Being a skilled and successful investor in stocks requires a combination of different skills. Unfortunately, the different sets of skills don’t seem to often occur in combination in the same person, and that’s especially problematic nowadays. Broadly, successful stock investors need to be competent in several different activities which are layered on top of one another.
At the first level they need to be able to tell good companies from the non-good. Here, good is defined as those that will make increasingly more money with a constant or higher efficiency in capital use. This tells them which companies can be invested in. At level two, they need to identify whether the good companies are available at a low enough price to make gains a likely occurrence. This tells them when and at what price they should invest in these companies. At level three, they need to combine these stocks into a portfolio. Here, they need to understand how various stocks counterbalance each other’s strengths and weaknesses and how different combinations make sense for disparate kinds of investors and dissimilar investment goals.
At level four, the nature of the game changes fundamentally. Investors need to predict how the ebb and flow of broader economic forces affects their portfolio. Just as an example, you could have a great selection of infotech (IT) services stocks which get knocked over backwards when the dollar gets cheap at a fast rate. And at level five, investments get impacted by non-economic forces: elections, epidemics, terrorists — some foreseeable and others not — all belong at this level.
The problem with almost all investors — individual and professional — is that there’s a sharp fracture between level three and four. Those who are good at levels one, two and three can rarely figure out what’s going on at the higher levels. In recent times, this has become an even greater problem than it used to be. The oil price shock, the global credit crisis, the deep recession in the western economies, the surprises in Indian politics, and the United Progressive Alliance’s (UPA) leftward lurch in the budget have all been events entirely outside the competence of even the best stock pickers to figure out.
Some big institutional investors have in-house economists who do this part of the job, but I don’t know with what degree of success. The result is that even investors and investment managers, who have got good portfolios, keep swinging between holding their stocks and taking shelter in cash in order to limit their losses when they think the markets will head broadly downwards. But markets turn up when least expected and the managers, in their quest to avoid losses, end up avoiding gains.
This is a losing game. You invest in equity not to lose less, but to earn more. No matter what type of investor you are, it’s better to make sure that you are holding stocks that are worth holding and not dabble in guessing the unguessable.