The RISK of RISK of Investing in Stocks, which OPIUM Managers Don’t Talk About

Summary: Just because you have taken on a risk by investing in stocks, doesn’t mean high returns are going to materialise.


The only function of economic forecasting is to make astrology look respectable –
John Kenneth Galbraith.

It was sometime in October-November 2010. I had just joined a weekly personal finance newspaper, which for reasons I did not understand and for reasons above my paygrade, was to be run out of Delhi.

During the course of one editorial meeting, we had to decide what sort of return would systematic investment plans (SIPs) into equity mutual funds generate over the next decade. This was necessary as a part of a regular feature to be published in the newspaper, which would help a featured family come up with an investment-savings plan.

It was assumed that SIPs into equity mutual funds would generate 15% per year return. I protested against the assumption saying that 15% per year return was way too high but was overruled by the Delhi bosses.

At that point of time it had almost become fashionable to say that the stock market generates 15% return per year in the long term (In fact, there are people who still believe in this myth, which I shall write about in detail in the time to come).

Getting back to the point. We are now in 2020. 10 years have gone by. As I pointed out in a piece yesterday, the SIP returns on index funds have been rather subdued over the last decade. The average per year return over the last decade in case of the three Nifty index funds I checked was slightly over 9% (around 9.17% to be very precise). Index funds are funds which have a mandate to invest money in stocks that make up a stock market index, in the same proportion that they do.

The per year return of a little over 9% was nowhere near the assumed 15% per year return. Let’s say an individual had invested Rs 10,000 per month religiously through the SIP route for ten years. On this if he had earned a return of 15% per year, the value of his portfolio at the end of 10 years would be Rs 27.5 lakh.

If the return was 9.2% instead as it actually turned out to be, the value would be around Rs 19.6 lakh or around 29% lower. If the individual was saving towards a certain goal, he would end up way short. But that’s the rather obvious point here.

The question is how did the market narrative of stocks giving 15% return in the long-term come about? The first time I heard this 15% argument being made with a lot of confidence by marketmen was sometime in late 2006 or perhaps early 2007.

This, after the Indian economy had grown by greater than 9% in real terms for three consecutive years, 2004 to 2006. The zeitgeist or the spirit of the times that prevailed was that come what may India will now grow by at least 8% in real terms. Add an inflation of 5-6% on top of that and we will grow at 13-14% in nominal terms, year on year.

Assuming that the earnings of companies which are a part of India’s premier stock market indices would grow a tad faster than the nominal growth, we arrived at 15-16% year on year growth in earnings.

This would be reflected in stock prices growing by 15-16% per year as well. From here came the assumption, the stock market growing at 15% in the long-term. There is a lot more to this assumption including Sensex returns from 1979 on, but I will leave that for another day. For the time being knowing this much is fine.

In fact, over the years, I have seen this logic being offered by people who make their money in the stock market by managing other people’s money or OPM or even better OPIUM, with great conviction. These tend to include fund managers, analysts, traders, salespeople etc. (Oh, if you still didn’t get it, OPM and OPIUM sound the same. Rather childish, but good fun nonetheless). Those in the business of managing OPIUM really believe that stocks give 15% per year return over the long-term (I even wrote a piece on this titled Why Economic Growth Cannot Be Created on an Excel Sheet. You can read it here).

The trouble is that this assumption has turned out to be all wrong. The earnings growth has been nowhere near what the OPIUM managers have been projecting. This is reflected in the 10-year return on stocks, which as of August 20, 2020, stood at 8.7% per year (based on the Nifty 50 Total Return Index, which takes dividends paid by companies into account as well, unlike the normal index).

The funny thing is that the stock market has delivered a return of just 8.7% per year over the last decade, despite the valuations being at all time high levels. The price to earnings ratio of stocks that comprise the Nifty 50 index is around 32 these days. This basically means that for every rupee of earnings for these stocks, the investors are ready to pay thirty-two rupees as price. As I pointed out yesterday, such high valuation has never been seen before.

And despite such a high valuation the decadal per year return on stocks on an average is less than 9% per year. This is the irony of it all. It also makes me wonder why investors think that the stock market is doing well. Yes, it has done well in comparison to where it was in late March 2020, but clearly not otherwise.

Of course, when the OPIUM managers talk about 15-16% return per year from stocks over the long-term, they also highlight the fact that for higher return a higher risk needs to be taken on by the investor. The higher risk is the risk of investing in stocks for the long-term.

But what they don’t talk about is the fact that just because you are taking the risk of investing in stocks for the long-term, doesn’t mean that higher returns are going to materialise. I would like to call this, the risk of risk of investing in stocks, something which most OPIUM managers don’t seem to talk about.

The question is why does this happen? The answer lies in the fact that OPIUM managers are in the business of driving up assets under management for the firms that they work for. More the money that gets invested in a fund, the higher the fee earned by the firm to manage that money. And in this business of soliciting money, you need to sound confident.

The moment you start getting into nuance about high risk not guaranteeing high returns, you start losing the average prospective investor. Hence, the projection of confidence that the prospective investor is looking out for, leads to simplistic one-line market narratives like stocks will definitely give a 15% per year return, over a decade. Such narratives are easier to sell.

In a world full of complex uncertainties, the prospective investors are looking for certainty and those in the business of managing OPIUM can’t consistently project confidence to tackle the complex uncertainties, unless they believe in stocks giving 15% per year return in the long-term, themselves. This is the con of confidence which fools people on both sides.

The trouble is such narratives hurt. As  economists John Kay and Mervyn King write in Radical Uncertainty – Decision Making For an Unknowable Future: “Markets narratives are occasionally ‘dishonest and manipulative’, but normal people make honest use of narratives to understand their environment and guide decisions under radical uncertainty.” (King and Kay’s book is a terrific read though not a breezy one. Highly recommended).

This is not to say that one should not invest in stocks and invest all our money in bank fixed deposits. Not at all.

All I am trying to say is that just because you have taken on the risk of investing in stocks, doesn’t mean higher returns are going to materialise and which is why it’s called risk in the first place. So, you might end up short on the corpus you were trying to build (assuming you are trying to do this in a systematic way).This is something that needs to be kept in mind while investing in stocks either directly or indirectly through mutual funds. This is the risk of risk of investing in stocks. While all mutual fund ads have a disclaimer at the end saying that mutual fund investments are subject to market risk, nobody really explains to the investor what exactly this market risk is.

The economist Allison Schrager makes this point in the context of saving for retirement in her brilliant book An Economist Walks into a Brothel—And Other Unexpected Places to Understand Risk. The conventional wisdom is that when it comes to saving for retirement it makes immense sense to build up as large a retirement corpus as possible and then spend it at the rate of, say 4%, per year, after retirement.

The problem with this strategy is that 4% per year isn’t really a fixed amount. It depends on the retirement corpus one has been able to build up in the first place. And that in turn depends on how the stock market has been doing. As Schrager writes: “That’s where the strategy goes wrong.”

One way of getting around this problem is that in the years approaching retirement you take your money out of stocks and invest it in fixed income investments, everything from bonds to fixed deposits. This mitigates the risk to some extent but not totally.

What if the stock market is not doing well in the years before retirement? What do you do then? Do you continue staying invested in the stock market in the hope that it recovers, and you build a better corpus? What if it doesn’t?

That’s the risk of it all. At the cost of repeating just because you have invested in stocks and taken on a higher risk doesn’t mean higher returns are automatically going to materialise.

To conclude, it is important that as a stock market investor you realise this, irrespective of whether the OPIUM managers communicate this or not.

Stay safe and enjoy the weekend.

Will see you now on Monday (or perhaps Tuesday, depending on what my brain throws up over the weekend).

Disclaimer: This article is meant for educational purposes only.  

In the media, if it bleeds, it leads

Bill_Bryson_edit
I am a big fan of the British-American writer Bill Bryson. And I think it’s unfair that he tends to get categorised as a travel writer. He is much more than that, though it is very difficult to categorise him. His latest book is called The Road to Little Dribbling—More Notes From a Small Island. In this book, one of the things that Bryson talks about is the uniquely British phenomenon of attacks by cows on human beings, making national news.

As he writes: “In America, cow trampling would never make the national news other than in highly exceptional circumstances. If, let’s say, Dick Cheney was trampled to death by cows (and we can always dream), that would be national news.” But the same is clearly not true about Great Britan.

“In Britain if a single cow tramples a walker anywhere in the country, it will almost certainly make national headlines,” writes Bryson.
Cow attacks on human beings are pretty rare. But the surfeit of news in the British media about cow attacks, leads the British to believe that cow attacks are very common in Britain. This belief comes from reading about the attacks in the media at regular points of time.

Economists and psychologists refer to this tendency as an availability bias. As Leonard Mlodinow writes in The Drunkard’s Walk—How Randomness Rules Our Lives: “In reconstructing the past, we give unwarranted importance to memories that are most vivid and hence most available for retrieval. The nasty thing about the availability bias is that it insidiously distorts our views of the word by distorting our perception of past events and our environment.”

Air-crashes are an excellent example of this. As Jason Zweig writes in The Devil’s Financial Dictionary: “Flying is among the safest ways to travel, but on the rare occasions when an airplane does crash, the fireball on the runway is broadcast worldwide and burned into the brain of everyone who sees it.”

This leads people to believe that airplane travel is unsafe. But what they don’t realise is that the media does not report about the thousands of planes that land safely every day all over the world. It also does not report the many car crashes that happen all over the world every day, unless a celebrity is involved.

The same logic works in case of a stock market. Every big fall is reported on the front pages of newspapers and by the other media. As Zweig writes: “Market crashes are rare, too, but the spectacular damage they cause is also seared into the collective unconscious. That leads many investors to miss out on the gains stocks can generate during the surprisingly long periods between crashes.” Like safe airplane landings, the media does not report the small gains (or losses) that add up, over a period of time.

Further, the advent of cable TV has brought war into our drawing rooms. But is the world more unsafe that it was let’s say 70 years back or 100 years back or may be even 500 years back? The feeling that the world has become more unsafe than it was in the past, is another excellent example of the availability bias.

As Steven Pinker writes in an essay titled A History of Violence: “Several historians have suggested that there has been an increase in the number of recorded wars across the centuries to the present, but, as political scientist James Payne has noted, this may show only that “the Associated Press is a more comprehensive source of information about battles around the world than were sixteenth century monks.” Associated Press is a wire news agency, which reports from all over the world.

This is not to suggest that the world is a totally safe place and that wars have come to an end. Nevertheless, things are not as bad as they seem to be.
To conclude, dear reader, when you are reading a newspaper or a digital publication, it is always worth remembering that old saying in journalism: “If it bleeds, it leads.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared in the Bangalore Mirror dated December 2, 2015

The Make in India lesson I learnt when I bought a television set

make in indiaVivek Kaul

Yesterday’s edition of The Times of India had a very interesting newsreport. As per the newsreport: “Data available with the Bureau of Indian Standards (BIS) shows that over 60% of the recently registered products are “Made in China.””
These include products like mobile phones, printers, power adapters, notebooks, tablets and so on. What this tells you clearly is that a vast majority of electronic products that we buy in India are not made in India, but in China.
Interestingly, the last time I bought a television set few years back, it came with a weird looking plug—something that I had never seen before. It wouldn’t fit into the electrical socket at home. It took a helpful neighbour to solve the problem. He told me that I would need a converter to fit the plug into the socket. The converter cost me Rs 25 and left me wondering that why did a company which sold a product worth Rs 15,000 inconvenience its customers for something worth Rs 25? Maybe marketing professionals can throw some light on that.
Last year when I bought a smart phone a similar experience awaited me. But this time around I was prepared and as soon as the smart phone was delivered at home (I had ordered it online), I went out and bought a converter, which cost Rs 20 this time around.
As you must have figured out by now, dear reader, both the products were made in China. Not just technology products which are made in China are flooding the Indian market. There are other products as well. As The Times of India newsreport referred to earlier points out: “There are a vast majority of goods — from electricity bulbs and thermometers to Ganesha and Laxmi idols — where the government is yet to have domestic standards resulting in unregulated entry of Chinese product.” Even Rakhis are now made in China. Indeed, this has been a worrying trend for sometime now.
The reason for this is fairly straightforward—no country has gone from developing to developed without the expansion and success of its manufacturing sector. As Cambridge University economist Ha-Joon Chang writes in 
Bad Samaritans—The Guilty Secrets of Rich Nations & the Threat to Global Prosperity: “History has repeatedly shown that the single most important thing that distinguishes rich countries from poor ones is basically their higher capabilities in manufacturing, where productivity is generally higher, and more importantly, where productivity tends to grow faster than agriculture and services.”
And the Indian manufacturing sector cannot flourish with products being made in China. For a while there was great hope that India does not need to go through a manufacturing revolution to pull its citizens out of poverty. And that the information technology led services revolution would do that trick. But services by their very design have certain limitations.
As Chang writes: “There are certainly some services that have high productivity and considerable scope for further productivity growth—banking and other financial services, management consulting, technical consulting and IT support come to mind. But most other services have low productivity and, more importantly, have little scope for productivity growth due their very nature (how much more ‘efficient’ can a hairdresser, a nurse or a call centre telephonist become 
without diluting the quality of their services?).”
So, where does that leave us? Over the last few years the education infrastructure that has been built to feed trained individuals into the services sector has been huge. As Akhilesh Tilotia writes in The Making of India: “An analysis of the demand-supply scenario in the higher education industry shows significant capacity addition over the last few years: 2.4 million higher education seats in 2012 from 1.1 million in 2008.” In 2016, India will produce 1.5 million engineers. This is more than the United States (0.1 million) and China (1.1 million) put together.
The number of MBAs between 2012 and 2008 has also jumped to 4 lakh from the earlier 1 lakh. As Tilotia writes: “India faces a unique situation where some institutes(IITs,IIMs, etc.) are intensely contested while a large number of the recently-opened institutes struggle to fill seats…With most of the 3 million people wanting to pursue higher education now having an opportunity to do so, the big question that should…be asked…are all these trained personnel required? Our analysis seems to suggest that India may be over-educating its people relative to the current and at least the medium-term forecast requirement of the economy.”
What this means is that a large number of people going in for higher education will find it difficult to find jobs which are commiserate with the kind of money they have paid for their education, after they pass out. And they will not be the only ones having a tough time. India is adding nearly 13 million people to the workforce every year. And enough jobs are not being created.
This is something that the latest economic survey points out: “Regardless of which data source is used, it seems clear that employment growth is lagging behind growth in the labour force. For example, according to the Census, between 2001 and 2011, labor force growth was 2.23 percent (male and female combined). This is lower than most estimates of employment growth in this decade of closer to 1.4 percent. Creating more rapid employment opportunities is clearly a major policy challenge.”
And these rapid employment opportunities will be created only if more and more products are made in India and not China. For products to be made in India, major labour reforms need to happen.
A report in The Indian Express seems to suggest that the government is working on this front. It is planning to make amendments to the Industrial Disputes Act, 1947. The government is also planning to: “codify the Central labour law architecture wherein the labour ministry plans to merge all 44 Central legislations into four codes on labour laws — one each on wages, industrial relations, social security and safety & welfare. Apart from industrial relations and wages, other codes are likely to be released during the course of the year.”
Let’s see how far is it able to go with this. 

The column originally appeared on The Daily Reckoning on May 6,2015

From cutting up a debtor’s body to SARFAESI: Small borrowers have always got a bad deal

rupee

Vivek Kaul

In November last year, Raghuram Rajan, the governor of the Reserve Bank of India, made a very important speech, in which he discussed the inequality between the small and the big borrowers, when it came to recovering loans they have defaulted on.
As Rajan said: “
The SARFAESI (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests) Act of 2002 is, by the standards of most countries, very pro-creditor as it is written…But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”
The promoters of big companies on the other hand are able to hire expensive lawyers and get away with it. Though the nation has to bear the cost of their actions. As Rajan had said: “
As just one measure, the total write-offs of loans made by the commercial banks in the last five years is Rs 1,61,018 crore, which is 1.27% of GDP.  Of course, some of this amount will be recovered, but given the size of stressed assets in the system, there will be more write-offs to come. To put these amounts in perspective – thousands of crore often become meaningless to the lay person – 1.27% of GDP would have allowed 1.5 million of the poorest children to get a full university degree from the top private universities in the country, all expenses paid.”
The trouble is that this is how small borrowers have been treated through much of history. In
Coined—The Rich Life of Money and How Its History Has Shaped Us, Kabir Sehgal writes: “Interest bearing loans predated the invention of coins by thousands of years. Around 5000 BC, in what is now known as the Middle East, various types of debt instruments emerged..Interest bearing loans started with agriculture and farming: seeds,nuts, grains, and cows borrowed by destitute farmers who repaid the loan with interest—in the form of the surplus from their harvest.”
And what happened if these farmers did not repay? “Declaring personal bankruptcy wasn’t an option, so there was some creative license in making payments…There were even instances of men giving up their wives or sons to avoid interest payments…A debt contract effectively turned a person into an object or commodity to settle an account, contorting the familial sphere into the commercial one,” writes Sehgal.
In fact, debt prisons were the order of the day through much of human history. It was a common practice even in ancient Rome. As Sehgal points out: “During the Roman Empire, a creditor could arrest the debtor for debt delinquency and haul him into court. If guilty, the debtor could land in a private jail and after sixty days become a slave, a bonded laborer, or even be killed. Though uncommon, creditors were allowed to cut up a debtor’s body into chunks commensurate with the debt owed.” It was that bad. Debtors prisons continued in the Western world through much of the nineteenth century. The United States got around to banning them only in 1869. “In 1830, more than ten thousand people were imprisoned in New York debt prisons. Many times the debts were minimal. In Philadelphia, thirty inmates had debts outstanding of not more than a dollar. There were five people imprisoned for debt delinquency for every one put away for violent offense,” writes Sehgal.
In contrast, some of the biggest borrowers like Kings and governments have gotten away with huge defaults, direct as well as indirect, through the course of history. An indirect default happens when a government creates inflation by printing money and in the process ends up eroding the value of money. This means that when it repays debt, it is actually paying back money which is worth a lot less than it was in the past. And this is nothing but an indirect default.
What this clearly tells us is that the small borrower has always had a tougher time in comparison to the large borrower. And this should not be the case. As Rajan put it in his November speech: “What we need is a more balanced system, one that forces the large borrower to share more pain, while being a little more friendly to the small borrower. The system should shut down businesses that have no hope of creating value, while reviving and preserving those that can add value.”
In fact, research shows that this even has an impact on the amount of innovation that happens in a country. As Rajan put it: “A draconian law does perhaps as much damage as a weak law, not just because it results in a loss of value on default but also because it diminishes the incentive to take risk. For think of a mediaeval businessman who knows he will be imprisoned or even beheaded if he defaults. What incentive will he have to engage in innovative but risky business? Is it any wonder that business was very conservative then?  Indeed, Viral Acharya of NYU and Krishnamurthi Subramanian of ISB show in a compelling study that innovation is lower in countries with much stricter creditor rights. Or put differently, the solution to our current problems is not to make the laws even more draconian but to see how we can get more equitable and efficiency-enhancing sharing of losses on default.”
And this is something worth thinking about.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Apr 22, 2015

The Indian Hustler

Ramalinga_Raju_at_the_2008_Indian_Economic_SummitVivek Kaul

At the heart of it most scams are very simple—Satyam was no different. Sometime in 2003, B Ramalinga Raju, the founder and chairman of Satyam Computer Services started over-declaring revenues of the company. The process continued till 2008. On January 7, 2009, Raju in a letter to the board of directors of the company admitted to fudging the accounts of Satyam.
Between 2003 and 2008, Raju over-declared revenues of the company by creating fictitious clients. Once he had over-declared revenues he automatically ended up over-declaring profits. Over-declared profits had to be invested somewhere. This led to the creation of fictitious bank statements and fixed deposit receipts. With a rapid advancement in the quality of colour printers, creating fictitious bank statements wouldn’t have been very difficult.
In his letter to the board, Raju admitted that the cash and bank balances were hugely overstated. The cash and bank balances of the company as on September 30, 2008(the last time the company declared quarterly results) were at Rs 5,313 crore. Th actual number was at a much lower Rs 273 crore. More than half a decade of declaring fictitious profits had led to a massive jump in the cash and bank balances of the company. But the number, like the profits of the company, was fictitious.
The company was guzzling whatever “real” cash it had at a very fast rate. By the time January 2009 started, the company’s actual cash and bank balance of the company would have been much lower than Rs 273 crore.
One of the theories put forward after Raju admitted to all the wrongdoings in the letter was that only when he realized that the company wouldn’t have enough money to keep paying salaries to its employees did he decide to come out with the truth. As Raju said in his letter: “The company had to carry additional resources and assets to justify higher level of operations…It was like riding a tiger, not knowing how to get off without being eaten.”
The irony is that Raju had to get off the tiger, and he still hasn’t been eaten. Like all big businessmen in India, Raju is also a survivor. A special court in Hyderabad has found him and nine others guilty of cheating, criminal breach of trust, destruction of evidence and forgery. The court pronounced a seven year-jail term for the founder and also imposed a Rs 5 crore fine on him.
It took the judicial system six years and three months to sentence Raju. And this is not the end of it. The decision will be challenged in higher courts and the process will continue for a while.
The question I want to explore in this column is the timing of Raju’s confession. Raju sent a tell-all letter to the Satyam Board in January 2009. Why didn’t he do the same in January 2008? Or even earlier, for that matter, is a question worth asking.
The probable reason is that Raju was confident enough of pulling off the scam till he wasn’t. And why is that? It is worth remembering that between 2003 and 2008, the stock market in India had a huge bull run. The economy was also booming. And in such a scenario, when the financial system is flush with money, it is easy to keep a scam going.
As economic historian Charles Kindleberger writes in
Manias, Panics and Crashes: “The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom.” This precisely what Ramalinga Raju was busy doing.
The stock market started crashing from early 2008, due the advent of what we now call the global financial crisis. And because of this, money wasn’t as easy to raise as was the case earlier. Raju tried to plug the huge gap in Satyam’s balance sheet by buying out two real estate firms Maytas Properties and Maytras Infra. Both these firms were owned by his family (Maytas is the opposite of Satyam).
But by late 2008, an era of easy money had come to an end. And sham transactions were not as easy to pull through. The idea here was to use Satyam’s fake cash and bank balances to buy out the real estate firms and thus have “real” assets on the balance sheet. As Raju wrote in the letter: “ The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones…Once Satyam’s problem was solved, it was hoped that Maytas’ payments can be delayed.” But this deal fell through after the independent directors on the Satyam board raised issues about an IT company taking over real estate assets. In fact, if Raju had tried to push this deal through a year earlier, chances are that the board might have agreed, given that the going was good at that point of time. And when the going is good no one wants to spoil the party by asking inconvenient questions.
As the economist John Kenneth Galbraith writes in
The Great Crash 1929: “At any given time there exists an inventory of undisclosed embezzlement. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. In good times people are relaxed ,trusting, and money is plentiful. … Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. … Just as the (stock market boom) accelerated the rate of growth (of embezzlement), so the crash enormously advanced the rate of discovery.”
Interestingly, the Satyam scam was the first of many scams that were to hit the nation starting in 2009. It was followed by the 2G, Commonwealth games and the coalgate scam. Sahara, Saradha, Rose Valley and many other big Ponzi schemes came to light. The National Spot Exchange scam came to light as well. These scams were mostly executed during the period between 2003 and 2008, when the economy was doing well and the stock market was going from strength to strength, but they were only revealed after the good days came to a stop.
In that sense Raju set the trend of things to come. We have to give him credit for at least that.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared in the Daily News and Analysis on April 12, 2015