I stumbled upon this thought when I was sitting at a seminar, where this doyen of Indian Finance was being feted for his sterling career with one of the best industrial houses in the country. At one point, he remarked, "We do not speculate..."
He was talking about market risk. As you know, nobody believes more than me that this is predictable, manageable and profitable - exactly what most people think it is not. The reason that dabbling in markets is called "speculation" is that most people expect very little predictability in what you do.
In my lexicon, speculation is what you do when you have no idea where you are going. It is like equating my trade with that of quacks. I feel like an astrologer who gets all his predictions right, and then has to explain the failures of his brethren.
Speculation is like driving blindfolded; forecasting is the job of the strategist and Risk Manager, jobs that fall squarely within the domain of the CFO of a company. In markets, the trader has to forecast, or else he is speculating. The astrologer who looks at the world through the eyes of his parrot is definitely speculating, but that should not give astrology a bad name. Yet, people give the whole community a bad name. Sure, there are more quacks in the markets than anywhere else, but the few spectacular exceptions should prove that there is some strength in the argument that Risk Management works.
That is the other way to look at it. Risk management, like the principles of good driving, does reduce risk. Look at the chart of any equity, commodity, currency and tell me this:
- Do you see a repeating pattern of ups and downs?
- Can you link significant events with the ups and downs, with or without a time lag?
- Are those significant events predictable? For example, if there is an uptick in Balrampur Chini, is it linked to sugar/ethanol prices? The stock chart of Balrampur would look fairly 'unpredictable' if you do not have background data on sugar production, forward prices, acreage under cane, and a few other important variables.
- Despite all the ups and downs, is there a 'sigma distribution' possible? That is, is it possible to locate a price range from the chart that gives you a 95 per cent (you choose the probability) chance of seeing higher stock prices? Similarly, is there a price range from which you can see that there is a 75 per cent probability that you would see lower prices? Take these prices, and recalculate the Forward PE, P/BV, P/S and P/CE, and see whether the Sigma chart makes more sense.
- Set yourself a 'trading rule' that allows you to set your portfolio 'buy' at the lower end of prices, and the portfolio 'sell' at the higher end of the price range.
- Does any of this sound like speculation? Yes, it is a bumpy, emotionally uncomfortable ride, mainly because we as human beings are not evolved for handling volatility. Also, we care too much about money, second only after sex (and sometimes not even that). So besides all the above 'technical' skills, you also need the emotional construction of a person who can survive, even enjoy the roller-coaster ride of markets.
The right emotional constitution
The people who are actually 'born right' are built so, through multiple accidents of fate. Yes, the emotional make-up has to be intrinsic, and can sometimes be developed by training and education. But along with that you need many fortuitous accidents that allow you to pick up the 'technical skills' needed for good risk management.
In my case, I have located one huge weakness in my emotional make-up: I need to fill my day with activity, preferably social activity, to prevent me from coming back to the markets, and 'over-watering' my investments. Warren Buffet says so very clearly: "Let time hang heavily on your hands." As in agriculture, once you have got the mix right, any further incremental activity erodes value rather than adds to it. Yet, having been born hunters, we use all our excess energy to range around, trying to push things. Such extra energy might be a good idea in the world of labour, but is a terrible idea in the world of risk management.
No link between effort and reward
So let's get back to the point that I set out to make. The use of the word 'speculation' denotes a helplessness against understanding complexity; the human mind seeks a 'perfect' link between effort and reward. That is why manufacturing companies, which are used to 'doing things', find it so uncomfortable to live with the uncertainty of markets (commodity, forex, debt, equity). That makes them prime customers for volatility-reducing products like insurance, derivatives and the like, where the financial markets take these 'risks' off them, and live off the fat of the land. That is the cause of much heartburn just now, because financial markets have failed in their 'risk reduction' role, and have actually added to risk because of their activities, with the real economy having to take up the burden.
Much of the trouble that non-Finance people face when they deal with the financial markets comes from this anthropological construction of 'just wanting' our 'just' reward: it creates this unhappy picture of widows and orphans, and clumsy CFOs of big manufacturing companies who have been 'deceived' by the financial markets. Their 'just' efforts have been destroyed, and their rewards taken away by the rising Yen or the falling Euro. And they have this mental image of the 'happy speculator' who is swimming on Miami Beach, just because of a single but accurate trade on the Euro, Yen or whatever.
Almost all the financial security in my life has come from reading three up-down sugar cycles right. For the rest, I have just held a mediocre job in a not-very-understanding set of companies. It would look like 'speculation' has been good for me, even as I have spent almost all my time and energy in obeying my masters. But if I die richer than my masters, it will not be for lack of obeying them; it will be for the thoughts that I carry as I go to the bathroom, or the ideas I get when I am driving!
Understanding complexity
'Speculation' does not account for serendipity, but research or analysis does. To give up on understanding complexity is to be unfaithful to the mandate that an employer gives to you when he trusts you with the management of a company. We do not have the right to decide what creates value, and whether it suits us and our mental make-up. If it creates outstanding, well-differentiated companies, it should be done; and if one person cannot do it, another one should be found to do it. To limit the definition of your business simply because it makes you uncomfortable is to limit the value-creation potential of your company: if your shareholders were to find out, they would not look at you kindly.
Do we speculate when we drive? Don't we take on unknown risks (of that child crossing the road, or the teenager swaying through traffic)? Yes, all drivers use the same tools (clutch, brake, accelerator), speak the same language, but have markedly different safety track records. And yes, 85 per cent of drivers think they are good (drivers), just as 85 per cent of investors think they will make money in the markets. But it is the remaining 15 per cent from which the successes emanate; the rest are plain 'speculators'!
The result: you have 'speculative' markets, and 'dangerous' Delhi roads...with very confident investors and very 'good' drivers!
This article was originally published on August 06, 2010.
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