Beliefs and pshycology-In Investing

I love this story of Cialdini’s Three Legged Stool. The stool is stable because it has three legs. Take one away and it will fall. However, this magical stool does not fall because when one leg is taken away, another one grows to replace it.

The human mind pretty much works like the three-legged-stool. You do something for a reason, and then more reasons are created in your mind to justify your decisions. And when the original reason for doing that thing is taken away, new reasons are invented to allow you to continue with the decision. You are never wrong this way because there are always enough reasons to maintain your prior beliefs.

Take an example. You buy a stock because you think its prospects are good. Then you learn that the company’s earning power will be hurting for the several years in the future. In the meantime, the stock has fallen 20% from your cost. You mind will now invent new reasons to hold on to the stock. You will start thinking that this is just a temporary adversity, or the drop in price has made it even a better bargain so you should buy more, or you have new cash coming in which you can invest in new opportunities so no point liquidating this position, or the company is developing a new product line and that will surely result in resumption of profit growth, or the company has become an attractive acquisition target and will surely be acquired at a large premium to the prevailing price, or blah blah blah – you get the point I think.

Is your mind the functional equivalent of the three-legged stool magically growing legs to allow you to be consistent with you past dumb calls?

Equity Dilution : The unseen enemy….

The startling observation that the BSE 100 Index’s “real” EPS growth lagged India’s “real” GDP growth over a three and five year horizon. Over the three year period, FY07-09, the BSE 100 real EPS CAGR at 4.7%, was much lower than the 8.5% real GDP growth. Over the five year horizon, FY05-09, real EPS growth at 8.4% was marginally below the 8.5%. The primary reason behind this was equity dilution.

There have been tomes written about how India will be the one of the key global growth engines for the next decade (at least) and how as investors we should hop on to the bandwagon by investing in equities. No doubt this appears to be compelling logic since “net profit” growth has often outpaced GDP growth rates. However, “real” EPS growth has not kept pace mainly because capital intensive companies have diluted their equity at regular intervals. Although there are some sectors/companies which are cash rich (frontline FMCG and IT companies are prime examples) most other sectors require dollops of capital in order to attain the next level.

While the overall financial leverage in our corporate sector has reduced over the past two years, this has often been achieved not through retained earnings but by refinancing high-cost debt through fresh equity issuances. Buoyant equity markets provide a temptation that few promoters can resist. There have been some promoters who have even candidly admitted that they are raising money while the going is good even though they do not have any concrete idea as to how to deploy it profitably.

The James Montier of GMO stating that between 1970-2001, US, UK and Germany too experienced the same problem.

As investors, this could hurt us in two ways :

1. Money which may have deployed more profitably ourselves, could be transferred into the hands of promoters with vague notions and intentions.

2. Other than EPS growth, constant dilution also affects the Return On Equity (RoE) adversely since most dilutions take place close to the current market price and RoE takes the premium component into account too. This is especially true in case of projects being commissioned over the next few years instead of the near-term (Eg. Metals, mining and oil & gas companies).

While, it may be difficult to avoid such companies entirely we can take some precautions in order to ensure that only a small portion of our portfolio is in companies prone to regular dilutions. Of course, often cash-rich companies with predictable earnings command a stiff valuation premium. However, there are bouts when the premium reduces. This especially happens during frothy times when risk aversion is very low and the companies’ conservative nature and the cash on their books is actually seen as a liability. Patiently waiting for such times may serve us well……

Timing really is crucial

There are enough investing philosophies out there to make your head spin. Buy and hold. Ride the commodity wave. Value investing. Technical analysis.

Each has its own merits, but sometimes you just need to look at the numbers to make sense of it all.

Ed Easterling, who runs an investment management and research firm in Corvallis, Ore., did just that, and he illustrated his findings in a graphic that The New York Times has published.

As the Times describes it, in 2001 a client asked Mr. Easterling what kind of return investors should expect over the long term. Instead of rushing his response, Mr. Easterling did some research and found that the answer, as it is with so many things related to finance, is that it depends. What exactly does it depend on? Timing.

Mr. Easterling tracked the S&P 500 average real return -- that is, the return that accounts for dividends, average taxes, fees and is adjusted for inflation -- from 1920 on. His analysis determined an investor's average annual return depending on what year he or she entered and exited the market.

For instance, if money was invested in 1994 and held to 1996, the average annual real return was about 7 per cent. But if the investor got greedy and kept the money in there until 2002, the annual return over that period fell sharply.

The analysis also determined that the best 20-year period to invest in ran from 1948 to 1968, when the average annual real return hit 8.4 per cent. The worst 20 years ran from 1961 to 1981, when the average annual real return was negative 2 per cent a year.

The graphic might take few minutes to figure out, but it’s worth the time.

The secret to investment success: Self Awareness?

The secret to investment success: Self Awareness?

I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.

There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.

. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.

Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.

As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt idek,

Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes.

on value investing

On Value Investing

-Under 5% of all assets are run under value investors, a real minority in the investment world.
-The stock market is created for the other 95% of people, that is where your opportunity and challenge is.
-Biggest challenge: understand whether you are the 5% or the 95%
-It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
-5% have a spectacular return, but 95% of money probably always resides to somewhere else.
-Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
-If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
-You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
-The more you know, the better you are as an investor.
-Politics, science, technology, literature, poetry, everything can affect businesses and help you.
-Occasionally you can find insights that will give you tremendous insights that other people don’t have.
-Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?

Neuro-Economics

FOR MOST PURPOSES IN DAILY LIFE, your brain is a superbly functioning machine, steering you away from danger while guiding you toward basic rewards like food, shelter and love. But that brilliant machine can lead you astray when it comes to investing. You buy high only to sell low. You try to time the market. You follow the crowd. You make the same mistakes again. And again. How come? We're beginning to get answers. Scientists in the emerging field
of"neuroeconomics"-a hybrid of neuroscience, economics arid psychology-are making stunning discoveries about how the brain evaluates rewards, sizes up risks and calculates probabilities. With the wonders of imaging technology we can observe the precise neural circuitry that switches on and off in your brain when you invest. Those pictures make it clear that your investing brain often drives you to do things that make no logical sense-but make perfect emotional sense. Your brain developed to improve our species' odds of survival. You, like every other human, are wired to crave what looks rewarding and shun what seems risky.To counteract these impulses, your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind. And when you win, lose or risk money; you stir up some profound emotions, including hope, surprise, regret and the two we'll examine here: greed and fear. Understanding how those feelings-as a matter of biology-affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor,

Introduction to Options

Options are one of the most lucrative ways of making money in the markets. The flip side is that they can lead to huge losses if not dealt with correctly. Let us explore the world of options. To begin with there are 2 type of Options, Put option and a Call Option. Put Option gives the buyer to sell a stock or index at a particular strike. It gives the buyer the right to sell at a particular strike price but not the obligation to sell. It is similar to taking insurance on your house or car. Buying a call option gives the buyer the right to buy a stock or index at a particular price but not the obligation to buy the underlying. It is similar to giving a deposit amount to buy a house at a particular price.
Options are of 2 flavors. The American Options and the European options. The American Options can be exercised only on expiry day whereas the European options can be exercised on any day till expiry. In plain English, it means though you can buy sell these options every day as per market price of options, the actual difference between market price and strike price can be got only on expiry day for American Options and any day till expiry for European Options
Example:
1. Nifty 6000 CA Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry (Strike price 6000, Call Option, Flavor American)
What this means is I believe the Nifty will go much higher in the next 10 days and will expire say at 6200. On the day of expiry I will get 6200-6000 = 200 rupees. My net profit on the trade is 200-70 = 130 rupees. Now, let us assume the market falls to 5800 instead of going up. I will end up only losing the premium I paid.

2. Nifty 6000 PA Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
What this means is that I believe that Nifty will go down in the next 10 days and will expire say at 5800. On the day of expiry I will get 6000-5800 = 200 rupees if the Nifty expires at 5800. My profit is 200-70 = 130. Now, if against my expectations if the markets move up and expire above 6000, I end up losing only the premium paid.

Now, we have learnt what options are. There are 4 possible things one can do with Options.
1. Buy a Call Option
2. Sell a Call Option
3. Buy a Put Option
4. Sell a Put Option
What does all this mean? Buying a Call or Put Option means that we have the right to buy or sell an underlying stock or index at a particular strike price. The loss is limited to the amount of premium paid. Selling a put or call option means we are open to facing unlimited losses or profit if the market moves opposite to our direction.
1. Nifty 6000 CA Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry.
Now, I sell the 6000 CA option as I believe the markets will move down. So, if the expiry is below 6000, I pocket the entire 70 bucks premium. If my direction goes wrong and market moves to 6500, I have to pay 6500-6000 = 500 rupees to the option buyer. My net loss is 500-70 = 430 rupees

2. Nifty 6000 PA Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
I sell the Put Option because I believe the markets will go higher in the next 10 days. If they expire above 6000, I pocket the entire 70 rupees premium. If my direction goes wrong and market crash to 5500, I have to pay 6000-5500 = 500 rupees to the buyer. My net loss is 500- 70 = 430 rupees.

From the above examples, we can see buying options, the loss is limited and profit is unlimited. Selling options, profit is limited and the loss is unlimited. Yet, it is more lucrative to sell options rather than buy options.

Options are one of the most lucrative ways of making money in the markets. The flip side is that they can lead to huge losses if not dealt with correctly. Let us explore the world of options. To begin with there are 2 type of Options, Put option and a Call Option. Put Option gives the buyer to sell a stock or index at a particular strike. It gives the buyer the right to sell at a particular strike price but not the obligation to sell. It is similar to taking insurance on your house or car. Buying a call option gives the buyer the right to buy a stock or index at a particular price but not the obligation to buy the underlying. It is similar to giving a deposit amount to buy a house at a particular price.
Options are of 2 flavors. The American Options and the European options. The American Options can be exercised only on expiry day whereas the European options can be exercised on any day till expiry. In plain English, it means though you can buy sell these options every day as per market price of options, the actual difference between market price and strike price can be got only on expiry day for American Options and any day till expiry for European Options
Example:
1. Nifty 6000 CA Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry (Strike price 6000, Call Option, Flavor American)
What this means is I believe the Nifty will go much higher in the next 10 days and will expire say at 6200. On the day of expiry I will get 6200-6000 = 200 rupees. My net profit on the trade is 200-70 = 130 rupees. Now, let us assume the market falls to 5800 instead of going up. I will end up only losing the premium I paid.

2. Nifty 6000 PA Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
What this means is that I believe that Nifty will go down in the next 10 days and will expire say at 5800. On the day of expiry I will get 6000-5800 = 200 rupees if the Nifty expires at 5800. My profit is 200-70 = 130. Now, if against my expectations if the markets move up and expire above 6000, I end up losing only the premium paid.

Now, we have learnt what options are. There are 4 possible things one can do with Options.
1. Buy a Call Option
2. Sell a Call Option
3. Buy a Put Option
4. Sell a Put Option
What does all this mean? Buying a Call or Put Option means that we have the right to buy or sell an underlying stock or index at a particular strike price. The loss is limited to the amount of premium paid. Selling a put or call option means we are open to facing unlimited losses or profit if the market moves opposite to our direction.
1. Nifty 6000 CA Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry.
Now, I sell the 6000 CA option as I believe the markets will move down. So, if the expiry is below 6000, I pocket the entire 70 bucks premium. If my direction goes wrong and market moves to 6500, I have to pay 6500-6000 = 500 rupees to the option buyer. My net loss is 500-70 = 430 rupees

2. Nifty 6000 PA Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
I sell the Put Option because I believe the markets will go higher in the next 10 days. If they expire above 6000, I pocket the entire 70 rupees premium. If my direction goes wrong and market crash to 5500, I have to pay 6000-5500 = 500 rupees to the buyer. My net loss is 500- 70 = 430 rupees.

From the above examples, we can see buying options, the loss is limited and profit is unlimited. Selling options, profit is limited and the loss is unlimited. Yet, it is more lucrative to sell options rather than buy options.

Introduction to Options

Options are one of the most lucrative ways of making money in the markets. The flip side is that they can lead to huge losses if not dealt with correctly. Let us explore the world of options. To begin with there are 2 type of Options, Put option and a Call Option. Put Option gives the buyer to sell a stock or index at a particular strike. It gives the buyer the right to sell at a particular strike price but not the obligation to sell. It is similar to taking insurance on your house or car. Buying a call option gives the buyer the right to buy a stock or index at a particular price but not the obligation to buy the underlying. It is similar to giving a deposit amount to buy a house at a particular price.
Options are of 2 flavors. The American Options and the European options. The American Options can be exercised only on expiry day whereas the European options can be exercised on any day till expiry. In plain English, it means though you can buy sell these options every day as per market price of options, the actual difference between market price and strike price can be got only on expiry day for American Options and any day till expiry for European Options
Example:
1. Nifty 6000 CA Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry (Strike price 6000, Call Option, Flavor American)
What this means is I believe the Nifty will go much higher in the next 10 days and will expire say at 6200. On the day of expiry I will get 6200-6000 = 200 rupees. My net profit on the trade is 200-70 = 130 rupees. Now, let us assume the market falls to 5800 instead of going up. I will end up only losing the premium I paid.

2. Nifty 6000 PA Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
What this means is that I believe that Nifty will go down in the next 10 days and will expire say at 5800. On the day of expiry I will get 6000-5800 = 200 rupees if the Nifty expires at 5800. My profit is 200-70 = 130. Now, if against my expectations if the markets move up and expire above 6000, I end up losing only the premium paid.

Now, we have learnt what options are. There are 4 possible things one can do with Options.
1. Buy a Call Option
2. Sell a Call Option
3. Buy a Put Option
4. Sell a Put Option
What does all this mean? Buying a Call or Put Option means that we have the right to buy or sell an underlying stock or index at a particular strike price. The loss is limited to the amount of premium paid. Selling a put or call option means we are open to facing unlimited losses or profit if the market moves opposite to our direction.
1. Nifty 6000 CA Nov 26 is trading at 70 rupees and the underlying index is at 5950 with 10 days to expiry.
Now, I sell the 6000 CA option as I believe the markets will move down. So, if the expiry is below 6000, I pocket the entire 70 bucks premium. If my direction goes wrong and market moves to 6500, I have to pay 6500-6000 = 500 rupees to the option buyer. My net loss is 500-70 = 430 rupees

2. Nifty 6000 PA Nov 26 is trading at 70 and the underlying index is at 6050 with 10 days to expiry
I sell the Put Option because I believe the markets will go higher in the next 10 days. If they expire above 6000, I pocket the entire 70 rupees premium. If my direction goes wrong and market crash to 5500, I have to pay 6000-5500 = 500 rupees to the buyer. My net loss is 500- 70 = 430 rupees.

From the above examples, we can see buying options, the loss is limited and profit is unlimited. Selling options, profit is limited and the loss is unlimited. Yet, it is more lucrative to sell options rather than buy options. Why is this so? Let us look at this in my next post. I plan to write a series of posts every month which would take us from the basics of options trading to complex strategies

SIMPLE INVESTING

Investing isn’t all that difficult-at least, it doesn’t have to be.

Warren Buffett: I have three boxes on my desk: In, Out, and Too Hard.

The point is simple: Don’t invest in things (or in ways) that you do not easily understand. Sounds simple enough. What’s the catch?

The catch is…you have to do it. You have to be able to say, “No.” You have to say it a thousand times before you say, “Yes.” You have to be bored-practically to tears-at the lack of truly wonderful investment opportunities that are (or aren’t) available.

On top of it all, you have to have a solid, rational reason for buying a stock. You have to buy it as if you were buying the entire company. Then, you have to hold onto it regardless of what the professional gamblers do to the price. You have to believe that you are right-not because the price is changing, but because your rationale and reasoning is right.

When Is It Too Hard:There is a simple test to determine whether an investment opportunity is a Yes, No, or Too Hard: If you do not understand it in five minutes…it’s Too Hard. If you do not love it ten minutes after that, it is a No.

Will that eliminate 99.9% of your investment options? Yes-and that’s the point!. If 99.9% of 8000 companies traded in BSE are Too Hard or an automatic No, then there are five or so out there that are truly wonderful, easily understandable businesses selling at a discount to their true value.

Diversification: If you only invest in wonderful, easy-to-understand businesses, and you buy them on sale to their true value, you do not need to run out and diversify for the sake of diversifying. Your portfolio will eventually become diversified.

Think about it: We all know the story of Infosys, ITC, HUL. Selling for pennies in the 1980/90s. Anyone who bought it became a millionaire many times over. If you had the chance to go back in time, wouldn’t you put everything you owned into Microsoft back then?

Patience Is THE Virtue: Assuming you had purchased Infosys, ITC, HUL how long would you have held it? Would you have dealt with the daily, weekly, monthly, and annual fluctuations of 30% or more at any given time? How long before you would be “shook out” of your position?

Patience isn’t a virtue in investing-it is the virtue. You know who held on to these companies the entire time? People who understood its business and saw value in the company-regardless of the stock price that the gamblers set on a particular day.

Invest Like Warren Buffett

At any given time, in any given market condition and economy, some gambling guru will make a killing-in the stock market, in real estate, whatever-and everyone will take that gamblers word as gold, try to replicate the gamblers success, and usually lose money. Why do they lose money? A gambler can only make money for so long-a few months, a few years-before the market conditions change and the gambler’s system is no longer good.

On the other hand, for some 70 years, Warren Buffett has been successfully buying wonderful, easy-to-understand businesses when they are at a discount. And he has made billions from it.

When will you finally decide to stock worshiping gamblers and follow in the footsteps of the billionaire who made his money the easy way?