“My wife banned me from riding a bike” – musings of a behavioral finance victim

Recently my wife has banned me from riding my bike. And as weird as it seems, the reason is rooted in behavioral finance. Read on to find out why..

“Bike is banned for me” – your faithfully me (a behavioral finance victim)..

A few weeks back I had written an article here on how to wrap our heads over the fuzzy concept of “risk” in investing. And I had used the analogy of riding a bike to explain my understanding of risk..

This is how it went..

“When we say a higher speed is risky, what we really mean is that if there is some unexpected external event not under your control (say a broken road, an unexpected swerve from the car in front of you, a dog suddenly crossing in front of our bike, a drunkard crossing the road etc) your ability to maneuver the bike is a lot lower at higher speeds and hence the possibility of an accident and the expected impact from it is also very high.”

As fate would have it, I met with a bike accident while on my way to office a few weeks back. Call it coincidence, it was a dog running in front of my bike and crossing the road!

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I crashed into the dog which sent me flying and my bike skidding in different directions.

Since I was wearing a helmet and was at sub 40 km/hr speed the bruises were not major except for a few scratches here and there on my knees and arms.

But unfortunately I got dizzy and went unconscious twice post the accident. My worried folks had me admitted to a hospital and soon we found a doctor who was hinting possibilities ranging from a fracture, a brain concussion to an abnormal ECG reading which meant my heart might need a stent.

And of course, it scared the daylights out of me!

But as we took each and every test, the fracture, the heart issue and brain concussion were gradually ruled out. Several tears down, my wife Shalini heaved a sigh of relief. And I heaved a much bigger one.

This is definitely our most emotionally traumatic 3-4 hours ever.

Once the formalities were done and we came back home, she looked at me straight with a mix of relief and anger and shouted..

“No more bike. Ever! Bloody, start using our car!”

Mind voice of a behavioral finance victim..

Now while I completely get her point of view and I am equally scared on riding again,  here is a little backdrop..

I was wearing a helmet and was going at very reasonable speeds during the accident. And thankfully, the final outcome was a few scratches which have healed now. This is exactly how we want to interpret this whole incident.

But the whole trauma of several possibilities which could have instead played out (further worsened by the inexperienced doctor) suddenly makes the whole activity of riding a bike look a lot more riskier than it actually is.

And here is the scary part – I had done a lot more crazier stuff like riding all the way to Goa, Kerala etc from Chennai with a stupid windbreaker and a cheap knee guard for protection. This included the likes of highly idiotic stuff such as high speeds on unfamiliar roads, sleepless rides, night rides in the ghats amidst pouring rain, absolutely no safety precautions blah blah. And both of us never worried about the risks then.

While I survived all this, finally, a mellowed down “on-my-way-to-office” bike ride finally got me into trouble.

As expected, we suddenly find the whole bike riding activity (a 10 km drive to my office) too risky.

Image may contain: 1 person, motorcycle and outdoorImage may contain: 3 people, including Joseph Anand Raj, people smiling

Now here is the point:

All along there were times where my behavior had been really risky and yet bike riding was still fine. Now when I am a lot more matured in my riding, the sudden accident has made it look a lot more riskier than it is.

I don’t blame us as this is normal human behavior to overestimate the risk post an accident. And yes, behavioral scientists have a name for this behavioral quirk – Availability bias.

Behavioral finance has the answer..

Availability bias is a cognitive bias that lead us to overestimate the importance of information that are most available, more recent, more vivid, that were observed personally, and are more memorable.

Under the influence of this bias, we rarely check the reliability of the information we have readily available nor do we try to search for patterns beyond a time horizon that our memory can serve.

The main reason for this bias is that our lazy brain always chooses the path of least effort. In my case, accessing the fact that for 10 long years, I had thousands of rides and was pretty safe takes quite a bit of effort for our brain and hence we avoid it.

What does this have to do with investing?

Unfortunately the same bias plays out during a bear market. As we have earlier learnt, a bear market puts us under severe emotional stress (almost 2 times our pleasure during a similar upside) and most often than not, we sell out of equities and hope to get back in at the right time.

Now just like my accident, the memory of the emotional stress and market crash is fresh in our brains and it leads to us overestimating the risks in equity market.

Thus we end up staying out of equities for a far longer period as we are still fighting our “previous battle”. And normally the recovery from a bear market is damn swift and by the time we realize, we have missed a huge part of the recovery.

Check out what happened during the initial part of the market recovery from the 2008 crisis.

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This mistake is not jut reserved for the average investor like us but has even happened to experienced fund managers (check the March 2009 cash holdings of equity mutual funds and you will be in for a surprise)

Availability bias spares none!

Thus, availability bias becomes our behavioral enemy no: 3 during a bear market!

Now while it’s too late to prevent my bike ban (as both of us are scared and hope we come over it in sometime), dear reader please take sufficient precaution so that you don’t get banned out of equities when the next bear market strikes.

 

As always in the coming weeks, we shall explore our other behavioral enemies and finally try and come up with a solution.

Till then, happy investing as always..

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you need any help regarding your investments or want me to write about something or discuss regarding professional opportunities in your organization, feel free to get in touch at rarun86@gmail.com

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

 

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Oops the markets are falling – Spying on investor behavior – Part 2

Exploring the strange habit of selling near the bottom

In our last week’s post here, we had explored how our lizard brains which evolved millions of years ago are still stuck with their primary functions of ensuring our survival and hence end up doing a messy job when it comes to handling falling markets.

Today, we will explore the second behavioral enemy – Loss Aversion

Loss Aversion – Pain from a financial loss is twice the pleasure from a similar gain..

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Behavioral scientists Daniel Kahneman and Amos Tversky have done several experiments to understand how we humans psychologically react to losses vs gains.

Their key finding was that:

  • We all hate losses more than we love gains (duh, didn’t we all know this)

But here is where it gets interesting

The pain  from a financial loss is almost two times the pleasure derived from a similar gain!

  • The result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss
  • This phenomenon is called loss aversion

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Source: Franklin Templeton

So as the equity markets fall, the emotional pain that we experience is much more intense than the pleasure we had earlier experienced from similar gains.

Frequent monitoring of portfolios aggravates loss aversion..

Now as if this emotional pain was not enough, we further aggravate it with yet another behavior of ours – frequent monitoring of portfolios

The advent of mobile apps, has made it much more convenient to track our portfolios anytime, anywhere.

But this has a flip side, as it has been found out that:

The more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the moresusceptible we are to loss aversion

In a market correction usually we are anxious of what if this extends and becomes permanent. This usually leads us to monitor our portfolios more frequently during a market correction (based on anecdotal evidence witnessed from our clients).

Suddenly we have a deadly situation – Loss aversion on steroids!

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The reason why most of us panic and sell during a market correction must be obvious to you by now..

The lethal combination of loss aversion and frequent portfolio monitoring implies significant emotional pain during a market correction. In an attempt to avoid the pain we end up selling our equities.

But wait a minute, are we missing out something..

More than what meets the eye..

Now if this was the case, then most of us must actually end up selling our equities in the initial stages of a correction. However, historically investor behavior during a bear market suggests that majority of investors hang on for the initial part of the correction and usually cave in close to the bottom of the market.

 

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Investor emotions gradually moves across..

Initial stages of fall“It is only a temporary decline. I am in for the long run”

As the fall continues and prolongs“Phew. I give up. Maybe the markets just aren’t meant for me”

What explains this?

To understand this peculiar behavior we need to explore two more behavioral quirks

  1. Our Pattern Seeking Brain
  2. Cognitive Dissonance

Our Pattern Seeking Brain – The desire to see patterns in the market and extrapolate them into the future..

Humans have a remarkable ability to detect patterns. That’s helped our species survive, enabling us to plant crops at the right time of year and evade wild animals. But when it comes to investing, this incessant search for patterns causes more heartache than anything else.” – Jason Zweig

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Our brains are hard-wired to believe we can predict the future and make sense out of random patterns. In fact, it even, it even rewards us for doing so.

Further, according to the author Dan Solin,

The brain of a person engaged in pattern seeking and prediction, experiences the same kind of pleasure that drug addicts get from cocaine or gamblers experience in a casino.

Thus our never ending search for patterns in the equity markets leads us to assume that order exists in the markets. However the harsh reality is that stock markets are far more random and unpredictable than we like to admit.

Let’s put his insight into the current context..

The Indian equity market (represented by Sensex) is down ~10%

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What will happen to the markets going forward? Will the correction continue?

The honest answer is “I don’t know” (an even more honest answer is no-one knows)

But unfortunately our pattern seeking brain is already on to its prediction mode..

All recent market corrections have been followed by a sharp recovery – Taper Tantrum in 2013, China concerns & Oil crash in 2015-2016, Demonetization in fag end of 2016

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So our pattern seeking brain expects the same pattern to repeat this time too.

So we ride out the initial part of the decline as we expect the earlier pattern of quick recovery to repeat. Now if it repeats, well and good. Else we are in for a shock!

Eventually in equity markets, it is only a matter of time before which the pattern gets broken and the market decline prolongs. (but when it happens is anyone’s guess)

And the moment our identified pattern is broken, all hell breaks loose. We panic, our predictions go for a toss and you know the rest of the story –

We end up selling near the bottom!

Let us move on to the second explanation of why we panic close to the bottom.

Cognitive Dissonance: The action-belief mismatch..

The psychological discomfort that we feel when our actions are not aligned with our beliefs is called cognitive dissonance. All of us strive to avoid this as much as possible.
When cognitive dissonance happens, we try to reduce in different ways.

Remember the Aesop’s fable ‘The Fox and the Grapes”..

Driven by hunger, a fox tried to reach some grapes hanging high on the vine but was unable to, although he leaped with all his strength.

As he went away, the fox remarked, “Oh, you aren’t even ripe yet! I don’t need any sour grapes.”

The problem is that in order to reduce the dissonant feeling we can sometimes become biased to self-deception. We can be drawn into simplifying narratives or illusions or become guilty of rejecting valid but contrary viewpoints.

In a bear market, here is how cognitive-dissonance plays out in an investor

Most investors have created a self image of being a good decision maker. They believe they are intelligent and diligent investors and can predict the markets.

Self esteem Paige Soller Flickr

In a falling market, as our investments decline in value, we don’t like to admit that we were wrong. Cognitive dissonance sets in as the new reality – that our investments have declined conflicts with our own view of us being good decision makers.

Selling and realizing a loss only reinforces this and hence we will be reluctant to realize losses even when investment performance is bad. This leads to what is called the “disposition effect.” i.e we stick to our investment holdings despite loss. 

As the market fall continues, the cognitive dissonance continues to increase, but at the same time we cannot sell as it would hurt our ego and self image.

How do we find a way out of this?

As always, we come up with a cunning solution..

Looking for someone to blame

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The solution is simple – Let us put the blame on someone..

“My advisor is a cheat..he should have seen this coming”

“My fund manager sucks”

“The broker recommended me this dud stock”

Phew. Now that we have a scapegoat, we can relax. We suddenly find this a behaviorally easier solution to resolve our cognitive dissonance as we can still can maintain our positive self-image. 

And hence we end up selling, and at the same time manage to keep our self image intact!

Bear market behavior – Complex interplay of loss aversion, frequent monitoring, pattern seeking brains and cognitive dissonance

In the initial part of the market decline, the tendency to sell due to emotional pain from loss aversion and frequent monitoring is negated by our pattern seeking brain (which expects a quick recovery as seen earlier) and cognitive dissonance (which doesn’t allow us to sell to maintain our self image)

But as the decline extends and takes the form of a bear market, the emotional pain pain from loss aversion and frequent monitoring significantly increases. Further the earlier patterns are also broken and we seek to resolve our dissonance by blaming someone else.

As all these factors come together, we usually end up selling near the bottom of the bear market.

This post is not designed to argue that we should not sell equities in a bear market – in fact if the earlier investments were bad it makes all sense to sell out as early as possible.

However if the investments are good and a long term investment strategy is in place, panicking and not sticking to the plan can have disastrous consequences for us.

Thus the idea is to highlight the distinct behavioral challenge that all of us will face in a bear market.

Quick Summary

  • Loss Aversion
    • The pain  from a financial loss is almost two times the pleasure derived from a similar gain!
    • The result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss
  • Frequent Monitoring
    • The more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion
  • The lethal combination of loss aversion and frequent portfolio monitoring implies significant emotional pain during a market correction.
  • Pattern Seeking Brain
    • Our brains are wired to seek patterns
    • Our brains are still stuck in the earlier patterns of intermittent declines followed by quick recovery which is common in a bull market
    • The brain expects this correction to be no different and hence doesn’t want to sell right now
    • As the market fall extends, the pattern breaks, we panic and its the same story – we sell close to the bottom!
  • Cognitive Dissonance
    • The psychological discomfort that we feel when our actions are not aligned with our beliefs is called cognitive dissonance
    • Most investors have created a self image of being a good decision maker
    • A falling market conflicts with the self image
    • In the initial part of the fall, we hold on our equities to maintain self image
    • As the fall extends, we remove cognitive dissonance by blaming the poor decision on the advisor, broker or fund manager – and at the same time maintaining our self image
    • Thus we end up selling close to the bottom
  • In the initial part of the market decline, the tendency to sell due to emotional pain from loss aversion and frequent monitoring is negated by our pattern seeking brain (which expects a quick recovery as seen earlier) and cognitive dissonance (which doesn’t allow us to sell to maintain our self image)
  • But as the decline extends and takes the form of a bear market, the emotional pain pain from loss aversion and frequent monitoring significantly increases. Further the earlier patterns are also broken and we seek to resolve our dissonance by blaming someone else.
  • As all these factors come together, we usually end up selling near the bottom of the bear market

Now while there is an urge to come up with a solution to address this, the idea is to explore all other enemies, gain a holistic perspective as we connect the dots and at the end of it come with a solution to fight them all (hopefully).

So I plead patience for a few more weeks.

Till then, happy investing as always

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers!

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

 

Oops the markets are falling – Spying on investor behavior – Part 1

10 minute read

Equity market corrections are inevitable

If we are investing in equity markets, there is only one certainty – we will all inevitably  go through periods of market declines.

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History shows us that for Indian equity markets, it is reasonable to expect a 40%50% correction at least once every decade, 20-30% correction once every 3-5 years and 10-15% corrections almost each and every year.

But the sad part is that most of us (that includes me for sure) will find these corrections extremely stressful and there is a very high likelihood that we will panic, exactly at the wrong time.

Investor Misbehavior – Selling low and buying high

Usually this leads to disastrous investment pattern of selling low and buying high.

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This also ends up in what is called a “behavior-gap” i.e investor returns being far lower than the actual underlying investment returns over the long run.

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At the risk of grossly simplifying the issue, from an investor behavior point of view we have two problems to solve

  1. Selling low
  2. Buying High

Over the next few weeks, we will delve upon each of these two issues in detail and see if we can figure a way out.

First, let us focus on the 1st problem “Selling Low” and learn about the 8 enemies who influence us to sell during a bear market

Enemy No 1: Evolutionary roots and our three-in-one brain!

Scientists working on our brains have found out that while all of us have a single brain – not all parts of our brain were developed at the same time, instead, our brain actually evolved in three separate stages over millions of years as a part of human evolution.

reptillian-brainThe three brains – the reptilian brain, the limbic brain, and the neocortex – are radically different from each other in anatomical structure, in chemical composition and in function.

They are so different, that we can think of this as having three different brains crammed into our skull: a primal instinctive mind, an emotional mind and a rational mind.

This is called as the Triune Model of the Brain and was developed by the scientist Paul McLean in the 1960s.

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a. Reptilian Brain –

The reptilian brain, is the oldest part of the brain, the one that we share with reptiles, and has its origins about 500 million years ago.

This brain caters to the most primitive, instinctive human behaviors and the primary purpose of the reptile brain is survival, reproduction (sex) and protection.

Since this part of the brain is responsible for survival it is always active, even in deep sleep. Further, this part of the brain is NOT in our control and works at a subconscious level.

It controls the basic functions required for body maintenance like breathing, heart rate, metabolism, digestion, hunger, blood circulation etc and is also involved in arousal and responds to opportunities to have sex.

b. Limbic Brain – Head of Department, Emotions

The second to develop was the limbic brain or emotional brain.

 

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This is our emotional center which holds memories related to specific emotional events. It assigns specific emotions to events and habits.

For example, the reason why we may feel good after eating an ice cream is because the limbic system has assigned a pleasurable emotion to consuming that specific food.

The reason why we like or dislike certain activities is because our limbic system holds on to emotions assigned to that activity.

Let’s say we lost money in the stock market. Our limbic system will store an emotion of pain attached to stock markets. This event may then be the reason why we become scared of stock markets.

The functioning of the limbic system is based on the experience of pleasure or pain.

And here is the important part – we have very little control over the limbic brain.

Food, Fuck, Fight, Freeze, Flight..

Both the reptilian brain and the limbic brain together are sometimes also referred to as the Lizard Brain.

They together were designed to serve our ancestors who were were hunter-gatherers, living in small nomadic groups, pursuing wild animals for food, looking out for edible plants, searching for mates, avoiding predators and seeking shelter in bad weather.

Further the reptilian is always scanning the environment for potential threats.  Based on its evaluation of the threat along with the help of the limbic brain, it responds with a freeze-flight-fight response. (i.e it responds to threats either by mobilizing our energy for fighting back or for flight, or by freezing in helplessness in the face of an overwhelming situation.)

Sounds mumbo jumbo – check this video and you know why you need to thank your lizard brain

Seth_Godin_Lizard_Brain_GA_Course_Slide_20140409_121356_20140409_121359.png“The lizard is not thinking about the taxes and what he’s going to do tomorrow, how to secure his housing, mathematics; he’s just into food,fuck,fight,freeze,flight. That’s it. And it’s very real. Pure feeling.”

– Wim Woff a.k.a the Dutch “Iceman” who climbs the highest and coldest mountains in the world, shirtless only wearing shorts

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Since nothing matters more than survival, we are in fact largely controlled by the lizard brain!

Also, the lizard brain overrides the rational brain when it perceives threat and our survival and safety are in question.

We are all lizards deep inside!

A lot of the behavioral biases that we have owe their reason to these two parts of the brain

c. Neocortex – The Rational Brain a.k.a The Thinking brain

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The most recent and outermost part of your brain is the neocortex, which you can think of as your thinking brain. It’s responsible for reason and logic.

It’s also the part that gets hijacked when perceived threats and high emotion take over.

So basically, out of the three brains, the Neocortex is the one which is best suited for complex decision making required for stock market investing.

Now that we are done understanding the three brains, here is a quick summary to help you remember

Our brain – Latest software upgrade on an outdated hardware

As a part of evolution as the brain evolved from primitive to advanced, it didn’t get rid of its old parts. Instead, the new parts formed on top of the old ones. The older parts stuck to their age old functions of survival. The problem now is that we have a fairly recent software which is running on a hardware upgraded millions of years ago!

This forms the foundation of an entire field called “Behavioral finance” which explores the various behavioral biases which we have due to this mismatch.

The three brains and the falling market

Usually all these three brains operate together. But there are times when a certain segment will override or heavily influence other segments. And herein lies the problem.

The rational brain (neocortex) is overpowered by the emotional (limbic) and reptilian brain during times of danger

This makes perfect sense from an survival point of view, as in the presence of fear or danger, someone who delays is at a disadvantage; a fraction of a second can make all the difference between life and death.

Step on a snake, a dog suddenly chasing you, an stone flying towards your face, and your lizard brain will jolt you into jumping, running, ducking, or taking whatever impulsive response that should get you out of trouble in the least amount of time.

But what if the lizard brain is wrong in its interpretation of danger and has received a false signal – given the instinctive response, you would have acted by then.Apparently this is still fine.

For our ancestors, this system worked perfectly well, as there was little harm in confusing a false alarm vs a real one. If your lizard brain sent you running trying to escape a tiger, you are safe. Even if it was actually only a movement in the grass due to wind which you mistook for a tiger, you still end up fine as your running away from that place did you no big harm.

Lizard brain’s premise : Better safe than sorry

But the real problem is when a potential threat is financial instead of physical.The lizard brain is only used to physical threats and never had to handle a financial threat during its hunter-gatherer times.

Hence when faced a financial threat such as a fall in markets it cannot differentiate it from a physical threat.

As a result, it triggers the same fear reaction, during a market fall as you lose money or believe that you might!

In fact according to Jason Zweig, the author of “Money and your Brain

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Financial losses are processed in the same area of the brain that responds to mortal danger. Losing money can ignite the same fundamental fears you would feel if you encountered a charging tiger, got caught in a burning forest, or stood on the crumbling edge of a cliff.”

So the lizard brain in charge of our survival comes into action overriding our rational brain during a market fall when you start losing money!

This is a recipe for disaster as the rational brain which is best suited to handle investing decisions is shut off, and the old lizard brain which has no clue on the stock market is called upon to handle investment decisions.

The lizard brain still stuck in our ancestral hunter’s environment, as a response to the threat decides to take the flight response.

“Sell, Sell, Sell” shouts the lizard brain!

Unfortunately, in the world of investing, a panicky response in a falling market is usually disastrous in the long term. Selling all your stocks or equity mutual funds just because the Sensex is falling – will put you in far more trouble than it will get you out of it.

A moment of panic is all that it takes to screw up our long-term investing strategy.

The story usually ends with us fleeing the market at a low point and missing out when the market bounces back!

Thus it is important to realize that, in a falling market our lizard brain (mistaking the financial loss as a survival threat) is hell bent to make us sell out of equities.

And mind it, this is a powerful brain which has evolved over millions of years – our new age rational brain more often than not will not stand a chance against this.

Add to it the fact that, we can quickly execute our sell decisions in seconds thanks to our cellphones.

No wonder majority of us panic and sell during a market crash!

Takeaway:
To panic during a bear market is not our fault, we are all wired that way.
Blame our evolutionary roots and the lizard brain.

Thus the 1st enemy in a falling market is unfortunately our own brain and our evolutionary roots 😦

(to be continued)

In the coming weeks, we shall explore each and every one of the other enemies, gain a broader perspective as we connect the dots and at the end of it come with a solution to fight them all (hopefully).

Till then, happy investing as always 🙂

P.S: By no means am I a brain expert. So most of these learnings are from several articles, books, videos etc . The intent of this series is to primarily spur your curiosity and explore why we actually panic during a market correction. If you are brain related scientist and got pissed off at my naivety please feel free to take my case via the comment section 😦

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers 🙂

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

Dude, Shall I cut my equity exposure?

5 minute read

Last week a friend of mine, who had read my recent rants on the need to focus on risks over returns at the current juncture called me up.

Dude, shall I cut my equity exposure? Looks like the markets are correcting and as you mentioned valuations are also expensive!”

I am sure most of us are grappling through the same issue. Let us see if we can find an answer to this million dollar question..

I personally think the markets are slightly expensive and the global interest rate scene is extremely uncomfortable for me. So there is an inherent itch in me to play it “cute” – Should I take out some money and park it into safe assets such as debt funds and get back in post a correction.

My first investment mistake..

Thankfully, I have already gone through this question 5 years back during the 2013 crash due to taper tantrum. And this is also when I made my first it-can’t-get-dumber than this mistake.

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In 2013, around May the US Fed had announced that they were planning to gradually reverse their quantitative easing programme (read as no more money printing).

The Indian equity markets were down by 10% and the Indian currency had moved from 53 to 66 levels! India was classified as fragile 5.

It was the “shit-hit-the-ceiling moment” for me.

Being the dumb me, I poured over various brokerage reports and not to be surprised, all of them scared the daylights out of me.

And if you haven’t guessed it till now – yours faithfully panicked!

Yep, despite all the support system I had in terms of a great organization, access to best fund managers, intelligent colleagues, sophisticated market data and analysis subscriptions which cost a bomb, still I panicked!

I sold of 30% of my equity allocation and stayed in cash. And you know what happened next.

The markets recovered!

And thankfully, I did enter back. But by the time I entered back all my stocks were above my selling price 😦

What was the learning?

Look out for a better market timing model and figure out various factors which impact the equity markets..blah..blah

Grr..not again..but thankfully, common sense prevailed over my intellectual enthusiasm.

The solution was not a better timing model. It was far more simpler as a how-did-it-not-strike-me-earlier-kinda insight stuck me.

I realized that I was still in my 30’s and had a hell a lot more years of earnings and savings to be invested!

This meant that my current corpus was a paltry amount compared to the expected corpus 15-20 years down the line. So the real question was – why all this market timing drama at this stage?

Understanding Human Capital vs Financial Capital..

To help you appreciate the true dumbness of my blunder, let me introduce you the concept of – Human Capital vs Financial Capital

Human Capital is simply the amount of money you are yet to earn using skills, knowledge and experience, over the course of the rest of our lives. The more skills/knowledge/experience you have, the higher your human capital.

In Indian context, assuming most of us retire at around 60 to 65, human capital is what we are yet to earn till we are 60 to 65. So your human capital is at the maximum when we start working and diminishes as we near our retirement.

 On the other hand, financial capital is basically the sum of all of your assets minus your debts – i.e your net worth. In my case since I don’t have debt or real estate, my financial capital is in effect my entire investment portfolio value.

Financial capital is the inverse of human capital where usually, it’s lower when you’re younger and gradually grows till you reach retirement.

pharmacits-human-capital-chart-v31.jpg

Source: http://pharmacistsfirst.com/pharmacists-most-overlooked-asset/

Now you can clearly see that, my real blunder was that, I had completely ignored the invisible part of my portfoliomy human capital – i.e the savings from my earnings over the next 20-30 years!

If I had framed my portfolio value taking into account my overall potential future portfolio (taking into account my future earnings), my current portfolio size would have been minuscule compared to the 30 years of earnings and savings left.

Suddenly I would have realized that, all I needed to do was to shut the f**k up and focus on saving and investing regularly in the initial stages.

This would have allowed me to keep it simple and stick to a 100% equity portfolio – instead of trying to time the market.

Re-frame your portfolio..

The table tells us how an investment of Rs 10,000 every month which is increased by 5% every year and provides a return of 15% will fare over different time periods.

Future Portfolio Estimates.png

Refer here for a detailed explanation

The first thing for you to do if you are young is to roughly approximate your  portfolio value 15-20 years down the line. (Assuming you want to become financially independent a lot earlier than your 60s)

If you do a monthly investment of Rs 10,000 and assuming that you increase it by at least 5% in every year at 15% expected returns (from equities), you will end up with Rs 80 lakhs in the next 15 years and Rs 1.8 cr after 20 years.

So based on your monthly savings that you currently do, you can have a rough estimate of the portfolio value after say 15-20 years.

This would put in perspective your current portfolio and will help you put possible market corrections in the right perspective.

For Eg: The moment I put my current entire 100% equity portfolio as a % of the final value after 15 years it works out to be just around 6%.  With this sudden shift in frame, the answer to “Should I act cute and try asset allocation strategies with just 6% of my targeted corpus” becomes obviously simple.

A lot of us (I am no exception) end up doing this mistake of overthinking, analyzing and trying to act extra cute during the initial years of wealth building where in reality, its predominantly our ability to earn and save which really matters initially.

Keep it simple..

Since my friend is in the same boat as me, our solution became a lot simpler.

Let us not act cute. We shall just stay put and ride the volatility out (however painful it may be).

Also if we don’t test and understand our behavior (ability to withstand declines) now at a smaller corpus, then at a larger corpus it may become too late.

But obviously as our portfolio grows in size, we will reach a point in time, where the returns from our portfolio is much larger than the incremental savings. This is the point where an SIP or monthly investing does little to address overall portfolio volatility (as the 100% equity portfolio has significantly grown in size and a 50% temporary decline like that in 2008 can emotionally derail us from equities forever. You can read more about this here)

So I have a simple thumb rule – only when my portfolio size crosses 5 times my yearly salary will I start attempting to be cute and implement an asset allocation strategy. (You can fix your own cut-off no based on the no of years of salary you wont mind seeing in red during a temporary (hopefully) market decline). Logic being at a larger size, protecting my existing portfolio becomes as important as making it grow!

Till then, let the people with large corpus of money worry about asset allocation, market timing etc while we relax, focus on our careers and continue investing regularly.

Image result for simple

Summing it up

  • In your 20’s and 30’s, a long investment time horizon & large human capital are the biggest advantage you have
  • To take advantage of this, go for a equity heavy portfolio (assuming you have your short term requirements sorted through safer avenues such as fixed income funds, FD etc)
  • A high equity allocation also comes with the caveat that you must be mentally prepared for a 50% correction once in 5-7 years, 25-30% correction once every 3 years and 10% correction every year (all these are rough estimates and not cast in stone)
  • Your portfolios might look risky because of high equity exposure, however, if you take into account the potential future portfolio size, the current portfolio will usually be minuscule in the context of future portfolio size
  • So even if your investment capital falls by 50%, if you frame it as a % of your total expected future portfolio, the fall would only be a few % points because you still have another 20-30 years of human capital left
  • Your ability to earn and save dwarfs the loss in your portfolio
  • So, in the initial stages of your investing, focus on things under your control – career & earnings, spending & savings pattern, regular investing and hanging on to the portfolio (not getting knocked off by intermittent scary declines)
  • During initial stages of wealth building, don’t complicate life by getting into the nuances of market timing, asset allocation calls etc (which you will save for another day when your investment portfolio has grown reasonably large)
  • Try and automate your savings & investing habits to large extent – keeping decisions to the minimum

Happy investing folks 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free super interesting investment insights delivered straight to your inbox. Cheers 🙂

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

A visual way to think about future equity returns

5 minute read

Here is a fun visual way to think about future returns from the equity market.

As explained earlier here , the future returns from equities are made up of three components

  1. Earnings Growth:
    • Ultimately this is the most important driver of long term equity returns
  2. Valuation changes (in PE ratio):
    • Here we measure for every rupee of earnings how much are we ready to pay (sometimes when the mood is good investors have paid up to 25 times and sometimes when the mood is bad and everyone has given up on equities this metric has gone as low as 9 times).
    • This component is simply the reflection of the aggregate mood of all the market participants. It is impossible to predict future valuations as who the hell knows how the mood of investors will be a year down the line (honestly I won’t be able to predict my own mood).
    • This component is the most unpredictable one and is the culprit responsible for equities being an extremely volatile asset class
  3. Dividend Yield: This has generally been around the range of 1.5% historically for the Sensex

So,

The future returns of the Sensex = Earnings Growth * Change in Valuations + Dividend Yield

Investing at average valuations.png

If you are investing at average valuations, then you should expect the future returns to be around the earnings growth (+ dividend yield of 1.5%).

 

Investing at high valuations

If you are investing at high valuations, then you should expect the future returns to be lower than the earnings growth + dividend yield of 1.5% (as drop in valuations shave of some of the earnings growth from translating into returns)

 

Investing at Low valuations.png

If you are investing at low valuations, then you should expect the future returns to be higher than the earnings growth + dividend yield of 1.5% (as increase in valuations add returns over and above earnings growth)

What if the valuations at the end of tenure are not equal to the average valuations?

As earlier mentioned, I have no clue on what the exact valuations would be on the last date of your investment tenure. But however, historically Sensex valuations have always mean reverted to 17-18 times at least once in all possible 2 year periods of the last 18 years.

While there is no compulsion that this has to repeat, going by history it is fair to assume that you will get an exit at around 17-18 times in the last 2 years of your investment period.

Max PE 2Y

What should be a reasonable expectation on equity returns going forward?

Current PE ratio: 23.2                           (Source: https://www.idfcmf.com/)

Assuming it mean reverts to 18 times, this implies a knock of 22%.

That works out to approximately a 5% detraction of returns on an annualized basis over the next 5 years.

Earnings growth expectation:

In order to arrive at our approximate estimates for the next 5 year earnings growth, we need to project these two parameters

  1. Nominal GDP Growth (i.e Inflation + Real Growth)
  2. Corporate Profits as a % of GDP

corp pat as a % of GDP.png

Assumptions

  • For nominal GDP growth, let us go by RBI estimates which is around 6-7% real growth + 4-5% inflation = 10 to 12% Nominal Growth
  • We will assume that the corporate profit as a % of GDP moves closer to the long term average (5% of GDP) over the next 5 years. (to around 3.5% to 4.5% as a % of GDP)
  Final 3.0.png

Going by this, our reasonable estimates of earnings growth for the next 5 years can be around 15% to 21%.

for a detailed explanation refer my earlier post here

Summing it up:

  1. Earnings growth can be around 15% to 21% over the next 5 years
  2. Valuations will lead to a negative impact of around 5% over the next 5 years
  3. Dividends will add around 1.5%

Thus overall return expectations for the Sensex over the next 5 years can be approximately around 11% to 17%

This being said, given the high valuations at this juncture

  • We should at least have a minimum time frame of 5 years (with a mindset to extend by 2-3 years if required)
  • Be prepared for intermittent sharp declines

The idea here is not to predict but just a rough process via which we can set some reasonable expectations on what to expect going forward over a longer time frame.

Remember: The short term as always will be unpredictable and possibilities of a steep fall cannot be ruled out if an external negative event hits given the high valuations

What can go wrong?

As clearly seen a high earnings growth remains the key driver of returns for the next 5 years. Since valuations are already high it will also remove a portion of returns that will actually be provided by earnings growth.

So for the next few years – there are only three things that matter – earnings growth, earnings growth and earnings growth!

As always, take this projection business with a pinch of salt.(Link) I would love to hear your comments on if I am missing out something. Also please feel free to post your suggestions on how we can improve this and make it a usable framework for all 🙂

Happy investing folks 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 1800+ awesome people. Look out for some free super interesting investment insights delivered straight to your inbox. Cheers 🙂

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

And the award for the world’s best risk manager goes to..

A 10 minute read

In my last post I had indicated that at the current juncture investors are underestimating risks and overestimating returns, and hence we need to focus on risk over returns at this juncture.

While this looks like an eloquent statement, I could hear you go “WTF..What exactly does that mean ?”

Unfortunately, risk is an extremely fuzzy concept and it’s hard to precisely measure it. But as Einstein says..

Einstein Quote.png

So let us try and understand more on how to evaluate risk and its nuances.

Predicting a crash in hindsight..

Nowadays a lot of the mutual fund presentations have a default slide in all their presentations as to why today’s market is not anywhere close to the 2007 peak levels.

bsl ppt

Kotak 2007 vs 2017

Source: Kotak Mahindra AMC and Birla Sun Life AMC

Somehow hindsight makes it crystal clear that 2007 markets had all signs of a bubble.

Just for the sake of being curious, why don’t we actually travel back to 2007 and check out what the fund managers had to say during those times.

Prashant Jain – HDFC Mutual Fund (26-Nov-2007)

Do you see a market crash in the near future?
In my opinion, a “crash” is probably too strong a word for the Indian market. But a correction can never be ruled out. It is true that the Indian market is somewhat expensive, but it offers a unique combination of size and growth. Global investors are increasingly looking at India as a mainline asset class and are therefore, investing with a long term view. If you look at Indian P/E’s of nearly 20, 15-20 per cent earnings growth, interest rates of 4-6 per cent prevailing outside India and an appreciating currency, then Indian P/E’s still look reasonable. India is somewhat expensive compared to the past and to the prevailing interest rates locally. But when viewed in the global context and in view of improved size, fundamentals and visibility of the Indian economy, the market does not appear to be unreasonably valued.

Source: Link

Mahesh Patil – BSL MF (28-Nov-2007)

Do you see a market crash in the near future?
I don’t see a major market crash in the near future. The long term trend is still up. However, after the smart rally we have seen in the last few weeks, one can expect a short correction of about 5-7 per cent in the near future.

Source: Link

A Balasubramaniam – Birla Sun Life AMC (24-Dec-2007)

Do you see a market crash in the near future?
During the recent run up of the market, post the US Fed cutting the Fed rate, we have seen the CNX MidCap under perform the larger indices. This has resulted in an increase in the valuations gap between large- and mid-caps. We analysed the results of all manufacturing companies in the BSE 500. We saw sales rise by 24 per cent while PAT grew by 70 per cent on year-on-year basis. Given the lower the inflation and a softer interest rate regime, we expect the coming quarters to go quite robust. This would widen the valuations gap between large- and mid-caps further. Hence we believe mid-caps would be very attractively valued.

Source: Link

Birla Sun Life AMC Factsheet (31-Dec-2007)

Investors have now started worrying about a possible US recession and the consequent impact on the emerging markets including India. We believe that a near recessionary US economy is unlikely to have as significant an impact on emerging markets as in the past. Indian economy, is resilient to the impact of any potential US slowdown (domestic consumption driven and low export-to-GDP ratio at about 15%). India has diversified its exports base – commodity and country wise – share of US exports now stands at 15% of India’s total exports from 22.8% in FY2000. Research indicates that for every 1% fall in GDP growth in the US, India’s growth will only be affected by 0.25%.

 We believe India is entering a period of increased stability with limited impact on growth. India’s level of trend growth is expected to be sustained at  8% plus, due to  improved  macroeconomic stability, liberalization in a number of key areas and gradual improvement in infrastructure.”
 Source: Link

Srividhya Rajesh – Sundaram AMC (6-Dec-2007)

Do you see a market crash in the near future?
While we are of the opinion that there may be a bubble (in terms of valuations) being formed in the market, we do not forsee it being pricked in the near future. Given the global liquidity conditions, we expect the bubble to last longer.

Source: Link

Anand Shah – ICICI Prudential AMC currently the CIO of BNP Paribas Mutual Fund (20-Dec-2007)

Do you see a market crash in the near future?
The rise is the reflection of very strong GDP growth rates in the last three years and expectation of the same being sustained in the foreseeable future. We believe that strong earnings growth of India Inc will sustain going forward and thus market valuations are reasonable on a one-year forward earnings basis. Also, the balance sheet of India Inc is stronger then ever. We are of the opinion that the market might remain volatile in times to come, however a market crash is unlikely.

Source: Link

ICICI Prudential AMC Factsheet (31-Dec-2007)

As we step into 2008, Indian economy seems to be in fine shape, more capable of handling global slowdown than many peers. Globally, subprime related issues are resulting into credit squeeze. Banks are worried to carry out normal borrowing and lending amongst each other. ECB and US Fed are pumping liquidity to ensure that credit squeeze does not result into recession. Our feel is that with minor hiccups central banks world over will be able to stimulate global economy with series of rate cuts, pumping of liquidity and pro-growth statements.
Indian economy aided by domestic growth is likely to be an oasis of growth among the global desert. Q3FY08 results are likely to be in line with market expectations, except for some treasury gains or losses which are difficult to forecast. Big queue of IPOs and QIPs expected in 4QFY08 will keep up the supply pressure and also maintain momentum. FIIs, after turning sellers of Indian equities in 3QFY08 will have to think twice before selling in 2008. Chinese markets are running at higher valuation than Indian markets and as long as that gap is maintained, there is not much worry on the de-rating of Indian valuations. The domestic investors led by retail, insurance companies and mutual funds are taking lead over FIIs in articipating in Indian equities.
Net-net, the outlook for Indian equities in 2008 seems to be positive on the back of:
  • Economy, which is likely to grow above global average based on domestic factors
  • Valuations which are at premium over other EMs but at discount to China H share market
  • Domestic investors now stepping up to take lead over FIIs

Source: Link

Sadly the other AMCs dont publish their historical factsheets 😦

But the story is pretty similar across most of the interviews which you can find in value research here

Most of them are amongst the top respected names of the industry and have a solid performance track record spanning decades. There is no doubting their integrity or intellectual capabilities and these are people who have been-there-and-done-that.

Yet, none of them got it!

While everything looks easy to predict in the hindsight why weren’t even the best able to predict the crash.

Before we naively start to blame the fund managers, there is an important lesson for us..

Welcome to the world of alternate histories..

Our first instinct is that all factors such as high valuations, high credit growth, high capacity utilization, high corporate earnings, asset shift towards thematic funds, high retail participation etc were clearly indicating a crash and why hadn’t the fund managers spotted them as they mention in their current presentations.

Here is where the concept of alternate histories come –

  • What if the same crisis stuck after 2 years – say in 2010 instead of 2008?
  • And what if instead of 2 years it took 5 years for the crisis to manifest?

All the fund managers would have been right in this alternate history (and you may also argue that this version of history might have been the most probable one)..

The fact that something happened doesn’t mean it was likely, and the fact that something didn’t happen doesn’t mean it was improbable. Improbable things happen all the time, just as likely things often fail to occur
                                                                                                  – Howard Marks

The key here is to note that the actual trigger for the event was the sub prime issue.

And ironically, the manifestation of sub prime had nothing to do with the parameters which we were evaluating such as high valuations, high credit growth, high capacity utilization, high corporate earnings, asset shift towards thematic funds, high retail participation etc

And the reality is that the sub-prime could have hit at any point in time. Who knows!

Unfortunately most of the negative triggers in the past that led to large corrections also had nothing to do with the domestic markets. In 2016 it was the Chinese slowdown, in 2013 it was the Fed taper, in 2011 it was the euro debt crisis, in 2008 it was the subprime, in 2000 it was the dotcom bubble, in 1997 it was the Asian currency crisis etc.

There are 195 countries in the world and something will always go wrong somewhere. Further there are thousands of variables which can impact markets and the unpredictable complex interplay between them makes it next to impossible to exactly predict and time a market correction.

Thus a negative trigger which is the catalyst for a market decline is impossible to predict and time with consistency

Takeaway 1: It is impossible to consistently predict and time the next crisis

But is everything lost, now that we know that we cannot predict these negative triggers and to our solace even the best guys weren’t able to predict.

Hang on, we have some valuable clues to solve this issue from another mundane activity that most of us do everyday – driving!

Your own driving has the answer to the puzzle

comparison-motor-bikes-cars-bugatti-world-fastest.jpg

When I first started riding my bike, I never had a concept called accident in my mind. An accident was always something that happens to someone else. For years together, I was an extremely rash biker (the jackass who goes between two trucks, overtakes on the left etc) with an ability to over speed at the drop of a hat. And yet, while there were several close calls there was not a single scratch on me and my bike.

And then came 2004, my first accident where I nearly scraped my right eye off and broke my hand. I still have the scar below my right eye reminding me of the accident.

For the first time in my life I realized – things could go wrong.

And then came the killer. After a few weeks I started riding again but at much lower, controlled speeds and was going to meet my doctor to check on my hand. As fate would have it, a small kid suddenly ran across the road excited on seeing her mother. I fervently swerved, missed the kid by a whisker and met with my second accident, all in a span of 1 month.

This incident taught me all that I needed to know about investing.

Accidents can happen anytime. You have freaking no clue when they happen.

The first time I met with accident, I had taken more risks since I drove rash and at high speeds.

The second time despite a lower speed and lower risk, I still met with an accident but ended up with lesser injuries and saving the kid as I could maneuver better.

Outcomes are the same – an accident. But which driving style should I follow going forward?

Welcome to the world of understanding “risks” and evaluating outcomes.

When we say a higher speed is risky, what we really mean is that if there is some unexpected external event not under your control (say a broken road, an unexpected swerve from the car in front of you, a dog suddenly crossing in front of our bike, a drunkard crossing the road etc) your ability to maneuver the bike is a lot lower at higher speeds and hence the possibility of an accident and the expected impact from it is also very high.

But the real cause for the accident is actually the unexpected event and not the speed. So while the unexpected occurrence might not happen everyday, if you keep over speeding everyday, then your chances of an accident are very high in the long run.

Even at lower speeds, this unexpected event might lead to an accident. However at lower speeds your ability to maneuver is much better and hence the chance of minimizing the impact of the accident is also very high.

In reality the only way you can predict an accident is to exactly foresee the unexpected event. Now the irony is that it is called an unexpected event precisely for the reason that it is unexpected!

So all we do while driving is to focus on what is under our control – the speed at which we drive our vehicles. We try to manage risk by increasing and decreasing the speeds based on the road conditions.

This is precisely what we should try and do in investing too – control investment risks

Controlling investment risks

Just like in driving, we have no clue where and when the next trigger for an investment accident (read as crisis) is going to originate.

However similar to driving, in investing while we cannot predict the time and magnitude of a crisis, we can always prepare for them.

Just like how we control our speeds based on the road conditions, we need to control risks in our portfolio based on the investment environment.

This risk control can take the form of adjusting equity allocation, staying out of overvalued segments, exposure to reasonably valued and contrarian segments, diversification, asset allocation, hedging strategies, extending time frames etc

Unfortunately, the process of evaluating risk cannot be put into a mathematical formula. Accessing risks in the equity market still requires skilled and subjective judgement .

Takeaway 2: While we cannot predict, we can still prepare


Checklist for assessing risks

Here is a good starting point – a checklist for identifying bubble risks from ICICI Prudential AMC

ICICI Pru Checklist for market tops.png

The key thing to remember is that even if all these factors turn negative at some point in time, it still does not mean equity market will crash immediately.

All it means is that, if and when a negative trigger hits, the impact to your equity portfolio will be substantial.

So technically, now all these factors are not negative, but if there is a negative trigger which occurs the next week, the markets can still crash. The magnitude of the impact will depend on the risks taken in the portfolio.

I personally use valuations in the context of earnings cycle, corporate balance sheets and investor sentiments as an indicator of equity risks. (will explain them in detail in future posts)

The whole idea of controlling risks is to reduce the impact of declines (by reducing risks when likelihood of reasonable returns are low) while ensuring sufficient participation in the upside (by taking intelligent risks when likelihood of reasonable returns are high).

So what does this mean for us?

A negative trigger is the necessary catalyst for a crash which none of us can time and predict. A high risk in the portfolio only magnifies the impact if and when it hits.

Takeaway 3: When you evaluate that risks are high, all that you mean to say is that if some negative trigger hits, the magnitude of the fall can be substantial! If and when it happens is anyone’s guess.

This implies that any strategy which aims to reduce risk is not a market timing strategy (something which will exactly predict the top and bottom of the market). Most often than not, these type of strategies will be early in their decisions and will focus on reducing the overall declines while providing sufficient participation in the upside. It will work well only over longer periods and can under perform in the short run.

Takeaway 4: Any strategy that pursues to control risk, is not a market timing strategy and will inevitably undergo periods of short term under performance in pursuit of long term out-performance

In a nutshell

  • Any crisis is easy to predict in hindsight
  • Even the best of the fund managers, weren’t able to predict the 2008 crisis
  • The future is always a set of possibilities while the same future in hindsight is always a precise outcome
  • Always evaluate alternate histories to understand the quality of a investment decision
  • A negative trigger which is the catalyst for a market decline is impossible to predict and time with consistency
  • Takeaway 1: It is impossible to consistently predict and time the next crisis
  • In driving, you can never predict an accident but you try to manage that risk by controlling your driving speed
  • Similarly in investing, while we have no clue about the negative triggers which keep hitting the markets from time to time, we can manage and navigate them by focusing on controlling risks
  • Takeaway 2: While we cannot predict, we can still prepare
  • Controlling risks while cannot be put into a mathematical formula, involves a qualitative judgement on valuations in the context of earnings growth cycle, corporate balance sheets and investor sentiment (captured by flows).
  • High risk does not equal to immediate market crash and vice versa!
  • Takeaway 3: When you evaluate that risks are high, all that you mean to say is that if some negative trigger hits, the magnitude of the fall can be substantial. If and when it happens is anyone’s guess!
  • Any investment strategy that focuses on risk – more often than not, will be early in its decisions and will focus on reducing the overall declines while providing sufficient participation in the upside
  • Takeaway 4: Any strategy that intends to control risk, is not a market timing strategy and will inevitably undergo periods of short term under performance in pursuit of long term out-performance

Now that we understand the importance of evaluating risk, in the coming weeks we shall actually go about evaluating various risks at the current juncture and see how we can manage the risks in our equity portfolios.

And in case you haven’t guessed till now, the award for the world’s best risk manager goes to the driver in us for navigating the Indian roads each and every day 🙂

As always, happy investing 🙂

If you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3000+ awesome people. Look out for some free super interesting investment insights delivered straight to your inbox. Cheers 🙂

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

Seat Belts, Condoms and the Indian Equity Investor

The Seat Belt mystery

Image result for seat belts

In early 1970s, when the use of seat belts were made mandatory in the US to improve driver safety, something strange happened.

Instead of road accident deaths coming down they actually went up!

While the regulators were perplexed by this phenomenon, an economist by the name Sam Peltzman came up with a controversial answer.

Image result for seat belts + peltzman

He argued that though the drivers had lower risks due the additional safety that a seat belt provides,  many drivers actually compensated for the additional safety by driving more recklessly (driving faster, not paying as much attention, etc.) under the comfort of the added safety.

“The safer they make the cars, the more risks the driver is willing to take”

This meant that bystanders – pedestrians, bicyclists etc – would receive no safety benefit from the seat belts but would rather suffer as a result of increased recklessness.

He termed this effect “risk-compensation” but it is popularly known as the Peltzman effect.

Although the study has had its fair share of criticism, the Peltzman effect has been observed in a number of different settings.

Condoms and HIV prevention

Image result for condoms and hiv

In the late 1980s, Thailand and the Philippines had roughly the same number of HIV/ AIDS cases at 112 and 135 cases, respectively.

In the early 1990s, the Government of Thailand enforced the “100% Condom Use” program in its booming commercial sex industry while the Philippines was characterized by its very low rate of condom use and the firm opposition of church and government to condoms.

In 2003, almost fifteen years later, the number of HIV/ AIDS cases in Thailand had risen to 750,000 while the number in the Philippines remained low at 1,935 cases despite Philippines population growing to more than 30 per cent that of Thailand. Thailand ranks as the country with the highest HIV prevalence in Asia.

Source: Link

Mike Roland, editor of Rubber Chemistry and Technology states that wearing a condom reduces the risk of AIDS by a factor of 3 but simply choosing your partners wisely reduces the risk factor by 5,000.

While it is obvious that wearing condoms during promiscuous sexual activity reduces the risk of HIV, counter intuitively the lower risk of HIV can actually have the effect of tricking people into blindly engaging in more risky promiscuous sexual activity.

Its our peltzman effect at play 🙂

Titanic – The ship even god cannot sink

All of us know what happened to the Titanic. I would rather let the below picture do the talking.

Related image

Image result for titanic captain couldnt sink

Yep, its peltzman effect, yet again!

Olympic Boxing – Good bye Head Guards

boxing helmets banned

Did you know this – the Olympics ditched boxing headgear in 2016 for the first time since 1984!

The decision, according to the International Boxing Association, or AIBA came down to safety. 

Several studies, including one commissioned by the association, found that the number of acute brain injuries declined when head guards were not used.

The studies pointed out that

Headgear creates a false sense of safety and boxers take more risks.

By now, you know what is happening 🙂

Our behavior adapts to perception of risk

Now while all this goes against our intuition – the underlying point is that

When our perception of risk reduces, we usually adapt our behavior by taking higher risks

Indian Investor and the Peltzman effect

What does this have to do with the Indian investor?

Based on the Peltzman effect, if investor perception of risks in the equity market reduces, then it means that investors will respond by taking additional risks.

Let us evaluate the current investor perception of risk.

From a purist point of view – risk is the probability of permanent loss of capital.

However, when there is a market decline, most of us at that juncture do not know if it is permanent or temporary. (and unfortunately a lot of us give up and jump out at the bottom).

So for the purpose of this post, I will assume that investor perception of risk will depend on the intermittent declines in equity market that he/she has witnessed in recent times.

 

Here is an interesting chart which shows the intra-year declines which an investor in Indian equity markets would have witnessed in the last 27 years.

Nifty Intra Year Returns

An interesting thing to notice is that, the 20 year period from 1991 to 2011 has witnessed significant declines each year and 20% declines or more (indicated by the red bars) were a common occurrence.

So any investor who invested in equities during that period, eventually had to go through these significant but temporary declines year after year.

However, if you notice the recent 5-6 years, the declines have been significantly lower.

In fact the intra-year decline for 2017 is the lowest ever!

The other way to confirm this thesis is to look at the index which indicates volatility – Nifty VIX index (It measures the degree of volatility or fluctuation that active traders expect in the Nifty50 over the next 30 days).

INDIA VIX Stock Price  NSE Market Indices  INDIA VIX Price  Stock Performance   Comparison.png

The Nifty VIX index is also close to its all time lows!

Thus the first takeaway is:

Takeaway 1: Indian Equity Market fluctuation is extremely low in recent times           (leading to a perception of lower risks in equity markets)

Further the markets have also rallied since 2013.

Nifty.png

Takeaway 2: Indian Equity Market Returns have been awesome in recent times

Further real estate returns have been poor in recent times and are showing initial signs of a decline (see here)

Gold returns have also been very dismal over the last few years.

Spot Gold

Bank FD rates and debt fund returns have also significantly dropped due to lower interest rates.

Takeaway 3: Real Estate, Gold, Bank FD – all fall down!!

Now if we combine the above three takeaways, it’s a deadly combination where equity returns are high, equity volatility is low (read as – perception that risk is also low) and none of the alternatives are performing.

Now if we apply the Peltzman effect, this means Indian investors will adjust their behavior to take on more risk!

Is this true? Let us see if Indian investors have increased their risk..

Equity Mutual Fund Industry – Unprecedented Flows!

Equity Flows.png

You read that right – In the last 2 years, the money that we Indians invested in Equity Mutual funds is more than the earlier 16 years put together!

If you further drill down, the largest amount of money came in the last year (more than previous 3 years put together)

CY Equity Flows.png

And here is the scary part – the flows for 2017 currently represent 1/4th of the entire equity AUM – and investors who have brought in this money have never witnessed true equity declines (20% and below which was the norm a few years back) as they have come at a point where the volatility is at its historical lows.

CY Equity Flows 2017.png

Balanced Funds are the new FD replacement – WTF?

In every bull market, there is always some product which is mis-sold.

This time it is the balanced funds – a category of funds where equity is around 70% of the portfolio and the remaining in debt instruments.

Unfortunately, this equity heavy product is being mis-sold as a 1% every month dividend product which will give you 12% tax-free returns every year and as a FD replacement.

This is clearly reflected in the staggering growth of inflows witnessed in 2017

Balanced Fund Flows 2017.png

Here is an interesting article which explores this further – Link

Equity Market Valuations have moved up significantly led by flows

Nifty PE chart.pngSource: www.equityfriend.com

Small Cap funds & PMS signalling “Enough! We can’t take more”

Given the whopping out-performance of small and mid cap funds over large caps recent money has been chasing this segment leading to insane valuations for most of the companies in this segment.

Funds Monitor   Value Research Online.png

Source: Value Research

To the extent that certain funds have shut down their funds and returned their money back to investors.

DUZWJohVwAAQD34 (1).jpg

Source: ET, Read the entire article here

Some other funds which have restricted their funds for new money –  DSP BlackRock Micro Cap Fund, Reliance Small Cap, Mirae Asset Emerging Bluechip and SBI Small and Midcap Fund.

Peltzman effect at play – Time to be cautious and focus on risk

At this point, it seems pretty clear that the perception of equity risk is currently very low amongst investors and this has clearly manifested in higher risk taking behavior across Indian investors.

Everything at this juncture is about returns as risk has taken a backseat.

Hence we as investors must remain cognizant of the exuberant expectations being built into the current market. While earnings growth cycle is yet to begin, lofty valuations imply the possibility of sharp intermittent declines if in case something goes wrong. (and usually something always does go wrong in the interim)

So, at the current juncture the key is to focus on risk. Also

  1. Pare down return expectations
  2. Stay away from mid and small caps
  3. Stick to your asset allocation plan

If you don’t have an advisor to help you out with asset allocation, then dynamic equity allocation products can be a good option for incremental money allocation.

In a nutshell

  1. Peltzman effect – Introduction of safety belts in cars increased accidents as drivers compensated for the additional safety by reckless driving
  2.  Observed in several settings such as HIV prevention via condoms, Titanic, Olympic boxing etc
  3. Peltzman effect visible in current equity markets
  4. Deadly Trio: Indian Equity Volatility at all time lows + Great returns in equities + Alternative investments (Real Estate, Gold, FD) not doing well
  5. This lower perception of risk in equities leading to risky behavior in Indian investors
  6. Signs visible in 1) Unprecedented Equity MF inflows 2) Balanced Funds being sold as FD replacement 3) High Valuations 4) Small Cap funds restricting flows
  7. Time to be cautious and shift focus on risk (rather than returns)
  8. Things to do: Pare down return expectations, Avoid mid & small caps and stick to asset allocation

Happy investing 🙂

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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments