pitfalls of backtesting. The key reasons why the historical test results differ from actual trading are as follows
- trader effects : As more traders use the system, the effectiveness of the system is lost
- Random effects
- Overoptimization paradox:
- Curve fitting: Fitting the system to data

The chapter then discusses how these distortions can be resolved and backtesting results improved.

The next chapter discusses how one can get better results from backtesting. One approach is by using better measures such as RAR (regressed annual return), R-cubed and a robust sharpe ratio. In addition a representative sample and appropriate sample size can help to get better results. The author also discusses about monte-carlo simulations to analyse the various systems based on historical data.

Book notes – Way of the Turtle - III

The sixth chapter discussed various trading concepts such as support and resistance. These concepts are discussed in detail in this chapter with examples.

The seventh chapter is crucial to help answer the question: How can you know if a system or a manager is a good one. I would suggest reading this chapter in detail and understanding it and applying it when selecting or evaluating a trading system. A lot of trading systems refer only to the returns and choose to ignore risk. The chapter refers to four types of risk.

Drawdown – String of losses than can reduce capital in the trading account. It is the maximum loss the trader / manager or trading strategy incurred at any point of time.

Low returns – period of small gain where the trader cannot make enough money to make a living

Price shock – sudden price change which can wipe out a trader

System death – Change in market dynamics that causes a previously profitable system to start losing money.

The chapter discusses each type of risk in detail with examples for various trading systems. I was amazed with level of volatility which a lot the trading systems show. For example the author refers to trading systems which can generate returns of almost 35%+, but incur drawdowns of 40-45%. So there would be times when your capital would drop by 40%.

How many of us have the nerve to withstand this kind of losses?. So the next time around if some one recommends a trading strategy with high returns,ask about the drawdown. If the other guy cannot tell you the drawdown of his strategy, run (he does not know about trading or is trying to fool you). If he does give you a number, try to figure if you can tolerate that level of risk. The book also indicates that the higher the level of return, higher is the volatility and higher the drawdown. So if one is a beginner, try for a system which has a lower return and lower drawdown.

The next chapter revisits risk and money management again. The author again cautions the reader from underestimating risk and blindly accepting the claims of vendors or money managers. Curtis’s advise is to go for returns at which the risk is manageable and let compounding do its magic. No point in trying for 100% to 200% returns and then blowing up (losing all the money).

The author makes a very important point in this chapter. He says that trading is simple, but not easy. He gives the example of people like dentist or doctors who are smart and under the assumption that if they are smart and successful in their profession then they should be good at trading too. The reality is that these folks are not good traders.

I find this comment interesting. I have seen this all around me. A lot of people I meet are smart and very good at their jobs. They automatically assume that they will be good at investing. Intelligence may be a necessary but not a sufficient ingredient for success at investing. It is surprising that most professionals think that they can put 1-2 hours a week into investing and be a great investor. By that analogy, all of us should be good doctors and architects too. Anyone can be a good or great investor, but like most other pursuits in life, one has to work at it.

Coming back, the author also says that most new traders underestimate the pain of a drawdown. They believe that they can live through a 50-60% drawdown, but when it hits them, they may stop trading completely or change methods at the worst possible time. I have faced a drop of almost 25% early in my life as an investor and even that was painful. When you are starting off and face this kind of drop, it is easy to question the process.

Posts on previous chapters here and here

Book notes – Way of the Turtle - III

The sixth chapter discussed various trading concepts such as support and resistance. These concepts are discussed in detail in this chapter with examples.

The seventh chapter is crucial to help answer the question: How can you know if a system or a manager is a good one. I would suggest reading this chapter in detail and understanding it and applying it when selecting or evaluating a trading system. A lot of trading systems refer only to the returns and choose to ignore risk. The chapter refers to four types of risk.

Drawdown – String of losses than can reduce capital in the trading account. It is the maximum loss the trader / manager or trading strategy incurred at any point of time.

Low returns – period of small gain where the trader cannot make enough money to make a living

Price shock – sudden price change which can wipe out a trader

System death – Change in market dynamics that causes a previously profitable system to start losing money.

The chapter discusses each type of risk in detail with examples for various trading systems. I was amazed with level of volatility which a lot the trading systems show. For example the author refers to trading systems which can generate returns of almost 35%+, but incur drawdowns of 40-45%. So there would be times when your capital would drop by 40%.

How many of us have the nerve to withstand this kind of losses?. So the next time around if some one recommends a trading strategy with high returns,ask about the drawdown. If the other guy cannot tell you the drawdown of his strategy, run (he does not know about trading or is trying to fool you). If he does give you a number, try to figure if you can tolerate that level of risk. The book also indicates that the higher the level of return, higher is the volatility and higher the drawdown. So if one is a beginner, try for a system which has a lower return and lower drawdown.

The next chapter revisits risk and money management again. The author again cautions the reader from underestimating risk and blindly accepting the claims of vendors or money managers. Curtis’s advise is to go for returns at which the risk is manageable and let compounding do its magic. No point in trying for 100% to 200% returns and then blowing up (losing all the money).

The author makes a very important point in this chapter. He says that trading is simple, but not easy. He gives the example of people like dentist or doctors who are smart and under the assumption that if they are smart and successful in their profession then they should be good at trading too. The reality is that these folks are not good traders.

I find this comment interesting. I have seen this all around me. A lot of people I meet are smart and very good at their jobs. They automatically assume that they will be good at investing. Intelligence may be a necessary but not a sufficient ingredient for success at investing. It is surprising that most professionals think that they can put 1-2 hours a week into investing and be a great investor. By that analogy, all of us should be good doctors and architects too. Anyone can be a good or great investor, but like most other pursuits in life, one has to work at it.

Coming back, the author also says that most new traders underestimate the pain of a drawdown. They believe that they can live through a 50-60% drawdown, but when it hits them, they may stop trading completely or change methods at the worst possible time. I have faced a drop of almost 25% early in my life as an investor and even that was painful. When you are starting off and face this kind of drop, it is easy to question the process.

Posts on previous chapters here and here

Book notes – Way of the Turtle - II

I have been reading the book – Way of the turtle for the past few days and have found it to be a good book. It is a book on trading. I posted my notes on the first two chapters earlier.

Notes on 3rd, 4th and 5th chapters follow –

The third chapter refers to the risk of ruin. This is risk a trader faces that several of his trades will go against him and he could lose his entire capital. The way to manage this risk is via Money management. This involves putting the position in small chunks called as units which are sized based on the type of the market, volatility measure of the market etc (please refer to the book for more details).

The third chapter refers to four key points

- Trade with an edge: Find a trading strategy which can produce positive returns over the long run as it has a positive expectation (see an earlier post on edge, kelly’s formulae etc here)
- Manage risk: Control risk via money management discussed earlier
- Be consistent: execute plan consistently to achieve the positive expectation of the system.
- Keep it simple

All the above points are equally valid for an investor as it is for a trader.

The fourth chapter focuses on thinking in the present and aviod thinking of the future. Successful traders do not attempt predict the future. They do not care about being right, only about making money. A key point is that good traders are also wrong a lot of times. However they do not beat themselves over it. They are focussed on sticking to a plan and trading well and not worrying about the success of each trade or do not look at each trade as a validation of their intelligence.

One of the biases namely recency baises can impact a trader severely, especially if he is on a losing streak. People have a tendency to overwiegh recent data. Recency bias results in a trader over wieghing recent performance, especially bad performance and the trader may end up abondoning a successful system. The way to avoid this bais is to focus on probabilities and to know that every system has a certain odd of failure (A certain number of trades will go wrong). However by focussing on the process than the outcome and being confident that the system works well in the long run, one can remain rational and continue with a successful system.

The fifth chapter discusses about the concept of edge in more detail. The chapter introduces various concepts such as MAE (maximum adverse excursion – loss over the time frame) and MFE (maximum favourable execursion – gain over a time frame). The E-ratio (edge) is ratio of MFE/MAE adjusted for volatility. This ratio can calculated for various duration such as 10 days, 50 days etc.

To find an edge, you need to locate entry points and exit points where there is greater than normal probability that the market will move in particular direction within the desired time frame. The various components that make an edge for a system comprises

- portfolio selection : alogrithms which markets are valid for trading on any specific day
- Entry signals : alogrithms that determine when to buy or sell to enter a trade
- Exit signal : alogrithms that determine when to buy or sell to exit a trade

Book notes – Way of the Turtle - II

I have been reading the book – Way of the turtle for the past few days and have found it to be a good book. It is a book on trading. I posted my notes on the first two chapters earlier.

Notes on 3rd, 4th and 5th chapters follow –

The third chapter refers to the risk of ruin. This is risk a trader faces that several of his trades will go against him and he could lose his entire capital. The way to manage this risk is via Money management. This involves putting the position in small chunks called as units which are sized based on the type of the market, volatility measure of the market etc (please refer to the book for more details).

The third chapter refers to four key points

- Trade with an edge: Find a trading strategy which can produce positive returns over the long run as it has a positive expectation (see an earlier post on edge, kelly’s formulae etc here)
- Manage risk: Control risk via money management discussed earlier
- Be consistent: execute plan consistently to achieve the positive expectation of the system.
- Keep it simple

All the above points are equally valid for an investor as it is for a trader.

The fourth chapter focuses on thinking in the present and aviod thinking of the future. Successful traders do not attempt predict the future. They do not care about being right, only about making money. A key point is that good traders are also wrong a lot of times. However they do not beat themselves over it. They are focussed on sticking to a plan and trading well and not worrying about the success of each trade or do not look at each trade as a validation of their intelligence.

One of the biases namely recency baises can impact a trader severely, especially if he is on a losing streak. People have a tendency to overwiegh recent data. Recency bias results in a trader over wieghing recent performance, especially bad performance and the trader may end up abondoning a successful system. The way to avoid this bais is to focus on probabilities and to know that every system has a certain odd of failure (A certain number of trades will go wrong). However by focussing on the process than the outcome and being confident that the system works well in the long run, one can remain rational and continue with a successful system.

The fifth chapter discusses about the concept of edge in more detail. The chapter introduces various concepts such as MAE (maximum adverse excursion – loss over the time frame) and MFE (maximum favourable execursion – gain over a time frame). The E-ratio (edge) is ratio of MFE/MAE adjusted for volatility. This ratio can calculated for various duration such as 10 days, 50 days etc.

To find an edge, you need to locate entry points and exit points where there is greater than normal probability that the market will move in particular direction within the desired time frame. The various components that make an edge for a system comprises

- portfolio selection : alogrithms which markets are valid for trading on any specific day
- Entry signals : alogrithms that determine when to buy or sell to enter a trade
- Exit signal : alogrithms that determine when to buy or sell to exit a trade

Book notes – Way of the Turtle - I

I referred in my previous post about a book on trading – Way of the turtle which I have been reading for the past few days. Now why should a guy who displays a mental block against trading, read a book on the topic? The short answer is to challenge my own biases against trading.

I can definitely say that this is a good book and anyone wanting to learn about trading or wanting to evaluate a trading system (in a book or being sold by someone) should read this book. What follows over this and the next few posts is my own summary (not review) of the book with my own thoughts and comments (which I cannot resist putting :) )

The book is written by curtis faith who was one of the turtles (traders) recruited by richard dennis and william eckhardt as a part of an experiment that trading can be taught. The author was one of the original recruits (and probably one of the most successful) who made more than 30 million for Richard.

The book describes the difference between an investor and a trader. An investor buys stocks, but is really buying an underlying business. A trader in contrast is concerned only about price and is essentially buying and selling risk. The second chapter of the books talks of the turtle mind, which I think is equally relevant for an investor.

As we all know that markets are populated by individuals who are driven by fear, greed and all other cognitive biases, which create opportunities for a trader. The book refers to various biases such as loss aversion – higher preference to avoid losses over gains, sunk cost effects – tendency to treat money that has already been committed as more valuable than money to be spent in the future, disposition effect – tendency to lock in gains and ride losses, outcome bias – tendency to judge a decision by the outcome than by the quality of the decision at the time it was made and several other biases such as recency biases, anchoring etc.

The second chapter describes each of these biases in detail and how it affects a trader. The chapter continues with various trading styles such as trend following, counter-trend trading, swing trading and day trading.

One the key points I realised from the initial chapter was that each of these trading styles are valid for specific types of market. Curtis refers to various markets such as stable and quiet, stable and volatile, trending and quiet and trending and volatile. For example, trend followers love markets that are trending and quiet where they can make more money than a volatile market which is more punishing to trend followers. In contrast counter-trend traders love markets that are stable and volatile.

Another key learning for me in the chapter – successful traders never try to predict the market direction. Instead they look for indications that a market is in a particular state and trade accordingly.

I will be posting the rest of my notes over the next few posts. You can find the author’s blog here.

Book notes – Way of the Turtle - I

I referred in my previous post about a book on trading – Way of the turtle which I have been reading for the past few days. Now why should a guy who displays a mental block against trading, read a book on the topic? The short answer is to challenge my own biases against trading.

I can definitely say that this is a good book and anyone wanting to learn about trading or wanting to evaluate a trading system (in a book or being sold by someone) should read this book. What follows over this and the next few posts is my own summary (not review) of the book with my own thoughts and comments (which I cannot resist putting :) )

The book is written by curtis faith who was one of the turtles (traders) recruited by richard dennis and william eckhardt as a part of an experiment that trading can be taught. The author was one of the original recruits (and probably one of the most successful) who made more than 30 million for Richard.

The book describes the difference between an investor and a trader. An investor buys stocks, but is really buying an underlying business. A trader in contrast is concerned only about price and is essentially buying and selling risk. The second chapter of the books talks of the turtle mind, which I think is equally relevant for an investor.

As we all know that markets are populated by individuals who are driven by fear, greed and all other cognitive biases, which create opportunities for a trader. The book refers to various biases such as loss aversion – higher preference to avoid losses over gains, sunk cost effects – tendency to treat money that has already been committed as more valuable than money to be spent in the future, disposition effect – tendency to lock in gains and ride losses, outcome bias – tendency to judge a decision by the outcome than by the quality of the decision at the time it was made and several other biases such as recency biases, anchoring etc.

The second chapter describes each of these biases in detail and how it affects a trader. The chapter continues with various trading styles such as trend following, counter-trend trading, swing trading and day trading.

One the key points I realised from the initial chapter was that each of these trading styles are valid for specific types of market. Curtis refers to various markets such as stable and quiet, stable and volatile, trending and quiet and trending and volatile. For example, trend followers love markets that are trending and quiet where they can make more money than a volatile market which is more punishing to trend followers. In contrast counter-trend traders love markets that are stable and volatile.

Another key learning for me in the chapter – successful traders never try to predict the market direction. Instead they look for indications that a market is in a particular state and trade accordingly.

I will be posting the rest of my notes over the next few posts. You can find the author’s blog here.

Assumptions and beliefs

I read somewhere that all of us have a set of underlying assumptions based on which we create a model of the world. This model involves all aspects of life, but I will restrict myself of investing.

I am aware of a few assumptions on which my investing style or philosophy is based. These assumptions are not universal truths or applicable to others. Its just that I have developed these assumptions over a period of time. Some may be valid and some not. I constantly test these assumptions against my performance and try to discard those that work against my long term performance.

So here goes my list

1. Value investing is an extremely productive approach to investing for my circumstance. I have a regular job, a family and can devote only a limited time to investing. So for me value investing and an as an extension, buy and hold makes sense.
2. Trading is time consuming, too stressful and not a game in which I can or want to excel. In addition, I have a mental block against trading (which must quite obvious). I am currently reading a great book on trading – Way of the turtle (on which I will post next) to learn more about it. My initial reaction – Trading is not for the faint hearted, is a tougher (especially emotionally) way to make money and definitely not a part time activity.
3. Investment advice especially from analysts and financial website is baised and not worth following. Blogs are a different matter as the bloggers do not have a hidden agenda.
4. It is impossible to predict the markets in the short run. Don’t waste energy on that. Time is better spent in learning other aspects of investing
5. One can get better at investing if one is ready to put the effort into it.
6. Avoid options, derivatives and other avenues such as gold as there are enough opportunities in equities. No point in spreading my self thin. Knowing a little bit of equity, a little bit of commodities and gold will not get me superior returns. Focus on one area and do well in that.
7. Avoid stocks with high PE unless I am very very certain of the business prospects. Avoid stocks above a PE of 20 in most of the circumstances.
8. Avoid IPOs (see my logic here)
9. Investing in not an intrinsic talent usually. There are a few exceptions to it like warren buffett. I can learn to be a better investor.

I am a buy and hold investor. This has been gospel for me in the past. I guess if you follow warren buffett as much as I do, you end up following his philosophy completely. However over the past 1 year I am trying to expand beyond this approach. I would still prefer to buy and hold stocks for which the instrinsic value is increasing rapidly. However I have started looking seriously at a few more approaches such graham type deep value investing, special situations and also looking at how momentum may be combined with value investing . My core philosophy is still value investing, however I am trying to expand the scope.

Assumptions and beliefs

I read somewhere that all of us have a set of underlying assumptions based on which we create a model of the world. This model involves all aspects of life, but I will restrict myself of investing.

I am aware of a few assumptions on which my investing style or philosophy is based. These assumptions are not universal truths or applicable to others. Its just that I have developed these assumptions over a period of time. Some may be valid and some not. I constantly test these assumptions against my performance and try to discard those that work against my long term performance.

So here goes my list

1. Value investing is an extremely productive approach to investing for my circumstance. I have a regular job, a family and can devote only a limited time to investing. So for me value investing and an as an extension, buy and hold makes sense.
2. Trading is time consuming, too stressful and not a game in which I can or want to excel. In addition, I have a mental block against trading (which must quite obvious). I am currently reading a great book on trading – Way of the turtle (on which I will post next) to learn more about it. My initial reaction – Trading is not for the faint hearted, is a tougher (especially emotionally) way to make money and definitely not a part time activity.
3. Investment advice especially from analysts and financial website is baised and not worth following. Blogs are a different matter as the bloggers do not have a hidden agenda.
4. It is impossible to predict the markets in the short run. Don’t waste energy on that. Time is better spent in learning other aspects of investing
5. One can get better at investing if one is ready to put the effort into it.
6. Avoid options, derivatives and other avenues such as gold as there are enough opportunities in equities. No point in spreading my self thin. Knowing a little bit of equity, a little bit of commodities and gold will not get me superior returns. Focus on one area and do well in that.
7. Avoid stocks with high PE unless I am very very certain of the business prospects. Avoid stocks above a PE of 20 in most of the circumstances.
8. Avoid IPOs (see my logic here)
9. Investing in not an intrinsic talent usually. There are a few exceptions to it like warren buffett. I can learn to be a better investor.

I am a buy and hold investor. This has been gospel for me in the past. I guess if you follow warren buffett as much as I do, you end up following his philosophy completely. However over the past 1 year I am trying to expand beyond this approach. I would still prefer to buy and hold stocks for which the instrinsic value is increasing rapidly. However I have started looking seriously at a few more approaches such graham type deep value investing, special situations and also looking at how momentum may be combined with value investing . My core philosophy is still value investing, however I am trying to expand the scope.