Flawed Mental Model - By Dhirendra Kumar

Here's a joke that has a great pedigree in the investment world. The father of value investing, Benjamin Graham, apparently used to narrate this story to his students and draw a parallel to the behaviour of stock market punters.

So this oil prospector dies and goes to heaven. At the gate, St Peter reads the account of his life and tells him that he's qualified for heaven, but there was a problem. “See that crowd over there? They're all oil prospectors who've arrived before you. And the way things work here, you can' get in until after them. So I' afraid this looks like a long wait for you.” “Not a problem", replies the man, “I know how to get rid of that crowd.” So he turns towards that crowd of oil prospectors and shouts out, "Hey, did you hear? Oil has been discovered in Hell.” And sure enough, as soon as they heard him, every single one of them ran off towards hell. Looking at this, St Peter reluctantly said, "Well, it seems your way is clear. You can enter heaven now." But the oil prospector had his doubts. “You know what? I think I'll follow the guys. The rumour could be true.”

As Graham used to point out, the oil prospector's behaviour has much in common with what passes for investment research nowadays. As sophisticated commentators would point out, their mental model of how the market works probably leads them to believe that if a lot of people believe in something, then it must be true. A mental model of something is our idea of how it works internally.

A flawed mental model can be a problem. For example, in the early days of email, a friend of a mine believed that if you reduced the font size in an email message, then the message would become smaller and therefore easier to send. It was a flawed mental model, or rather, it was the fax mental model being applied to email.

I believe one of the fundamental reasons why so many people have trouble investing in the stock markets is that they have severely flawed mental models of what determines a stock price. While there are many mental models of how the stock markets work, some are more common than others. Here's the commonest. “There are people who know when a stock's price is about to rise. If one of them tells me, then I can make money.”

This is the 'tip' model of the stock markets. It isn't so much a mental model as the lack of one. Unfortunately, this is a very common one. There seem to be a lot of people who believe that someone out there knows which way things will move and everything depends on somehow getting to know these secrets.

A little broader than the 'tip' model is the 'operator' model. Under the operator model, people believe that there are people (“operators”) who manipulate stocks and what one needs is to figure out what the operators are doing and then somehow, manage to ride the stock while the operator is pushing it. This model is actually realistic. Outside the big, high volume tickers, many, many stocks are routinely manipulated by the so-called 'operators', at least in the short-term.

However, this model is useful only for the operators themselves. To succeed, operators need greater and greater fools to buy into the stock they are operating on. Basically, if you are not an operator yourself, you are under considerable risk of giving away your money to an operator. There is, of course, yet another model. This one is about observing how much companies earn and estimating how much they'll earn in the future and how they'll compete and other things like that. But compared to the other two models, few seem to believe in it so I suppose it can't be very important.

Harry Potter and the Amazing Investor

The other day I met someone who claimed to have doubled his investments every month for more than a year now. If I do the maths it turns out that this man must have multiplied his money to more than 4,000 times what it was. That's 4,000 times, not 4,000 per cent. The interesting part is that not only do such people expect to be believed, there are those who believe them. If you ask a random collection of people whether they think it possible that somewhere in the world there exist investors who can go on doubling money every month, then you'll get a surprising number of yeses. It's like believing in Harry Potter.

No one who invests in the stock markets ever loses any money. Or at least, that's what I will have to believe if I take at face value whatever someone says about their personal performance in managing their investments. I'm serious. Because of my profession, a lot of people talk to me about their investments and I can hardly remember anyone saying for months now that they lost money. It's amazing, actually. The markets fall. Dubious stocks shoot up and people keep buying them and then when the markets fall and stagnate no one admits to having lost any actual money.
To be fair, there are some who admit to holding investments that are way under water from their purchase price, but claim that this is not a loss but a temporary dip.

That's a point of view, I suppose. Not only does this undying faith in the existence of supernatural rates of return persists, it does a lot of real harm.

The refusal to admit to wrong investing decisions means that we miss the opportunity to learn from them. I know this sounds like a slogan from one of those motivational posters that are sold on footpaths, but failure really is a very good teacher. Provided one makes the effort to learn from it.

And at least in the case of investments, it isn't all that difficult to learn from bad investments.

What one has to do is to honestly think of the reasons why one bought that investment and then resolve not to repeat that reason without any further refinements.

Let me illustrate with a couple of examples.

Let's say you put a chunk of money into a new mutual fund because the fund salesman said other funds of that fund company had a great track record. Now that this new fund has done worse than the older ones, you only need to think back carefully at your reasons for the investment and the cure is self-evident.

Of course there's a danger in not making this analysis general enough. Let's say the brother-in-law of your boss recommends a stock and you buy it without any further inquiry and then the stock price collapses. Surely, the lesson is not that you shouldn't buy a stock on the recommendation of the bosses' brother-in-law or even brothers-in-law in general but that you shouldn't make investments you do not understand. Chance and luck may have played a role in a big success that someone may have had. It isn't very wise to mistake that for magic and imagine that it's repeatable by waving a wand.

Slow & Steady Wins the Race

It's the time of the year when we need to think of our tax-saving investments. No, this article isn't appearing three weeks later than it ought to have. You are reading this on 9th April and I'm talking about this year. This is actually the right time to plan for the tax-saving investments that many, if not most of us, would normally wait for till about March 2008. Perhaps we have become so used to catching deadlines at the last moment that we don't even think of planning taxes till very late in the year. Since we all see tax-planning as the purpose of these investments, and we get exactly the same tax break no matter when we make the investment, it seems fine if we ignore them till very late in the year. However, this is not true. There are a lot of advantages of planning these tax savings investments right at the beginning of the year and spreading them out throughout the year. Let's see how.

For most salary earners, the formula that tells how we should decide where to make our Section 80C investments is very simple in my opinion. Just subtract your annual provident fund contribution and any other pre-committed 80C eligible deduction (school fee, insurance premium etc) from Rs 1 lakh and invest the balance in a good tax-saving equity mutual fund (sometimes called ELSS funds). Since tax-saving investments are long-term investments, equity makes the most sense. However, equity investments offer higher returns and lower risk if you invest steadily over a period of time instead of all at one go.

Therefore it's best to calculate the amount you need to invest during the year, divide it by 12 and start an SIP (Systematic Investment Plan) for that amount right now in the month of April.

Investing in this drop-by-drop fashion has many advantages. For starters, you will invest without feeling the pinch of a large outgo at the end of the year. When March 2008 comes you will already be through with investments. Just as important, investing gradually in equal monthly amounts will protect you from the vagaries of the stock markets. You will end up acquiring more fund units when the markets are down, something that will automatically ensure higher gains eventually. This is always the best way to invest in equities and the predictable nature of tax-saving investments makes it specially easy to do it this way.

However, even if you decide that equity is not your cup of tea and you'd rather stick to a guaranteed investment like Public Provident Fund (PPF) or bank fixed deposits (which are now eligible for deduction under section 80C), it still makes sense to invest steadily throughout the year rather than at the end just to avoid a single big hit in March. In fact, if you are going to invest in PPFs or FDs and you happen to have the money lying around in a savings account or another ready form, then it's probably better to do the entire investment right now. After all, the tax savings investments have a lock-in period and the sooner you start the lock-in, the sooner it will eventually end and thus free up the money for other uses.

Volatility? What Volatility? - Dhirendra Kumar

The Indian stock markets have not become significantly more (or less) volatile at least for the last 25 years or so. I know that when I say that it will instinctively sound incorrect to you. You're probably waiting for the 'but…' part of that sentence. But there is no but. It really is true. At Value Research, we're doing some research on whether, as is the general impression nowadays, the stock markets have become more volatile. The study isn't complete yet but it's clear that as far as the bellwether Sensex goes, volatility is essentially unchanged since 1979. True, there was a huge peak in the Sensex' jumpiness during 1992, but that just lasted a few months.

Then why do all of us feel that the markets have become a lot more fickle? There are a bunch of reasons but the major one is simply the media's obsession with the absolute figure of the Sensex. It is a simple fact of arithmetic and mass media that on large bases, percentage changes are much less exciting than absolute numbers. Consider this data: On 15 June 2006, the Sensex closed 616 points higher than the previous close. This was a 6.9 per cent rise. Two decades ago, on March 25, 1986 the Sensex closed a much larger 9.1 per cent higher than the previous close. But in those days the Sensex used to be around 500 points so this was a rise of a mere 48 points. Closer to present times, the Sensex fell by exactly the same percentage (6.9) on April 17, 1999, but this was just 246 points. When I see headlines in newspapers and on TV channels focusing exclusively on the actual numbers of points, it's clear to me that there's a fake idea of the markets' volatility that is being peddled just to add a sensation because sensation sells.

After all, if you were a TV or a print newsman, which of these two headlines would you have chosen for the day when Mr Chidambaram presented Budget 2007: 'Markets register fourth worst fall ever'; or, 'Markets register 96th worse fall ever'. The first one is by absolute points and the second by percentage. Both are technically true but I believe that the first one is misleading and shows a certain contempt for readers' intelligence. Absolute numbers must never be used to compare quantities that have different bases. When a headline says that 28th February was the fourth worst ever, it is comparing all 6,000-plus days on which the Sensex has existed. Every one of those days had a different base and should thus be compared only on the basis of percentages. By any standard of mathematical or statistical literacy, such headlines are nonsense.

By the way, aren't you surprised that leave alone the worst five, the recent much-celebrated declines of the Sensex barely make it to the list of worst 100 one-day declines? That this comes as a surprise to so many people shows how completely we've all been fooled by this volatility story that's being peddled.

So is there no other reason beyond these fun-with-maths headlines that contributes to investors' volatility psychosis? I for one am hard-pressed to think of one. True, our study isn't complete and we'll be looking at indices as well individual companies more closely but my hunch is that this is the way it is.

I'm not ruling out more volatility in the future, at least temporarily, but you know something, the sky isn't really falling. There's a deep bedrock of current and potential economic growth which won't vanish overnight just because of new taxes in China or whatever. And that's going to be true for quite some time to come, even if new-fangled technology like percentages catch on or not.

A Fool and His Money... By Dhirendra Kumar

My friend Sanjiv Pandiya, who writes some of the most interesting stuff that is being written nowadays about investing, is fond of using the word fool. But he doesn't do it the normal way - the way, say, a school teacher does. Instead, he imbues it with an enhanced meaning that makes it easier to understand the markets. For example, I remember him once saying that banks were the default suppliers of foolishness in the markets. This idea of foolishness in this special sense makes it easier to understand why markets behave the way they do. What exactly is this foolishness? I think it's best defined as what is not.

We've all heard of the Efficient Market Hypothesis, which says that financial markets are 'efficient', meaning that the prices of stocks (or other securities) reflect all known information and therefore incorporate the collective beliefs of all investors about the future. For the hypothesis to be correct, people must have equal access to all information and have rational expectations.

I think the kind of foolishness we are talking about is everything that is the opposite of all those factors that make the market efficient. It's a bit like heat and cold in physics. You could say that the flow of knowledge and rational expectations keep the markets efficient or you could say that it's the flow of foolishness that keeps the markets inefficient. Isn't that a problem? No, it isn't, most certainly not. Inefficiency is what keeps the stock market interesting and profitable. If the markets were as efficient as the hypothesis says, then those who can identify and mark out foolishness would make less money.

Therefore, a steady and limitless supply of foolishness is the greatest of assets. Foolishness is the life blood of the stock market. Without foolishness, we would be nowhere. Instead of worrying about how well companies are doing and how much the economy is growing, smart stock investors should instead worry about whether an adequate supply of foolishness will be maintained. I'm happy to inform readers that if present trends continue, they have nothing to fear.

Over the last one month, I have been roaming around this great country and have visited 17 cities and have met and talked to investors in each. Although most of the people I met had disappointingly low foolishness levels, in each location there were at least some who showed great promise and gave me hope that the supply of foolishness to the stock markets is in safe hands.

It'll take just a few examples for me to convince you that my optimism about the future of foolishness is well-founded. One crucially important observation I made was that the most promising suppliers of foolishness use a different calendar than the rest of the country. I met people who thought the term 'long-term' in long-term investing meant six months. I also met those who thought it meant three months and some who thought it meant one month. These are not isolated examples, there are a large number of people in this country who use such calendars. However, the definition of long-term that gave me most hope was, "When there are profits it's short-term, when there are losses it's long-term".

Don't ask, I don't know what that means either.

Picking Winners - By Dhirendra Kumar

Sensex crosses 14K intra-day. Sensex touches 14K peak on strong fund support. Sensex hits 14Kmark. Freak surge sends index beyond 14K. Sensex crosses14,000 mark. Sensex kisses 14K. Sensex touches 14K mark. Crazy kiya re: Sensex kisses 14K. Sensex scales 14K peak, finally.

These were some of headlines that newspaper in the country carried on Wednesday, 6th December. Yes, I know it's strange that three out of ten (presumably) independently-written headlines thought of the word 'kiss' but that's what happened. However, some big headlines and the usual collection of permanently breathless TV anchors aside, there was precious little excitement among real investors.

To us symbolism-seeking humans, Big Round Numbers (I hereby coin the abbreviation BRN) always seem to have a deeper meaning than they actually have. See how many people expressed shock recently when Chinese foreign currency reserves reached 1 trillion dollars. But investors aren't really excited by the Sensex' BRNs any more. They've seen far too many of them in far too short a time. They've got BRN fatigue. From 6,000 to 14,000, there have been nine first-time BRN events and nine is one too many to get excited about. Also, even though the professional excitement peddlers studiously ignore the arithmetic, a thousand points of the Sensex isn't what it used to be. When this bull-run began four years back, the journey from 3,000 to 4,000 meant a gain of 33.3 per cent. From 13,000 to 14,000, the gain is just 7.7 per cent. Investors are now so used to big gains that 7.7 per cent just doesn't hold any excitement. I think the next BRN that anyone should seriously get excited about is 20,000 but whether that will come around in one year or ten, I have no idea.

I'm serious. I didn't put that ten year range in that last paragraph just to frighten you. Ten years to reach 20,000 is just as possible as one year. Equity markets are like that. There's nothing you can do about it. There is a great deal of fear in markets and many of the best fund managers had configured their portfolios defensively. Conventionally, this means loading up with large companies which are assumed to be more stable in a falling market. In the Indian markets, this is true only on a relative basis. When the markets fall, large companies fall a lot but they do fall a lot loss then the small unknowns that have been punted up by the tips being circulated by speculators. The difference is that eventually the big scrips rebound but the purely speculative ones don't, having served the basic purpose of transferring wealth from the clever to the impatient.

I think the real action lies in being able to identify the next lot of companies that will one day join the ranks of the big blue chips. Everyone knows that the big stocks are safer and everyone knows that smaller stocks are riskier. But there are many medium-sized companies that are knocking on the doors of blue chip status. A very large number of them are being pitched as potential blue chips. When the goings gets a little less easy, only a small number of them will be recognised as having made the mark. I suppose some serious rewards will go to those who will manage to correctly foretell which ones will these be. Or perhaps just make some lucky guesses.