Jun 24, 2017

Weekend Reading- The Man who Drowned

There is a story of a man who wanted to cross a river that had a depth of “four feet on average.” Feeling fairly confident about it he set about on his journey only to drown somewhere near the centre.

Beware of the ‘averages’!

In his brilliant little book- “How to Lie with Statistics”, Darell Huff introduces us to this particular concept and how the human mind gets lulled in to understanding the term ‘average’.

Think about it like this. Suppose you were building data on incomes of all your neighbours. If we took an average then it is possible that with some accuracy we could tell you what each person was earning. But what if one of your neighbours was Mukesh Ambani? Wouldn’t the average income number be way off the mark?

Finding exceptions in your Data Set

A sense of confirmation bias (covered earlier) and an inability to conceptualize a black swan (like having Mukesh Ambani as your neighbour) can create problems for us like the man who drowned. It is therefore imperative for us to:

1. Understand the sample set of data that we are reading and 
2. Actively look for exceptions to the rule.

How does this play out in your finances?

“Equity markets have returned 15% on average over the long-term.”

“Real-estate will beat inflation on average.”

“My salary will increase at 10% per year since that has been the past average.”


Can you see exceptions to all those cases? What can cause them? Are you at the crest or trough of your sample space? Each of these can have wide-leading ramifications to the way you ‘plan’.

Jun 10, 2017

Book Recommendation- The Black Swan- Nassim Nicholas Taleb

One of the most profound ideas of recent times that has become mainstay in academic and philosophical circles is the idea of the “Black Swan”. This term was made famous by Nassim Nicholas Taleb’s book “The Black Swan”. Published in 2007 this book became an immediate best seller (No 1 on the New York Times list).
Taleb dwells on the unpredictable and the uniquely human attribute of ‘rationalizing’ the past. The term is coined from the Latin expression- “rara avis in terris nigroque simillima cygno" ("a rare bird in the lands and very much like a black swan"). The ancients believed all swans had to be white. This was of course till the discovery of black swans in New Zealand. Thus a black swan is an event that everyone believes is impossible till it happens (Trump election anyone?).  
From a financial/ investing perspective the idea of the Black Swan is an important concept to imbibe in planning and portfolio construct. This is a highly entertaining and useful read.
https://www.amazon.in/Black-Swan-Impact-Highly-Improbable-ebook/dp/B002RI99IM?_encoding=UTF8&portal-device-attributes=desktop&tag=googinhydr18418-21 

May 26, 2017

Confirmation Bias

A doctor wanted to demonstrate the ill-effects of alcohol to a group of alcoholics. So he took a glass of whisky and placed a worm in it. After some time the worm dies. He turns to his audience and asks what they learnt from the experiment. Pat came the reply from one of the alcoholics- "It means if you drink alcohol you won't have any worms in your stomach." The above is an example of 'selective listening' or what we call 'confirmation bias'. We fit reality in to our beliefs and not vice-versa.

Philosophers and scientists have long-struggled with the confirmation bias. We have all come across the famous quote- "the eyes only see what the mind wants to." This sort of behaviour happens to all of us and is an example of a heuristic (short- cut) employed by the brain in order to take quick decisions. Take the case of the gambler who's on a losing streak. The evidence is clear that things are not going well for him and yet he will continue as he sees the streak of losses as a test of his 'belief' in his own skill.

One of the first steps to counter the bias is of course to be aware of it. When you want to buy that new car your mind will automatically start telling you about how fantastic the new car looks and what great mileage it gives and how your social-status improves and/or how you need to live life in the moment etc. When you want to buy a new stock you will see that the reports are great and the share price is high (or low!) and that the economy is about to take off due to GST etc. Similarly if you are going to buy a new property then your mind will tell you that real estate is beaten down (so a great time to buy!) or I need to have another house or this area will boom etc.
PS: note you will have opposite sentiments if you are looking to sell your car(look how old it has become), sell your stock (it has run too high) or sell your property (I needed a bigger house).

The second step is to actively seek dis-confirming evidence. Ask your self 'why I shouldn't do it?'. Why I shouldn't buy that car? (Not, 'why shouldn't I buy that car', small but important difference). Maybe my present car will run another few years? Maybe financially it isn't a very smart proposition? Maybe if I spent some money on the present car I could improve it's mileage etc? Maybe I could use the money better elsewhere? It's only when you look at both sides objectively will you be able to make a more informed decision.

I'll end this with a poem from Shannon L. Adler that further illustrates the concept-
Read it with sorrow and you will feel hate.
Read it with anger and you will feel vengeful.
Read it with paranoia and you will feel confusion.
Read it with empathy and you will feel compassion.
Read it with love and you will feel flattery.
Read it with hope and you will feel positive.
Read it with humor and you will feel joy.
Read it without bias and you will feel peace.
Do not read it at all and you will not feel a thing.

 

Mar 28, 2017

Market Update- 28/3/2017

The equity markets, Sensex and Nifty, are trading at close to their two year highs. The Sensex has moved from 25,807 (close on Dec 26th) to 29,237.15 (today’s close) in a period of 3 months. The market absolute return over the last 3 months has been 12.3%. Demonetization has not really had too much of an effect on the economy. The market is all gung-ho with the GST bill expected to be passed shortly and the results of the UP elections indicating that the current government remains strong and popular. We evaluate to see if this rally is sustainable and what needs to be our strategy in the coming days and months. 

29,500 on the Sensex is an important long-term technical resistance. If the markets cross this and close above this for a sustained period we could be looking at historical highs for the markets. The indicators are all extremely bullish. However, this suggests that we should be cautious in ‘adding equity’ at this point of time.
 
Valuations wise we are way above long term average valuations as per trail Sensex and Nifty earnings. Earnings growth has not picked up. Accordingly we have pruned allocations to equity. This is contra to what most of the market seems to suggest but is in line with our investment philosophy of being fearful when others are greedy and being greedy when others are fearful. While GST will be a net positive for the economy, we believe that like with demonetization, there are bound to be implementation hic-cups which the market may not be pricing accurately.

ULIPs, PMS products and small & mid-cap funds have found favour with many clients and advisors basis last 3 year returns. Our call as always is to ask the investor to be cautious and do thorough research on ‘risk’ as well as return before selecting any product.

Debt generally seems to be out of favour in the market which is why we are more allocated in to the asset class at this point of time. Repeated policy flip flops by the RBI has sent the debt markets in to a tail spin. Despite this, we believe that debt will give decent returns over the next 3 years as interest rates should continue to drop. We are cautious here in indicating the time-frame. We are not suggesting a drop in the coming quarter or the next few quarters. But, the indications are that over the medium term interest rates will continue to fall considering the interest rate cycle and the general economic structure.

However, we are not going extremely bullish and putting all money in to long-duration. In fact we believe the ideal play is in short term income funds. And this is where most allocation has been made over the last few months.

‘Accrual funds’, the market term for credit opportunity funds, seem to have found favour in the market (as an alternate to the perceived volatility of income funds). Here, we will advise clients to be cautious as the Indian debt markets are not deep enough and with more money chasing higher yields there are bound to be compromises in portfolio quality. Even one default can adversely affect portfolio performance and clients will have to be very cautious. We are currently staying away from credit opportunity portfolios as we believe that over a 3 year time frame (when these investments become tax-effective) there is too much risk considering the economic scenario.

The Rupee has gained in strength over the last few months indicating strong inflows from FIIs. Technically the Rupee has reached a resistance of 65 to the dollar. It will be interesting to see if the Rupee could break this resistance. However, it is our belief that the Rupee will not sustain above this for too long and will trade in between 65-70 for some time.