Very few investors give a serious thought to the underlying issues involved in an investing style and if it fits their personal risk-profile, says Devangshu Datta.
Trend following, or going with the herd as it's less politely described, is safe from an emotional viewpoint. If you're wrong, so is the crowd and misery loves company. Also, since money does move prices, the probability of a "win" is higher.
Successful trend followers are just a little late latching onto a new trade and just a little early in closing out.
By being slightly late into the trade, you allow it to build up momentum. By getting out a little early, you miss the theoretical maximum return but also introduce a higher degree of safety.
The other trading philosophy is to beat the rush: Identify trades early and get in before the crowd does. Obviously this aims at profit maximisation and carries larger risks.
The lack of crowd validation also makes this style more emotionally demanding. The tools of technical analysis fall into two categories that fit these philosophies. There is one set of trend-following tools, such as moving averages.
The other set consists of lead-indicating tools such as the Relative Strength Index (RSI) and its close relative, the Williams %R.
Trend-following tools assume that, once a trend is in force, it will stay alive long enough to be exploited. Lead-indicators identify oversold-overbought levels where trends are likely to reverse.
It's unclear which style works better in practice. Trend followers generate profits more consistently. But they take massive losses when the market is collectively wrong. "Leaders" are less consistent. But they make larger profits when correct. Also, because leaders are inured to being wrong, they are usually more disciplined about stop-losses.
Fundamental analysts rarely discuss this issue explicitly. The tools of balance-sheet analysis are all trend-following by definition. They deal with information that may be quite dated. However, it could be argued that technical analysis is about price history and all forms of stock-analysis are about forward projections made from historical patterns.
"Fundamentalists" do have definite stylistic differences. A fan of Warren Buffett would tend to avoid IPOs, for example, due to the lack of reliable financial history. Some, including Buffett himself, will also avoid all new technology-driven sectors. The (perfectly sound) logic is that they feel uncomfortable investing in sunrise industries they don't personally understand.
More aggressive "leader-oriented" investors will enter IPOs. The really high risk-takers take pre-listing investments, via private equity or venture capital. Not coincidentally, PE and VC both actively target sunrise industries. The risks are more because information is scanty and projections can be wrong by magnitudes. The returns can also be huge.
Somewhere in-between, there are empiricists like Peter Lynch or Philip Fisher. While they pay heed to balance-sheet analysis and history, the empiricist-investor is willing to back growth at a relatively early stage of the business cycle, on relatively little information.
Lynch for example, often bought companies on a quarter's worth of results. Fisher had a penchant for sifting gossip and backing stocks very early in the cycle when he had a hunch that growth was about to zoom.
As with technicals, it's difficult to state that any style of investment is definitely the best. A large part of it depends on personal risk-appetite. However, when one is investing across sectors, markets and economies at different stages of development, there could be objective differences.
A conservative investor for instance, may be left behind in a very tech-driven economy. In emerging markets, where information dissemination isn't good and crony capitalism is rife, a gossip-driven approach that anticipates balance-sheets may also be forced upon the investor.
This is true in India, where information-quality is often dubious and government policy decisions can cause huge swings in sector-viability. But it is also true that somebody can generate a good return in Indian equity by tracking predictable businesses.
The risk profile for somebody who owns a stable predictable business is very different from that of an early bird, who subscribes to IPOs and enters sunrise industries.
The contrast in styles imposes contrasting modes of money management. A risk-taker needs to monitor his portfolio more often, set more rigid loss-limits and generally be prepared to be more active.
Very few investors actually think about the underlying issues of style and whether it fits their personal risk-profile. This is one reason why investors often mishandle even potentially great investments. They enter a stock without realising that they are personally uncomfortable with the method of management required. Next time somebody offers you a tip, think very hard about this.
