Wednesday, February 20, 2008

Investing Paths

Everyone who starts investing will try to understand the stock markets by talking with others who have been investing. Then we all move on to reading books by the Grahams, Lynchs and Buffetts of the investing world. Probably after losing more money, we will gravitate towards the technicals and charting gurus: the waves, oscillators, fibonaccis, RSI, momentum, etc. So what do we end up with?

Some of us stick to a tried and trusted way of investing, or just something we are comfortable with, or something we can understand. So which groupie do you belong to?

Fundamental Analysis – This group basically looks at the cause-effect in investing variables. This can be broken up into two groups, namely, top-down or bottom-up. The former refers to getting the macro picture and capital flows correct. This will give the investor a proper perspective on country and currency exposure. If you get the country and currency correct, it doesn’t really matter much about picking the right stocks. Get the big picture wrong and it matters little whether your have picked some great value stocks – great value stocks would remain just that, great value, not performing stocks.

Then there are those who would swear off the big picture volatility analysis, seeing stocks as basically long term companies doing a certain kind of business. The bottom-up investor would stay focus on picking undervalued stocks and based on the theory that holding a good long term stock would eventually outperform in the long run, riding out the volatility.

A financial analyst or business analyst would be doing things from a bottom-up perspective. Breaking down product lines, revenue streams, debt levels, cash flow analysis, product outlook, business model, margins and sustainability of earnings, among others.

To be fair, most fundamentals investors employ both approaches in some way or other. A top-down person would need to be more well versed with economics while the bottom-up needs to appreciate the nuances of accounting. People in this camp wants everything to be explained, the cause-effect. If they did not spot the correction beforehand, its because they haven’t been giving adequate attention to certain investing variables.

Put another way:
Top-Down Investing People with a bit of economics knowledge but scared shitless about accounting Bottom-Up Investing People who knows a bit about accounting but hates fiction

Then there are the ones who embraced technicals and charting religiously. These are basically pattern seekers, they try to find pattern from historical prices. To me, these are people who have basically given up trying to understand stocks. They are basically saying there is not much point trying to understand fundamentals, its either too hard or that it doesn’t matter much really in the end. On the other hand, the patterns and data may yield more than just trends, they believe that the human psychology and the way people invest are already reflected in past data: and they tend to repeat themselves. If you are able to decipher trends, breakouts and supports: you are golden.

To be fair, there are some who employ a mish-mash strategy of fundamentals and charting in investing. Here, I am not trying to say which is the better option as most reported studies tend to come to the conclusion that it is very difficult to beat the market in the long run. People like Buffett and Lynch are explained as minor aberrations to the data. This doesn’t sound good for the average investor, does it!

Big investment houses employ highly paid quants to do analysis and highly evolved econometric models to squeeze anomalies (returns) from the market place. Quantitative finance might sound like rocket science but even they are not infallible. Just look at the LTCM and Goldman Sach’s in-house hedge fund experience.

Hence, we cannot roll our eyes if a seasoned trader said that he/she relies on market rumours or whispers to make his/her stock selection. A bull market has the effect of making almost everyone think that they have harvested the ability to be brilliant stock pickers. A bull market only made it easier to pick performing stocks.

It is probably the mystique of being successful in investing that keeps investors baffled yet attracted to the field.
I am terribly sorry that I am not able to provide a better alternative to the above. I do feel that there are strengths and weaknesses with each of the investing strategy.

If I may try to add some value, is to encourage young investors to pay more attention to behavioural finance in addition to the stuff in textbooks. It is important to understand the madness of crowds. Another point is to read up more on investing variables, examine their cause-effect relationship, and then rank them in your head in order of importance. The trouble is you can read books and watch the business programs but you will be inundated with information overload. We have to learn to rank and sift the b.s. from the things that address the issues at hand properly.

To extend on the cause-effect on investing variables, we need to go further down the chain of events. Its like a good chess player and a grandmaster. A good player may be able to think 3 or 4 moves ahead but a grandmaster can go much farther. I do think by stretching your analysis, it gives you an edge.

We need all the help we can get. As Soros rightly put it, "More importantly, it is how much money you make when you're right about the market and how much you lose when you're wrong. " To do that: we need to get the big picture right; we need to get the exit, entry and cut loss prices right; and we need to pick the right stocks with corresponding valuation and growth implied, and note them when the variables start to deteriorate. We need all the tools that will help us achieve that.


MP said...

this post looks familiar ... idn't you post this earlier?

Salvatore_Dali said...

its the article which appeared in The Star Biz Weekly... I can only post them after they have appeared in the paper.

Encik Wan said...

My suggestion for new investors is to find the style/method/strategy that you are most comfortable with. Eveyone starts with nothing. Hopefully your losses are smaller than your gains.

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