Ranjit Kulkarni

Ranjit Kulkarni is an author with a penchant for portraying characters from the real world and weaving stories around their apparently mundane lives. He is the creator of Jigneshbhai and Swami. Born and brought up in Mumbai, Kulkarni spent his childhood in the environs of urban, middle-class India. As an adult, he’s travelled the world, exploring the cityscapes of America, getting lost in the natural beauty of Europe, and absorbing the tastes and sounds of Asia. With his constant knack for observation and a deep seated fondness of reflection, he loves crafting tales that entertain and provoke thought. When not writing, Kulkarni loves reading and going on trips with his wife. He is an avid traveller, a passionate investor and a devoted student of spirituality. He loves ice-cream and chocolate too. He lives in Bangalore India.

Selecting Mutual Funds for Investment: What to and What not to look for

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For the equity part of their portfolio, individual investors have the choice of either directly buying stocks or following the equity mutual fund route. Many individual investors, including myself earlier on in my investing life, make the mistake of evaluating mutual funds similar to stocks. The way to evaluate funds is quite different from evaluating stocks for investment.

whichmutualfundWhy is that? While direct stock investment involves researching and valuing businesses, and buying/selling them at the right price, mutual funds are pools of stocks where the fund manager takes those calls. Hence, what is important to evaluate is the ability and track record of the fund manager to take those calls, and whether that results in performance that is worth paying a fee for. The markets already do stock selection for you in the form of an Index for free. So what the fund investor needs to evaluate is whether the fund manager is worth paying the fees to – so as to get returns that are better than the Index on a consistent basis.

What to base your decision on:

Mandate: As mutual funds are a vehicle and have a role to play in the portfolio, it is important to ensure that the mandate of the fund is in line with your objective, and that the fund has a record of sticking to the mandate, despite changes in ownership or fund managers.

Costs: The disadvantages of high costs of research and fund management can tend to surpass the advantages of better performance of actively managed funds, specially over long periods of time. So choosing funds with low costs is important. Index funds typically have the lowest costs, and guarantee returns in line with the Index. So an actively managed fund’s higher costs need to be compensated by its better long-term performance.

Performance versus Index: This is often exaggerated as a standalone metric, specially over short periods of time. An investor should resign himself to the possibility of even his best fund choices not being the top performer at least some of the time. Even the best performing funds over long periods of time will have periods of under-performance. It is also difficult to predict which fund will deliver better performance in the future, even though it may have done so in the past. So rather than constantly shifting to the best performing fund, it may be better to choose one that has a record of beating the Index or being in the top 10% most of the time, and sticking to it over long periods.

choosingmfWhat not to base your decision for:

Price: The price or NAV of the unit is completely irrelevant, and depends largely on the starting point of the fund. This feels counter-intuitive to most individual investors, and takes a while to understand. An investor should not even look at the NAV of the fund or compare it to others before purchasing it.

Dividends: Dividends paid by the stocks held by the fund are reflected in the NAV. Dividends paid by the equity mutual fund are simply a reflection of profits booked by the fund for you and paid back to you. Again this is counter-intuitive for most investors to understand, and lot of fund companies perpetuate this fallacy by marketing their funds based on historical dividends paid. An investor has no reason to feel anything positive about a fund because it pays dividends regularly. If at all, it may even be a negative specially if the fund is booking profits prematurely and not in line with the mandate of compounding capital appreciation.

So broadly, while choosing individual equity mutual funds to fit into his portfolio, the individual investor should neglect price and dividends, and evaluate funds based on adherence to mandate, low costs, and consistent performance versus index; and based on the same, construct a diversified mutual fund portfolio to meet goals.

Gold and its Glitter: Role of Gold in Portfolio Asset Allocation

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“You can fondle it, you can polish it, you can stare at it. But it isn’t going to do anything.”

That’s what Warren Buffett had to say about gold. Essentially it is a useless commodity. But it has gone up every year for the last 10 years. It has given returns that are, perhaps, better than almost all asset classes over the last decade, including stocks and real estate.

goldimagesFor investors like Buffett, having gold in their portfolio may not make sense, but for an individual investor, it might make some sense to have a part of his money in gold. The reasons are not far to see.

As an asset class, gold is a funny asset which is difficult to understand and value. It has no inherent value as such. Neither does it produce anything useful, nor does it go as input into producing anything useful in a meaningful way.

Gold is different from other metals or commodities. To some extent, commodities and metals have material value as inputs to something, and their prices can vary based on supply and demand cycles. You may not like the extent to which they may fluctuate, but at least there is some basis on which someone can say that it does not make sense to pay so much for a particular commodity, or that it is cheap at a particular price.

Gold is also different from stocks – which are productive business activities and have the potential to give you both dividends and capital gains if selected well. There are multiple ways in which you may value stocks or companies, but there is a clear economic rationale for each of these. Opinions may never reach a common point, due to which you have markets and all the related volatility, but at least one can have an opinion based on a method of valuing stocks or businesses on their own.

Gold is different from real estate too – in the sense that one can broadly estimate the cost of constructing a property including land and material prices as the base minimum value,  a potential rental income based on economic conditions as the minimum rate of income return, and add capital gains which are broadly in line with inflation as the long-term returns from real estate. It is possible to, at least, broadly value it.

It is even possible to value currencies – based on the country’s macro-economic situation and speculation on what might happen.

goldeggimagesBut Gold? How does one value it? It is just there. One can calculate the cost of mining it as the base – but it is far too low, and not increasing at the rate at which gold prices are. Gold has historically been a hedge against almost everything. Most of the time it is useless as a productive asset. It may at best match inflation, thereby growing at a rate at which currency falls. But in times of crisis, it tends to become a currency of its own. Specially when people want to sell all their stock and run (not exactly that – but are jittery in general), are not confident of real estate prices going up due to some reason, and also do not believe in the value of currencies due to huge economic problems, the thing they seem to rely the most on is Gold. For some reason, some of these fears have been around in the global economy for the past few years, and perhaps will stay on for a few more. So Gold has risen, and may keep doing so – till those conditions continue.

Individual investors should still have stocks, real estate and cash/fixed income as core to their assets. But have a bit of gold too – anywhere from 5% to 20% based on your preference. A chaotic environment favors gold, and if it subsides, you anyway have the other assets. Gold will help provide some stability when others are unstable. Purely as an insurance and for diversification, there is still some truth in grandma’s advice to buy some gold.

The Projection and Protection Approaches to Stock Selection

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“Researching and selecting your own stocks is not necessary; for most people, it is not even advisable. However, some investors do enjoy the diversion and intellectual challenge of picking individual stocks – and, if you have survived a bear market and still enjoy picking stocks, then nothing that Graham or I could say will dissuade you.”

That’s a comment made by Jason Zweig on Graham’s writings on Stock Selection Criteria in his legendary book “The Intelligent Investor”.

With this backdrop in mind, assuming that you still want to take a shot at individual stock selection, there are, perhaps, two broad mindsets or approaches towards stock selection – the approach of projection and the approach of protection. And which approach to apply when, is dependent on the investor and the object of analysis, namely the company, itself.

The stock selection criteria that the investor chooses therefore is a combination of three factors: Firstly, fundamentally what type of investor you want to be, Second, what bucket of the market does the company you are considering belong to, and Thirdly, whether you should apply the projection or the protection approach.

past-present-futureJust to clarify this a bit further, here it what this distills to.

If you have made a choice to be a ‘defensive’ investor and still want to select individual stocks, your attention should largely be restricted to the small universe of companies that have adequate size, performance history and dividend record. Some degree of projection can then be applied, simply because there is a long historical record on the basis of which projection can be justified. You are unlikely to get these companies selling really cheap, except in exceptional circumstances, because they are likely to be established good businesses that the market values at a premium. These would generally include Index or Large Cap Non-Index companies. So, your attempt should be to purchase good businesses of adequate size and historical performance (i.e. high margins and return on equity, low debt compared to equity, and dividend paying record), when they are available at reasonable valuations.  The mindset being that of projection that these companies will continue with the same in the future.

If you have made a choice to be an ‘enterprising’ investor, your choice of stocks can, then, be from an unlimited universe. The same criteria of projection will continue to be applied by you when looking at large, established good businesses. But once you step out of that bucket of the market, your mindset needs to be essentially that of protection rather than of projection.  Purchases in these businesses should be made when the downside is protected both from an earnings and assets perspective (Low Price/Earnings and Price to Book Value), thus using the approach of protection.

The largest mistakes that investors make are not of buying good businesses when market levels are high, or buying not-so-good businesses when market levels are reasonable or low. But they are when they buy not-so-good businesses at high market levels and are stuck with them. i.e. applying the projection approach on non-established businesses. Hence, outside of the ‘projection’ bucket of the market, the mindset of protection should be dominant – the primary assumption being that, in normal course, most of these businesses are likely to be non-existent after a few years.

Broadly the approach of projection boils down to buying good businesses at reasonable prices, and the approach of protection boils down to buying reasonable businesses at good prices. It is debatable which one works best in terms of investment results – but it is disastrous when an investor mixes the two.

Are Markets Efficient and does it matter?

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A lot of investing debate and styles of investing are supposed to emanate from this question. The roots of this debate are in an old financial theory called the Efficient Market Hypothesis – which says that all that is to know about a stock is reflected in its price at any point in time, so it is futile to analyze stocks as no one can do it. The very theory challenges human nature so much that it is no surprise that, depending on who you are and what your place is in the financial services industry, you are almost compelled to take a view on it – one way or the other.

marketefficient-garfield_dont_care_black_shirtBut for an individual investor, is it really relevant? Does it matter whether markets are efficient or not, or is it just another debate to confuse him? Again – like so many other things in investing, this may be a great question for experts to debate on, but for an individual investor, a wrong question with many right answers. For an individual investor, letting go on this debate on whether markets are efficient is the best choice. “I don’t know” and “It doesn’t matter” are the best responses. The answer to this question is said to determine whether you as an individual or a fund manager who manages your money can beat the market or not. Again – this is perhaps the wrong question. What if I decide that the markets are efficient and hence invest in Index funds, and then later (at the end of  a year or two) realize that there are lots of funds beating the Index? On the other hand, what if I decide the market are not efficient and hence invest in an Actively Managed fund or decide to manage my money myself, and then later realize that it has not beaten the Index? In other words, the market turned out to be not efficient, but so did my fund manager and my investing techniques!

So actually the prudent answer for an individual investor to the question on whether the markets are efficient or whether I or my fund manager can beat the Index is “I don’t know and it doesn’t matter”. Because the reality is, irrespective of whether they are efficient or not, it is practically impossible to predict in advance whether and/or which stock or which fund manager will beat an Index. Hence – “I don’t know and it doesn’t matter”. Well – I don’t know is fine, but an individual investor may ask why “it doesn’t matter”? It doesn’t matter because what matters more is to have an investment plan, asset allocation and re-balancing strategy in place. What forms part of those assets once you have a plan in place does not matter that much. So whether you choose an Index fund, or an individual stock or an actively managed fund within that asset allocation and re-balancing plan based on your answer to the question “Are markets efficient” may not matter much, at least if you are broadly close to market averages, and in so far as reaching your financial goals are concerned.

So – leave the debate of whether market are efficient to the experts to fight over and resolve. Post that, let them decide whether to focus on large caps versus mid caps; or to use fundamental analysis or technical analysis. For you as an individual investor, what matters more is a proper investment plan to reach your goals that is in line with risk profile, has the right asset allocation and re-balancing strategy in place, and the discipline to stick to it. Post that, you are free to keep deciding what assets to put into that plan, based on performance every year or every couple of years. If the markets turn out be efficient, you are free to move the actively managed fund and individual stocks out of that plan, and hold an Index fund.  If the markets are not efficient and you end up with a good fund manager (or if you yourself are able to beat the market) , good for you, as the stocks and funds you hold may beat the Index. And finally, if you realize that markets are not efficient, but your investment style or fund manager turn out to be equally inefficient :-), you are free to move that money to an Index fund!

So let the debate on Market Efficiency continue, and let the experts argue and make a case for your money. You as an individual investor are in an enviable position, because when asked your view, you can continue saying – “I don’t know and it doesn’t matter.”

Sunk Costs should not affect decision making

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I had gone for a music concert yesterday evening with my wife. It was a great show – but it rained quite heavily a couple of hours before the show, and there were real chances of the show getting cancelled due to it. While at my house before starting, it was natural for us to think whether the show would happen, and if we should go – specially the distance being long, and traffic chock-a-block while the drizzle had subdued a bit. But the one thing that tilted the decision in favor of going was the fact that we had paid for the tickets in full already.

sunkCostSo what’s the point? Well – the point is that the fact that we had paid for the tickets should not have been the deciding factor. If the rains were heavy, and we had no chances of making it – that alone should have been the criterion. Because the money was gone anyway. It was a different matter that in the end the rain stopped completely, we got there on time despite the traffic, and the show was superb, and hence the risk was worth it – but sometimes it may not work out that way. And even if it does, the reason we took the decision should have been based on whether there was any risk in going or not – rather than because we had paid for the tickets. This is a common ‘sunk cost’ fallacy that a lot of investors are victims of.

Pretty similar situations are likely to arise very often in an investing lifetime. If you are stuck in a situation where a stock you bought falls a lot, assuming you are able to handle the notional fall, your immediate urge is to ‘average the price’ and takes over your thinking. In some cases, it may be the right decision, in fact over time, it may work out and end up being a smart move. But very often, the fact that you bought the stock earlier at a higher price weighs so heavily on you, that you do not evaluate, in enough detail, whether the fundamentals of the company have deteriorated, and if there is a higher risk in buying the stock now, even at the dropped price. There may be real reasons for the fall – and hence averaging out may not be the best strategy. But the ‘sunk cost’ trap comes into play, and affects your decision-making, urging you to average out – rather than buying as a result of a more rational analysis where a purchase at a lower price is deemed to be a sound investment decision irrespective of earlier transactions.

Similarly, assume that you are faced with a situation where you bought stock A and stock B for an equal amount, and a year later, you need 20% of the money invested for some reason. Stock A has gone up 30% and Stock B has fallen 10% by that time. It is likely that you will try to meet your requirements by selling Stock A – simply because you bought it at a lower price and it is 30% up. Again – that may be the ‘sunk cost’ phenomenon at play. The ideal way would be to evaluate the stocks again and then take a call on which one to sell in what quantity. If that is not possible, perhaps selling both to raise an equal amount may be a more rational decision. But the sunk cost paid for the stock weighs so heavily on the mind of the investor that it affects his decision-making, and more likely than not, he will raise money from the stock in which he is in at least some profit.

So what’s the way out of avoiding sunk cost traps? Looking at individual investments in isolation is the problem here – looking at the portfolio as a whole will likely lead to avoiding sunk cost traps. Re-balancing the portfolio (i.e. selling part of your winners and moving them to other assets) is a great long-term strategy, but only if it is set out as a deliberate strategy, and not if it is a result of a sunk cost trap. Hence, it is best if one makes a conscious effort to recognize the sunk cost behavioural trap, and ensure that decision-making is not being affected by the same. Like so many things in investing and finance, unfortunately, there is no clear answer here – on what exactly to do – but it is left best to an investor and his situation to come to a conclusion based on a clear awareness of the possibility of getting into a sunk cost trap.

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

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