A conservative investor should start booking profits and move it to short-term debt.
There are endless arguments about the merits of trading versus investing. In theory, the comparison of respective risks and returns should be possible. But there are huge practical difficulties with measuring trading returns.
An expectation of investment return can be derived with a benchmark of the Nifty's long-term CAGR. The standard deviation of the Nifty's averaged year on year return is a reasonable proxy for risk. The 10-year Nifty CAGR is 14 per cent, the average year-on-year (YoY) is 22 per cent and the standard deviation of YoY is 42.5 per cent. So an investor hopes to double his money roughly every five-six years. But the progression is not smooth. The standard deviation indicates that minus 20 per cent in any given year is very possible.
Now, making a clear differentiation between “trader” and “investor” is tough. Assume for argument's sake, that anybody using leverage is a trader, while all delivery transactions are investments. This ignores hedgers; it ignores traders who take delivery; it ignores those who borrow to take delivery. So it is not rigorous but it is a start.
Traders deploy far more money than investors. Derivatives volumes dwarf cash (even adjusted for leverage) and delivery ratios in cash are below 50 per cent. But it’s impossible to figure out average trading returns, or a benchmark CAGR, without access to exchange data.
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An average is not a useful measurement. Trading returns are distributed according to the Pareto Principle. One study on BSE said over 80 per cent of traders lose money. Around 20 per cent make huge profits. Trading is zero-sum and the losses of many become the profits of a few.
We can only make guesstimates about trader-expectations. At the least, a trader hopes to multiply investment return by leverage. Depending on the leverage ratio, which could vary from 2:1 to over 30:1 for options, return expectation could vary from 25-30 per cent per annum to 500-plus per cent.
Another way is to break it down, session by session. Traders ride volatility. The Nifty is the largest volume underlying. It has an daily high-low range of 1.5 – 2 per cent. If a Nifty index trader is correct just over 50 per cent of the time, with leverage and good stop-losses, he may make 0.1.per cent per session. If he's very good, he might make 0.5 per cent.
Compounded over 250 trading sessions, a 0.1 per cent return works out to about 28 per cent. A 0.5 per cent return works out to 250 per cent. This is an idealised picture. Some traders play low probability scenarios with astronomical returns. They are happy to be right once a year. Others play strategies of small but frequent gains, risking the occasional huge loss.
Amazingly, anecdotal evidence suggests the upper range numbers (250+) are not unreal. Very few traders generate such returns and even fewer, consistently. But some do. The risks are equally enormous. All the counter-parties to every big winner suffer heavy losses. Anecdotal evidence suggests a lot of traders get wiped out every year.
Since trading is popular, behavioural science suggests people see the potential upside more clearly than risks. By chasing the pot of gold, traders create liquidity, arbitrage prices and generally make life easier for everyone.
This brings us to another question: Are there situations where trading may generate returns while investing cannot? India has seen long periods where stock prices have range-traded. Japan has seen two decades of bearishness. In such situations, some trader will still generate returns while it's an act of faith to stay committed for investors.
In bear-markets, the investor can seek future returns in beaten-down stocks. The most frustrating scenario is a high-PE bull market, where value investing is near-impossible. This market is edging in that direction. The Nifty is running at PEs of 22+ and the 10-year record suggests that this happens less than 15 per cent of the time.
There is some upside. Indian bull markets usually peak above PE 28. Also, good Q4 and full-year results should push earnings up and reduce PE. There are plenty of stocks valued below market average. But it's already uncomfortable for passive index investors. If the PE moves above 25, trading seems a more attractive proposition – provided you can be a winner. If you're conservative, you should start shifting surplus to short-term debt and wait for reactions.