Month: April 2011

Insurance is not Investment

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It is an indication of the sorry state of affairs in investor education that market linked insurance schemes get more fund inflows than mutual funds in India. The war between the capital market and insurance regulators was never fully resolved, though it led to some changes in structure of market linked insurance plans, and perhaps a lesser complex cost structure. It did not solve the issue of higher commission payouts to insurance salesmen, though it left mutual fund companies in the lurch – due to their inability to pay commissions to their distributors. Of course, a smaller evil cannot be a solution to a larger evil – and the world is not a perfect place – so while things have improved, the fact remains that investor education is still so low that financial products get sold rather than bought.

insurance-notinvestmentThe fact of the matter is that everyone needs insurance, and everyone needs investment solutions. More important than that, everyone needs an ability to differentiate between the two, and a discipline to stick to the differences. Nobody except the companies selling them needs market linked insurance products. An individual needs adequate levels of low cost insurance, and a clear investment plan. A mixed product like market linked insurance product simply combines the two, adds some complexity to make it a nice sales pitch, and eventually depends on the investor’s confusion and the salesman’s skills to collect the premium.

Insurance is a game where you take a bet on your longevity, and pay a premium to protect against unexpected death or loss of earning power. The only basis for selecting insurance should be a product where the odds are in your favour – in the form of a low premium for a large insured sum, preferably at a young age. Investment is a game where you take a bet on the future earning capacity of an asset, and pay a price which you think is lower than the sum of future earning capacity. These are two unrelated things – and combining savings or investment plans with insurance – is like adding apples to oranges. The only excuse to go for a market linked insurance product instead of a mutual fund can be an investor’s lack of discipline which an insurance product provides no escape from, unlike a mutual fund or stock which can be sold in panic. But that is more an investor’s problem to solve through better education and self-discipline rather than locking himself to a high cost product.

If an investor has education and self-discipline, there is no reason whatsoever for him to go for a market linked insurance scheme – which is simply high cost investment in disguise. And in the absence of education and self-discipline, it is unlikely that anything can help him.

Book Synopsis: The Intelligent Investor by Benjamin Graham

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Have read “The Intelligent Investor” by Benjamin Graham many times, and every time I read it fully or even in part – I am amazed by the depth, clarity and advice laid out in the book, and relevant every bit today, irrespective of the fact that it was written in the 1940’s. Such a piece of Investment Advice is available nowhere else in such crisp form for the individual investor. It is almost like financial philosophy, akin to the ‘Bhagavad Gita’ of investing and finance for the individual investor – whenever you pick it, you learn a new piece of investment wisdom every time.

TheIntelligentInvestorIt is difficult to pick up the best parts from such a book which is so all-encompassing – it covers everything from definition of investment to specific criteria for stock selection. Here are some of the key takeaways from the book that are invaluable for the individual investor – many of which are well discussed, but still worth repeating and re-reading.

1. Investment versus Speculation: Graham presents a very clear definition of investing, which in his view, means any operation that on thorough analysis promises safety of principal and an adequate return. Anything not meeting these – i.e. there must be thorough analysis, must promise principal (he does not use ‘guarantees’ but promises), it must have adequate return (which he goes on to elaborate later), and finally, it must be like an ‘operation’ – business-like.

2. Bonds versus Stocks in Asset Allocation: He presents a simplistic 50:50 formula of allocation between fixed income bonds and stocks that works for most investors – giving a leeway of 25% on either side. i.e. at no time should the allocation of either stocks or bonds fall below 25%. The guiding rule is to keep re-adjusting this allocation when one component increases above a certain defined limit, like 60%, by selling the additional 10% of the increased component and buying the other. This does not guarantee the highest returns – but is a mechanical program that is most likely to practically work – simply because it advises selling and buying when it is counter intuitive, and “chiefly because it gives the investor something to do”.

3. Defensive versus Enterprising Investors: Graham makes a distinction between types of investors not based on risk taking abilities or age – as was traditionally thought. Return is not dependent on risk, but rather on the amount of intelligent effort that is put into an investment operation. The Defensive investor will place emphasis on avoidance of serious mistakes and losses, and seeks freedom from effort, annoyance and the need to make frequent decisions. The Enterprising investor will be able and willing to put in time and effort in the selection and tracking of securities that may appear to be better valued than the general market from time to time – which may help him achieve better returns than the market over long periods of time. Majority of investors would fall into the Defensive category. To achieve satisfactory results available to the defensive investor is easier than most people realize, to achieve superior results sought by the enterprising investor is harder than it looks.

4. The famous Mr.Market: This is perhaps the most valuable part of the book – on how to approach the widely fluctuating markets that an investor will face number of times in his investing life. Treat the market as an obliging, emotional partner in your businesses – i.e. the securities of which you own.  Every day, he tells you what he thinks of the value of the share of business that you own, and offers to buy your share at a price or sell you his share at a price. Sometimes his fears overtake him offering you rock bottom prices, while sometimes he is too excited about the future offering you great prices. The best part is he does not mind being neglected – he will come back again tomorrow if you neglect him. Your best interests are then served if you only transact with him if and when you agree with his prices – the rest of the time, it is best for you to neglect him and focus on the operations of your business.

In the book, Graham goes on to provide clear stock selection criteria for defensive and enterprising investors – with great examples to help stock evaluation practically. But more than those, the clear framework based on the above – definition of investment, asset allocation, the decision on type of investor, and the attitude towards market fluctuations – are most valuable for an individual investor to go about his investment operations.

Graham’s advice and wisdom are unlikely to make anyone rich in a hurry – perhaps only when one gets old. But the principles are timeless and practical, and unlikely to be available in such fullness anywhere else in today’s financial clutter. That alone makes it a case for the ‘best book about investing ever written’ in Warren Buffett’s words, to be a guiding light on your desk throughout your investing lifetime.

We have met the enemy, and he is us: Are you being your own enemy?

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April 22 is Earth Day – and this was the slogan used on a cartoon poster on the first Earth Day in 1970, with the character Pogo saying – “We have met the enemy, and he is us.” While it still holds true in the context of mankind being the earth’s biggest enemy due to multiple reasons, I think the statement is strikingly true even when it comes to investors.

In market crashes, there is this unending search for who is to blame for it, and multiple theories abound on whose actions led to it. Every time the reasons for the crash are different in terms of the context of the economy, from Harshad Mehta to Technology Dot-com boom to Sub-prime crisis, but the culprits blamed are many, and the enemy is still not to be found. Investors lose money, get out of the market thinking that I cannot find the enemy here, I do not understand this game, and I am not playing it – in most cases, not quite realizing that the enemy can often be found within themselves.

The biggest enemy of an investor is the investor himself. And that has got to do with the emotions of fear or greed, and a lack of a plan (or if it exists, a lack of discipline to adhere to it). The reality is that investment is less about which stocks will rise or which funds to buy, and more about what is your plan and whether you are willing to stick to it. If the investor focuses his attention away from the markets and more towards what his plan is, with respect to his goals, he is making every effort to ensure that he stops being his own enemy. A simple plan that is not dependent on market movements charted out to meet his goals, and the discipline to adhere to it through thick and thin are his best friends.

We all play games like cricket or monopoly – and most players or teams will increase their chances of winning if they have a plan and stick to it. Some times one will have to make slight changes when unexpected things happen and your ability to withstand pressure will matter then, but the importance of a plan and sticking to it cannot be undermined and is paramount. For example, for a game of cricket, you may have a plan to go for the slog in the first 15 overs and then consolidate your position for the next 25 with wickets in hand, and then go for the kill in the last 10 overs. You may lose a few wickets more than expected, and have to modify the plan a bit, but if you still manage to hold on to the plan, you are more likely to reach your target. Or in monopoly, the plan is simply to buy sites, houses, exchange them for hotels, and wait for people to land there and keep paying you rent or buying it from you – so that you get rich. You may get unlucky, and someone else might get the prized sites sometimes, but there is a clear plan to take if you want to win.

In the investment markets, the reason most people are their own enemies is because they do not have a clear plan. So the answer is simple – figure out what strategy or strategies work best for you given your goals, make a plan around them, and have the discipline to stick to that plan. Market prediction becomes irrelevant when an investor has a plan prepared. Market movements help him then only to the extent of assessing if any actions are needed in the context of his plan when the movements happen – and in most cases, irrespective of whether they are up or down – they are likely to be more than welcome for the investor. The search for an enemy will then reduce, as he is likely to see none!

The psychology of happiness: Why money has little to do with it

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It is unusual for a large global investment bank to present research on the psychology of happiness as part of their Global Equity Research. But that is exactly what I found in this attached document from Dresdner Kleinwort Wasserstein.

If you are looking for investment related advice, read no further. Also, if you invest in the hope of being financially well-off – so that you will be happy one day – you perhaps will learn from a reading of this piece of rational financial philosophy. Because according to them (and well – no surprise perhaps for a lot of Indians or followers of Eastern Life Philosophy), Money is not the source of happiness – beyond the point of lifting you out of poverty and giving you the basic means of a decent life.

MoneyHappinessAnd the source of happiness (or as they say – the contributors of happiness) revolve around three factors. First – your genetic make-up which you inherit from your parents or family is a 50% contributor to your happiness. Some people are just genetically pre-disposed to being happier than others. Second – your life circumstances – things like demographics, marital status, income, health, religious affiliations – are only a 10% contributor to your happiness. And Thirdly – the remaining 40% is determined by intentional activities that you do to increase your happiness by focusing on your happiness one day at a time.  These activities include 3 types: behavioural i.e. habits like exercising; cognitive i.e. mind-related like consciously focusing on living in the moment; and volitional i.e. discretionary activities like devoting yourself to serving a cause.  Basically – you make 40% your own happiness by doing activities that increase them!

So there it is – the writing on the wall – from people who advise other people on how to make more money – telling their clients that, after all, it won’t make them happy. Happy Reading!

Happiness

Attention Surplus Disorder: Are you paying for paying too much attention?

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We have all heard of Attention Deficit Disorder – which refers to the lack of an ability to concentrate on an activity or task – something on the lines of low attention span. I have often been (and I guess a lot of individual investors will also identify with it) a victim of what I will call here as Attention Surplus Disorder when it comes to investments.

This is the state in which you pay so much attention to your investments (than is necessary) that it leads you to take actions that you should not or would not ordinarily take – if you were not paying surplus attention. With all the business newspapers, television channels, stock tickers, online portfolio statements, websites and email, there is a high likelihood that a lot of investors (and I refer to people who honestly start with an intention of long term investing, and not traders or speculators) are victims of attention surplus disorder.

A majority of the financial services industry and its revenue is essentially based on two sources: One is the size of your assets, and Two is the amount of your transactions. A third source, in a few cases, is a percentage of your profits. Most constituents that ordinary investors deal with make money based on a percentage of either of the first two. It is in their interest, therefore, that you either suffer from or are made to suffer from Attention Surplus Disorder – in the hope that you will then be motivated to do something that leads to either newer assets or newer transactions.

So all the clutter (a.ka. analysis, views, news or similar) to get your attention to your portfolio and to the markets – with new technical and fundamental analysis everyday, how which stock is best to sell now or buy now, or how some mutual fund beats the index this month, quarter or year versus some other last year, month or quarter; or how you should add new asset classes to or change your asset allocation of your portfolio – and much more – are all essentially noise that gets your attention, and leads you to become a sureshot victim of attention surplus disorder. It is likely to take an ordinary investor a lot of education first, and then a lot of will power and discipline next, to get himself into a position where he escapes becoming a temporary or permanent victim of attention surplus disorder.

Why the emotion of loss aversion could kill your returns

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Risk (or uncertainty) in equities is often measured by the degree of volatility. While this is a measure that may have some utility for portfolio management (specially if one has a need to exit positions in case of price drops), I have often felt risk in investing is best measured as the probability of permanent loss of capital. That is because, it is not risk or uncertainty that investors really fear, but losses (notional or permanent) as measured by decrease in capital value that they are afraid of. Any volatility in market prices that does not result in notional losses does not affect the investor (emotionally) precisely because of this tenet.

lossaversionThis is demonstrated aptly by the concept of ‘Loss Aversion’ in behavioral finance – the field of study that analyzes the impact of emotions on investing behavior. The key tenet is that human reactions to the probability of profits and losses are different. We become conservative when faced with profit chances, and take undue risks when faced with prospects of loss.

Consider this scenario – where you have Rs.10,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed gain of Rs.5000/- OR (b) Choose to toss a coin – if its heads, you gain Rs.10,000/- and if its tails, you gain nothing. Which option will you choose?

Now Consider another scenario – where you have Rs.20,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed loss of Rs.5000/- OR (b) Choose to toss a coin – if its heads, you lose Rs.10,000/-, and if its tails, you lose nothing. Which option will you choose?

It is likely for majority of people to choose option (a) in the first scenario, and option (b) in the second scenario. Why is it that in the first scenario, we are not willing to take a chance on more profit, even though we lose nothing, while in the second scenario, we are willing to take a chance to reduce loss, even though we may lose more? That is because, in the first scenario, we have guaranteed profit, so the pleasure we get out of more profit is high, but not as high as the pain we will suffer in case that profit goes away, and we are not fine with the prospect of remaining at status quo. Whereas in the second scenario, we are faced with sure losses, but we are willing to take the chance, even though those losses could actually double, because of the possibility of not having to lose anything. Again the pain of loss is so high, that we take higher risk, just to get back to status quo, even though we could possibly face even higher losses.

lossaversionProspect theory IIISo in case one is unable to keep emotion out of investing, and unable to handle market declines with a calm and rational mind, this is a key emotional or behavioral takeaway that one will do well to remember: we like profits, but we hate losses even more. So when faced with possible losses, we are prone to take higher risks to avoid the possible loss, but when faced with possible gains, we are prone to lock in our gains without taking risks.  Therefore, most investors will end up booking profits early and riding their losses rather than the other way round. Selling losers because the fundamentals have changed is one of the most emotionally painful things for individual investors to do. Well -if you genuinely believe in a company’s earning prospects and valuations and are able to keep your head, it is prudent to hold and even buy more during falls, but one must be aware that – that is the real reason for one’s actions, and not the loss aversion tenet at play.

So, in conclusion, are people risk averse or loss averse? It is not that people do not like risk or uncertainty so much, but it is pretty clear that they hate losses a lot, much more than they love profits. Awareness of this tenet will perhaps help investors to decide truthfully on the best way forward specially during price declines when the stomach is churning and the heart in fear, and use their head to take a rational rather than an emotional decision. As the popular Indian ad says, “Darr Ke Aage Jeet Hai.”

Book Synopsis: The Millionaire Next Door

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This is the title of a famous book that was a result of multi-year studies and research done by Dr Stanley and Dr Danko to discover the profile, lifestyle and habits of America’s wealthy households and how they became wealthy. The title is intriguing as they say, because initially they started their research by surveying people in upscale neighborhoods across the United States, and in time, discovered something odd. That many people who live in expensive homes and drive luxury cars do not actually have a lot of wealth. And then they discovered something even odder: many people who have a lot of wealth do not even live in upscale neighborhoods.  A lot of people with high incomes who live there actually have a lot less wealth than they should. And a lot of people who are really wealthy – do not look like they are, hence the name – the Millionaire Next Door.

the-millionaire-next-door-book-reviewThe definition of wealthy for the purpose of this research is important to understand. Obviously one criteria is the actual net worth number. The nominal cutoff was households with a minimum wealth of 1 million USD. But their intention was to research not the mega rich, so they dropped the ones with households of wealth greater than 10 million USD. About 95% of millionaire households in the United States had a net worth between 1 and 10 Million USD (in the mid 1990’s when this was published), and that was the focus of this survey. This is typically the level of wealth that, in their view, could be attained by many working class regular Americans at that time. I am sure something like this can be extrapolated to other countries too like India, with the nominal figures a bit different, but broadly similar distribution statistics between the “mega-rich” and the “ordinarily wealthy”, and perhaps, a similar set of findings.

Another way “being wealthy” was defined is one’s expected level of net worth, in comparison to one’s age and income. Multiple your age times your pretax household income from all sources except inheritance. Divide that by ten. This, less any inherited wealth, is what your net worth should be. To be comfortably well positioned as a prodigious accumulator of wealth, you should have twice the level of wealth expected.

So taking both the nominal (absolute) and relative definitions of wealth, this survey was done almost over a period of a decade from the late 80’s to the early 90’s.

So what were the key findings of America’s wealthy households? Is there a typical portrait of a millionaire household? Is there a set of factors that contribute to their being wealthy? The answer is Yes – there is a prototypical wealthy household, and a set of lifestyle patterns they follow that is conducive to building wealth. Here are a few of them:

1. Typically male lead earner of the household (>75% of income), became wealthy in his early fifties (i.e. when he could retire without income), Lived well below means throughout working life, Very frugal towards consumption

2. 65% either self employed professionals or own a small business, <25% from the high income employed group

3. 50% wives do not work (number one occupation of wives who work is a teacher, working wives contributed to 25% of household income), wives are meticulous planners and are prepared to live on a budget

4. Household income is 7-8% of current wealth (so lives on only 7-8% of net worth)

5. 97% are homeowners, and have lived in one or maximum two houses for the past twenty years or more

6. 87% are first generation affluent, their parents did not provide them with anything materially substantial in their adult life till they died (inheritance)

7. Change cars on an average once in 6-7 yrs (79% buy them without lease), Highest spend of income is on children and grand children education

8. Fastidious investors, invest 20% of income for over 10 yrs, 79% have 1 or 2 brokerage accounts, make own investment decisions, 25% of wealth in publicly traded securities and mutual funds, rarely sell (42% did not have any sell transaction in past 18 months, average holding period of 7 years), 21% of household wealth in their business

9. Save 35% of earned income, live in a neighborhood where they have typically 5 times the wealth of their neighbors (non-millionaire neighbors outnumber them three to one)

10. Their adult children are economically self sufficient, and they do not intend to provide any economic support to their adult children till they plan inheritance

11. Are proficient in identifying market opportunities, niches and chose the right profession, that they have been pursuing for long periods of time

In summary, 80% of the millionaire households are ordinary people who have accumulated their wealth over one generation. There is a set of patterns related to their lifestyle and habits that are conducive to wealth building. As they say, while there are a hundred paths to Nirvana, but if one adopts some of these, it is more likely than not, that one will find oneself being a Millionaire Next door – not in a hurry, but slowly and surely!

Guru Speak: Walter Schloss, Truly conservative value investing

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Among the famous investors of Graham-and-Doddsville that Warren Buffett refers to as ‘super-investors’, the most conservative yet in no small measure less successful was Walter Schloss. He was perhaps the closest to what was commonly referred to as ‘cigar-butt’ investing, and someone who perhaps followed the bargain hunting principles in stock picking perfectly and over the longest period of time with highly successful results.

“Over the entire 45-year period from 1956-2000, Schloss and his son Edwin, who joined him in 1973, have provided their investors a compounded return of 15.3% per year…Every dollar a fortunate investor entrusted with Schloss at the start of 1956 has grown to $662 by the end of 2000, including all charges for management.  A dollar investing in the S&P Index would have been worth $118.”*

walter-schlossA lot has been said about the legend and his style of investing – a very simple style based on buying depressed stocks trading close to book value, of companies with some record of reasonable performance and with little or no debt. His famous lack of interaction with management because “I am not a good judge of people” and dependence on buying something that is so cheap that “something good will happen” are largely responsible for his success. The sheer conviction and high degree of comfort that Schloss had on this approach that he consistently followed with his son for over 40 years to give results surpassing most traditional investors is almost ascetic.

“Their office – Castle Schloss has one room – is spare; they don’t visit companies; they rarely speak to management; they don’t speak to analysts; and they don’t use the Internet. Not wanting to be swayed to do something they shouldn’t, they limit their conversation.  There is an abundance of articulate and intelligent people in the investment world, most of whom can cite persuasive reasons for buying this stock or that bond.  The Schlosses would rather trust their own analysis and their long standing commitment to buying cheap stocks.  This approach leads them to focus almost exclusively on the public financial statements that public firms must produce each quarter.”*

* from the book “Value Investing: From Graham to Buffett and beyond” by Greenwald

Their approach to investing is something that any individual investor with conviction in it can follow with reasonable effort and study – with no need to predict the future or understand businesses beyond a point; but with only a single objective of weeding out companies to find price less than value.

Here is a valuable document that Walter Schloss shared a few years ago, when asked about how he goes about making his investing choices –  a clear and simple set of golden rules of the Walter Schloss style of truly conservative investing.

Walter Schloss and 16 golden rules of investment

Is your house an asset?

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Opinion is divided on whether your house is an asset based on who you ask. Some financial planners recommend that you make your investment plan first, save for a house, buy it only when the rent vs buy equation makes complete sense, and treat the monthly payment as a pure expense (after accounting for tax deductions). Some others say that a house is an investment, and even better than stocks as it is not risky and volatile, and you generally will not lose your money there.

houseasset

Like most matters in finance, there is no single answer – but here is an attempt to simplify the thought process. In pure accounting terms, a house is an asset on your books, funded partly by the loan liability. The real question that should be asked is whether it is a good investment? In most cases, it turns out to be a good investment, simply because the asset on your books appreciates faster than both the cost of your liability and inflation. But whether it really happens at a rate where it qualifies as a good investment depends on a multiple set of factors.

(a) Price that you paid for it: Like economic cycles, housing goes through boom and bust cycles, though not as severe as stocks. Hence, the price at which you buy a house is paramount, like all other investments, in deciding whether it will turn out to be a good investment. As it is a high value asset that most people hold for a long time, most people pay much more attention to the price they pay for a house, versus what they pay for a stock. But nevertheless, it is still the single most important factor in determining if it will turn out to be a good investment.

(b) Loan to Value ratio: Leverage (or mortgage) has a definite role to play in the house purchase. The higher the loan component, the higher the chances that the investment will be not be lucrative in a short period of time. The more you can put down in payment, the more (and earlier) you are converting your cash into a share in an asset that will eventually fight inflation.

(c) Your cost of funding versus inflation or expected rate of growth: If the expected rate of return from a house is about 1-2% more than the rate of inflation, and the cost of funding is lower, that is a perfect scenario where buying a house using borrowed funds will turn out to be a good investment. Specially over longer periods where the power of compounded asset value will surpass the cost of the loan liability.  And if one regularly prepays it in the initial stages, one will save lots of interest in the long run.

(d) Last but not the least, where does it fit in your asset allocation: Finally, as compared to your income and net worth, the proportion that you have locked in a house will also determine how comfortable you are with buying the house, the more likely it is that you will take a financially sound decision, hence increasing its chances of working out as an investment.

So overall, multiple factors will go into deciding whether a house will turn out to be a good investment. In a best case scenario, buying a house at a reasonable price with less than 75% leverage at a leverage cost less than or close to inflation, and ensuring that it does not account for more than 40% of assets is almost a sure-shot recipe for a house being a great investment. For most mortals, it may not turn out to be that rosy – in which case one or more of these parameters are likely to get stretched, leading to some financial bleeding, at least for a while.

In general, irrespective of the pure financial matters and even discounting the emotional security it provides, a house is definitely likely to be a worthwhile investment for most normal individual investors if they are prudent in ensuring they balance the above factors in their purchase. As most house purchases are held for long periods, they invariably turn out to be good investments standalone.  They may lead to some missed opportunities due to locked capital, but that’s another matter. After all, I never saw a house owner of 10 years saying I really regret having bought my house. And there’s no dearth of stock owners saying that!

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