Investing Is Less About IQ & More About EQ

– Meghashyam Sinkar

Investing specially in equity is correlated to intelligence . Of course, one needs to understand the numbers , its analysis & its implication . But is intelligence enough to score high in this subject ?

Sir Issac Newton was one of the smartest people to ever live. The man who conceptualized three laws of motion, pioneered calculus, and discovered the colour spectrum among other accomplishments, was a terrible investor. Because there’s a big difference between being a smart physicist & smart Investor .

In early 1700s in England , The South Seas Company was formed in anticipation of having a monopoly on trade to the Spanish colonies in South America after the War of Spanish Succession (1701-1714). Investors warmed to the appeal of this monopoly and the company’s shares began to rise. Sir Issac Newton also got attracted towards so called obvious opportunity . So , he invested and pocked some handsome gains of £7,000 . But the stock continued to rise. So he jumped back in, this time with an even bigger bet. Shortly after, the bubble bursted and the sell-off started. Newton lost the majority of his fortune and forbade anyone to utter the words “South Seas” in his presence ever again.

That is when the great physicist muttered that  “I can calculate the motions of heavenly bodies, but not the madness of people”.

Here’s a look at South Seas moved back then

South sea company

We regularly get to see such cases in stock market .

Albert Einstein – Father of Modern Physics and one of the greatest scientist that have ever lived. He developed the theory of relativity and is also well-known for his mass-energy equivalence formula E = mc2 .

Going back in the year 1921, the Nobel Prize winner in Physics – Einstein was awarded with 121,572.54 Swedish kronor. This is equivalent to more than twelve years’ income for Albert Einstein back then.

He invested a significant portion of this prize in the stock market but unfortunately lost the same in stock market crash in 1929. His wisdom in physics is not as good as his wisdom when it comes to analysing market conditions.

Long-Term Capital Management (LTCM)

In 1993 ,two mathematical genius , Fisher Black of Goldman Sachs &  Stanford’s Myron Scholes along with third economist , Harvard Business School’s Robert Merton had developed a revolutionary new theory of pricing options . ( Options in finance are part of derivatives) . The starting point of their work as academics was the long established financial instrument known as an option contract which works like this .

If a particular stock is worth , say Rs 100 today and you believe that it may be worth more in the future around Rs 200 (say in year’s time ) , It would be nice to have the options to buy it at that future date for say Rs 150 . If you are right , you make profit . if not , well , it was only an option , so forget about it . The only cost was the price of option ,which seller pockets . The big question was what that price should be . They wanted to work accurately on option price instead of just guesswork . So , they developed and reduced the price of the options to his formula:

LTCM formula
Source : From the book ” The Ascent of Money”

To make money from this insight , they partnered with renowned Salomon Brothers bond trader John Meriwether and formed the company ” Long Term Capital Management” in 1994 .

The going was smooth for initial 4-5 years, when markets behaved as expected and LTCM made hefty returns for its investors and managers. However, then struck some of the black swan events and that too with unexpected frequency. First, the East Asian crisis in 1997 and then Russian default in 1998.

Such un-natural events and the resultant fear & irrationality of markets could not be predicted and therefore could not be factored in mathematical models. The result was that all their widely diversified investments, which were supposed to behave independent of each other, started losing money simultaneously. LTCM started to bleed money on each trade every single day.

The fund was finally bailed out by intervention of Federal Reserve in 1998 and was dissolved in 2000.

A famous quotes from well known duo of Birkshire Hathaway sums up above message nicely

“A lot of people with high IQ’s are terrible investors because they have got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains.”-Charlie Munger

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” – Warren Buffett

Some of the lessons learnt from this History

  1. Leverage kills : LTCM is a classic example of excessive leverage & its risk .
  2. Intelligence (IQ) cannot guarantee good returns in markets.
  3. Investing is not pure science. It requires common sense.
  4. Markets can stay irrational longer than you can remain solvent.
  5. Keep emotions out – specially greed .
  6. Plan your cash flows & goals and then invest into asset which suits to your goals instead of following the trend . In short, avoid herd mentality .

Happy Investing !!!

The First Step Towards Financial Independence

– Meghashyam Sinkar

The group of retirees was interviewed once in Boca Raton , one of the Florida’s wealthiest retirement communities . Interviewer asked the people – mostly in their seventies – If they had beaten the market over their investing lifetimes .  Some said yes, some said no , most were not sure . Then one man said “Who cares? All I know is , my investments earned enough for me to end up in Boca .

Could there be a more perfect answer ? After all , the whole point of investing is not to earn more money than average or others  , but to earn enough money to meet your own needs . The best way to measure your investing success is not by whether you are beating the market but by whether you have put in place a financial plan and a behavioural discipline that are likely to get you where you want to go . If you have made enough money and met your goals then you are a successful investor.

Carl Richard – A financial planner from New Zealand in his book ” The Behaviour Gap” nicely given below sketch which is reality .

Carl richard - Money vs Income

Ask yourself these questions ” Why money is important to you? What does money do for you ?  What is the purpose of doing the investment? Take a time and write down the answers .

No doubt, money is an important part of life.  But it is easy to fall into trap of money to worry endlessly about how to make more .How much is enough ? And the more you have the more you need . It is better to think about what do you need money for ? What is your goal? But goals should not be influenced by external forces like peer or social pressure . Find out what gives you a happiness . What makes you to jump out of bed ? what gives you  peace ? So , it is important to have money but not more than the goal it serves. Make your financial plan , prepare cash flow , know yourself in terms of where are you now and where you wish to go ? And finally get into action accordingly . It does not matter whether Rakesh Jhunjhunwala, Warren Buffett, a fund manager, your friend, bunch of other strangers have beaten the market and you don’t . No one’s gravestone reads ” HE BEAT THE MARKET. 

“Financial Planning is not about the markets , not about the products . Its about you & your journey.”

Benjamin Graham in his book “The Intelligent Investor” quoted that Investing isn’t about beating others at their game . It’s about controlling yourself at your own game.” 

Happy Independence Day and Happy Investing !!

How do you earn returns in equity ? Expectation Vs Reality

– Meghashyam Sinkar

Once a man wanted to cross the river and he was not sure about the depth of the river . So , he asked the Statistician . He replied that the average depth of the river is 3 feet . The height of the man was 5 feet 11 inches so he comfortably proceeded to cross the river . As he approached the middle of river , he suddenly realised that the river was, in fact , very deep and he almost drowned .  This is called Law of Average Fallacy. 

Law of avarage

Similarly ,when it comes to return on equity investment , it is commonly said that equity will give you the average return of 12% to 15% . And this is when the expectation gets built on getting regular & steady return but reality is totally different .

Please find the Sensex year wise ( break-up ) returns for last 21 years .

Sensex Data

You often come across the advertising of mutual fund generating 40x – 50x returns in last 20 years or so .

HDFC Equity Fund has generated the returns of 63x ( 63 times ) of the initial investment . The value of Rs 1,00,000/-  invested on Jan 1, 1995 is Rs 63,56,160/- as on Aug 1 , 2019 which is compounded annual growth rate (CAGR) of 18.41% . But the returns have not come that easy . You can see in below chart that there was no growth in first 5 yrs and lot of ups and down in between till now and will continue in future . However, the fund has still delivered one of the best returns across all asset classes .

HDFC equity data

The below graph shows how it moves in long run to get ‘x’ times of returns if your economy is growing .

HDFC equity graph

Jason Zweig ,a well know personal finance columnist once posted on Wall Street Journal – 

“In order to capture the potentially higher returns that stocks can offer, you have to reconcile yourself to the certainty of horrifying short-term losses. If you can’t do that, you shouldn’t be in stocks—and shouldn’t feel any shame about it, either.”

It is very important to understand that equity does not give linear returns and the returns can be muted for long period of time . But the patience , temperament and belief will subsequently rewards the long term investors  .

Happy Investing !!!