Investing

Of Yuvraj Singh, stock markets and the Vietnam War

 yuvraj

Vivek Kaul

 It is in the last week of March 2014 that I am writing this piece. The stock market in India is flirting with all time high levels. At the same time in the T20 cricket World Cup that is on, Yuvraj Singh’s bad form with the bat continues (as I write India has played two matches, and in both, Yuvraj has failed with the bat).
Despite the fact that the stock market is flirting with all time high levels, there are still a lot of investors who are holding onto stocks they had bought at the peak levels reached in 2008. Real estate and infrastructure stocks were a favourite among investors back then.
Once the stock market started to crash in 2008, these stocks crashed big time. They still are nowhere near the high levels they had achieved way back in 2008. And more than that, the prospects for these sectors(particularly real estate) in India, are not looking good either. Nevertheless, there are still some investors who have held onto these stocks bought in 2008, in the hope that these stocks will make money for them one day. So what is happening here? Barry Schwartz explains this in his book The Paradox of Choice. As he writes “People hold on to stocks that have decreased in value because selling them would turn the investment into a loss. What should matter in decisions about holding or selling stocks is only your assessment of future performance and not (tax considerations aside) the price at which the stocks were purchased.”
But the price at which the stock is bought does turn out to matter. This fallacy is referred to as the sunk-cost fallacy by behavioural economists.
And what about Yuvraj Singh? What is he doing here? Vijay Mallya owned IPL Royal Challengers Bangalore bought him for a mind-boggling Rs 14 crore in a recent auction in the Indian Premier League(IPL). The tournament starts in mid April, right after the T20 World Cup ends. From the way things currently are, Yuvraj doesn’t look in great form. But despite that he is likely to be played by Royal Challengers Bangalore in all the matches that they play.
And why is that? Simply because the sunk-cost fallacy will be at work. The Royal Challengers Bangalore have paid so much money to buy Yuvraj that they are likely to keep playing him in the hope that he will eventually start scoring runs. Schwartz discusses this in the context of professional basket ball players in the United States. “According to the same logic of sunk costs, professional basketball coaches give more playing time to players earning higher salaries independent of their current level of performance,” he writes.
The sunk-cost fallacy is a part of our everyday lives as well. Many of us make instinctive expensive purchases and then don’t use the product, due to various reasons. At the same time, we don’t get rid of the product either, in the hope of using it in some way in the future.
Richard Thaler, a pioneer in the field of Behavioural Economics, explains this beautifully through a thought experiment, in a research paper titled Mental Accounting Matters. “Suppose you buy a pair of shoes. They feel perfectly comfortable in the store, but the first day you wear them they hurt. A few days later you try them again, but they hurt even more than the first time. What happens now? My predictions are: (1) The more you paid for the shoes, the more times you will try to wear them. (This choice may be rational, especially if they have to be replaced with another expensive pair.) (2) Eventually you stop wearing the shoes, but you do not throw them away. The more you paid for the shoes, the longer they sit in the back of your closet before you throw them away. (This behaviour cannot be rational unless expensive shoes take up less space.) (3) At some point, you throw the shoes away, regardless of what they cost, the payment having been fully `depreciated’.”
Along similar lines people hold on to CDs they never listen to, clothes they never wear and books they never read. Keeping these things just holds up space, it doesn’t create any problems in life. But there are other times when the escalation of commitment that the sunk-cost fallacy causes, can lead to serious problems. As Daniel Kahneman, writes in Thinking, Fast and Slow “The sunk cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects. I have often observed young scientists struggling to salvage a doomed project when they would be better advised to drop it and start new one.”
As far trying to salvage doomed projects go, CEOs and businesses seem to do it all the time. As Kahneman points out “Imagine a company that has already spent $50 million on a project. The project is now behind schedule and the forecasts of its ultimate returns are less favourable than at the initial planning stage. An additional investment of $60 million is required to give the project a chance. An alternative proposal is to invest the same amount in a new project that looks likely to bring higher returns. What will the company do? All too often a company afflicted by sunk costs drives into the blizzard, throwing good money after bad rather than accepting the humiliation of closing the account of a costly failure.”
A similar problem afflicts a lot of government infrastructure projects as well, where good money keeps getting thrown after bad. It also explains why the United States kept waging a war in Vietnam and then in Iraq, even though it was clear very early in the process that Vietnam was a lost cause and that there were no weapons of mass destruction in Iraq.
To conclude, it is important to understand why human beings become victims of the sunk-cost fallacy? “Sunk-cost effects are motivated by the desire to avoid regret rather than just the desire to avoid a loss,” writes Schwartz. And if you, dear reader, do not want to become a victim of the sunk-cost fallacy, this is an important point to remember.

 The article originally appeared in the April2014 issue of the Wealth Insight magazine.

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

What is the right price of anything?

rupee Vivek Kaul  
A few years back when I went to get a new pair of spectacles made, I was given an estimate of Rs 5,700. “Chashma khareedna hai, dukan nahi (I want to buy a pair of spectacles, not the shop),” I quipped immediately.
The shopkeeper heard this and quickly moved into damage control mode. He showed me a new frame and we finally agreed on a price of Rs 2,700. The frame I ended up buying was not very different from the one that I had originally chosen. The shopkeeper tried to tell me that the earlier one was more sturdy, easy on the eyes, etc.
But to me both the frames looked the same. I have thought about this incident a few times since it happened, and come to the conclusion, that the shopkeeper was essentially trying to figure out the upper end of what I was ready to pay. In the end he sold me more or less the same product for Rs 2,700 even though he had started at Rs 5,700. He was playing mind games.
Was he successful at it? Prima facie it might seem that I saved Rs 3,000. (Rs 5,700 minus Rs 2,700). But is that the case? One of the selling tricks involves making the customer feel that he has got a good deal. Barry Schwartz provides a excellent example of this phenomenon in his book The Paradox of Choice: Why More is Less.
He gives the example of a high-end catalog seller who largely sold kitchen equipment. The seller offered an automatic bread maker for $279. “Sometime later, the catalog seller began to offer a large capacity, deluxe version for $429. They didn’t sell too many of these expensive bread makers, but sales of the less expensive one almost doubled! With the expensive bread maker serving as anchor, the $279 machine had become a bargain,” writes Scwartz.
Now compare this situation to what I went through. Before you do that, let me give you one more piece of information. When I went to the shop looking to buy a pair of spectacles, I had thought that I won’t spent more than Rs 2,000 on it. But I ended up spending Rs 2,700.
The shopkeeper’s first prize of Rs 5,700 gamed me into thinking that I was getting a good price. Thus, I ended up spending Rs 700 more than what I had initially thought. Behavioural economists refer to this as the “anchoring effect”. As John Allen Paulos writes in A Mathematician Plays the Stock Market “Most of us suffer from a common psychological failing. We credit and easily become attached to any number we hear. This tendency is called “anchoring effect”.”
Marketers use “anchoring” very well to make people buy things that they normally won’t. As Schwartz points out “When we see outdoor gas grills on the market for $8,000, it seems quite reasonable to buy one for $1,200. When a wristwatch that is no more accurate than one you can buy for $50 sells for $20,000, it seems reasonable to buy one for $2,000. Even if companies sell almost none of their highest-priced models, they can reap enormous benefits from producing such models because they help induce people to buy cheaper ( but still extremely expensive) ones.”
Anchoring is used by insurance agents as well to get prospective customers to pay higher premiums than they normally would. As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them “If you’re on the “buy side” purchasing life insurance, for example you’ll be susceptible to any suggestions about normal levels of coverage and premiums. All that an enterprising agent need to tell you is that most of people at your age have, say, $2 million worth of coverage, which needs $4,000 a year and that will likely become your starting point of negotiations.”
Hence, it is important for consumers seeking a good deal to keep this in mind, whenever they are thinking of buying something.
The column originally appeared in the Mutual Fund Insight magazine, March 2014 
(Vivek Kaul is the author of Easy Money. He can be reached at [email protected]) 

Sensex hits 22,000: Why you should drink the stock market SIP by SIP

indian rupeesVivek Kaul  
One of the investment lessons that gets bandied around when it comes to investing in the stock market is that stocks are for the long run. Of course, no one really gets around to tell you how long is the long run.
The BSE Sensex touched an all time high level of 21,919.79 points on March 7, 2014. As I write this it is at 21,942.11 points, which is higher than the all time high it touched on March 7. During the course of trading today (i.e. March 10, 2014), it even crossed 22,000 points briefly.
The question is what are the returns that the Sensex has generated. Between January 2, 2008 and March 7, 2014, the Sensex has given an absolute return of just 7.11%. Yes, just 7.10%, over a period greater than six years.
You, dear investor, would earned significantly better returns by just letting your money lie idle in a savings bank account which pays an interest of 4% per annum (or actually 2.8% if you come in the 30% tax bracket). If you had made the effort to move your money into a bank, like Yes Bank, which pays up to 7% interest on the money deposited in a savings bank account, you would have done even better. And these returns would have been guaranteed, unlike the returns from a stock market. So much for stocks being the right investment product for the long run.
The BSE Sensex is made up for 30 stocks listed on the Bombay Stock Exchange. And in the last six years the stocks that constitute the index have been changed majorly. Dhirendra Kumar of Value Research points out in a column that “ The Sensex has seen large changes since that time. Nine of the thirty companies have been replaced. It’s literally not the same Sensex any more.” And if one were to re-calculate the value of the Sensex assuming these stocks would have continued to be a part of the Sensex, the Sensex would have actually been at 20,400 points today, writes Kumar. This is close to around 6% lower than the March 7 high that the Sensex achieved. Also, this is not totally accurate given that one of the companies Satyam Computers, no longer exists.
So a buy and hold strategy on the Sensex does not really work. But does that mean you should not invest in the stock market? Should you stay away? Not at all.
The best way to invest in the stock market continues to be a systematic investment plan(SIP). If you would have started an SIP on the HDFC Equity Fund in January 2008 (which was one of the better funds back then) it would have given you a return of 12.96% per year, assuming had continued your SIP till date through the ups and downs of the stock market.
You would have done even better if you had started an SIP and invested regularly in ICICI Prudential Dynamic Fund. The returns in this case would have amounted to 14.43% per year. An SIP on DSP Black Rock Top 100 fund (which was also one of the better funds back then) would have earned you a return 9.54% per year, whichi is not as high as HDFC Equity Fund or ICICI Prudential Dynamic Fund, but not bad nonetheless.
Also, it is worth remembering that these returns are tax free. Any mode of investment giving a tax free return of 9% or higher, in these difficult times, is a pretty good bet.
Of course, most people would have missed out on these returns, given that they would have started to cancel their SIPs once the stock market started to fall in 2008, in the aftermath of the financial crisis. But what they forgot is the basic principle behind an SIP.
For SIPs to give good returns, the stock market needs to move both up and down. When the stock market goes down, then investors are able to buy a greater number of mutual fund units for the same amount of money. And these units bought when the markets are low, provide the kicker to the overall returns once the stock market rallies.
When it comes to mutual fund SIPs, it is best to remember the old Hero Honda advertisement. Fill it, shut it, forget it. 
Discloure: Vivek Kaul is a writer. He tweets @kaul_vivek. He invested in all the mutual funds mentioned in the piece, through the SIP route, at some point of time.
The article originally appeared on www.FirstBiz.com on March 11, 2014

Personal finance advice in 87 words: Lessons on investing from Scott Adams

 scott adams[1]Vivek Kaul
One of my bigger mistakes in life was to spend two years doing an MBA. ‘Herd mentality’ usually leads to disastrous decisions. After completing my MBA, I discovered Scott Adams and his cartoon character ‘Dilbert’. Dilbert(and effectively Adams) taught me more about management and how companies ‘really’ work, than two years I spent at a business school.
Interestingly, in the recent past, I have also picked up some basic personal finance lessons from reading a few books written by Adams. In his latest book How to Fail at Almost Everything and Still Win Big, Adams shares some of his experiences and draws a few personal finance lessons from them.
When the dotcom boom was on, Adams invested in this start-up called Webvan. “You could order grocery-store items over the Internet and one of Webvan’s trucks would load your order at the company’s modern distribution hub and set out to service all the customers in your area,” writes Adams.
He thought that Webvan would do for grocery what Amazon had done for books and bought the shares of the company. As the dotcom bubble lost steam and the stock price of Webvan fell, Adams bought more stock (probably following the strategy of dollar cost averaging). As the price of the stock fell, he repeated this process several times.
As Adams writes “When management announced they had achieved positive cash flow at one of their several hubs, I knew I was onto something. If it worked in one hub, the model was proven, and it would surely work at others. I bought more stock.”
A few weeks later, Webvan went out of business. “Investing in Webvan wasn’t the dumbest thing I’ve ever done, but it’s a contender…What I learned from the experience is that there is no such thing as useful information that comes from a company’s management.”
Adams also talks about this phenomenon in the context of professional stock analysts in his book Dilbert and the Way of the Weasel. As he points out “Professional stock analysts can do something that you can’t do on your own, and that is to talk directly to senior management of the company. That’s how a stock analyst gets all the important inside scoop not available to the general public, including important CEO quotes like this: “The future looks good!””
After his disastrous experience with Webvan, Adams decided to that get some professional help in investing all the money that he was making once the royalties of Dilbert started to pour in. As he writes in How to Fail at Almost Everything and Still Win Big “I didn’t have the time to do my own research. Nor did I trust my financial skills…My bank, Wells Fargo, pitched me on its investment services, and I decided to trust it with half of my investible funds. Trust is probably the wrong term because I only let Wells Fargo have half; I half trusted it. I did my own investing with the other half of the money.”
The results of the half trust weren’t any good either. “The experts at Wells Fargo helpfully invested my money in Enron, WorldCom, and some other names that have become synonymous with losing money. Clearly investment professionals did not have access to better information than I had. I withdrew my money from their management and have done my own thing since then,” writes Adams. He has been investing in index mutual funds since then.
Adams discusses the problem of listening to so called experts in Dilbert and the Way of the Weasel. As he writes “My problem is that I listen to financial experts, who give valuable advice for moving my money from me to them. My first clue that experts are less than omnipotent might have been that they all recommended different and conflicting things. The one thing that all their recommendations have in common is that is that if you follow their advice, they will get richer.”
Adams also talks about the importance of investors concentrating on systems and not goals. “Warren Buffett’s system for investing involves buying undervalued companies and holding them forever, or at least until something major changes. That system (which I have grossly oversimplified) has been a winner for decades. Compare that with individual investors who buy a stock because they expect it to go up 20 percent in the coming year; that’s a goal, not a system. And not surprisingly, individual investors generally experience worse returns than the market average,” writes Adams in How to Fail at Almost Everything and Still Win Big. This is a simple but a very important point to understand for every investor.
In fact, Adams once even tried to write a book about personal investing. As he writes in Dilbert and the Way of the Weasel “It was supposed to be geared toward younger people who were investing for the first time. After extensive research on all topics related to personal investing I realized I had a problem. I could describe everything that a young first-time investor needs to know on one page. No one wants to buy a one-page book even if that page is well written…People would look at it and say, “That’s all well and good, but I’m paying mostly for the cover.””
In fact, the plan was not even one page. It was just 87 words and here it is:
Make a will. Pay off your credit cards. Get term life insurance if you have a family to support. Fund your 401k to the maximum. Fund your IRA(individual retirement account) to the maximum. Buy a house if you want to live in a house and can afford it. Put six months worth of expenses in a money-market account. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement. (as described in Dilbert and the Way of the Weasel) (401k and IRA are essentially what we call provident funds in India).
These 87 words summarise all that is there to know about personal finance.
The article originally appeared on www.FirstBiz.com on February 15, 2014
 (Vivek Kaul is a writer. He tweets @kaul_vivek)  

Why investors behave like football goalkeepers and how that hurts

goalkeeperVivek Kaul  
A very good friend of mine recently decided to take a sabbatical. But two weeks into it he started getting fidgety. The prospect of not doing anything was turning out to be too hot to handle for him. So, one morning he called up his boss and told him that this decision to go on a sabbatical was not the right one, and given this, he wanted to get back to work.
My friend’s boss, had taken a sabbatical last year, and understood the value of a big break away from work. Given this, he refused to let my friend get back to work so soon, and suggested that he continue with the sabbatical, now that he had decided to take one.
One more week into the sabbatical, my friend simply couldn’t handle it. One day he simply landed up at work, without consulting his boss. And thus ended his sabbatical.
The point in sharing this story is that it is difficult “do nothing”, even though at times it might be the most important thing to do.
In a recent interview to Wisden, the former Australian cricketer Dean Jones, pointed out that two thirds of Sachin Tendulkar’s game was based around forward defence, back-foot defence and leaving the ball, without trying to play it. As Amay Hattangadi and Swanand Kelkar write in a research eport titled The Value of Doing Nothing and dated February 2014 “As any coach would vouch, letting the ball go is possibly as important as hitting good shots in the career of a batsman.”
In fact, not doing anything is a very important part of successful investing. But the investment industry is not structured liked that. They have to ensure that their customers keep trading, even if it is detrimental for the them. As Arthur Levitt, a former Chairman of the Securities Exchange Commission, the stock market regulator in the United States, writes in Take on the Street – How to Fight for Your Financial Future “Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage. They want you to buy stocks you don’t own and sell the ones you do., because that’s how they make money for themselves and their firms. They earn commissions even when you lose money.”
The brokers only make money when investors keep buying and selling through them. This is also true about insurance and mutual fund agents, who make bigger commissions at the time investors invest and then lower commissions as the investors stay invested.
As Adam Smith (not the famous economist) writes in The Money Game “They could put you in some stock that would go up ten times, but then they would starve to death. They only get commissions when you buy and sell. So they keep you moving.”
Levitt proves this point by taking the example of Warren Buffett to make his point. “Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc and one of the smartest investors I’ve ever met, knows all about broker conflicts. He likes to point that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy. A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But, any broker who did that would have starved to death.”
Hence, it is important for stock brokers, insurance and mutual fund agents to get their investors to keep moving from one investment to another.
But how do stock brokers manage to do this all the time? Andy Kessler has an excellent explanation for this in Wall Street Meat. As he writes “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days [250 days – the four days on which companies declare quarterly results]. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table—whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.”
But why are these analysts taken seriously more often than not? As John Kenneth Galbraith writes in The Economics of Innocent Fraud “ And there is no easy denial of an expert’s foresight. Past accidental success and an ample display of charts, equations and self-confidence depth of perception. Thus the fraud. Correction awaits.”
This has led to a situation where investors are buying and selling all the time. As Hattangadi and Kelkar point out “In fact, the median holding period of the top 100 stocks by market capitalisation in the U.S. has shrunk to a third from about 600 days to 200 days over the last two decades.” Now contrast this data point with the fact that almost any and every stock market expert likes to tell us that stocks are for the long term.
This also happens because an inherent action bias is built into human beings. An interesting example of this phenomenon comes from football. “In an interesting research paper, Michael Bar-Eli2 et al analysed 286 penalty kicks in top soccer leagues and championships worldwide. In a penalty kick, the ball takes approximately 0.2 seconds to reach the goal leaving no time for the goalkeeper to clearly see the direction the ball is kicked. He has to decide whether to jump to one of the sides or to stay in the centre at about the same time as the kicker chooses where to direct the ball. About 80% of penalty kicks resulted in a goal being scored, which emphasises the importance a penalty kick has to determine the outcome of a game. Interestingly, the data revealed that the optimal strategy for the goalkeeper is to stay in the centre of the goal. However, almost always they jumped left or right,” write Hattangadi and Kelkar.
Albert Edwards of Societe Generale discusses this example in greater detail. As he writes “When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”
But the goalkeeper doesn’t do that. And there is a good reason for it. As Hattangadi and Kelkar write “ The goalkeepers choose action (jumping to one of the sides) rather than inaction (staying in the centre). If the goalkeeper stays in the centre and a goal is scored, it looks as if he did not do anything to stop the ball. The goalkeeper clearly feels lesser regret, and risk to his career, if he jumps on either side, even though it may result in a goal being scored.”
Investors also behave like football goalkeepers and that hurts them.
The article originally appeared on www.firstbiz.com on February 8, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)