Just as you have macro and micro analysis of global markets, a macro and micro level analysis is necessary for investing “process”. When you buy a house or a stock or book a fixed deposit you are involved in a micro level process. Macro level process involves proper asset allocation, bucketing timeframe of your investments, defining risk appetite and understanding your investing skillset and level of expertise. We call them 3Ds of investing.
(1D) Valuation - relative valuation within and across asset classes
(2D) Timeframe - bucketing your investments into different holding periods
(3D) Skill/Experience - your circle of competence and level of expertise
Let’s have a look at them in more detail
Market valuations are dynamic. Interest rates are reviewed twice in a quarter, stock prices almost change every day and movement in business earnings are reported every quarter. Hence your investments are interacting with a market place that has moving parts. Views/opinions of individuals may not be objective enough to correctly assess the variations and ideally a computer program should be used. Are these variations big enough to justify detailed analysis? Yes, because consider this: when a stock falls 20% or more (which they easily do in a span of 3-months), not only you can buy 25% additional quantity but also have more margin of safety and additional returns if it rallies from there. Timing price movements perfectly is tough, but valuations can be quantified. One can also define the valuation (or range of valuation) which is comfortable for buying/selling.
Example: Nifty’s Price to Earnings ratio has ranged from 12 to 28 in the last 20-years and 10-year returns have ranged from min 6% and max 20% depending on at what valuation you bought it at. An investor who bought at PE of 12 would have a much better investing outcome from another who bought at 28. Nifty has much lesser volatility than most stocks, so the range of outcomes will have more variations for stocks.
Check detailed numbers here (historical returns tab): http://quantifyindia.in/investing.html
Also remember when one buys equities, the opportunity cost is the prevailing interest rates. The other choices are real estate and gold. Allocating capital to an asset class has an inherent view that the expected returns will be higher from the other asset classes for that investing timeframe.
Whether you can invest for a year, 3y, 10y or 30y will decide what avenues are open for you. Misplaced expectations or wrong combinations can hurt. The chosen asset class must be in line with the expected holding period. Real estate, gold, equities in general have long gestation periods. Even in fixed income, concept of duration must be understood. Volatility are also a function of time and determines the expected variation of returns in a certain time period. If you hold equities instead of bonds, the risk is higher is short term but lower in the long term. If investing time horizon is 1y bonds are good investments, but for 10y they may not be. Hence, capital should be divided into different timeframe buckets and then allocated appropriately.
In investing there are a range of experts - real estate, commodities, private equity, portfolio managers (equity, debt or diversified), traders (cash and derivatives) etc. There are different styles of operating too- early stage start-ups, value, growth, quantitative, technical analysis etc. Everyone starts as an amateur and over time becomes an area expert or chooses an expert on their behalf. The key is to identify one’s area expertise, level of expertise or find out an expert. Choosing yourself or an expert is also a decision that requires skill, research, experience and wisdom. The choice also depends on market cycles, the past performance, factors like risk appetite and willingness, investing timeframe etc. An amateur is recommended systematic investment plans in diversified funds to achieve average returns to mirror broader market returns and eliminate the risks involved in this selection. Deviations from the amateur prescription requires additional skill/experience. For example, an options trader essentially is taking a call that “after costs, taxes and opportunity cost of time spent on trading” the expected returns will still be worthwhile. The idea behind this dimension is simple and intuitive, yet most people take time to understand its importance.
Think about 3Ds of investing process and get the macro level right before placing micro level bets. Macro level processes are as or even more important than the micro level processes. Hopefully that would help you avoid blunders in your investing journey.Tweet