Essay

“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.

For 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.

But 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.

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.

But 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.”

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.

So 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.

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.

This 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.

So 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.”

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.

Which Stocks?

So something as basic as how should I select 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.

Don’t Invest in Stocks Directly

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.

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.

Can you beat the Index?

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.

Funds trump Direct Stocks mostly

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.

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.

Life Circumstances, not Age

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. Whereas 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 a market crash catches him 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.

Risk Tolerance, not Age

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 you tilt your asset allocation comfortably towards equity. And age has, perhaps, little but not much to do with it.