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Let’s say I sent you 12 letters in the past calendar, one each month. At the beginning of each month, based on my proprietary algorithm, I had predicted whether the markets would rise or fall for the month. Now let’s say I got it 100 percent right. If I asked now, given my exceptional algorithm and track record, would you invest in my fund?
Well, you definitely shouldn’t.
I did it that way. I started with 204,800 emails in my database in January. I sent half of the people (102,400) predictions that the markets would go up and the rest that they would go down. If the market rose this month, I would remove the addresses of those who got the wrong prediction from my database. For February, I repeated the process with the 102,400 people who got the correct forecast for a month. For example, half of the people (51,200) received a letter predicting the market would rise and the other half received an email saying it would fall. I repeated that every month. By the end of December, 100 people had got the correct predictions for the past 12 months, and you happen to be one of them.
On the basis of just probability (50 percent of the market up or down), I now have 100 people who might think I am a genius.
The main takeaway is that when evaluating outcomes as predictors, we need to keep two things in mind. First, the process that leads to the generation of the results, and second, the likelihood of repeat success. From the numbers I put out, we now know that the probability of future success (the strategy above) is a meager 0.05 percent (100 divided by 204,800).
We often overlook this when we access success stories in the markets. Today, when asked about successful NBFCs, you will likely name Kotak Mahindra Bank, Bajaj Finance, or Shriram Transport. And you’d be right; all three were founded in the 1980s. But, you know, they all underperformed terribly during the NBFC boom in the 1990s. Of the 1,420 deposit-accepting NBFCs (2), these three were barely any assets.
One of the fastest growing companies is CRB Capital Markets, which operates in merchant banking, asset management and lease finance. The growth was so overwhelming that CRB’s net worth rose from 20 million rupees in 1992 to over 4 billion rupees in 1996, and a banking license was also reportedly being considered.
To generate above-average returns, depositors and investors had overlooked glaring irregularities and lost billions of rupees in the downfall of CRB. The RBI later amended the RBI Act in 1997, giving it full control over NBFCs, and the cleanup began. Of the more than 4,000 NBFCs that dominated at the time, around 20 survived, and these are the ones we remember today (3). Again, CRB’s result was superlative (great increase in net worth), but its practices were questionable (raising deposits at 20 percent plus interest, upfront commissions, etc.).
In essence, processes are often a better predictor of success than the outcome itself. And not only that, the process is often more important than the first mover advantage. Peter Thiel calls this the “Last Mover Advantage†in his book Zero to One.
Consider the following cases: Book Stacks Unlimited was the first internet bookstore, not Amazon; Yahoo was the first search engine, not Google; MySpace was the first social media network, not Facebook; and CouchSurfing came before AirBnB. Those with better processes survived and these are the ones we remember.
With a fairly successful 2021 (despite some last minute bumps) coming to an end, it is a good time to remember that while returns are great for many funds, it is the process that makes predictability superior Returns determined. It’s also not a bad time to remind ourselves that the 22-year CAGR for Nifty is still only 12 percent, despite Nifty more than doubling since the Covid lows in March 2020. And given how macroeconomic and geopolitical factors play out on the CY22, it may be appropriate to track funds with a superior process, rather than those with just outstanding results. I wish all readers a happy new year.
(The author, Jigar Mistry, is a co-founder of Buoyant Capital. Views are his own.)
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