Ignore the index

I

I regularly try to understand the assumptions which drive my portfolio decisions, which in turn have a major impact on the long term returns . There is a fancy term for this process – meta congnition or ‘thinking about thinking’.

I have realized (and will continue to discover) that I have made sub-optimal decisions in the past due to various assumptions. One of the most damaging assumptions has been this – One should buy stocks when the market is low and sell when the market is high.

This assumption and way of thinking is more or less a stupid way of investing in the markets. I have engaged in it in the past and have paid a heavy price in terms of opportunity cost

Reason behind this thinking
I think the main reason behind this thinking is due the negative effect of all the media chatter and noise. The commentators on various financial channels are paid by the volume and not by intelligence. If a financial commentator recommended a great stock or great idea and then asked you check back after one year, do you think they will remain in business?

As a result of this bais (towards unnecessary activity), the media and a lot investors have to discuss about something. Now, you can’t discuss about the fundamental performance of stocks every day ..isnt it ? so what better topic to discuss than market levels and price action of various stocks?

Does the market level even matter ?
The first question I am asked after someone comes to know that I invest regularly is – do you think the market is high or low and should they wait for a particular level before they starting putting money into the market ?

What do you people mean by the market level ?

The market level is usually the index which in turn is a weighted average of a fixed number of stocks (for example nifty is an average of 50 stocks). So the notion is that the market is overvalued or undervalued at some number at a particular point in time.

The problem with this question is the market level is immaterial if you want to buy individual stocks. If the stock you want to buy is overpriced, then a low market does not matter and vice versa.

The only case where the market level would matter is if you plan to invest a large sum of money into the index.

How has this assumption hurt me?
I have engaged in this convoluted thinking in the past. As a result, I have slackened during bull runs assuming that most of the stocks would be overpriced. The reality is that even during bull runs there are stocks which are undervalued, but it takes more effort to dig them out.

I abandonded this thinking two years back and have started looking for good ideas irrespective of the market level. If the stock is underpriced, I will create a position in the stock irrespective of the market levels. If the market drops and the stock drops too, then all the better as I am able to add to my position further at a lower price.

A real example
One can have several counter points to the above thought process
– Should one not wait for the markets to drop so that you can buy the stock even cheaper?
– Will the stock appreciate if the market drops and remains at lower levels for extended periods of time?

To the first point – if you can see the future (know if the market will drop in the future), then either you are a gifted person or completely delusional. If you are gifted, then use your talents to do something big or world changing.
One cannot invest based on hindsight and we have to make decisions based on what we know now (the stock is cheap or not based on current facts!)

On the second point – The long term returns of a stock is dependent on the level of undervaluation and fundamental performance of a company and not entirely on the market level. As an example, in early 2008, mid cap IT stocks were among the most ignored group. The future was not bright for them.

I wrote about IT stocks (NIIT tech in particular) in Q2 of 2008 and felt that the market was over discounting the future. Interestingly the future turned out to be worse than anyone imagined. Inspite of that, these companies survived and have done fine.

The market has since then corrected the undervaluation and these stocks have doubled during this period whereas the index (aka market level) has been more or less flat.

Focus on the important and knowable
As warren buffett has said, an investor should focus on the important (fundamental performance of a company) and the knowable (current performance and not future market levels). The rest is noise and a smart approach is to ignore it.

18 comments

  • Hey Rohit, Valuble post as usual. What about investing in MF using SIP. Should we worry about Index here as MF generally (esp large cap Diversified funds) invest strongly in the companies that form the index. Any thoughts on this?

  • Nice post and idea. Easy to say and difficult to practice, like all other good things :-)Most of the investors (at least myself) cannot do a decently confident fundamental analysis and are forced to play with (against?) the tide.It was easier in 2008 to bet on Sensex staying above 6,000 than in 2010 to bet on Sensex not falling below 15,000 or even further.That it does not directly affect how NIITEC or NTPC will perform in next 5 years is a different matter altogether.Moreover, when almost all the largish-cap companies are fairly valued or overvalued, it is a choice between dabbling with the mid-cap/small-cap segment and keeping away. I choose the latter.I mean till I get more confident about my analytical skills 🙂

  • Agreed that the index value has no value in itself BUT the PE does has.NIFTY PE is hovering around 23-24.Thats on the higher side.Historically if you have seen the market has NEVER been able to sustain itself for long above PE of 24.The faster and higher it went above 24,the more it came crashing down,sometime even buckling on its knees.And when it comes down everything comes down – including the undervalued picks.So, according to me, it would be naive to completely ignore it.

  • I too believe that market shouldn't be taken too seriously…after all its stock price that makes Nifty to rise or fall… & not that Nifty leads to fall in share price

  • Hi Rohit, Thanks for another great post. I completely agree with you however cannot deny that current market level has been bothering me quite some time now 🙂 Hope this timely dose from you will keep me on course.I did sell some from my MF portion and also planning to do more to gain target asset allocation. I think only good part is that so far I haven't touched my individual stocks for the sake of market level.

  • Hi Rohit,I believe there is no single solution to this question and it depends on the level of expertise and diversification you have. Do you agree that a rising tide lifts all boats, so a bull market offers some protection even if you are on the wrong side, although not in all the cases. I believe watching market indicators such as high PE is not a bad idea if we lack expertise and finesse in investing. Good investors like you make money all the time because you have the knowledge, patience and nimbleness that is needed. For others like me it may be beneficial to play when odds are good, we might not make extraordinary returns but can have some protection for our foolishness.Like to know your thoughts on the same.Regards,Ranjit kumar

  • Hi karthikI think it comes down the horizon you have. let me make some over simplifying assumptionslets say your are 30 yrs old and have 25 yrs more to work. lets say we also assume india will do fine in the next 20 yrs ..some good years, some bad ..but overall india will give a fairly good GDP growth.lets say you are investing to have nice fund 25 yrs later. is it not sensible to put money regularly in an SIP ..sure some years will be good and some bad ..but i think in 20 odd years you will do well ?how can i be sure of that ? well i have done the timing thing in mutual funds in the last 12+ years and believe me it has not benefited me at allso best option is to invest regularly in an index using SIP unless you plan to pick stocks yourselfrgdsrohit

  • Hi lucky valid points. when i mean ignoring the index, i dont mean ignoring the valuation.my contention is ignore the index levels and focus on specific stocks. apply you effort and intelligence to it and if you find something cheap ..go for it. if everything is expensive then yes, one should wait.now usually the index would be high when almost everything is expensive and vice versa. but my point it the index level should not drive the decision to pick specific stocks or to avoid themrgdsrohit

  • hi navjotwhen i mean index levels, i mean valuations.my counter point to your argument is – if the PE of the index is 24 , will you still avoid a stock which you have analysed well and is available cheap just because the market may go down ?there have been times when market have gone up when the earnings have accelerated and the PE which looked expensive in hindsight was not and vice versa the PE was not high and still the market crashed.belive me ..i have seen both and tried exactly what you are suggesting.again if you really think the stock is cheap and good and the market crashes (which is again an if) then should you not load further on it ?finally if the market 'appears' expensive (because some index stocks are expensive) the only thing you can do is wait. but then does it not make sense that one watch a list of companies performance and valuations and build positions based on what is cheap rather than watch the index ?rgdsrohit

  • Hi sachinagreed if the target allocations are out of whack then you should sell something to get it to your target levelsbut if market levels are making you nervous, i would re-think the selling part.i will put a post on my own experiences in selling funds based on market levels ..in short run you look smart ..but in long run you lose out..unless you can keep jumping in and out of marketrgdsrohit

  • Hi ranjiti agree with the general point you make …investing when the odds are good, but my point is that those odds should be based on specific stocks and not the index levelthe index is a mix of cheap, expensive and very expensive stocks. an infy or L&T can skew the numbers. so why based stock specific decision based on the overall index valuation ?rgdsrohit

  • Teriffic stuff, remember buffet words 'investing is most intelligent if it is most businesslike'. As you see great business with margin safety you should act with conviction.

  • Hi Rohit!!I am a new visitor of your blog & have already become a fan.Just a query-Out of thousands of stocks available, I believe you would be zeroing in on some, analyzing them, & then finalizing a few.I would like to know how do you zero in on some at level-1?

  • Hi rohit…nice post!! to the point as usual…keep up the gud work,u r doing a lot of gud to naive investors like me…wud request u to write a post or two on basic financial planning that an individual can do..thanks again,Ashish

  • hi rohit,thanks for another post on the basic concepts of successful investing.i had a few quetions-q.do u use cash eps while evaluating a company or just eps?and why?q.i just saw a few stocks like coastal roadways and waterbase selling at very low free cashlow multiples.how important is free cash flow while investing? i mean, i find them selling at these ridiculously low valuations( basically wot im trying toask u , is wich one of us is going crazy, me or mr.market?)q.what are your views on the above stocks?q.what are ur views on teesta agro ?, i mean this is so looks like a ncav situation , u know, below cash,free cashflow,book value and even a low p/e(after u look at cash eps of course) . of course, there s 1 negative to the story of a preferential allotment taking place and 1 positive development that of their very 1st dividend.last AND the least important question ,were u by any chance a writer of red herring prospectuses in a past life or are u by any chance,related to geff gannon(u reallly shoul chek out the podcast!) , i mean u r so tough on ur stock pics…..lol!eagerly aw8ing ur reply,rayhaan

  • RohitNice point but I have doubt on this from value perspective. Isn't value investing all about patience. If there is low margin of safety between value estimated and price, it is betting on future growth. While you are right that irrespective of market levels there will be undervalued stocks but it is much more difficult to find and margin of safety much lower and potential of error much higher.Markets can be wrong for sustained period. And investing in cash is also a investment decision.

By Rohit Chauhan

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