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Sunday, April 13, 2008

Why tips will never make you rich?

In the past, Indian investors have faced a problem of information scarcity. In the 1990's & before, there was no internet, no business channels, only 1-2 business newspapers etc. People used to invest only on the basis of what their brokers/friends recommended without any knowledge of the company business, financial performance etc.

In present times this has changed to a problem of information overload. There are hundreds of websites, TV channels, business newspapers where analysts are recommending new stocks daily. The investors today have become smarter then past generation and so they listen to analysts before investing but still the returns of the portfolio are not as good as expected, why?

Let us try to answer this question using an analogy and the concept of 'probability' which we have all studied in schools.

There are 4 boxes and in each box there are 10 balls of either gold or brass.

. Ist box is Smart Investor No.1 and has 9 gold balls and 1 brass ball.

. IInd box is Analyst No.1 and has 8 gold balls and 2 brass balls.

. IIInd box is MF No.1 and has 7 gold balls and 3 brass balls.

. IVth box is TV Channel No.1 and has 6 gold balls and 4 brass balls.

Probability of finding a gold ball in each of the box is 0.9, 0.8, 0.7, and 0.6 respectively.

Now a person is blind-folded and asked to pick a ball randomly from each of the box. The probability of finding a gold ball becomes 0.6 x 0.7 x 0.8 x 0.9 = 0.30 which is indeed very poor.

As the number of boxes increase or the numbers of balls per box increase this is going to be even less. Probability is equally bad when there is only 1 box but the number of balls is higher.

We can calculate the probability of finding a gold ball for our portfolio by calculating the total number of boxes (sources of tips), number of balls (tips by each source) and the number of balls we pick (stocks we buy based on the tips).

Of course the person is frustrated and starts blaming the boxes (Analysts, TV Channels, Mutual Funds, Smart investors) or the balls (Companies) for the poor performance.

After a little introspection, the person decide to make extra efforts, does a bit of analysis/research and finds out that there are some characteristics that differentiates the gold ball from brass ball like smoother surface, a bigger size etc. but still he is not 100% sure. Out of 10 balls he can be sure 7 or 8 times. Next time he picks up a ball from each of the 4 boxes, he draws 3 gold balls out of 4. Great performance!

There are other reasons as well why you should not blindly follow the tips:

. Analysts can always change their views and they have no obligation to tell it to public (Example: Rakesh Jhunjhunwala bought TV today at 70% and stock went upto 120 in a few days as people rushed to buy it . After some time he switched from TV today to TV 18. People who bought it at higher price are in losses even after 3 years while TV18 has been a multibagger).

. Analyst can have a different time frame in mind while buying/selling a stock. He may have bought it for short term and you might think it is a good long term bet.

. There are some manipulators in markets like a recent case where the analyst had taken a reverse position on the stocks he recommended. He sold stocks he recommended to buy and bought stocks he recommended to sell.

. You may buy it at much higher price or sell at much lower price (Example Rakesh Jhunjhunwala still made profit on TV today while all others who bought at higher price made losses).

Unless you have a conviction of your own you will sell a good stock just because there is some bad period or the market sentiment is down.

Learning of the week:

We have find out a simple mantra of success in the markets. If a person is in a desert (equity markets) and wants to quench his thirst (desire to create wealth) he should dig his own well (analysis/research) rather then running after the mirages (tips). If he does not get time to dig the well he should use the services of a person (MF/portfolio manager) who has already dug a well earlier.

You can use the tips or analyst reports as the starting point but you have to understand the business as if you are buying a stake in the company, check the financial performance of the company quarterly/half-yearly and build a conviction of your own. This will help you stick with a good company even in difficult times.

If you do not get the time to do analysis or track the results of the stocks you hold, you should invest through either a Mutual Fund or a portfolio manager on whom you can rely fully. In US 95% of retail investors use this route and Indians will follow soon.
 
 

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