Anchoring

Of Suckers, Mutual Funds and the Old Rs 10 Per Unit Trick

There is a sucker born every minute. I was reminded of this earlier in the day today, when late in the afternoon, that time of the day when I snooze after having had my lunch, I got a random call. For some reason, truecaller didn’t pick up the name of the incoming caller, and I took the call.

The call was from a financial planner’s office and a female was talking at the other end. She said a new fund offer (the technical term for a new mutual fund scheme) from a mutual fund was being currently sold, and that I should invest in it. (Why in the world would I invest in a new scheme and not in something tried and tested, is a question that I didn’t bother to ask).

She started with the usual bull about the long-term returns on the mutual fund expected to be very good (Again, I didn’t bother to ask, if she knew the future, why is she making a living making calls. That would have been very mean).

I replied like I usually do when I am not interested, with a polite hmmm, which doesn’t mean anything.

And then she let it slip, very casually: “Sir, units are available for just Rs 10 per unit.” That caught my attention. It had been years since I had heard that.

The oldest mutual fund misseling trick, something I had made my career writing on during the days I used to write on personal finance, ten to fifteen years back.

It took me back to 2004 to 2007, when stocks were rallying big time and new equity mutual fund schemes were launched dime a dozen. I was reminded of one scheme which had a theme of investing in stocks depending on where the head office or the registered office of the company was (some such thing). Those were the days my friend. Anything sold.

Hoardings on bus stands across Mumbai were plastered with the advertisements of new mutual fund schemes, with the Rs 10 price at which you could buy a single unit of the scheme, being prominently displayed. Even the mutual fund was trying to anchor the prospective investors to the price of Rs 10 per unit.  

As Jason Zweig writes in Your Money and Your Brain in the context of anchoring:

“That’s why real estate agents will usually show you the most expensive house on the market first, so the others will seem cheap by comparison and why mutual fund companies nearly always launch new funds at $10.00 per share, enticing new investors with a “cheap” price at the beginning. In the financial world, anchoring is everywhere, and you can’t be fully on guard against it.”

The stupid me had assumed that all these misseling tricks would have been replaced by newer ones by now. But I guess with every bull run a new set of suckers are produced and India is a big country.

Anyway, I told the caller, madam no money. She then made some polite noises about this being a good opportunity and I should invest in it, and that was that.

For people who don’t know about this misselling trick this is how it works.  When a new mutual fund scheme is launched, the price is set at Rs 10 per unit. Investors buy these units. If the mandate of the scheme is to invest in stocks, the mutual fund collects the money and invests it in stocks.

The price of a unit at the launch is set at Rs 10 per unit. This creates a perception of a cheap price in the mind of the investor. The older schemes, given that they have been around for a while, have higher prices.

Let’s say an older scheme which has been around for a while has a price of Rs 100. This higher value is because the scheme was launched many years back and the stocks that the scheme invested in over the years have gone up in value. In the process, the price of the scheme has also gone up.

Now let’s say you invest Rs 1 lakh in the scheme with a price of Rs 100. Assuming no expenses for the sake of simplicity, you will get 1,000 units (Rs 1 lakh divided by Rs 100) of the scheme. Now let’s say instead of investing in the old scheme, you end up investing in the new scheme at Rs 10 per unit.

You end up with 10,000 units (Rs 1 lakh divided by Rs 10) in the new scheme. 10,000 units is ten times 1,000 units. This creates the perception of a cheap price in the mind of the investor, thus misleading the investor into buying the new scheme and not the old scheme.

But does it really matter? Let’s say the new scheme invests in exactly the same set of stocks as the old one. The price of these stocks goes up 10%. Thus, the price of a single unit of the old scheme goes up to Rs 110 and that of a single unit of a new scheme to Rs 11. But the value of the overall investment in both the cases is Rs 1.1 lakh (Rs 1 lakh plus 10% return on Rs 1 lakh).

Let me explain this in even simpler way. Let’s say you have Rs 10,000 cash lying with you. You can have it in five notes of Rs 2,000, 20 notes of Rs 500, 50 notes of Rs 200, 100 notes of Rs 100, 200 notes of Rs 50, 500 notes and/or coins of Rs 20, 1,000 notes and/or coins of Rs 10, 2,000 coins of Rs 5, 5,000 coins of Rs 2, 10,000 coins of Re 1 or in different combinations of these notes and/or coins. 

But at the end of the day, the total amount of money would still be Rs 10,000. It wouldn’t matter what denominations of notes and coins you have that money in. In the same way, the number of units you own in a mutual fund doesn’t really matter. What matters is how well the money you have invested in the mutual fund scheme, is invested further, and at what rate it grows (or falls for that matter).

Which is why, it makes little sense in investing in new schemes. But it makes absolute sense in sticking to old schemes which have had a good track record. Of course, for the mutual funds it makes sense to rely on these subtle misseling tricks because more the money invested with them, more the money they make. 

Anyway, I didn’t think I would need to write this in 2021. But as the old French saying goes (and I don’t know how many times I have ended a piece with this), “plus ça change, plus c’est la même chose.” The more things change, the more they remain the same.

Of course, whether you want to be a sucker  or an informed investor, the choice is clearly yours. As the old Delhi Police ad went, marzi hai aapki aakhir sir hai aapka.

PS: An added bonus the legendary Baba Sehgal’s all time classic, mere paas hai mutual fund. 

The Javed Akhtar Syndrome in Real Estate

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Poets usually write poems on love, breakups, betrayal, friendships, alcohol, the women serving alcohol, the world at large, politics and so on. But very rarely does a poet write a poem or a couplet on the unaffordability of real estate in India. But Javed Akhtar has done that:

sab kā ḳhushī se fāsla ek qadam hai.
har ghar meñ bas ek hī kamra kam hai. 

A loose translation of this in English would be as follows: “Everyone is just one step away from happiness; Every house has just one room less”.

Given the fact that Akhtar has spent a large part of his adult life in Mumbai, the above couplet reflects or rather captures the sensibilities of the city that never sleeps, very beautifully.

Dear Reader, you must be wondering, why am I talking about a couplet written by Javed Akhtar on a rather muggy Tuesday in Mumbai. Allow me to explain.

Over the weekend, I met a friend who wants to sell his one-room-kitchen (a very Mumbai thing) apartment and buy a one-bedroom-hall-kitchen (one BHK) apartment. Basically, he feels his current apartment has one room less and he wants an apartment which has one room more than his current one.

Of course, the transaction cannot be carried out, unless he is able to sell his current apartment. The money generated from that will partly be used to pay off the current home loan. The new apartment will be bought with whatever remains after selling off the current apartment and repaying the home loan; along with this a fresh larger home loan will have to be taken. Over and above this, some financial savings accumulated through investing in mutual funds through the SIP route, will also have to be used.

My friend had bought the apartment for Rs 50 lakh, nearly three years back. He is looking at a price of at least Rs 60 lakh. In fact, more than looking, he is specifically anchored on to that price and won’t sell for anything less than that price.

As Garly Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them: “Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you.”

This is not the first time I am discussing the phenomena of anchoring in real estate, nevertheless, this example is interesting and different, because anchoring, as we shall see, is happening at multiple levels.

My friend is anchored on to a price of Rs 60 lakh because he feels that at that price he will be in a situation of no-profit no-loss, while selling his current apartment. The extra Rs 10 lakh, over and above the price he bought the apartment for, should take care of the home loan EMIs and the maintenance charges paid, over the last three years. This is his logic for being anchored on to a price of Rs 60 lakh.

The trouble is that at that the few buyers who have approached him do not want to pay more than Rs 55 lakh, while my friend remains stuck on the Rs 60 lakh figure.

In this case, the transaction is what we can call a relative transaction. The money that my friend gets for selling the current apartment will be used to buy a bigger apartment in the same locality that he lives in.

If he waits too long to get a price of Rs 60 lakh, chances are that the price of the bigger apartment that he wants to buy will also go up. Currently, the bigger apartment is available for a price of around Rs 80 lakh.

I tried explaining this point to him without much success. In fact, after I explained this point to him, my friend told me that he had a buyer who was willing to pay Rs 60 lakh. The trouble was that this prospective buyer needed to sell an apartment in another city to be able to raise the amount.

This buyer, because my friend had become anchored to a price of Rs 60 lakh, was also anchored to that price. Given that he was a senior citizen, he was not in a position to raise a home loan. Hence, he needed someone to pay Rs 60 lakh for his flat to be able to purchase my friend’s flat.

No one was willing to pay Rs 60 lakh for the flat. In this case, the prospective buyers were willing to pay anything in the range of Rs 55-60 lakh. But that was clearly not enough. And given this, the sale of both the flats remained stuck.

This example clearly shows as to how anchoring works at multiple level and not just at one level, as is often believed. This anchoring essentially stops the market from working. The more general conclusion from this example would be that anchoring working at multiple levels, is one of the reasons why the buying and selling of real estate has slowed down majorly.

The sellers (not necessarily the builders) are still expecting prices that their homes were worth until a few years back. But the buyers, who have paid more than their fair share over the years, are currently not willing to pay the price that the sellers want.

Ultimately, this anchoring on to a specific price will break down. It’s just that it won’t happen overnight and will take some time.

Until then writers like me will have enough masala to keep writing on real estate.

Keep watching this space!

The column originally appeared on Equitymaster on November 14, 2017.

India’s Real Estate Conundrum

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Economic forecasting is a difficult business. It is even more difficult when one has to answer something as specific as: “when will home prices become affordable?”

Almost, anyone interested in buying a home currently knows that home prices are expensive. This, despite the fact that homes aren’t selling, and builders are sitting on a large number of unsold homes. But, they don’t seem to be in a hurry to cut prices.

Conventional economic theory suggests that when something is not selling, prices need to be cut, to attract prospective buyers.

But this does not seem to apply in the case of Indian real estate. Why? In the period between 2002 and 2012, real estate prices in India went up at a break neck speed. A significant portion of the real estate transactions was carried out in black.

Hence, while buying a home 20-30 per cent of the price had to be paid in black (i.e. in the form of cash). The money that the builders made in this form, has ensured that they continue to be liquid i.e. they have enough cash going around to meet their day to day expenses.

In the process, they are in no hurry to cut prices. But builders are not the only one who have a stake in this real estate game. Over the years, many individuals have become real estate investors as well. ”

Real estate returns across the country have either been very low or in negative territory, over the last few years. Also, once we take the risk involved in owning real estate and inflation, into account, investing in real estate starts to make financial sense only when the returns are greater than 10 per cent per year. Now that kind of return has been elusive on this investment.

Hence, the question is why are real estate investors holding on to the homes they bought as an investment, even when that investment is really not throwing up any return. It would simply make more sense for them to sell the home and invest the money somewhere else. Even something as simple as a fixed deposit is likely to earn more.

But before we figure out why these investors are not selling, let me tell you a little story. Recently, I was in Bali for a small family holiday. I wanted to buy a wooden carving, which I had taken a fancy to. The seller’s asking price was 6,00,000 Indonesian rupiah (around Rs 3,000). I started at 2,00,000 rupiah (Rs 1,000) and stuck to it. The seller kept dropping his price, till he came down to 2,50,000 rupiah (Rs 1,250).

After that we kept haggling for a good five minutes, but he stuck to his price. He wouldn’t drop it further, come what may. He had become “anchored” to that number, due to some reason. And this anchor ensured that finally I had to up the price I was willing to pay to 2,50,000 rupiah and seal the deal.

Anchoring is a very important concept in real estate. In his book A Man for All Markets, Edward O Thorp writes: “Anchoring is a subtle and pervasive aberration in investment thinking. For instance, a former neighbour, Mr Davis (as I shall call him), saw the market value of his house rise from his purchase price of $2,000,000 or so in the mid-1980s to $3,500,000 or so when the luxury home prices peaked in 1988-1989. Soon afterward, he decided he wanted to sell and anchored himself to the price of $3,500,000.”

Mr Davis became anchored to this price of $3.5 million. The trouble was that home prices started to fall pretty soon. But Mr Davis had become anchored to the high price and he wouldn’t sell.

The Indian real estate investors are going through a similar phase right now. They are anchored on to the high real estate prices they saw nearly five to six years back. The trouble is no buyer is willing to buy at that kind of price.

In fact, this psychological dimension in real estate, makes it even more difficult to predict, when home prices will become affordable, despite it being very clear that real estate prices are due for a huge correction.

The column originally appeared in Bangalore Mirror on October 25, 2017.

Why Real Estate Prices are Going Down at a Slow Pace

A few days back an email popped up, asking us, why had we stopped writing on real estate. We would like to assure the reader that we haven’t stopped writing on real estate, just that we have taken a break from writing on the topic.

It’s just that it is very difficult to write new things about Indian real estate in a scenario where very little data is available. But yesterday while reading a book we came across a concept from behavioural economics which weaves in beautifully with the real estate scenario that prevails in India currently. So, let’s discuss that in today’s edition of the Diary.

In his book A Man for All Markets—From Las Vegas to Wall Street, How I Beat the Dealer and the Market, Edward O Thorp discusses the concept of anchoring in real estate. As he writes: “Anchoring is a subtle and pervasive aberration in investment thinking. For instance, a former neighbour, Mr Davis (as I shall call him), saw the market value of his house rise from his purchase price of $2,000,000 or so in the mid-1980s to $3,500,000 or so when the luxury home prices peaked in 1988-1989. Soon afterward, he decided he wanted to sell and anchored himself to the price of $3,500,000.”

And this is when the troubles of Mr Davies began. Luxury home prices started to fall pretty soon. But Mr Davies was anchored to a price of $3,500,000. While the price of $3,500,000 had meaning to Mr Davies, it did not have any meaning to the market in which he was trying to sell his house because the prices had come down. In fact, that is exactly how anchoring is defined. As John Allen Paulos writes in A Mathematician Reads the Stock Market: “We… become attached to any number we hear. This tendency is called the “anchoring effect”.”

Anyway, getting back to the story of Mr Davies. As he hung on to his “anchored” price, he didn’t find any buyers for his house. As Thorp writes: “During the next ten years, as the market price of his house fell back to $2,200,000 or so, he kept trying to sell at his now laughable anchor price. At last, in 2000, with a resurgent stock market and a dot-com-driven price rise in expensive homes, he escaped at $3,250,000.”

In the end Mr Davies ended up selling the house at more or less his anchored price. Of course, what he forgot or perhaps ignored in the process of being anchored to the price that he was, was that there is a certain time value of money. As Davies writes: “In his case, as often happens, the thinking error of anchoring, despite the eventual sale price he achieved left him with substantially less money than if he had acted otherwise.”

The point being that if Davies had sold at a price slightly lower than his anchored price and invested the money somewhere else, he would have ended up with more money by 2000, than the $3,250,000 he managed for the house.

Now how is this concept of anchoring relevant in the Indian context? In a weak real estate market the dangers of anchoring are faced by the seller of a house. This is precisely what is happening in India right now. Over the last few years, in many markets in the country, real estate prices have fallen. Despite this, many sellers are still anchored on to the peak price their home had achieved a few years back. I see this phenomenon play out very well in and around Delhi.

And given this, they aren’t ready to sell at the current market price. In some other cases, the home prices have been stagnant over the last few years. And investors are anchored to a higher price at which they are likely to make a good return on their real estate investment. I see this phenomenon play out in cities like Pune. These investors are also not in a mood to sell.

This has essentially led to a situation where real estate transactions have crashed across many markets in the country but the prices haven’t. This isn’t good for the real estate market because unless homes that have already been built are sold to buyers who want to live in them (and not invest), the huge inventory of built up homes with no one living in them, won’t clear.

Unless this inventory clears, no new homes will be built or homes will not be built at the same pace as they were in the past. And the new homes that will be built will only add to the inventory of homes that is already there. Clearly, we have a problem here. Also, with the home owners anchored on to a price, they will lose money in the years to come, given that it is highly unlikely that real estate prices will go up or even if they go up, they will not go up at the rate that they did in the past.

Meanwhile, the home owners will have to bear the cost of maintenance, property tax etc. Hence, overall, they will lose money on their real estate investment. In fact, they might just be better off by selling their home and investing the money even in a fixed deposit.

But that of course is not going to happen given that the idea that real estate prices only go up, is highly ingrained (or should I say we are anchored to it) in us Indians. And that is not going to change anytime soon.

The column originally appeared on Equitymaster on March 23, 2017

 

The UnReal State of India’s Real Estate

India-Real-Estate-Market

Over the weekend a friend called and we talked about an interesting conversation he had had with his landlord.

My friend’s landlord is a successful corporate executive and doesn’t live in the same city as my friend does. The landlord had bought the flat that my friend currently lives in, sometime in late 2004.

At that point of time he had paid around Rs 18 lakhs for it. This is what my friend could gather from the conversation with his landlord. The flat is currently worth close to Rs 1.3 crore.

In a period of close to 12 years, the market value of the flat has gone up more than seven times. And this is where things get interesting.

My friend currently pays a rent of around Rs 27,000 per month or Rs 3.24 lakh per year for this flat. The rental yield works out to around 2.5%. Rental yield is obtained by dividing the annual rent by the current market price of the flat.

The question is why would someone want to continue owning an asset which generates a return of 2.5% per year. The interest rate offered on money kept in savings bank account is at least 4%.

So the point is when you can earn a minimum 4% fixed return with none of the headaches that come with owning real estate, why would you choose to earn 2.5%? Also, the actual rental yield is lower than 2.5%, given that a certain amount of maintenance has to be paid to the building society every month.

Then there is the cost of maintaining the flat. Further, property tax also needs to be paid every year. In this scenario it makes perfect sense to sell the flat and invest the money in bank fixed deposits, which currently pay around 7-8% per year.

I put this thought across to my friend and who in turn spoke to his landlord. And the answer he got was very interesting.

The landlord told my friend that his rental yield was 18%. It took me a while to understand how he came around to this number. He was calculating the rental yield on the original price that he had paid for the flat.

A rent of Rs 3.24 lakh on a purchase price of Rs 18 lakh works out to a yield of 18%. While, this is totally wrong, but this is the way my friend’s landlord is currently thinking. He thinks he is earning 18% from his flat and won’t sell.

But he can sell the flat, pay tax on the indexed capital gains and invest the remaining amount in a fixed deposit and earn much more than Rs 3.24 lakh he is currently earning. Over and above this, this investment comes with none of the headaches of owning real estate.

This is not exactly rocket science. It is simple mathematics. So what exactly is preventing my friend’s landlord from selling out? One answer could be tax deduction on the interest payment of the home loan that he had taken in order to buy the house.

But given that the loan is in its twelfth year of repayment, the interest component will be quite small in comparison to the landlord’s current income and really not worth the trouble.

So what gives? The landlord is totally anchored into the price appreciation that has happened till date. His investment has increased in value from Rs 18 lakh to Rs 1.3 crore in a period of over 11 years.

And this is something that is stuck in the landlord’s mind. Before I go any further, it is important that I explain the term anchoring here. As Garly Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them: “Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you.”

This applies in case of my friend’s landlord. He has seen the price of the appreciate from Rs 18 lakh to Rs 1.3 crore and has a strong belief that the appreciation will continue. In the process he has held on to this flat. He is anchored into that belief.

Is a similar sort of increase possible? It would mean that the price of the flat would be more than Rs 9 crore (Rs 1.3 crore x seven times) eleven years from now. That is totally unbelievable.

Also, the real estate prices haven’t gone anywhere over the last few years. Most people don’t take that into account. The money illusion is at work. As Belsky and Gilovich write: “This involves a confusion between “nominal” changes in money and “real” changes that reflect inflation.”

Real estate prices have remained flat across large parts of the country over the last few years. The average rate of inflation between 2012 and now has been around 7-8%. Once we factor this into account, the real estate prices have actually come down by a reasonable amount in real terms.

Again, this is something that my friend’s landlord in particular and most other real estate owners in general don’t seem to understand. It will take some time for these people to realise this. Plus, there is always the bit about owning something you can see and feel, which always works with owning real estate. This obviously does not apply to financial investments.

Further, with a huge amount of unsold inventory of real estate companies, as well as homes that have been built and bought as an investment, in the market, real estate is not going to match the returns that it gave between 2002 and 2012. Those days are long gone. Also, it has just become way too expensive.

Of course, people take years to come around to realising that they have been wrong for a long time. Mistakes are not easy to admit and this time will be no different. Until then, the stagnation in the real estate sector will continue.

The column originally appeared on Vivek Kaul’s Diary on April 11, 2016