What is better in dealing with terror? To remember or To forget

A lot of people I met or spoke to on Sunday 9/11 told me exactly where they were and what they were doing when the two planes crashed into the Twin Towers 10 years back. I too remember what I was doing at that time. I don’t know why people remember that, but this was one of those events that I classify as “Do you remember?” events.

For example, a lot of people in the United Stated also remember what they were doing when Kennedy was shot.

I, for one, remember being woken up close to the middle of the night when Rajiv Gandhi was assassinated. My South Indian friend Swami remembers exactly what he was doing when Indira Gandhi was killed.

There are a few happy moments too. Like many Indians remember where they were when Mohinder Amarnath trapped Holding leg before and took India to World Cup victory in 1983. Similarly even 20 years from now, those who saw the six that Dhoni hit to give us the World Cup in 2011 will remember where they were then.

I used to have distinct memories of where I was and what I was doing in the month or so of the Mumbai riots of Dec-Jan 1992-93, and I also used to remember what I was doing when the Mumbai blasts that happened after that in 1993. That in some sense was India’s 9/11. At that time those were genuinely significant events. Now after so many blasts and riots, it is a bit confusing. Like 9/11, we have started naming them 7/11 and 26/11, may be we will have more. Not quite sure whether to remember or forget.

That gets me back to 9/11. Americans chose to remember it. Perhaps because it was the only major terrorist attack on their soil, and they did not quite understand how to handle it. It is not 9/11 the event itself, but remembering 9/11 that actually caused harm to the US, I think. That led to Americans living in constant fear, whereas actually they were still living in one of the safest countries in the world. That led to the pointless wars in Afghanistan and Iraq, and led to a total disproportionate increase in defense spending – thinking that these measures will help prevent further attacks. That also led to racial profiling. Americans started thinking of every minor thing in terms of a terror attack.

Of course, there were no further attacks, but that was because the US was always difficult to attack. Before or after 9/11, it was always difficult to attack the US, specially at that scale. 9/11 was an exception. So while it was a “Do you remember?” event, the world and the US would, perhaps, have been better off if the US had forgotten about it over time.

In the 10 years after that, while nothing of anything close to that scale happened in the US, 38 blasts of some kind happened in India. And we are not counting the ones before 2001. The ones between the original Mumbai blasts and the Twin Tower attacks. I am sure the total will exceed 50 at least. And Indians chose to forget those blasts, more or less.

Hence, we did not have citizens living in fear (in fact life resumed in most cases in a day), perhaps there were other things to be afraid of. Nor did we have increase in defense spend, perhaps there were other things to spend on. While we reached close to war once (in 1999 after the nuclear tests), we did not have a war due to this – apparently we could not afford a war. But the attacks continued, spurring us on. In trains, in buses, in markets wherever. We chose to forget the attacks, and good harmless people continued to die. Eventually we were told to live with it as we were in a troubled neighbourhood. And we started thinking of even major blasts like road accidents. They happen.

So the US had one 9/11 and major wars after that, huge defense spends leading mostly nowhere. But they had no other attacks after that. And India had 50+ attacks, no wars, even arrests of the terrorists in some cases, but still leading more or less nowhere. But the attacks continued.

Our responses to “Do you remember?” events have been different. India’s approach has been to forget, while the US approach has been to remember. I am not sure which is better eventually.

God no.1: Celebrating Ganesha Festival in Mumbai and Bangalore

The festival of Gowri-Ganesha in Bangalore has quite a few differences from the festival of Ganpati in Mumbai.

gowriganeshabloreIn Bangalore, it is a private festival while in Mumbai it is a public festival. Almost everyone in Bangalore gets a ‘मूर्ति’ at home. While in Mumbai it is generally restricted to the eldest member of the extended family, though that is changing too with shrinking families, I think.

Everyone goes to everyone’s home for ‘दर्शन’ and ‘प्रसाद’ and some gossip-gupshup in Mumbai. Once they know you have an idol at home, you get on to their annual visit list. No one does that unless invited in Bangalore – partly also because it is a private festival, partly because everyone has their own idol at home.

Also, while I was in Mumbai, I thought Ganesha idols are to be kept for a pre-determined number of days and that is to be followed every year. So you have 1.5, 3, 5, 7, 10 and 11 as the common number of days that idols are kept for in Mumbai. Most public idols and a lot of ‘serious’ private idols are kept for the entire period. In Bangalore it is relatively flexible. Most people do the immersion on the first day, and very few have it for all 10 or 11 days. Some people immerse the idol on weekends as it is convenient. Some people start initially with the intention of immersing in 1-2 days, and then think that maybe couple of days more will do no harm, so let’s extend. So that way it is quite flexible in Bangalore.

In Mumbai, the ‘प्रसाद’ is generally sweet – with ‘मोदक’ leading, but supported by a whole lot of others – almost everyday a new sweet makes its appearance. In Bangalore, it is mostly not sweet – generally rice and ‘चना’, sometimes ‘वडा’, sometimes fruit salad maybe.

The idols are also different. In Mumbai, you have all shapes and sizes, with various contemporary events unfolding on stage as well as in the idol. This year I was told the main ‘themes’ are the World Cup and Anna Hazare. Even small home idols come in all avatars with the Lord sometimes taking forms ranging from the funny to the outrageous. They make them with all materials from clay, plaster-of-paris to whatever. In Bangalore, all idols are more or less standardized, mostly made of mud, and look more or less similar. All you can choose is height that works for you, and maybe the color at best. They are quite understated definitely.

ganeshmumbaiPeople in Mumbai immerse the idols in the sea. So, everyone from the smallest home idols to the largest public idols go to the nearest sea-shore on the west, and make a beeline. That way, Mumbai is lucky that it has a sea – difficult to imagine which other water body could absorb so much, and what a ruckus it would be without the sea-shore (not that it is any lesser now). In Bangalore, it is the lakes with specific designated areas for immersion – it is quite a disciplined affair. People also immerse their idols in buckets or tanks in their homes, and use the water for gardening. Initially, I used to find it awkward, but now I think it is a great idea that everyone should adopt.

Honestly when I look at another year of the Ganpati festival, these differences do not matter much. The styles, rituals, methods may be different, but I think the underlying emotion, perhaps, is more or less the same. Just the scale and grandeur may be different. I also think what a wonderful festival it is, during which people actually bring God to their homes and public places, worship him and then give him a sendoff. And what an idea it was that Tilak came up with, when he decided to literally ‘take it public’.

Therefore, despite the fact that we bring ‘God no.1’ into our homes every year for this period, it is quite ironical that when my son cries as we immerse Ganpati with slogans of ‘पुढच्या वर्षी लवकर या’ every year, I have to tell him, “God is not in that idol, he is in your heart”. He does not seem convinced. He will wait for next year.

The End of Magic: Tribute to the Last of Harry Potter

Avada Kedavra said Voldemort for the last time yesterday, and in the final battle, when the curse rebounded, it signified the last victory of Harry over his evil bete noire. The audience applauded heartily for the final time, and as my son and I left the cinema hall, he was left with an empty feeling that this was indeed the end.

harry-vs-voldemortMy son was just born when the first hints of Potter-mania hit the world, and to that extent, we have been late entrants into the Potter club – only perhaps for a year or so. But in that year, Harry, Ron and Hermoine along with Dumbledore, Snape and the entire professor-hood of Hogwarts, plus Voldemort and his Death-eaters had well and truly taken over our household. In a relatively short period of a year, reading all the seven books one by one, some of them twice, and then watching each of the first seven moves at least twice, my son had become a walking encyclopedia on Potter and his gang. And doing what only a 10 year old Potter fan can do, he had successfully converted his parents, both his sets of grand parents and perhaps most of his friends in to die hard Potter fans too.

It was then that I realised how much of a void the end of this last movie is likely to create in a generation of children (and their parents) that grew up on Harry Potter. Right from mesmerising children with the initiation in the early couple of movies (which most people watched agape) to almost frightening their parents in the last two Deathly Hallows, the rivalry of good and evil in a world of magic cast its spell on a generation of children. The last few months our home has been full of children making wands from broken twigs playing ‘Expelliarmus’ with each other, riding on imaginary broomsticks playing quidditch with their snitches taking roles of Harry, Ron and Draco, and calling their parents ‘Muggles’. As the early playfulness of the three friends quickly matured into an intense plot of rivalry, the games suitably changed with the early characters of schoolmates being replaced with Dumbledore, Snape and Voldemort and his deatheaters.

But beyond the now familiar spells, characters and the world of magic that Rowling and the movies based on her books took us into, there are some amazing subtle hints of wisdom that she threw at children – through the words of some amazing characters, specially Dumbledore and sometime Sirius Black and Severus Snape.  Like when Dumbledore tells Harry in the Chamber of Secrets: “It is our choices that show what we truly are, far more than our abilities.” Or tells him in the Prisoner of Azkaban: “Happiness can be found, even in the darkest of times, if one only remembers to turn on the light.” Or when Sirius Black advises Harry in the Goblet of Fire: “If you want to know what a man’s like, take a good look at how he treats his inferiors, not his equals.” And finally the one that I heard Dumbledore say yesterday in the Deathly Hallows when Harry asks him whether this is real or it is happening in his head: “Of course it is happening inside your head, Harry, but why on earth should that mean that it is not real?”

CA.0802.harry.potter.hallows.2.For mere ‘muggles’ who have not quite experienced this magic, it has always been a puzzle what the fuss is all about. But for those who have had this potion, it is always a case of the charms taking over. Finally it all ends – as far as the books and the movies are concerned. But it will continue to stay with this generation forever. Perhaps by some spell of magic, it may get a rebirth too. So till we meet again on platform number 9 and a 3/4, this is indeed the end of magic as we know it.

How to Use Loans and Prepayments to Your Advantage

The banking industry is a very funny one – whose basis for lending is that of insecurity. A smart individual investor can use it to his advantage to create wealth. In a consumption oriented and growing economy, most households have some exposure to debt of some kind – the most common being housing loans and car loans. A lot of popular advice or propaganda is centered around how much loans to take, how to save for down payments, how to negotiate on interest rates, how not to get under the debt burden, etc. Also further on how a housing loan makes sense, a car loan may be ok, but personal loans and credit card loans are avoidable. These are all valid topics and important micro advice, things to be carefully considered before one goes out and borrows. But for an individual investor who gets caught up in them too much, they can be akin to focusing on the small stuff and missing the bigger picture; focusing on data and information, missing out on knowledge and wisdom. A lot of that big picture view about loans and their prepayment that might be very important, and something that is structural.

home_loan_prepayment20110907013037Fundamentally, as I said, the banking industry is based on the premise of insecurity. Let me elaborate. It wants to give money out because it is in the business of lending and making money out of it. So it wants to make sure that its capital is safe when lent to someone. Hence it has processes to evaluate credit worthiness of individuals, and depending on the stage of the economic cycle, that process either gets lax or becomes stringent. But further to that, once the creditworthiness is established, the way a bank or any lender makes money is through the interest the borrower pays. So it also wants to make sure that it is going to get the interest. Which means it does not want too much of prepayment, else it loses out on interest and its profits may come down. Hence it comes up with two mechanisms – one, it collects most of the interest in the initial parts of the loan tenure when it assumes that most borrowers are unlikely to prepay, and two, it charges penalties on prepayment anytime during the loan tenure. That’s the reason it is playing to balance two types of insecurities. The first insecurity is that of principal repayment or fundamentally loss of capital, and the second insecurity is loss in collection of interest. Its security against loss of capital is processes to evaluate credit-worthiness and mortgage or hypothecation of the asset i.e. housing or vehicles. And its security against loss of interest is prepayment penalties or general discouragement of too much prepayment. An individual investor who understands this can take advantage of this insecurity of the lender to build wealth.

So what is the way? The way is simple. The trick is to put a slightly lesser amount in down payment than you can afford to, take a higher loan initially, negotiate no prepayment penalties, and save more cash in the early loan tenure to prepay part of the principal. How does this help? The structure of most loans is such that if you do not prepay in the first few months or years, the interest gets collected by the lender via the installments. The key for an individual is to ensure that larger part of that installment is going towards principal rather than interest. That never happens when it is most needed i.e. in the initial tenure of the loan. The traditional advice given is if you can earn more than the interest rate on your loan through other means, do not prepay, specially on a housing loan – where reasons such as it is an appreciating asset and you get income tax cuts are provided as further reasons on why not to prepay. But that is exactly what works to the advantage of the lender rather than the borrower. If one looks at the structure of a loan, it is not about interest rate, but about absolute interest that you pay in the first few years. You may be paying a uniform interest rate, but collection of the interest amount is not uniform – it is skewed in favor of the lender. So even if you garner more returns than the rate of interest on your money through other means of investment, the bank has already collected the interest early. The borrower’s returns on money not prepaid will compound only after a few years once capital and returns accumulate, but the bank’s interest gets paid early in the tenure. So if the borrower prepays early, he stops compounding of that interest for the lender early on by reducing the capital outstanding. This gets even better for depreciating assets like cars where interest rates are higher, and the asset is depreciating – so you are essentially paying interest for asset usage and left with some small residual value.

There are no two ways about it. For the borrower, the effects of early prepayment even in small amounts are unequivocally positive, and can be almost magical in terms of interest savings. A borrower can check amortization calculators to check on the impact – it definitely is more than what most individuals expect. And if one has managed to buy an appreciating asset at the right price, has a reasonable loan to value ratio, and low EMI-to-income ratio, it is a sure recipe for creation of wealth over the long run at the expense of the lender.

The trick is in managing that well. The financial industry will try its best to trap borrowers with a high loan to value, high EMI-to-income ratio, and high prepayment penalties – which means a borrower will have no option but to keep paying EMIs regularly for a long period – by which time the lender has collected interest and made money on your loan. And after which point, there is no logical incentive to prepay as the loan has now become cheaper. The risk of the loan for the lender is gone. The trick is to be in a position where you can prepay early in the tenure, and let compounding of interest (or lack of it in this case) work for you rather than against you.

Of Skill, Temperament and The Wall: Investing Lessons from Rahul Dravid’s batting

A couple of days back I was privileged to watch one of the best recent displays of classical Test Match batting by Rahul Dravid. That day (as so many times in the past too), Dravid secured a painstaking century on a minefield of a pitch to get India into a position of victory. He has done so earlier on similar pitches against much lethal bowling and in worse team situations. What is amazing is he was never directly focused on getting the runs. Runs seemed to be incidental outputs. His singular focus was to handle each ball as it comes, survive and score when possible – which in turn led to the century and eventually set up India’s victory. Dravid has been following that approach for the past 15 years, ball after ball, match after match, year after year – and it is no surprise that he is India’s second highest run getter in Tests.

dravid1Well – this note is not about his achievements or why he remains my favorite Test batsman. This is about the approach he brings to batting. There is so much to learn for individual investors from the way Dravid bats. If only one thinks of oneself as Dravid, and everything around him as the markets – the pitch, the bowls coming down, the excitement,  the team situation, one will realize the value of his approach and its application in the area of investing.

Dravid’s approach to batting is akin to Graham’s or perhaps even Buffett’s approach to investing . The first rule is never lose your wicket i.e. never lose money. The second rule is always follow the first rule. His expertise and experience in handling pitches like Sabina Park is tremendous, but he is still a student. He still does not know what exactly it has in store – i.e. which ball will seam and which will bounce, and does not try to pre-judge. Very much akin to the vagaries of the market which are futile to predict. His mind is almost trained with a plan for every over that sounds like – leave, leave, defend, leave, score, defend. His patience wears off the bowlers, so that they start bowling to where he wants them to.  dravid2

They try out-swingers which he leaves even if slightly off line, bouncers which he ducks without any ado, inswingers and short pitched balls which he gets behind and defends solidly. And finally he gets a wayward delivery on his legs which he flicks, or one that is wide outside the off stump which he drives. The entire process and journey by which he collects his runs and builds his innings is amazing, and more or less guaranteed to provide success if anyone could follow it well.  Wickets keep falling and other batsmen score faster with boundaries from the other end, but when Dravid is at the crease, he is still thinking – leave, defend as his natural choices by default, and only if the ball is in his zone, he scores. And those opportunities surely come more often than not. When everyone around him is struggling – including the bowlers unable to comprehend what the ball will do next on this pitch, fielders bored with nothing seemingly happening, and non-strikers flashing their bats in a bid to do something – Dravid is patiently batting – in his zone.

dravid3Isn’t the experience that normal individual investors have in the market similar to what batsmen face at pitches like Sabina Park most of the time? Sometimes you do have belters in big bull runs where you just get bat to ball, and it flies to the boundary. Investors that invest the way Dravid bats may temporarily look like fools on such belters. But most of the time, the markets are pitches like Sabina Park. You never know which way it will go. Defend or Leave is perhaps the best option for most individual investors on most deliveries thrown at them. Patience is then the biggest virtue, specially when you have a long innings to play. And when the market wears out and throws you a sitter, you grab it and accumulate your runs. If you do this ball after ball, match after match, year after year, through multiple economic cycles, good form or bad, a couple of things are sure. It is very unlikely that you will get out on a bad ball i.e. you are unlikely to suffer huge losses due to making bad investments. Most investors never recover or get back to markets after that. And finally, it is very likely that you will end up with a tally like Dravid’s by the time you are done.

The Six Hats of an Individual Investor

Dr Edward De Bono came up with a famous theory of the six thinking hats, as a tool for group discussion and also individual thinking – as a means to think from all angles, more effectively, and to come up with successful decisions. The contention of the six thinking hats is that the human brain is capable of thinking in multiple ways, and hence, if – for critical decisions – an attempt is made to deliberately think in each of the six different ways, a new and better decision may be possible.

Six-Thinking-HatsFor an individual investor, I think something similar to make successful investing decisions over time may be required. Here is an attempt to articulate the six hats that may be required for effective investment.

Analytical Hat: While the ability to gather facts and analyze information is quite important, in my view, it may be a bit over-rated. It is certainly not the most important ability required in an investor. Though it is necessary, by no means is it sufficient. The analytical hat is perhaps the starting point, but just about it.

Optimistic Hat: An investor needs to be an optimist at heart. Investing is about putting money in the belief of better returns of the future. Hence, unless an investor has a positive view of the future, it is unlikely that he will hold his investments, specially during downturns.

Skeptical Hat: A skeptical outlook which looks at all businesses, advice, opinions and information with a pinch of salt – like ‘guilty till proven innocent’ is extremely important. It may seem contrary to the optimistic hat – but it is not. The most important advantage of a dominant skeptical hat is to avoid big blunders – which is as important as making the right decisions.

Patient Hat: The capacity and willingness to endure waiting, delays or provocation without getting upset or losing track – is perhaps the most important hat that an individual investor will need. It is also the one required the most often. At so many points in an investor’s life, the other hats will have nothing to work on, and the only hat in operation is the patient hat – and the ability to endure that is invaluable.

Wisdom Hat: There is a lot of knowledge but no wisdom. That is an apt characterization of the state of capital markets in today’s connected world. An innate wisdom hat allows the investor to discern and make a judgement on what is the right thing to do, or whether to do anything at all is extremely valuable. Perhaps one of the most critical hats for an individual investor.

Rebel Hat: The ability to refuse to obey, or go against what may seem like popular is the Rebel hat, that will need to come into play in times of high swings in the market. And the rebel hat will ensure that the investor buys when everyone is telling him to sell, or sells when everyone thinks he is a fool in doing so. Importantly, a rebel hat combined with the others is necessary for the big returns.

So here are the six hats required for an individual investor. At various times, one hat may seem to be more prevalent than the other. But like Dr De Bono’s contention – a deliberate attempt by an investor to wear all hats before making investing decisions, will perhaps ensure that the right decisions are made most of the time.

Why Compounding is The Best Kept Secret of Investing Success

It has been a while since I wrote here, and the reason was that I was away for a nice family vacation. It was a truly wonderful experience, in the midst of good weather, the beauty of nature and great company – a meeting of like minds, a time to relax, the agenda being no agenda.

It made me wonder whether having no agenda is the reason one enjoys vacations so much more than work. 🙂 We had a number of long unhurried discussions on everything from work, investing, achievements to marriage, travel and life itself. That brings me to one of the topics we discussed and the key topic of today’s post – the stark similarity between what I reckoned to be the driver of success in investing as well as achievement – the single magic phenomenon of compounding.

einstein-compound-interest-rule-of-72Everyone knows that Einstein called compound interest the eighth wonder of the world. Most people would also have heard the story of the poor farmer who robbed the rich king in less than three months, when he asked to be given food starting with a single grain today, just doubling the number of grains every day. A recent book called “Outliers” had a similar “Compounding” explanation for super achievement. The author argued that there was no real secret to superlative achievement – people whom he called “Outliers” going by the statistical term. While we always like to give credit of super success to things like inborn talent, genius or luck, the answer in the author’s view was a set of circumstances that simply led the “Outliers” to put in the number of hours required to be “Outliers” – and in his view, what looks like genius starts surfacing after 10000 hours of working at the same thing.  Which means most “Outliers” need to start early in life in their area of work, need to really love that thing a lot to be able to put in the necessary daily grind, and need to consistently keep at it for a long time to reach a level of excellence that looks like genius to other normal individuals.

That does not seem too different from the drivers of investing success. For compound interest to work, one needs to give it sufficient runway, which means start early. Secondly, unless one really loves finding a good deal or is wired with the right temperament to go through inevitable ups and downs of the economy, one is unlikely to keep at it. And finally, the true effects that start looking like investing genius, sometimes simply due to the mathematical magic of compounding – will start coming in only when keeps doing it for a long period of time.

So the key takeaway is that – whether it is compounding for investment success, or compounding of effort for super achievements, there seem to be three common drivers:

Start Early, Love the Journey, Keep at It for long periods of time.

The sad reality is very few people are so placed to be able to meet all the three drivers perfectly. That is, perhaps, the reason why we have so few super achievers and so few super investors.

Why Having Fixed Income is Important for Portfolio Goals

The best portfolio strategy for an individual investor is to start by setting a prudent desired asset allocation between risky equity assets and fixed income that the investor is comfortable with and is sustainable, and implementing it by a continuous timely re-balancing of the portfolio. This would mean selling a certain percentage of the equity part when equities have done well, and buying the equivalent fixed income part, thereby resetting the asset allocation to the desired level, and vice versa.

fixedbondsstocksOne of the requirements of implementing this strategy is to have substantial holding of the portfolio (50% to start with) in fixed income or debt funds. Unless one has that holding, it is not possible for the investor to take advantage of low market levels with timely re-balancing. One of the chief advantages of this strategy is not purely mathematical or higher returns, but psychological – related to the mental stability that the average individual investor will experience in the face of falling markets. And if he is in that state, it is likely that he will not only continue investing, but if he has the temperament and discipline, he will also shift fixed income instruments to equity at a time when market levels are low – thus enhancing long-term portfolio returns. This strategy of holding fixed income to some extent when equities are going through the roof also will give him the ammunition to do the right kind of re-balancing when equities tank, and will ensure that like other investors hurt in the crash, he will not run away from the market.

But that also means that when equities are running high, the investor has to be content (and can get a bit impatient) with lower returns due to the debt component. This will take considerable will power and temperamental maturity to stick to, even for the most disciplined individual investors – at least in the initial years of their experience.

So does fixed income play a role or is it only for fuddy-duddy’s to hold? That is a question best answered by the investor himself. But in my experience it does play a role – though that role diminishes as the equity portion of the portfolio increases specially after the investor has seen a couple of economic cycles. So the best path may be to start with an ideal, conservative allocation of 50:50 in the initial few years of investing. The investor will inevitably face the mentally tough situations of large market falls, and get tested. In such situations, the investor is likely to experience and observe his own behavior – whether he falls prey to market vagaries by selling his equity holdings, and stopping further equity investments; or whether he focuses on his asset allocation and shifts some of his debt holdings to equity to re-balance, thus taking advantage of lower market levels. Similarly, he is also likely to go through easier, seemingly feel-rich market situations when equities go through the roof, and see for himself whether he has the mental orientation to sell equities and shift to debt, or ends up going with the crowd increasing his equity exposure.

After having gone through a few such situations in the initial few years, the role that debt funds play in an individual investor’s portfolio is likely to be self-evident. In case he is actually investing regularly with increasing income levels with time, and has gone through a couple of market cycles, it may then be prudent for such an investor to progressively reduce the percentage allocation to debt. Simply because he is confident that he can handle market volatility easily, and secondly because, his portfolio is likely to have reached a size where the effects of re-balancing will likely give diminishing returns.

So yes – debt funds or other fixed income instruments do play a definite role throughout an individual investor’s lifetime. It plays a larger role in the initial years when the effect of asset allocation and re-balancing need to be proven and seen by the investor himself. Unless an investor has fixed income investments, it is not possible to take advantage of market falls by making tactical shifts to equity – thus losing out on long-term portfolio returns. Beyond the first few years, fixed income will still play a similar role where it acts as an income earning store of booked past profits, as well as a pool to access when lower market levels warrant a shift to equity. But the investor can potentially afford to be a bit more confident of his ability to handle market volatility at that stage, and progressively reduce the allocation to fixed income to enhance returns – while still maintaining the percentage of fixed income assets to a significant level. It may be prudent to start with 50:50 allocation initially, and over years and experience of making regular investments, and implementing the asset allocation and re-balancing strategy, progressively reduce the fixed income allocation – but perhaps, never dropping it below 25%. As market vagaries will still continue, and he will still need a store to take advantage of it – and in larger quantities to make an impact as his portfolio size increases.

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

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.

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