Investing

A Primer on Bank Interest Rates for Real Estate Companies, Lawyers, Judges, Government and Everyone Else

The Supreme Court is currently hearing the loan moratorium case. Arguments have been made from different sides, on whether banks should charge an interest on loans during the moratorium and if an interest should be then charged on that interest.

I wanted to discuss a few arguments being offered by lawyers who are representing borrowers of different kinds in the Supreme Court. Either their understanding of interest rates is weak, or even if they do understand, they are just ignoring that understanding in order to make a powerful argument before the Supreme Court.

Let’s look at the issue pointwise. Also, this piece is for anyone who really wants to understand how interest rates really work. Alternatively, I could have headlined this piece, Everything You Ever Wanted to Know About Interest Rates But were Afraid to Ask.

1) Appearing for the real estate sector, Senior Advocate C A Sundaram told a bench of Justices Ashok Bhushan, R S Reddy and M R Shah: “Even if the interest is not waived, then it must be reduced to the rate at which banks are paying interest on deposits.”

What does this mean? Let’s say a real estate company has taken a loan of Rs 100 crore from a bank. On this it pays an interest of 10% per year. For the period of the moratorium the company doesn’t pay the interest on the loan. At the end of six months, the interest outstanding on the loan is Rs 5 crore (10% of Rs 100 crore for a period of six months). In the normal scheme of things this outstanding interest needs to be added to Rs 100 crore and the loan the builder now needs to repay Rs 105 crore. Of course, in the process of repaying this loan amount, the company will end up paying an interest on interest. If it wants to avoid doing that it simply needs to pay the outstanding interest of Rs 5 crore once the moratorium ends and continue repaying the original loan.

What Advocate Sundaram told the Supreme Court is that even if the interest on the loan during the moratorium is not waived, the interest rate charged on it should be lower and should be equal to the interest rate that banks are paying on their deposits.

The question of not charging an interest rate on loans during moratorium is totally out of question. Banks raise deposits by paying a rate of interest on it. It is these deposits they give out as loans. If they don’t charge an interest on their loans, how will they pay interest on their deposits?

Bank deposits remain the most popular form of saving for individuals. Imagine the social and financial disruption something like this would create.

Even the point about banks charging an interest rate during the moratorium which is equal to the interest rate they are paying on their deposits, is problematic. Other than paying an interest rate on deposits, banks have all kinds of other expenditures. They need to pay salaries to employees and off-role staff, rents for the offices and branches they operate out of, bear the cost of insuring deposits and also take into account, the loan defaults that are happening.

If the banks charge an interest rate on loans equal to the interest rate they pay on deposits, how are they supposed to pay for all the costs highlighted above?

2) More than this, I think there is a bigger problem with Senior Advocate Sundaram’s argument. Allow me to explain. Interest on money is basically the price of money. When a bank pays an interest to a deposit holder, he is basically compensating the deposit holder for not spending the money immediately and saving it. This saving is then lent out to anyone who needs the money. This is how the financial intermediation business works.

If real estate companies could today ask the courts to decide on the bank’s price of money, the banks could do something similar tomorrow. They could approach the courts with the argument that real estate companies need to reduce home prices, in the effort to sell more units, so that they are able to repay all the money they have borrowed from banks.

If courts can decide on how banks should carry out their pricing, they can also decide on how real estate companies should carry out their pricing. This is something that needs to be kept in mind.

3) This is a slightly different point, which might seem to have nothing to do with interest rates, but it does. The real estate industry is in dire straits and hence, wants the government, Reserve Bank of India (RBI) and the Supreme Court, to help. (I am going beyond what Advocate Sundaram told the Court).

In fact, banks and non-banking finance companies, have already been allowed to restructure builder loans. Former RBI governor Urjit Patel refers to the commercial real-estate-sector as the living dead borrowers in his book Overdraft.

The real estate sector had a great time between 2002 and 2013, for more than a decade, when they really raked in the moolah.

While they did this, they obviously kept the after-tax profits with themselves and they didn’t share it with anyone else. So, why should they be supported now? Why should their losses be socialised? And if losses of real estate sector are socialised, where does the system stop? This is a question well worth asking.

If these losses are socialised, the banks will try making up for it through other ways. This would mean lower interest rates on deposits than would otherwise have been the case. This would also mean higher interest rates on loans than would otherwise have been the case. There is no free lunch in economics.

4) Senior Advocate Rajiv Datta said that banks should not take the moratorium as a default period to charge interest on interest to individual borrowers, including those repaying home loans. As he said: “Profiteering at the cost of individual borrowers during a pandemic is like Shylock seeking his pound of flesh. Individual borrowers were not defaulting.”

While I have no love-lost for bankers, but generations of bankers have had to suffer thanks to the way the William Shakespeare portrayed a Jewish money lender in his play The Merchant of Venice.

The question is why is everyone so concerned only about the borrowers. What about the savers? The average fixed deposit rate is now down to 6%. This, when the rate of inflation is close to 7%. The savers are already losing out. Why should they lose more?

5) Another argument was put forward by Senior Advocate Sanjay Hegde, where he said that banks never passed the benefit of lower repo rate to consumers in the whole of 2019 to garner bigger profits. “When there is a pandemic, they should not think of profiteering and pass on the benefits granted by the RBI to borrowers by lowering the interest rate on loans,” he said.

This is a fundamental mistake that many people make where they assume a one to one relationship between the repo rate and loan interest rates. Repo rate is the interest rate at which the RBI lends money to banks. The idea in the heads of people and often portrayed in the media is that the repo rate is coming down and so, should loan interest rates, at the same pace.

In December 2018, the repo rate was at 6.5%. Since then it has been reduced to 4%. There has been a cut of 250 basis points. One basis point is one hundredth of a percentage. During the same period, the weighted average lending rate on outstanding loans has fallen from 10.35% to 9.71%, a fall of a mere 64 basis points.

So is Senior Advocate Hegde right in the argument he is making? Not at all. As I said earlier, the link between the repo rate and the lending rate is not one to one. The reason for that is very simple. Banks raise deposits and lend that money out as loans. For lending interest rates to fall, the deposit interest rates need to fall.

The weighted average deposit interest rates since December 2018 have fallen from 6.87% to 5.96% or a fall of 91 basis points. We see that even the deposit interest rates do not share a one to one relationship with the repo rate.

Why is that the case? If a depositor invested in a deposit at 8% interest three years back, he continues to be paid that 8% interest, even when the repo rate is falling. Further, even though banks reduce the interest rate they pay on new fixed deposits, they cannot do so on the older fixed deposits. The fixed deposit interest rates are fixed and that is why they are called fixed deposits.

If the repo rate and the fixed deposit interest rates need to have a one to one relationship, meaning a 25 basis points cut in the repo rate leads to a 25 basis points cut in deposit rates, which translates into a 25 basis points cut into lending rates, then banks need to offer variable interest rate deposits and not fixed deposits. Again, that is a recipe for a social disruption.

If we look at fresh loans given by banks, the interest charged on them has fallen from 9.79% in December 2018 to around 8.52%, a fall of 127 basis points, which is much higher than the overall fall of just 64 basis points. This is primarily because the interest rate on fresh fixed deposits has fallen faster than the interest rates on fixed deposits as a whole.

This still leaves the question why has the overall lending rate fallen by 64 basis points when the overall deposit rate has fallen by 91 basis points. One reason lies in the fact that banks have a massive amount of bad loans and they are just trying to increase the spread between the interest they charge on their loans and the interest that they pay on their deposits, by not cutting the lending rate as fast as the deposit rate.

This will mean a higher profit, which can compensate for bad loans to some extent. Over and above this, there is some profiteering as well. But the situation is nowhere as bad as the lawyers are making out to be.

The reason for that is simple. There is a lot of competition in banking and if a particular bank tries to earn excessive profits, a competitor can easily challenge those profits by charging a slightly lower rate of interest and getting some of the business.

To conclude, allowing banks to set their own interest rates is at the heart of a successful banking business. And no one should be allowed to mess around with that. Also, for the umpteenth time, interest rates are not just about the repo rate.

Why is the stock market going up when the economy is going down?

The total collections of the goods and services tax (GST) between March and July stood at Rs 2.73 lakh crore. This is 34.5% lower than what the government earned during the same period in 2019.

The stock market index Nifty 50 has rallied by 53% to 11,648 points between March 23 and August 28. It had touched this year’s low of 7,610 points on March 23.

So, what’s the point in comparing the Nifty 50 with GST collections? The GST is basically a tax on consumption. If the GST collections are down by more than a third, what that basically means is that private consumption is down majorly.

When consumption is down, the company earnings are bound to take a beating. Take the case of two-wheelers and cars. When people don’t buy as many of them as they used to, their production takes a beating. When that happens, it has an impact right down the value chain. It means lower production of steel, steering, glass, tyres, etc. A lower production of tyres means a lower demand for rubber.

A lower production on the whole means lower demand for power. Industrial power largely subsidises farm power and home power (where power is stolen). If industrial power consumption goes down, the losses of state electricity boards go up. When this happens, their ability to keep paying power generation companies goes down. When these companies don’t get paid, they are in no position to repay loans they have taken from banks. So, the cycle works.

Many people buy two-wheelers and cars on loans from banks and non-banking finance companies. When the buying falls, the total amount of loans given by banks also comes down. When banks don’t get enough loans, they need to cut the interest rate on their fixed deposits.

When this happens, people who are saving towards a goal, need to save more. This means they need to cut down on their consumption. Further, people who are largely dependent on interest from bank deposits will see their incomes fall. This means they need to cut down on their consumption as well.

This cycle will also lead to a fall company earnings. A Business Standard results tracker for 1,946 companies reveals that the sales of these companies for April to June 2020 were down 23.1% in comparison to the same period in 2019. The net profit for these companies was down 60.8%.

The stock market does not wait for things to happen. It discounted for this possibility and the Nifty fell by 32.1% between end February and March 23. The market was adjusting for an era of falling company earnings. But it didn’t stay at those low levels and has rallied by more than 50% since then.

The trouble now is that the valuations are way off the chart. The price to earnings ratio of the Nifty 50 index, as of August 28, stood at 32.92. This means that investors are ready to pay close to Rs 33 for every rupee of earning for stocks that make up the Nifty 50 index. Such a level has never been seen before. Not during the dotcom bubble era and not even during early 2008 when the stock market rallied to its then highest level.

Why has the stock market jumped as much as it has? Does this mean that the company earnings will jump big time in the near future? Not at all. The covid-induced recession is not going to go anytime quickly. Also, the pandemic is now gradually making its way into rural India.

So, why is the stock market rallying? The Western central banks led by the Federal Reserve of the United States, the American central bank, have printed a lot of money post February, in order to drive down interest rates and get people and businesses to borrow and spend. The Federal Reserve has printed more than $2.8 trillion between February 26 and August 5. Some of this money has made it into India.

During this financial year, the foreign institutional investors have net invested a total of Rs 83,682 crore into Indian stocks, after going easy on investing in India over the last few years. This is clearly an impact of the easy money policies being run in much of the Western world.

Further, the participation of the retail investors in the stock market has increased during the course of this year. Between December 2019 and June 2020, the number of demat accounts has gone up by 39 lakhs or 10% to 4.32 crore accounts. In fact, between March end, after a physical lockdown to tackle covid was introduced, and up to June, the number of demat accounts has gone up by 24 lakhs.

The latest monthly bulletin of Securities and Exchange Board of India, the stock market regulator, points out: “We have seen a huge surge in participation of retail investors in the equity market in the last few months. The fact that there is also a surge in opening up of demat accounts suggests that many of these retail investors are perhaps first time investors in the stock market.”

With after tax return on bank fixed deposits down to 4-5% when inflation is close to 7%, these investors are coming to the stock market, in search of higher returns.

The question is, with the stock market at all time high valuations, will their good times continue? Or once the dust has settled, is another generation of investors ready to equate stock market investing to gambling? On that your guess is as good as mine.

This article originally appeared in the Deccan Herald on August 30, 2020.

The ‘GULZAR’ Principle of Investing for Regular Income and Safe Returns

Summary: There is no real way of earning a regular and a safe income that is enough to meet the monthly expenses.

The headline was a clickbait. But now that I have your attention, let me explain the logic behind it.

The title song of the 1979 Hindi film Gol Maal was written by the lyricist Gulzar (Honestly, calling him just a lyricist is doing his talent a great disservice. Other than being a lyricist, he has written screenplays and dialogues for a huge number of Hindi films. He is a poet and a short story writer. He is also a translator of repute. Oh, and he has also directed a whole host of Hindi movies as well as a few TV serials along the way. Also, for the millennials, Hrishikesh Mukherjee made Gol Maal, much before Rohit Shetty started using the title for everything he could possibly think of).

Now getting back to the point I was trying to make. In the title song of Gol Maal there is a line which goes: “paisa kamane ke liye bhi paisa chahiye,” essentially meaning, in order to earn money, you first need money. And that is what I am going to write about today.

In the twenty months, as the economy has gone downhill, people have been getting in touch with me on email and the social media, with a very basic financial query. The numbers were small first but post-covid this has turned into a deluge. The question being asked is how a reasonable monthly income can be generated from savings, without taking any risk, in a safe way.

The answer to this question has become very important as people have lost their jobs or seen their salaries being slashed and incomes falling. What does not help is the fact that the post-tax return from bank fixed deposits are now largely in the range of 4-5%. The inflation as measured by the consumer price index is close to 7%.

Before I try answering this question, it is important to understand why interest rates on bank fixed deposits have fallen. The simple answer to this lies in the fact that there is too much money floating around in the financial system, with the banks not knowing possibly what to do with it.

Between March 27 and July 31, a period of little over four months, the non-food credit given by banks has contracted by Rs 1.32 lakh crore or around 1.3%. The banks give loans to the Food Corporation of India (FCI) and other state procurement agencies to primarily buy rice and wheat directly from the farmers at the minimum support price declared by the government. Once these loans are deducted from the overall loans given by banks, what remains is non-food credit.

What does non-food credit contracting tells us? It tells us on the whole borrowers have been repaying loans and at the same time not taking on enough new loans. It also tells us that banks are reluctant to lend. Further, as we shall see, there has been a huge surge in fixed deposits with banks, as people have increased their savings in the aftermath of the spread of the covid-19 pandemic. Banks will take time to lend all this money out.

Between March 27 and July 31, the total deposits of banks have gone up by Rs 5.95 lakh crore or 4.4%. In an environment, where the non-food credit of banks has contracted whereas deposits have jumped big-time, it is but natural that interest rates on fixed deposits have fallen. In fact, the weighted average term deposit interest rate or simply put average fixed deposit interest rate has fallen from 6.45% in February to 6% in June, the latest data available. Now that we are in August, the interest rates may have possibly fallen even more.

In fact, there is nothing new about interest rates on fixed deposits falling, this has been going on for close to eight years now. Having said that, interest rates shouldn’t be looked at in isolation, it is important to compare them with the prevailing rate of inflation. Take a look at the following chart. It plots the average interest rate on fixed deposits during the course of a year, along with inflation as measured by the consumer price index. The difference between the two is referred to as the real rate of return on fixed deposits.

Interest v/s Inflation


Source: Reserve Bank of India.

What does the above chart tell us? Between 2014-15 and 2018-19, there was a healthy difference between the average interest paid on fixed deposits and inflation. (Of course, this is without taking tax on fixed deposit interest into account, else, the difference would have been lower).

These were the years when first Dr Raghuram Rajan and then Dr Urjit Patel were at the helm at the Reserve Bank of India. In 2019-20, the real return on fixed deposits narrowed to 1.6%. Shaktikanta Das took over as RBI Governor in December 2018.

Let’s take a look at the real return on fixed deposits month wise since December 2018, the month when Das took over as RBI Governor. The real return on fixed deposits as explained earlier is the average interest rate on fixed deposits minus the prevailing rate of inflation.

Crash in real returns


Source: Author calculations on data from the Reserve Bank of India.

This chart is as clear as anything can get. The real rate of return on fixed deposits has simply collapsed since end of 2018. This has happened as the interest rate on fixed deposits has fallen and inflation has gone up.

The interest rate on fixed deposits has fallen primarily because the rate of loan growth for banks has crashed over this period. This we can see from the following chart.

Loan growth crash


Source: Reserve Bank of India.

The above chart clearly tells us that the loan growth of banks has crashed since December 2018. In fact, for the week ended July 31, it stood at just 5.4%. Given this, the Indian economy was slowing down even before covid-19 pandemic struck.

Hence, as economic growth has slowed down, the loan growth of banks has slowed down and this has led to fixed deposit interest rates coming down as well. The point being that in economics everything is linked.

Of course, there is more to this than just the economy slowing down. Since February,  like the rest of the central banks, the RBI has printed and pumped money into the financial system to drive down interest rates, in the hope of getting businesses and people to borrow more.

Also, with collapse in tax revenues, the government will have to borrow more this year, in order to keep its expenditure going. Hence, it likes the idea of borrowing more at lower interest rates. The RBI goes along with this because among other things it also acts as the debt manager of the government.

The problem is that India’s economic crisis has grown worse since the covid pandemic hit the world, leading to a lot of individuals losing their jobs or facing salary cuts. Small businesses have been majorly hit and incomes have come down dramatically.

In this environment, people are now looking to generate some sort of a regular income from their savings. Of course, most them want to do this in a risk free way. As one gentleman recently asked me: “I am currently not employed after having worked in the corporate sector for 10 years. My request to you is to honestly guide me on how and where to invest to earn steady income especially when the fixed deposit interest rates have fallen so low.”

The first thing I can clearly say is that the gentleman believes that there is a solution to his problem. He believes that it is possible to generate a good steady income despite fixed deposit interest rates having fallen.

I see this belief among many people. My guess is, it stems from the fact that way too many personal finance publications believe in offering solutions to everything. I mean, why will a reader read you, if at the end of it you say something like there aren’t really any solutions to this problem that you might have. At least, that’s how their thinking operates. Also, they need advertisers. And advertisers love solutions to everything, even when none really exist.

In June 2020, the average rate of interest on a fixed deposit was 6%. Once we take income tax into account, the rate of return would be much lower. Of course, there are banks out there which are offering a rate of interest of 7% or more. Nevertheless, these banks are perceived to be among the riskier ones. So, the question is are you willing to take on more risk, for a 1-1.5% higher return? If yes, then these investments are for you.

While, we live in an era where no bank is going to go bust, they can and have been put under a moratorium or periods under which only a limited amount of money can be withdrawn from them. And money that can’t be spent when it is needed, is essentially useless. Hence, if you do end up putting money in a bank which offers a 1-1.5% higher return, do remember not to put all your money into it.

There are corporate fixed deposits which offer a slightly higher return but again they don’t have the same safety as a bank does.

If you are senior citizen, you can look at the Senior Citizens Savings Scheme. But that comes with the pain of dealing with the post office.

Debt mutual funds as many people have found out over the last one year, come with their own share of risks. They were marketed to be as safe as fixed deposits, but they weren’t anywhere close. Also, irrespective of what financial planners and wealth managers might say, debt mutual funds are fairly complicated products, which I am sure most people selling them don’t understand. And that’s why they are able to sell them in the first place.

A lot of individuals in the last few months have turned towards investing in stocks. The logic is that the stock market has rallied from its March low. On March 23, the BSE Sensex, India’s premier stock market index was at 25,981 points. Yesterday, August 26, it closed at 39,074 points, a jump of over 50% in a period of a little over five months. This rally has been driven by a few stocks and if you had invested in the right stocks, you would have ended up with good gains by now.

While, one can’t question this logic, but what one needs to remember is that on January 12, the Sensex was at 41,965 points. From there to March 23, it fell by 38% in a little over two months. The point being the stock market can fall as fast or even faster than it can rise. Also, do remember this basic point that a 50% fall can wipe off a 100% gain. (A 38% fall would have written off a 61% gain).

Hence, the larger point here as I mentioned in this piece I wrote a few days back is, just because an investor takes a higher risk by investing in stocks, it doesn’t mean he will always end up with higher returns, precisely the reason the word ‘risk’ is used in the first place. And by the way, the 10-year return on stocks (including dividends) is less than 9% per year.

So, the question is what should a person looking for a regular and safe income, actually do? As helpless as it might sound, there aren’t many options going around beyond the humble fixed deposit, especially for people who aren’t senior citizens. The trouble is the fixed deposit interest rates are at very low levels.

If you need to generate a monthly income of Rs 20,000 at 6% per year, this needs an investment of Rs 40 lakh.

The moral of the story here being that if you want to generate a regular safe income which is enough to meet your monthly needs, you need to invest more money. Or as Gulzar wrote in Gol Maal: “paisa kamane ke liye bhi paisa chahiye.” I would like to call this the Gulzar principle of investing for a regular income and safe returns.

Also, there are corollaries to this. These are very difficult times. Hence, there is a good chance of individuals ending up in a situation where they might have to spend their savings (rather than just the return on savings) to keep meeting expenditure.

Let’s take the example of a middle-class household with monthly expenses of Rs 50,000. In order to generate this income through a fixed deposit, an investment of Rs 1 crore is needed. Of course, the chances of a middle-class household with expenses of Rs 50,000 per month having savings of a crore, are rather minimal. In this scenario, they will have to resort to spending their savings. Given this, as I keep saying, the return of capital is much more important now than the return on capital.

In the short run, the only way to generate a good regular and safe income is find a job or any other source of income by selling the skills that one has (Like I write. I can do that for a media house or do it individually). In the long run, the next time you see interest rates of 8-9% available on fixed deposits or any other safe investment, invest in these assets and lock in the high returns for as long as possible.

While, this might not sound much like a solution but that is the long and the short of it.

Why HDFC Finds Homes to Be More Affordable, When They Clearly Aren’t

Summary: HDFC is getting better home loan customers that doesn’t mean homes have become more affordable. HDFC’s conclusion of homes becoming more affordable is an excellent example of survivorship bias.

Before I start writing this, I have a confession to make. I have written about this issue before, around five years back. But given that things haven’t really changed since then, it is a good time to write about it again. Hence, to all my regular readers who have been following me over the years and might have read this earlier, sincere apologies in advance.

Home loans in India are given by two kinds of institutions – banks and housing finance companies (HFCs). Among the HFCs, Housing Development Finance Corporation (HDFC) has been a pioneer in the area of home loans.

The company regularly publishes an investor presentation along with every quarterly result.

I am not sure for how long the company has been doing this, but its website has these presentations going as far back as March 2013, a little over seven years. Since then, the company has had a slide in its investor presentation which talks about the improved affordability of owning a home in India. Usually, it is the eight or the ninth slide in the presentation (sometimes, but very rarely tenth).

This is the slide in the latest presentation for the period April to June 2020.

Improved affordability of homes

Source: HDFC Investor Presentation, June 30, 2020.

Let’s look at the chart between 2000 and 2020, the last two decades. The home loan market in the country before that was too small and evolving and hence, prone to extreme results. So, it makes sense to ignore that data.

What does the chart tell us? It tells us that affordability of homes in the country has gone up over the years. The chart defines affordability as home price divided by the annual income of the individual buying the home.

In 2020, the average home price has stood at around Rs 50 lakh. Against this, the average annual income of the individual buying the home stands at around Rs 15 lakh. Given this, the affordability factor is at 3.3 (Rs 50 lakh divided by Rs 15 lakh).

Hence, the average individual in 2020 is buying a home which is priced at 3.3 times his annual income. (Please keep in mind that the property prices are represented on the left-axis and the annual income is represented on the right axis).

As can be seen from the chart, the affordability factor at 3.3 is the lowest in twenty years. Hence, affordability of homes has gone up. QED.

The trouble is, this goes totally against what we see, hear and feel all around us. Real estate companies have lakhs of unsold homes with absolutely no takers. They have thousands of crore of unpaid loans. The banks and non-banking finance companies (NBFCs) have restructured these loans over the years and not recognized them as bad loans in the process, with more than a little help from the Reserve Bank of India (RBI). Bad loans are loans which haven’t been repaid for a period of 90 days or more.

Further, investors who bought real estate over the years have been finding it difficult to sell it. Indeed, if homes had become more affordable, this wouldn’t have been the case. Real estate companies would have been able to sell homes and repay the loans they have taken from banks and NBFCs. And the RBI wouldn’t have to intervene.

So, what is it that HDFC can see that we can’t? Before I get around to answering this question, let me tell you a little story. During the Second World War, the British Royal Air Force (RAF) had a peculiar problem.

It wanted to attach heavy plating to its airplanes in order to protect them from gunfire from the German anti-aircraft guns as well as fighter planes. The trouble was that these plates were heavy and hence, had to be attached strategically at points where bullets fired by the German guns were most likely to hit. The British couldn’t plate the entire plane or even large parts of it.

The good part was that they had historical data regarding which parts of the plane did the German bullets actually hit. And this is where things got interesting. As Jordan Ellenberg writes in How Not to Be Wrong: The Hidden Maths of Everyday Life: “The damage [of the bullets] wasn’t uniformly distributed across the aircraft. There were more bullet holes in the fuselage, not so many in the engines.”

So, historical data was available and hence, the decision should have turned out to be a very easy one. The plates needed to be attached around the plane’s fuselage. But this logic was missing something very basic. The German bullets should have been hitting the engines of airplanes more regularly than the historical evidence suggested, simply because the engine “is a point of total vulnerability”.

A statistician named Abraham Wald realised where the problem was. As Ellenberg writes: “The armour, said Wald, doesn’t go where bullet holes are. It goes where bullet holes aren’t: on the engines. Wald’s insight was simply to ask: where are the missing holes? The ones that would have been all over the engine casing, if the damage had been spread equally all over the plane. The missing bullet holes were on the missing planes. The reason planes were coming back with fewer hits to the engine is that planes that got hit in the engine weren’t coming back.” They simply crashed.

This is what is called survivorship bias or the data that remains and then we make a decision based on it.

As Gary Smith writes in Standard Deviations: Flawed Assumptions Tortured Data and Other Ways to Lie With Statistics: “Wald…had the insight to recognize that these data suffered from survivor bias…Instead of reinforcing the locations with the most holes, they should reinforce the locations with no holes.”

Wald’s recommendations were implemented and ended up saving many planes which would have otherwise gone down. (On a different note, both the books from which I have quoted above, are excellent books on how not to use data, especially useful if you are in the business of torturing data to make it say what you want ).

If you are still scratching your head and wondering what does this Second World War story have to do with HDFC finding homes more affordable, allow me to explain. Like the British before Wald came in with his explanation, HDFC is also looking at the data it has and not the overall data.

Look at the left-hand of the corner of the chart, it says based on customer data. The analysis is based on HDFC’s own historical customer data. When HDFC talks about an average home price of Rs 50 lakh and an income of Rs 15 lakh, it is basically talking about the set of people who have approached the HFC for a loan and gotten one. Hence, HDFC’s conclusion of better affordability is drawn from the sample it has access to.

But does this really mean that affordability has improved? Or does it mean that the quality of HDFC’s customers has improved over the years? The customers that HDFC is giving a home loan to are ones who can afford to buy homes. The HFC clearly has no idea about people who want to buy homes but simply do not have the financial resources to do so.

They don’t show up as a part of any sample, hence, the evidence on them is at best anecdotal. These people are like planes whose engines were hit and hence, they did not make it back to their base, in the Second World War. And like there was no data on the planes which got hit and didn’t make it back, there is no data on these people as well. Basically, HDFC’s data and conclusion are victims of the survivorship bias

In fact, HDFC’s investor presentation has always carried another interesting slide on low penetration of home loans in India. The following chart is from the latest presentation.


Home loans as a percentage of GDP

Source: HDFC Investor Presentation, June 30, 2020.

Total home loans outstanding given by both banks and HFCs in 2020 stands at 10% of the GDP (On a slightly different note, the ratio of homes loans given by banks to home loans given by HFCs is 64:36). In March 2014, the total outstanding home loans in India had stood at 9% of the GDP. If homes indeed were affordable this ratio would have gone up faster.

To conclude, it’s time that HDFC remove this misleading slide from its investor presentation or at least say that the affordability has improved for its customers and not for the country as a whole.

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.