At social gatherings, I dread the inevitable: “What do you do?” All my answers can lead to boredom. As a journalist, I end up hearing blah-blah about NDA, UPA, Kejriwal, Romney, Obama, Syria, or I'm asked for inside details of scams. As an investor /trader, I am asked for stockmarket tips, or forced to listen to long accounts of how somebody made or lost money. I'm passionately interested in these subjects. I spend 10-12 hours a day immersed in them. But I'd much rather talk about music, or snow leopards, when I'm relaxing on an evening.
One question I've faced at cocktail parties is actually interesting but it can't be answered between two swallows of vodka. Somebody says, with a degree of aggression that varies according to the liquor intake, “Efficient markets theory tells us you can't make money as an active investor. So how do you survive?”
I say something mild like “Well, India isn't all that efficient a market” and try to change the subject. The real answer is, success or failure for an active trader or investor has much more to do with discipline and loss management, than with crunching economic data and predicting market direction.
Given a liquid, efficient market with low impact cost, the hypothesis is that information is disseminated with equal speed to many investors and hence, discounted by random price movements. It's true that it's difficult to consistently predict what will go up, and what will go down. Some people manage this but nobody gets it right all the time.
But even if you pick direction randomly, you will be right close to 50 per cent of the time. Instead of worrying about always right more often, think of financial markets as a game where thousands of coins are tossed up every day. The two sides of those coins are labelled “up” or “down”. You can bet on some coins landing “up”, and some landing “down”. It doesn't matter how you select coins to bet on; you will never have a perfect strike rate.
I am right a little more often than half the time but not a great deal more. But when I lose my bets, I pay relatively small sums. When I win my bets, I am paid larger sums. My focus is on developing good loss:gain ratios, rather than trying to increase the number of times I'm right.
There is one thing everybody can do: control losses. Before you enter a trade, set a mental stop loss. If that limit is hit, exit without exceptions. Sometimes you will curse because the stock moves favourably immediately after you've booked losses. But sometime you'll be relieved because you would have lost a great deal more.
Once you get the hang of controlling losses, you are halfway to getting a good return. The sensible way to do this is to set your loss limits beforehand – cut your coat to suit your cloth. Everybody has a pain threshold. Decide what your threshold is and don't take a trade, which exposes you to higher losses than that. For example, if you're prepared to lose Rs 10,000 on a given position, don't take a trade so large that a minimum adverse move will cost more over Rs 10,000.
Manage position sizes. Work out the likely volatility of what you are trading. Set stop losses. Don't set targets when you get a winning position. Just move the stop loss up when you start receiving profits. That way, you will still lock in some profits if the price trend reverses.
I've offered versions of this answer a few times and encountered two psychological barriers. One is that, people get offended at this “gambler's perspective”. Most investors really want to believe that it is possible to beat the market by being clever, and processing more information. Well, most institutions are staffed by very smart people, backed with very good access to information. Most institutions don't beat the indices often.
The other mental block is that most investors think of stop losses purely as traders' tools. They are not. Stop losses are time-independent and level-independent. A trader may be prepared to lose Rs 10,000 in five minutes. An investor may be prepared to lose Rs 1 lakh over a 12-month period.
It amounts to the same thing. Both investor and trader have respective loss limits and they should use methods that cater to them. I've never met a consistently successful investor, who didn't have the humility to accept that he was often wrong and set up damage-control systems.
