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

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

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.”

Is your house an asset?

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.

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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!

How should I select which stocks to invest in?

In the area of finance and investing, like many other fields, the questions you ask are perhaps more important than the answers to them. But again in this area, even the simplest of questions can have a variety of complex answers. So something as basic as how should I decide which stocks to invest in – can have multitude of answers. In my view, this kind of question will, perhaps, have at least 3-4 questions as its answer to start with, when asked to an expert. When individual investors ask this question (or of a similar kind) to a financial planner or an advisor or an expert, the investor is most likely to get either unclear answers with a number of riders; or a set of additional questions like how long can you hold, what is your risk appetite, etc. And do not get me wrong. These are perfectly valid questions from the point of view of the advisor, as the expert is trying to assess the investor before giving a customized answer. But it will still leave the investor confused – specially the next time he wants to take a similar decision on selection on stocks. So, I am going to try and attempt simple answers to this question in this note.

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My first answer is – if you can help it, do not invest in stocks directly at all. Invest in an index fund instead (or if you like a fund manager – invest in an actively managed well performing fund). Despite that, if you still want to invest directly in stocks, my second answer would be restrict yourself to the Index stocks or the top 50 stocks by market capitalization, and simply construct a portfolio by buying companies that have high return on equity, low or no debt compared to equity, high profit margins over time and consistent dividend paying history; and buy them when their valuations as measured by Price to Earnings or Price to Book are lower or reasonable compared to long term averages. And better still, buy them regularly over time to build a portfolio.

Beyond this, if you still want to expand your universe of stocks, then the only reason you need to go outside the top stocks by market capitalization is if you can beat the index. And for that, you will need hard work, continuous research, adoption of an investing approach that is not followed commonly and lots of patience. Once you decide that you are prepared to do that, I think the parameters you look for in stocks for investment change. You then enter a territory where there is lack of credible historical performance, unpredictability, unproven business models and perhaps low liquidity. You are then buying a promise for the future, and your interests are then best served if you strictly buy value. In such a scenario, you should then look for stocks that are cheap in relation to assets and/or earnings. And cheap would mean different benchmarks depending on margins, growth expectations and debt – but essentially the focus should be on buying cheap.

So in a nutshell, the simple answer to this question of ‘how do I select which stocks to invest in?’ is firstly this – do not do that selection at all, leave it to the index or a fund manager who is smarter than you and the index. If you think you are smart, go ahead and buy index stocks over a period of time – you are then buying into good businesses at reasonable prices. If you think you are even smarter, go ahead and buy stocks outside of the top stocks family, when they are cheap by earnings and asset measures – you are then buying into reasonable businesses, so be sure you get them at a good price.

Using this simple framework, you will perhaps be in a position to answer this question on ‘how should I select which stocks to invest in?’ Though not precise, but at least, I hope, it provides a decent guideline to arrive at a stock selection decision.

Why age based asset allocation is mostly wrong

I have often heard a lot of financial planners advise an asset allocation strategy based on the age of the investor – something on the lines of invest 100 less your age into equity or similar. While the broad logic of this strategy is that with increasing age, the capacity of an individual to earn himself out of a market crash reduces, purely age based asset allocation might, like many other things in finance and investing, be the right answer to the wrong question.

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A student who has taken an education loan or a young married person saving for the down payment of a house can hardly justify investing 80% of his savings into equity, while a middle aged double income couple with their mortgage paid off or a retired millionaire with 20 more years of life would be foolish to invest majority of their net worth in fixed income. In fact, it would be risky for the youngster to put 80% of his savings into equity if he gets caught in a market crash when he needs the money for his house; and equally risky for the retired old man to depend on his fixed deposits to face 20 years of inflation.

I have found that asset allocation percentages need to be an output determined by life circumstances, net worth, current income, overall risk tolerance and age. Age can be a good determinant of some of the above, but it is too simplistic to assume that it is the only one. In many cases, it is not – and hence, it turns out that portfolios are more conservative or riskier than they should be. Historical data suggests that the possibility of losing money in equities over a 10 year period is quite low. Hence the equity percentage of the portfolio must largely depend on the ability of the individual to, more or less, forget his money and ride out a period of 10 years with no need for the money put in equity (and perhaps, put more into equity, if required during crashes). Now this ability is something that depends on factors like risk tolerance, current income, net worth, temperament and life circumstances, of which age is just one determinant.

The more you have of this ability, the more should your asset allocation be comfortably tilted towards equity. And age has, perhaps, little but not much to do with it.

Is Financial Independence an End in itself?

I have often wondered, specially when I read a lot of financial planning related articles, whether financial independence is an end in itself. A lot of financial planning is geared towards basically creating a corpus for a goal like retirement which can replace your current income stream in inflation adjusted terms. And it is all good when they profess getting out of debt, preach high rates of savings that are put in a manner across asset types to provide returns that enable oneself to reach that goal.

But I sometimes wonder whether financial independence can really be defined? And while the pursuit of that has been one of the key motivators of my life, I have sometimes wondered whether that pursuit of a financially free tomorrow has left me in chains today.money-vs-happiness

That’s where I realized that, perhaps, the goal of achieving financial freedom is not an end in itself. And while it is good to have a financial plan and work towards it (in fact, highly recommended for most individuals), a blind following of the same, specially without purpose, may be closer to slavery than to freedom. Also, I think the point of financial freedom can, perhaps, be defined to be the one where the marginal utility of having more money diminishes in the eyes of the individual. And this point is likely to be different for different individuals. Basically, from that point, 5 times more money will not make one 5 times happier. You may still continue to chase money beyond that, but in non-financial terms, you are already free from that point. I guess if an individual can carefully assess what that point is for himself, it would serve him well to make financial independence a good journey rather than a destination in itself.

So by all means, the pursuit of financial independence is a very worthy goal, but if one adds to it, a purpose as to why one wants to be financially free, and determines a point at which the marginal utility of money keep diminishing – the journey can be truly fulfilling and make life itself much more rewarding.

The Financial and Psychological Benefits of Rebalancing

I have always felt that individual investors (or perhaps any investor to some extent for that matter) have never got a complete handle of the decision on when to sell. Traders or speculators mostly have a fixed target for profit or stop-loss, but investors never seem to enter a stock with a clear exit goal.

rebalancing

Rebalancing as a strategy might provide answers to solve this quandary – more than anything else for the individual investor. At a portfolio level, it provides you with a clear answer on when to sell, and, if required, it can be translated and implemented at an individual stock level also by more mature individual investors. Setting asset allocation limits at various levels in a portfolio can provide you with clear triggers on when to sell. So then, you stop asking yourself questions like – should I sell stock A at this price or wait for some time – questions which have no clear answers anyway. On the other hand, that answer is provided at an overall portfolio level, based on allocation limits.

For example, to provide a complex set of rebalancing rules, consider the following: If you determine that equity will account for 60% of my portfolio, and within that, large cap stocks will account for 50% of the holdings, and then no industry will account for more than 25% and no stock more than 10%, then it becomes easier to take decisions on what and how much to sell when these allocation percentages go out of whack. And if you are not a direct stock investor, but take your exposure through mutual funds, it gets much easier than the above scenario, assuming that your fund manager is dealing with the rest. Therefore, ‘I bought stock A at X, should I sell it now at this price Y’ becomes a wrong and somewhat irrelevant question, and thankfully so.

Of course, rebalancing is not a strategy that guarantees the highest returns. In certain cases, you may end up selling your winners, which in hindsight may not feel great. But for individual investors, who may have no particular reason to feel a sense of conviction about a specific stock, it provides a good way to reduce or manage risk. I do not think at a mathematical level, rebalancing has a very high impact on returns, but it sure reduces risk of excessive falls and locks in some of the profits. And if done correctly, it will also ensure that you buy equity at a time when every one is running away from it – in which case rebalancing affects your long term returns too.

An important effect of this strategy might well also be at a mental or psychological level – because an individual investor feels he is in control and has been smart to book profits when his portfolio grows and to buy stocks when they were low in price.

Therefore, less for returns, more for managing risk, and most importantly for the psychological advantage of getting emotion out of buy/sell decisions, rebalancing is a crucial strategy for portfolio management for individual investors.

How to use Diversification to reduce 3 types of risks

The core objective of diversification is to reduce risk – the idea being that peaks and troughs in a specific investment does not affect overall portfolio return objectives.

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If one defines risk less as volatility, and more as a either a complete or partial, but permanent loss of capital, then an individual investor would be well-advised to consider diversification to reduce risk of a few primary types:

1. Asset Market or Systematic Risk: What if I am invested in the wrong asset class or market? This is best reduced by a prudent asset allocation decision. Investors should identify different types of asset classes that they want to be invested in along with ideal target percentages in each asset class. This will minimize the impact of being invested in the wrong asset class.

2. Unsystematic Risk: What if I choose the wrong stock or bond or property? This is best reduced by investing in a pool of candidates within the same asset class. So if it is equities, it is best to be invested in a bucket of unrelated good businesses, or in commodities or real estate, again try and be invested in unrelated asset candidates. This will minimize the impact of being invested in the wrong securities.

3. Timing risk: What if I invest at the wrong time? Well – you may have a well-diversified pool of securities in a well adjusted portfolio of asset types, but what if you invest at the peak of the markets? This is best reduced by making periodic investments in the assets of your choice, so that timing risk is reduced. This will minimize the impact of being invested in any asset at purely the wrong time.

For individual investors, more than chasing returns, if prudence is exercised in constructing a portfolio with the objective of reducing risk of the above three types, there are good chances that the returns will take care of themselves.

Is direct stock investing worth it or should mutual funds do?

Assuming that I want to “invest” in the stock market, and not “trade” or “speculate”, getting average market returns is a no-brainer. I just need to buy an open-ended index fund or an exchange traded index fund, and I am done. At the lowest cost, I am guaranteed returns that the market index will give – day on day, month on month, year on year.

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Why, then, should I be even interested in investing in actively managed mutual funds? There can be only a few reasons for that. First – they give returns better than the index after deducing costs.  Second – I want an exposure to companies outside the index in a specific market cap or sector or style that I am bullish about. So it may make sense to supplement my index fund holdings by some actively managed funds that suit these requirements.

After that, why should I directly invest in stocks? Is it really worth the time and effort? There are few reasons when it may make sense. First – I am a better investor and can beat markets consistently. Easier said than done, but if that is the case, there is no reason I need to invest through the fund route. It is likely to take sufficient time and effort, but if indeed one can beat the index, why depend on mutual funds? Second – I want to invest in some businesses that are either small or in under-researched sectors that funds are not allowed to, or not able to invest in. There is a section of the market that institutions are not interested in. An individual investor who understands those businesses and has conviction on a particular company, has an advantage by investing directly. Third – this is perhaps due to the structural constraints of mutual funds. Due to the inherent requirement of funds to keep beating the index, some great businesses cannot be held by funds for long periods of time. For example, a mid-cap fund has identified a great mid-cap company, but once it becomes successful and actually becomes large-cap, the fund has to sell it. Or, during a market crash, a fund has to sell some companies to honor redemptions – so a buy and hold is not possible, even in case of great businesses.

In such scenarios, it may be worth it for individual investors to invest directly in stocks instead of the mutual fund route. But as index returns are easy to get, one has to be sure that these additional investments will actually help better portfolio returns rather than dilute them. Therefore, overall – allotting majority of your equity allocation to mutual funds (index or active based on performance) might be a prudent strategy for individual investors. Investments through direct stock holding can be a small part of your equity allocation – only in situations where there are valid reasons for the same.

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