This too shall pass away ….

We have seen the significant correction last week across global market . The fear of coronavirus looks to be more than actual impact of corona virus . The world economy was already struggling from US China trade war, Brexit issues, Oil prices & supply concerns & many more . The Indian economy has been under stress for the last few quarters with GDP growth coming under pressure  . The things were about to stabilise but pandemic situation clubbed with real time news update has brought the Indian and global market  into panic situation . Nifty corrected more than 20% in last 15 days.

When lot of things have changed in 15 days period , then it becomes hard to think more than 15 days ahead . But ,do not let this short term pain hamper long term gain.

The irony is that long-term thinking is most powerful when everything is falling apart. The majority of long-term results are determined by decisions made during a minority of times, and right now is one of those times. It’s a tragic moment to become short-sighted.

Markets had experienced such epidemic outbreak earlier Mars, Ebola ,Swine Flu . Refer our recent article  But they have always rebounded once things got settled down. Ohio lawyer named Benjamin Roth write after The Great Depression “Business will always come back. It will remain neither depressed nor exalted.”

However , it is always overdone whether optimism or pessimism and boundaries of both can only be known in hindsight, once they’re passed.

Currently ,No one knows how long will it continue except Virus itself.

What should Investors do ?

Don’t Panic and don’t act in haste . Selling at this stage may not be good .

Investors should add more equities in stagger manner and use this correction as an opportunity .

Historically, investing during these volatile times has rewarded investors handsomely over 5 years period .

And remember , this too shall pass away .

It looks bad today.
It might look bad tomorrow.
But hang in there.
We’ll get through this.

Be Safe  !!!

Corona Virus

We are seeing the impact of corona virus on equity market across the world . India is off course no exception as well . 

The coronavirus outbreak halted trade , tourism , consumption and many other activities. The effect of this outbreak may push China’s economy into a period of dull growth for some time.  Will it impact other economies further?  …Yes if it spreads further…..Will market falls further? …..certainly if virus stays longer.  

Markets alway give knee jerk reactions for any positive or negative events . It is always overdone in the market . 

Long-term investing is often best disconnected from short-term economic reactions. 

We have seen such epidemic outbreaks in the past . Below table provide the sense of market reactions following major epidemics in recent history.

corona virus

Carl Richard has nicely depicted current scenario in his famous sketch BehaviorGap 

WhatsApp Image 2020-02-28 at 6.05.31 PM

We have written on couple of times on different events whenever the market corrected in past .

 

CoronaVirus will be history after few months .  You need to decide where to focus  on CoronaVirus or Karo Na Invest !!!

Happy Investing !!!!

All About BHARAT Bond ETF

– By Meghashyam Sinkar

We have already seen two successful equity ETFs , namely Bharat 22 and Central Public Sector Enterprises (CPSE) from the Government . Recently the Union Cabinet has approved the launch of India’s first corporate bond ETF – Bharat Bond.

What is ETF ?

ETFs are a basket of securities , similar to mutual funds (MF’s), but are traded on the secondary market like stocks and bonds.

The Bharat Bond ETFs will comprise bonds issued by public sector units, enterprises, financial institutions and other government organisations.

The ETF will have defined maturity period where you get your principal amount along with returns at the time of maturity . So , it is sort of FMP – Fixed maturity Plan . There are two bonds available right now maturing on April 2023 and April 2030 respectively .

The current yield to maturity (YTM) is 6.59% and 7.52% respectively . You can expect the returns close to this YTM at the time of maturity .

Pros :

  1. Safety : Since the bonds are from government companies mostly AAA rated bonds , the credit risk can be considered as almost zero . Please note that the Bond is neither Capital Protected nor Guaranteed Return Product.
  2. Cost : ETFs are generally much cheaper that normal mutual fund . The fund management cost of this ETF is 0.0005%.
  3. Since the ETF will track an index, the fund manager risk is zero .

Cons :

  1. Liquidity : We still do not have enough trading happening in ETF . The volumes are very low . Therefore , it will be difficult to sell the bond easily in case of liquidity requirement . Even if you get the buyer, you may have to sell at the discount in the secondary market .
  2. Interest Rate Risk : Since it is long term bond specially April 2030 , there is an interest rate risk because the interest rate and the bond prices are inversely related.When the interest rates go up, the bond prices go down. When the interest rates go down, the bond prices go up. And the extent of ups and downs depend on the duration (maturity) of the bonds. Longer the maturity, the higher the sensitivity.
  3. Demat account: One has to have demat account if wishes to invest into it . 

Taxation :

There is no interest income or payout from the bonds during the period of the bond . Interest is reinvested back to ETF , So you get the principal and gain amount at the time of maturity. Both the bonds are having more than 3 yrs of horizon , so it will qualify for long term capital gain which is taxed at 20% with indexation .  Click here to know more about indexation.

The current portfolio is as below

 

Nifty BHARAT Bond Index – April 2023

Issuer Credit Rating Weights
REC Limited AAA 15.02%
Power Finance Corporation Limited AAA 15.01%
National Bank for Agriculture and Rural Development AAA 14.98%
Housing & Urban Development Corp. Ltd. AAA 11.84%
Export-Import Bank of India AAA 8.00%
Power Grid Corp. of India Ltd. AAA 7.24%
Small Industries Development Bank of India AAA 7.01%
NTPC Ltd. AAA 6.65%
Hindustan Petroleum Corporation Ltd. AAA 4.87%
National Highways Authority of India AAA 3.86%
Nuclear Power Corporation of India Ltd. AAA 2.43%
Indian Railway Finance Corp. Ltd. AAA 1.88%
NHPC Ltd. AAA 1.21%
(Source : Edelweiss AMC , BharatBond.in)

Nifty BHARAT Bond Index – April 2030

Issuer Credit Rating Weights
Indian Railway Finance Corp. Ltd AAA 15.01%
Power Grid Corp. of India Ltd. AAA 15.00%
National Highways Authority of India AAA 14.99%
REC Ltd. AAA 12.73%
NTPC Ltd. AAA 11.64%
Indian Oil Corp. Ltd. AAA 8.00%
Nuclear Power Corp. of India Ltd. AAA 6.61%
Power Finance Corp. Ltd. AAA 6.51%
NLC India Ltd. AAA 3.92%
Export-Import Bank of India AAA 2.83%
National Bank for Agriculture & Rural Development AAA 1.48%
NHPC Ltd. AAA 1.27%
(Source : Edelweiss AMC , BharatBond.in)

PLEASE NOTE THAT THIS IS CURRENT INDEX CONSTITUTION. IT MAY CHANGE IN FUTURE.

Other details:

  1. The offer period is from 12 Dec 2019 to 20 Dec 2019 .
  2. The minimum investment amount is Rs 1000/- . Application up to Rs 2,00,000/- , it is under retail category and the application above Rs 2,00,000/- will be counted under non-retail category. Such categorisation will be applicable only during offering period. 
  3. The issue size of the 3-year Bharat Bond ETF is Rs 3,000 crores (with an option to extend it by Rs 2,000 crores.
  4. The issue size of the 10-year Bharat Bond ETF is Rs 4,000 crores (with an option to extend it by Rs 6,000 crores.
  5. Edelweiss AMC is managing the issue. Those who don’t have demat account , AMC is offering it through Fund of Fund (FoF) . However , the cost will go up .
  6. Non-resident Indians (NRIs) can invest in Bharat Bond ETF.

Should You Invest or Not ?

It is good for investors who are in 30% tax bracket and willing to block the funds for longer period with passive mode . Investors who are in zero or lower tax bracket should stick to traditional investment like Bank FD for liquidity , stability , regular payout if required .

Investors with time horizon of say 2 -4 yrs  should stick to debt funds with similar bond profile having fund maturity matching with their time horizon to avoid interest rate risk because these bonds would be more volatile .

Happy Investing !!!!!

Decoy Effect and It’s Influence on Your Financial Decisions

– Meghashyam Sinkar

Why does Apple always come up with three versions of iPhone?

Let’s understand this by an example.

Let’s say you are an ice-cream lover and one fine day, you are out to treat yourself. Shopkeeper provides you below options:

One Scoop Ice Cream : Rs 13/- 

Two Scoops Ice Cream: Rs 19/-

Three Scoops Ice Cream: Rs 20 /-

The negligible difference between the prices of 2nd and 3rd options gets your attention.

This is called Decoy Effect.

The Decoy effect, popularly known as the asymmetrical dominance effect with economists, is a phenomenon where people tend to have a change in preference between two options when presented with a third option that is asymmetrically dominated.

A 2nd option is just a Decoy option. Companies provide Decoy option so that customer can compare Decoy option with an expensive option and select the expensive one.

In the absence of a decoy option, the customer will compare: Rs 13/- vs Rs 20/- and may probably go with a cheaper option. But with decoy option, the customer now compares Rs 19/- vs Rs 20/- and most likely selects the expensive option.

Can you see a similar pattern in the pricing of iphone11 by Apple?

iPhone 11:
$ 699

iPhone 11 Pro:
$ 999

iPhone 11 Pro max:
$ 1099

Yes, Apple does use Decoy effect to drive consumer to buy the expensive version of their product.

It is explained very well in Dan Ariely’s book “Predictably Irrational”.

Here is a snippet from Dan Ariely’s TED talk which talks on psychological effects of options pricing.

Click Here => YouTube Dan Ariely TED Talk

How to avoid it ?

1. Make the budget and do not get swayed or confused by the number of models or prices.
2. Identify how much you need, so you don’t end up falling for ‘I can get so much more for “only Rs XX” extra.’
3. Try to Identify the decoy. Deliberately consider another reference point. Don’t ignore it while making the decision.

A popular saying goes “A Penny Saved Is A Penny Earned”

Happy Saving and Happy Spending !!!

The Concept of ‘IKIGAI’ In Financial Freedom

– By Meghashyam Sinkar

Financial freedom is achieved when you have the OPTION to work rather than being COMPELLED to work. It is achieved when you have reached a place where you are no longer stressed about money and feel at peace . So people trade their time or skill to earn money in order to achieve the financial freedom .

Now , if someone is loving what he /she does and continue to work and in this process , earn money then it’s perfectly ok . But how many of them are actually loving what they do.

In fact , in this modern societies & communities , people do what they are told to do or what others do , rather than what they want to do . This may be due to number of reasons like social pressure , peer pressure , lack of clarity on life goals , fear , greed etc.

Lets consider that someone works unhappily for 20 – 25 years in trade of money say Rs. 100 /- p.a. and the other person works happily for 40-50 yrs ( or till his body supports physically ) in trade of money say Rs 50 /- p.a and both of them are able to fulfil their financial commitments and achieve financial freedom . Which is better ?

This is where the concept of Ikigai’ comes into the picture.

‘Ikigai’ is the Japanese secret to a long and happy life. It’s a Japanese word which means your reason for being. It roughly means the “thing that you live for” or “the reason for which you get up in the morning.”

When you do what you love , then you get into flow .You work towards excellence which automatically sharpens the skills or processes which results into monetary benefits . It gives you sense of satisfaction. It keeps you mentally happy which has direct impact on your physical health. You don’t retire from your work which means money keeps coming for long period of time .

In the book “ Ikigai – The Japanese secret to a Long & Happy Life”, it talked about the real life example of people who have their Ikigai’ . One of the example, the author talks about is Jiro Ono. He is the owner of one of the most popular Michelin 3-star Sushi restaurants, enjoyed serving his perfection in sushi to happy customers. He is currently 91 years old, and once said that he might die while making the sushi he loved.

You can watch the documentary movie Jiro Dreams of Sushi here. 

You can find many more such examples .

E.g. Amitabh Bachchan currently 76 years old but most sought after & one of the busiest actor even at this stage of his life . He found his Ikigai’ which is Acting . Today after 50 years of working (ups and downs ) but doing what he loves to do with persistence made him a veteran in his profession . Money then automatically flows . Recently, in one of the interview ,he mentioned working till he can because that’s his Ikigai’ .

The other great example is Steve Job who discovered his Ikigai’ and that passion made him today what he is known for .

Tiger Woods does not play Golf for the money, he doesn’t need the money, yet he plays. In April’19, he won his 15th Major Grand Title almost after a drought of 11 years. In the past 11 years, he went through 4 back surgeries and one heck of a divorce that took the world by surprise. He lost all his sponsors and the best of brands abandoned him. But, at the age of 43, he made one of the greatest comebacks in the history of sports. Because , Golf is his Ikigai’ .

Warren Buffett is 89. He has made enough money – one of the richest man on this planet. Yet, he drives to work and actively invests. He does not need to. But investing is his Ikigai’ .

Discovering Ikigai’ and working towards it makes your cash flow / financial plan feasible in long run as your income (cash inflow) time frame expands along with incremental growth after certain period when you achieve excellence .Infact after getting over through survival period , these people don’t work for money . Money becomes a by-product . They just enjoy the journey and its process .

So , find where your Ikigai’ lies. Enjoy the process, the outcome will take care of itself for your financial freedom .

Happy Discovering & Happy Investing !!!

Pay Yourself First

– Meghashyam Sinkar

When you receive the salary / professional income , who do you pay first?

Do you not pay to your driver ? Do you not pay to your maid ? Do you not pay to your DTH , broadband services ? Do you not pay to employee ? Do you not pay to your milkman? Do you not pay to bank in case of EMI ?

But do you pay to yourself FIRST ?

You pay everyone for their work and services as soon as your receive your salary or profession income except YOURSELF . What about paying yourself for the work you do for 25- 30 days in a month ?

In 1926 , George Clason in this classic book “The Richest Man in Babylon” shares the secrets of creating wealth through few simple rules . It says – ‘Pay Yourself First’ 

The book says that the first principle is “A part of all you earn must be yours to keep.”

He goes on to explain that by first putting aside at least 10% of earnings — and making that money inaccessible for expenses. It should be not less than a tenth no matter how little you earn. It can be as much more you can afford .
Over and even longer time, it would grow into a lot of money, because of the power of compound interest.

Below is the simple analogy given by him in his book .

“Wealth , like a tree, grows from a tiny seed . The first copper you save is the seed from which your tree of wealth shall grow . The sooner you plant that seed the sooner shall the tree grow. And the more faithfully you nourish and water that tree with consistent savings , the sooner you may bask in contentment beneath its shade.”

Even a small amount can harness the power of compounding  and create the significant value given enough time. As the income grows, contribution grows . E.g.  A person with Rs 10 Lacs of earning keeps aside Rs 1 Lac every year for next 30 years can create a corpus of Rs. 1.64 cr. However , if the person keeps increasing the said contribution by 5% each year, then the corpus becomes Rs. 2.6 cr. That is huge difference in retirement nest.

Pay urself graph

Putting “Pay yourself First” strategy into practice will inculcate good savings habit . If you are not able to do it right now for some reason , then assess your cash flows , make budget sheet , see where you can curtail or prioritise your expenses and keep aside at least 10 % yourself first ,come what may.

Majority of the investors follow below equation

Income – Expenses = Savings . But it is conventional Thinking .

Financial Freedom thinking says Income – Savings = Expenses. So PAY YOURSELF FIRST.

The legendary investment guru Warren Buffett has quotably remarkably in simple word –

“Don’t save what is left after spending, spend what is left after saving.”

Happy Savings & Investing !!!

Illusion of Control

– Meghashyam Sinkar

Have you observed or seen anyone trying to make the call or to type the message while driving the car ? Or drinking and driving ? So, that person believes that he can control the car if anything comes in front of his car suddenly and hence he continues to do this activity with the belief that he is in full control of his future action or outcome . We underestimate risk because we are in possession of all the facts and we feel that we can control the situation when in reality we can’t.

This is called Illusion of control Bias .

Rolf Dobelli , in his book – “The Art of Thinking Clearly” shares the nice instance

Every day, shortly before nine o’clock in the morning, a man with a red hat stands at a busy traffic light and begins to wave his cap frantically. After five minutes he disappears.

One day, a policeman comes up to him and asks: “Sir! May I ask what you are doing?”

“I’m keeping the giraffes away,” replies the man.

The puzzled policeman looks around and tells him, “But there aren’t any giraffes here.”

“Well, I must be doing a good job, then.” says the man proudly.

You may conclude that the man with the red hat wasn’t in the good of his mental health. However , The man’s belief, that absence of evidence (giraffes) is a proof of his prowess in controlling giraffe traffic, is the result of a behavioural bias called Illusion of Control.

The illusion of control bias describes the tendency of humans to believe that they can control or at least influence outcomes when, in fact, they cannot.

Almost 50 years ago, a group of 3 behavioural scientists conducted an experiment. They asked people to place bets on calling the right number from a roll of dice. The dice was rolled by the persons placing the bets. For a few turns, the dice would be rolled, the outcome hidden, and the participant would be asked to place his bet on the outcome. For some other turns, participants would be asked to first place their bets, and then roll the dice. Bets could be of varied amounts each time. After gathering findings from a number of participants, for a number of attempts, the researchers found a clear pattern emerging. Bet sizes tended to be much lower when placed after the dice was rolled, and much larger when placed before the dice was rolled. Participants obviously believed in their own ability to somehow influence the outcome – which is why they were willing to place bigger bets before the dice was rolled, but much smaller bets after they had rolled the dice. A classic case of illusion of control.

Ten years after this experiment, another experiment was conducted, by a different team. Individuals were sold $1 lottery tickets. Half the participants were sold tickets that were randomly picked and given to them, while the other half were allowed to pick a ticket of their choice, after looking at number sequences and so on. A week later, on the day of the draw, just before the draw, each participant was asked to quote a price at which they were willing to sell their ticket. The average selling price asked by the group that was given randomly selected tickets, was $ 1.96. The corresponding number for the group that was allowed to pick tickets of their own choice, was considerably higher, at $ 8.67. Here again, those who picked their own tickets, had an illusion that they had higher control on the outcome, which is why their asking price for their tickets was much higher.

When you add money decision with this illusion of control bias then it becomes toxic combination . Illusion of control is often observed in stock investing, when investors who do a lot of hard work before picking up stocks believe that their hard analysis and knowledge gives them control over the future of stocks they own. If the stock price corrects then they buy more of it with the concept of averaging it out which is certainly not bad . However, sometimes investors exceed the desired weightage in stock or sector or particular asset class . 

Benjamin Graham , in his book “The Intelligent Investor” writes – 

“The only thing you can be confident of while forecasting further stock returns is that you will probably turn out to be wrong . The only indisputable truth that the past teaches us is that future will always surprise us – always !”

Individual investors don’t diversify their stock portfolio properly with defined framework. Their concentration keeps increasing if any particular stock is added with some insightful information with detailed analysis and they keep tracking it closing . The fact that they are doing things themselves give them the illusion that they know what’s happening .

Equity Traders who watch the markets quite frequently , follow all the market related information -domestic & global , always try to remain on the top of it and then apply their own analysis to take the stock position believe that they have an edge and can immediately control the situation if needed . But , Mr. Market behaves the way he wants and not what investors want .

In general, researchers have found that the illusion of control is more likely experienced  when following conditions are fulfilled:

  • One has early success at a task.
  • Many choices are available.
  • The task one is undertaking is familiar.
  • The amount of information available is high.
  • One has more control over the decision process.
  • One has a personal stake in the outcome of the choice.

How to overcome it ?

  1. The first step is to be aware of it. 
  2. Be open to the possibility of being wrong or getting wrong .  
  3. Honestly asking whether luck or just randomness played a significant role in initial success.
  4. Craft your investment plan / financial plan , define the framework and then stick to it.

Keep Learning and Happy Investing !!!

Nick Murray’s Advice

– Meghashyam Sinkar

Bull was dominating 2 yrs back on the market . Now Bear started dominating with the news of recession around the corner . Investors were grappling with the issue of whether to invest at high level 2 yrs back during bull markets and now with the issue of whether to invest in such depressed market with negative news looming around . The pendulum has swung , as Benjamin Graham ( Warren Buffett’s guru and an author of well known book – The intelligent Investor ) knew it always does , from irrational exuberance to unjustifiable pessimism.

I came across a very thought provoking set of core beliefs about Investing by Nick Murray (http://www.nickmurray.com/) which I am reproducing below. Nick Murray is a hugely successful US based financial advisor. He has been a financial advisory professional for more than fifty years and an author of a dozen books on financial services professionals .

His 10 core beliefs will help us to focus on what matters most for long term investing success.

1.        I believe that the fundamental investment risk is not losing one’s money, but outliving it.

2.        I believe, therefore, that the only safety lies in the accretion of purchasing power.

3.        I believe that the great long term risk of stocks is not owning them.

4.        I believe that everything you need to know about the movement of stock prices can be summed up in 8 words: The downs are temporary; the ups are permanent (for good managed businesses )

5.        I process the experience which most people describe as a “bear market” in two different words: big sale.

6.        I don’t believe in Individual Stocks, I believe in managed portfolios of stocks.

7.        I believe that dollar cost averaging will make the dumbest person in the world wealthy. Hey, look at me: it already has.

8.        I love volatility.

9.        I’m not afraid of being in the next 25% down tick. I am afraid of missing the next 100% uptick.

10.     I believe that, prior to retirement, people should own as close to 100% equity as they can emotionally stand. Then, after retirement, I believe they should own as close to 100% equities as they can emotionally stand.

If Investors embrace these 10 core belief and build convictions around them , then they can sail through this volatility happily to the path of successful wealth creation.

Happy Investing !!!

 

Cognitive Dissonance Bias

– By Meghashyam Sinkar

It is widely known and proven that tobacco use or smoking can harm the body & may cause multiple type of cancer , heart problem & unhealthy decreased life expectancy . Why do people still indulge or continue to engage in unhealthy behaviour .Everyone is aware of its side effect . The warning on the packet is quite vivid to understand . But then people convince themselves that ” its a just 2 cigarettes a day or A lot of things can kill you, can’t avoid them all. They try to rationalise which has conflicting thought with its basic truth or information .

The same thing is observed with morning walk . Everyone knows it how important or good it is to have morning walk . Initially there is conscious effort to continue with daily morning walk , but then justify why one can’t continue for number of reasons.

It is a response to conflict that allows our original beliefs to persevere, even in the face of contradictory evidence. It describes the discomfort felt when your beliefs are inconsistent with one another or with your actions. This is called Cognitive Dissonance bias in behavioural finance .

Cognitive dissonance is the unpleasant emotion that results from believing two contradictory things at the same time.

Within the realm of investing, cognitive dissonance can negatively affect investor behaviour as we rationalise a previously held belief, even in the face of contradictory evidence.

Let’s understand it with examples .

Example 1 :-

This bias is clearly observed in long term SIP investors . The ultimate benefit of the SIP is to accumulate the units irrespective of the short term market’s positive or negative movements . This is the information with which they start the SIP . However , as soon as market start declining in year or two , they start feeling nervous . They start questioning the basis of SIP i.e. rupee cost averaging concept .

Market Trend

Here , Situation 2 is much better than Situation 1 for regular long term investors . However , investors who have started the SIPs in last one or two years are worried now after seeing negative returns .Negatives events like economy slowdown , US China trade war etc are making the investors nervous . Some of them may stop the SIP in panic which is ideally injurious to their financial wealth .

In reality what should they be expecting after starting the SIPs or making regular investment ?

Market to rise in one direction which forces them to buy units at high prices at every instalment  OR  Market to fall down and remain low for longer period of time which helps them to buy units at lower prices ?

Strange isn’t it? They are aware what is right for them yet they are unhappy, feeling bad , nervous. It’s a perfect example of cognitive dissonance.

Example 2 :-

Let’s consider the current situation of market where there is lot of uncertainty mounting around . There is an Investor already invested in equities with long term horizon and knows very well that market will have strong volatility in between . He now believes that market is going to fall in coming 2 -3 months. He formed his opinion based on the many articles he has read on various websites and newspapers ( Nowadays what’s app forwards). Based on these theories he definitely believes that the market is going to go down.

He asked his financial advisor . Financial Advisor educates the client & suggests him to stick to his asset allocation & strategy .  However , client refused to listen to advisor and he cuts his portion in equity . A very next day market falls down by 5% . Client believed what he did was right.

After a month or so , the market rebounds again and looks good on fundamental terms . His advisor asks him to rebalance his portfolio again and suggests him to stick to his long term plan with decided asset allocation by investing in equities again . The client now regrets his decision and realizes that he has made a mistake but is not in a position to acknowledge his mistake.

The similar behaviour observed while investing in stocks .

The only way to overcome the negative effects of cognitive dissonance is to recognize  it and attempt to abandon such contradicting techniques. Investors who understand these differences become better investors and can take better decisions.

Happy Investing !!!

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 !!!