Principles of good investment don't change

Last Updated: Wed, Nov 21, 2012 07:22 hrs

Quantum physicists talk about the "observer effect". At the sub-atomic level, the very act of observation affects the results of experiments. It is impossible for example, to directly observe a photon without destroying it. IT specialists also refer to a more commonly understood version of the observer effect. When a program is run to test the speed of a PC, the program itself may use resources that slow down the PC.

Investors and traders run into their own version of such effects sometimes when they try to act upon an observed trend. Their actions and observations can change the way the market operates. If somebody tries an investment strategy and it works, it is then imitated by others. If a large number of people follow the strategy, it reduces the effectiveness and the expected returns.

For example, during the Depression Era (1929-1937), Benjamin Graham was highly successful buying profitable businesses trading at below book-value. Then Graham explained his seminal ideas. Other investors became aware of his value-investing concepts and also started identifying and piling into such depressed stocks. Once the herd started looking for this pattern, the strategy became much more difficult to implement. It is now rare to find genuinely profitable stocks trading at the right levels before they are identified by the herd.

Similarly Warren Buffett's methods have become well-known over the 50-odd years he's been so spectacularly successful. Finding a business Buffett would like isn't such a big problem. There are lots of consumer-oriented franchises with low debt and sustainable, stable growth prospects. But the world over, such businesses tend to be bid up to high PE ratios by Buffett imitators. So you're unlikely to be able to buy them at the sort of PE ratios Buffett would like.

The observer effect is why arbitrage is a game with ever-narrowing margins. As markets computerise and become more efficient, the machines start picking up every price imperfection in milliseconds. If there is a low-risk arbitrage, it will be taken instantly.

It is also a problem with following successful fund houses. Many people watch the investment patterns of successful institutions. Apart from front-running, which is an illegal but common practice, there is also a lot of imitation. If a big institution makes an investment, half a dozen others will blindly follow in its tracks. By the time the imitators have moved the stock with their concerted buying, there isn't much room for a late-comer to receive capital appreciation.

Traders find this to be a classic issue with well-known programmed strategies. There are multiple automated financial trading programs available. Many of them have excellent track records. If they are back-tested on previous financial data, they also give excellent returns. But they don't perform quite that well in practice. This is because too many traders use them and this has changed the way the market behaves.

For example, an old strategy was to look at closing prices and take a position under certain circumstances. For example, if a stock had closed higher for three sessions in succession, traders operating in the 1920s and 1930s noticed the price uptrend was likely to be sustainable. They advocated an entry early on day four.

Once these methods become popular, the herd started entering en masse on day four. But the clever traders would watch for only two sessions of successive price rises. They would buy towards the end of day three because they knew there would be willing buyers available on day four. On day four, they would book quick profits. This would lead to a break in the uptrend. Then, the really clever traders started buying at the end of day two in order to pre-empt the clever traders who bought on day three. The market behaviour pattern changed.

This is why a trader or investor needs to develop his own creative twist on strategies. It's no good running a standard programmed query and copy-pasting the results into your orders. A good trader or investor will try to understand the principles behind a popular strategy and then try and find a different way to exploit those principles.

Historical parameters change and behaviour patterns change once a sufficient number of investors have observed them. The principles of good trading and investment don't change. All the principles mentioned above – low Price -Book Value, low PE, identifying price trends, - remain valid. But it can be hard work to find the right way to apply such principles in a market where everyone else also knows the theory.

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