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

Image result for wimm woff dutch iceman

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

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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.

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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.

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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.

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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)
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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