For My Records

Thoughts

2009-08-09T08:18:00.000+04:00

"Chasing after the impossible, you lose what is possible."

House money effect and discount coupons

2009-08-09T08:16:00.001+04:00

B. Venkatesh

My wife and I converted the reward points on our credit cards to discount coupons redeemable at a certain store. We laboriously exhausted our coupons over three months. We would have certainly avoided some of the purchases at that store had it not been for the coupons. Why was our behaviour altered when we used discount coupons?

The answer lies in what behavioural economists call the house money effect. Suppose you walked into this store and found a top or a shirt for Rs 2,000. On a typical day, you would have been appalled at the rate. But on this day, you are not, shopping as you are with discount coupons. You, therefore, buy the top or the shirt. Why?

No pain of paying

You do not suffer the pain of paying for the purchase. You reason that the credit card company is paying you to spend at this store. This behaviour is called house money effect.

It is named after the behaviour gamblers exhibit after they win at the table. They typically feel that they have house (casino) money after a win and, therefore, take larger bets on the next round. It is the same behaviour that prompts an equity trader to take large bets after she profits on a trade.

Our purchase decision at the store carried a deadweight loss. That is, the utility value we derived from the products that we bought was far less than the price we paid for it with our discount coupons.

Irrational decision?

Were we irrational in our purchasing decision? Had we used our credit card just to earn the reward points, then our purchase decision at the store would have been irrational. Why?

The discount coupons would then carry a price — the wasteful shopping that we did to earn the reward points. But we did not. Even if all credit card companies stop offering reward points, we would (I presume) still spend the same amount with the plastic. The coupons were, hence, free money. We were in the wrong store.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Book-building at work

2009-08-09T08:13:00.001+04:00

Aarati Krishnan

Putting your money into a company’s IPO (Initial Public Offering) is now as easy as pie. Three clicks online and you’re done, without needing to fill out all those annoying little boxes in the application form. But what is NOT easy is wading through the tide of jargon that hits you in IPO season. Let’s decipher a few terms now whizzing around and put them in plain-speak.

Cut-off

First, the cut-off price. No, it’s nothing to do with buying a pair of jeans and hacking at it with blunt scissors to get a cooler-looking pair! Cut-off price is the price at which an IPO is finally priced. Or simply, the price at which you will finally be allotted shares in the company making the offer. Now, why call it cut-off? Because this is the price at which bids for the offer are literally cut off. Investors bidding below the cut-off price in a book-built offer will not get the shares they covet.

That brings us to how a book-built offer works. A book-built offer allows investors to put in bids at different prices for the shares of the company making the offer.

Much like in an auction, the company opens its “book” on a specific date (book-making is a term derived from horse racing) to invites bids for its shares.

Investors have a five-day window to decide on and bid for, the shares being offered. Just so we avoid the temptation to put in a ridiculously low sum, the company selling shares has the right to set a price band — the upper and lower limits — within which it will accept bids. Once the offer closes, the company will decide on the cut-off price or the winning price. If you tried to drive a hard bargain and bid below the cut-off price, your application will be rejected and you will receive a refund of all your money. If you put in a bid above the cut-off price, you will be allotted shares at the cut-off price.

Who wins?

How is this cut-off price decided? Does the highest bidder win? Or is it price chosen by the majority of investors?

Neither. The book-building process in India follows the Dutch auction method. In this kind of auction, the highest price at which the issuer gets bids for all the shares on offer, is the cut-off price.

Suppose Eat-away Fast Foods is offering 10,000 shares through a book-built IPO in the price band Rs 20-25. The IPO opens and at the end of five days, they find that: 5,000 bids are received at Rs 25, 2,500 bids at Rs 24 and another 2,500 bids at Rs 23. Rs 23 is the winning price, that can be set as the cut-off price. That is the highest price at which the issuer was able to get bids for all his shares. Once the price is “discovered” in this manner, the issuer can decide to set the cut-off price below this. But he cannot allot shares at any price higher than this level.

But wait, what if I have no clue how to value a company? How will I know what to bid? Well, that’s why retail investors alone have been given the extra option of bidding “at cut-off price” in every book-built IPO. When you choose the “Bid at cut-off” option on the application, you are basically telling the issuer: “I like this company but don’t know its price. So I’ll just sit back and let the other institutional guys fight over the price.”

Bidding at cut-off ensures that no matter what price is discovered for the IPO, you will be allotted shares at that price.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-08-02T08:30:00.001+04:00

"Failure means delay not defeat."

All-inclusive pricing

2009-08-02T08:28:00.002+04:00

B. Venkatesh

The cab drivers at the Bangalore airport charge an all-inclusive rate per kilometre for ferrying you to the city. That is, you are not charged additionally for using the air-conditioner (AC) in the car. This pricing system has affected their behaviour, for most of them seem reluctant to switch on the AC. Why?

Consider the normal practice, called partition pricing. You pay a variable rate per kilometre (km). If you use the AC, the variable rate is higher. Your conscious decision to pay a higher fare forces the cab driver to switch on the AC.

In an all-inclusive fare, the cab driver gets the variable rate, whether a customer uses the AC or not. The driver, hence, chooses not to switch on the AC, as that saves costs and increases his profits.

But is an all-inclusive pricing optimal? Studies in behavioural economics show that such pricing makes economic sense when the seller wants the customer to focus on the core offering.

Framing bias

Suppose you are shopping for a home AC. The seller can offer an all-inclusive price, which includes the stabiliser and the AC. Or he can offer a partition price, where each product is priced separately.

If the stabiliser is just a normal brand, the seller might as well offer an all-inclusive price. Why? Pricing the stabiliser separately catches our attention. We may choose not to buy it if we believe we can get better quality elsewhere.

If the seller instead makes an all-inclusive offer, we may focus our attention on the AC and just take the stabiliser that is given to us.

The difference in our behaviour, perhaps, has to do with the framing bias. Paying separately for the stabiliser means we need to take another decision besides buying the AC.

Our need to justify the pain of making another payment causes us to analyse the product. And reject it often. Taking a decision for an all-inclusive product is less difficult. Is that why the cab drivers adopt an all-inclusive price?

(The author is an investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-08-02T08:28:00.001+04:00

"Stop existing. Start living."

Flower power

2009-08-02T08:26:00.001+04:00

Adarsh Gopalakrishnan

Writers who profile financial manias can seldom resist the temptation to start with the Tulip mania of the 1600s. Tulip mania is a tale of how free markets, when not reined in, can wreak havoc on wealth and even society. Popular accounts of ‘Tulip mania’ portray an entire nation crazed and bidding for flowers and ultimately driving their prices sky high.

The ensuing crash in their prices was said to have bankrupted a nation. Most references to the Tulip mania cite Charles Mackay’s more popular account which uses this to describe how unfettered markets can lead to wild pricing. However, a more detailed and sober account by Anne Goldgar holds some subtle, yet valuable, lessons for investors.

Tulip exchanges

Here’s the tale of the Tulip mania. In the early 1600s, the price of several varieties of tulip bulbs were bid up several-fold on the back of heavy demand. In fact, certain varieties of tulips multiplied 12-fold between December 1636 and February 1637. There is even the case of a variety of tulip — Groot Gepluymaseerde — which saw its prices double in just two weeks!

Goldgar’s account suggests that Mackay’s account may be somewhat exaggerated. Firstly, the tulip was not a flower which appeared out of the blue and swept the Dutch off their feet.

Several varieties of the tulip bulb had appeared over 50 years, leading up to the crisis. They were used as gifts and on early occasions traded by individuals.

What actually brought the mania to a head was a newly affluent Dutch society, in the midst of the ‘Dutch golden age’. With trading fuelling the Dutch to the forefront of the global economy in the 1600s, the Tulip mania was a largely urban phenomenon with huge transactions happening in Amsterdam and Harleem.

Discussion and bidding for tulips happened in inns and taverns, which doubled up as informal “tulip exchanges”. The keepers of these inns often served as witnesses for the tulip transactions. The participants in a majority of these transactions were textile traders, brewers, artists and craftsmen.

Tulips remained in the ground for a large part of the year only to be dug out in May or June and, for longevity, replaced in the ground . Transactions would take place over the winter, with the buyer and seller agreeing on a price during winter for a bulb that would be harvested three-four months later.

The early beginnings of a “futures” market? The price of each Tulip was set based on the size, shape, colour and pattern of the expected flower. All four ‘features’ were subject to guesses, as very little knowledge on genetics or physiology existed then.

Soon, trading for tulips became a highly profitable venture and partnerships began to emerge. As the famous comparisions go, 1,000 florins ($12,000) could buy you 12,500 kilos of bread or a single Tulip.

Another comparison involved how two measures of wheat, four of rye, four fat oxen, eight fat pigs, twelve ox heads of wine, 3800 litres of beer, and so on, plus a ship to carry them in could buy a single viceroy tulip bulb! Why did prices climb so high? Well, one theory even has it that euphoria from having survived the plague aided the frenzy for Tulips!

How, then, did the crash happen? There are several theories, including one that a bidding war of less-than-expected enthusiasm led to a dominoes effect on Tulip prices. Finally, when the crash came along, several obese check books turned pleasantly plump. Business did slow down, bankruptcies (often wrongly attributed to the tulip mania) did happen. But tulip trading did not end….

What’s in it for investors

While it may appear silly for investors to have paid a fortune in December for flowers they could only see next summer, do note that many modern futures contracts are similar. When we bet on the September futures of Reliance, we are betting that the underlying assets will be worth more! This is not unlike paying for Tulips in December which one can see only in March.

The sane explanation could be that whether it is Tulips or shares, the price one is willing to pay for them is as much a product of psychology as it is of valuation. As Goldgar puts it, “value is a cultural construct”.

The concept of ‘good faith’, that is buyer and seller sticking to their end of the bargain, plays an important role in market confidence. When ‘good faith’ is tested by an event- like the crash in Tulip markets- the market fabric begins to unravel.

For the more cynical investor, Charles Mackay had a useful line ‘Men, it has been said, think in herds; it will be seen go mad in herds, while they only recover their senses slowly and one by one.’

Sourced from : http://www.thehindubusinessline.com/

The long and short of it

2009-08-02T08:23:00.000+04:00

Bhavana Acharya

“Don’t worry about market fluctuations. Think long term.” Now that’s something that investors, young and old alike, would have been told repeatedly while their equity investments yo-yoed with the ups and down in the stock market in the last two years.

But what exactly is long term? Is it a year or two or is it, like, forever? And should you really just take a nap while the market is battering your portfolio with its wild swings? Here’s more on the subject.

Defining tenures

Though investment gurus often ask us to hold for the “long term”, did you know that “long term” actually means different things to different people? Investment advisors such as Warren Buffet, who buy stocks on the strength of the underlying business, have been known to stick to their choices as the business grows and matures; for them, long term is a holding period of ten to fifteen years!

But investors in the Indian context tend to be a bit more impatient and even fund managers typically ask investors to take a “three-five year view”.

The definition of long term or short term can also differ based on who is talking about the investment. When a fundamental analyst recommends a stock on the basis of a company’s business, he would generally advise a holding period of at least three years. On the other hand, a technical analyst may peg short-term calls to between ten and twelve trading sessions, while their long-term calls take up to a year to deliver.

Taxmen too have a different definition of long term. Here, short-term investments indicate a holding period of less than a year. Any security held for a year or more becomes a long-term investment.

Why define tenure

The risk involved in investing for the short or long term varies much as how a stock behaves in a day or a week can radically differ from how it performs over a number of years.

While there are some stocks on which you can build gains only if you hold them for a few years and watch the business grow — such stocks move gradually and will provide rather meagre returns even over a few months — there are others you can only rely on for quick gains.
Most seasoned market players will be able to reel out a string of stocks that head for the stratosphere in every bull phase; but sink into oblivion when the markets aren’t scaling new highs every day.

Defining your investment period, therefore, assumes significance because the stocks you choose will have to fit into one of the above slots. The risk and returns involved too depend on how long you are willing to hold that stock.

As a rule, short-term investments hold greater risks, but may deliver higher returns (or losses), whereas for long-dated investments, there is enough time for the stock price to capture the growth of the underlying business.

If you’ve done a good job of identifying a growing business, the stock price will eventually catch up.

How to select

Well, so much for the risk. But how do you go about selecting stocks? Remember short and long-term investments are to be made with different returns perspectives in mind. The key in a long-term call lies first in the industry selection because some industries, such as sugar and pharma, are cyclical and may not deliver.

So, you’ve first got to study the prospects of the sector, and how it may develop over the next few years. In addition, study the fortunes of related key industries. Later on, a fundamental analysis of the company will give you the prospects of that company within the industry. On the other hand, short-term stock picks — primarily trading picks — must be based on analyses of charts and price patterns, immediate market outlook, tips and news flows.

Is there a ‘best option’?

Lesson one: Simply buying and holding stocks does not necessarily guarantee substantial returns, or even returns at all. Here’s why.

Had you bought the stock of textile company Arvind Mills back in July 2004, you would be sitting on a loss of 66 per cent per share today. Or if we take the Sensex itself, the five-year absolute returns (from July 2004 to July 2009) is a neat 200 per cent. But had you exited in December 2007, your returns would have been higher at 302 per cent.

Lesson two: However, holding a stock merely for a long period isn’t enough. Constant monitoring of investments is a must.

Consider the case of Gillette India. In the period between January 2000 and July 2009, the stock has lost 63 per cent of its price. Similarly, the stock of Sonata Software erased away 95 per cent of price in the last nine years.

Lesson three: Avoid the temptation to convert your bad short-term investments into your long term “portfolio”. That’s a good way to ensure that your portfolio is made up of stocks that you wouldn’t particularly like to own.

Suppose you bought the stock of Entertainment Network from a short-term perspective at, say, Rs 261 in end September ’08. In hindsight we know that the stock took a downward turn and hasn’t touched your expected sell price since. What should you do then? Investments marked for the short-term are best for the short-term only.

Converting them into a long term one may not be the wisest choice, even if you were sitting on losses on the stock. Continuing with Entertainment Network, had you held on to the stock, you would still be at a 26 per cent loss, which could have been less than 10 per cent had if you exited the stock in the beginning of October.

Standing by decisions

So, the point to note is that whatever your investment decision is, the key is discipline. Stick to your investment period, and your targeted return.

A short-term call isn’t likely to behave in the manner you wish in the long term. Losses you may be sitting on now may worsen in the long term if the industry or the company itself is on a downswing or if its business or operating capabilities are questionable.

In a long-term investment, don’t simply put your money in and then entirely ignore it and look at it after a good many years.

Keep a watch on the price from time to time, and if you are of the opinion that the price has run up from when you got it, or your stock has hit your expected sell price, cash in your profits while keeping your capital in. That way, you make a profit, but will still be able to benefit from a further price rise.

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-07-26T08:08:00.001+04:00

"A candle loses nothing by lighting another candle."

Brains or bull market?

2009-07-26T08:06:00.001+04:00

B. Venkatesh

Last week, I had an interesting discussion with two gentlemen about people’s faith in investment experts. If a professional money manager delivers higher-than-benchmark returns, we immediately presume that he is more skillful than the other managers. Is he?

You may choose a mutual fund that has performed well in the last five years. But there is a good chance that the fund will underperform the market in the future. Why?

Luck or skill

We do not know if that portfolio manager has beaten the market due to luck or skill. There may be so many variables that would have made the fund successful. The manager’s investment strategy need not be the only cause for it.

As one Hollywood executive put it, “If I had said yes to all the projects I turned down, and no to all the other ones I took, it would have worked out about the same.”

Of course, if the portfolio manager were to manage money for a really long time, we will then know if he has luck or skill. For it is argued that over the really long run, luck will run out and only skill will remain. Statisticians call this process ergoditicity.

Hot-hand effect

Psychologists have long studied our behaviour to see pattern in seemingly random events. One such study is the hot-hand effect. This essentially refers to the performance of a player during a particular match being far better than his normal record. Researchers found that if a player were to shoot three or four times in a row early in the game, the team would feed him through the match, thinking he had a “hot hand”. The study, however, showed that players do not have a “hot hand”.

Behavioural economists argue that is the same with portfolio managers. This is not to say that portfolio managers do not have skill. It is just that we may be unable to differentiate skill from luck. Or as the Wall Street adage goes “Do not confuse brains with the bull market”!

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-07-19T08:09:00.001+04:00

"The most beautiful things in the world must be seen from the heart."

Suffering from the endowment effect

2009-07-19T08:07:00.001+04:00

B. Venkatesh

Consider this. You buy an apartment for Rs 75 lakh and do some minor modifications to the living room. Soon thereafter, your employer asks you to relocate to Europe. You now want to sell your three-month old apartment. How much will you demand? If you are like my friend who found himself in a similar situation last month, you would want one crore! Why?

My friend suffers from what behavioural economists call as the endowment effect. It is a behavioural bias that prompts us to place a higher value for an object that we own than the value we are willing to pay to buy it.

Take the apartment. I am sure my friend would be willing to pay not more than Rs 60 lakh if he were a buyer. His argument then would be that real estate prices have declined sharply since 2008!

This phenomenon is true of the stock market as well. You would always find the ask price (seller’s price) to be higher than the bid price (buyer’s price). Why?

There could be two reasons for the endowment effect. One, we experience pain when we part with our possession. That is one of the reasons why you and I refuse to give away even stuff that we do not use!

Higher price, a premium

Experiments in neurosciences do, indeed, show that our insula is activated during selling; insula is the region in the brain that is associated with the prediction of monetary losses. The higher price is, perhaps, a premium for suffering the pain.

The second reason is that we simply like the objects we own. Of course, sometimes the objects that we own may be appealing because we have to justify our choices. And that prompts us to demand a higher price.

Whatever the reason, the endowment effect explains why sellers and buyers almost never agree on the price of an object. As economists state, the minimum willingness-to-accept a good is almost always higher than the maximum willingness-to-pay to acquire it.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-07-12T08:13:00.001+04:00

"Success is the sum of small efforts, repeated day in and day out."

Swayed to donate

2009-07-12T08:11:00.001+04:00

B. Venkatesh

Consider this. People come to your house and ask for some donation to a charity. You decide to donate Rs 500. They, however, insist that you should pay a minimum of Rs 1,000! You refuse. They politely turn down your money and leave. Is their decision rational?

One of our readers posed this question to us after his contribution was turned down by people from a charity institution. The answer lies in the objective of the people collecting the donation. Suppose they want to collect Rs 1,00,000. A minimum of Rs 1,000 from each person would mean that they would have to seek no more than 100 people.

But why not collect the occasional Rs 500 from some donors? If the institution accepts a donation of Rs 500, the likelihood of receiving Rs 1,000 from subsequent donors comes down.

Social conformity

Think about this. When someone comes to you for a donation, you peer into the donation book to see how much others have paid. And you pay more or less that amount. Why?

The reason is that we are swayed by the collective decision of other people. Behavioural psychologists call it social conformity. Solomon Asch, a social psychologist, conducted experiments in this area. He found that in a group-setting, an individual would suppress her own opinion and conform to the group view, even if the group was wrong! Asch found that individuals felt the strong need to fit into the group and not be ridiculed for carrying a different opinion. That led them to conform to the group.

With donations, social conformity has to do with us not wanting to be ridiculed by the society as being miserly. At the same time, we do not want to be extravagant, lest the charity turns out to be a hoax. That is why we are swayed into paying Rs 1,000 when the minimum amount in the donation book is Rs 1,000. Turning down a contribution of Rs 500 does not seem irrational in this context.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-07-05T08:13:00.000+04:00

"Happiness is a choice that requires effort at times."

Driven by ‘hot state’

2009-07-05T08:11:00.001+04:00

B. Venkatesh

Last week, I was down with severe stomach infection. When I was lying on the bed in pain, I decided that I will henceforth stop eating the greasy potato chips, the creamy cakes and the like. Two days later, when I got better and walked into the kitchen, I unconsciously (or so I think) grabbed the jar of chips not to mention the desperate search for some cake in the refrigerator. It was personally upsetting to know that I did not learn much from the pain that I suffered just two days earlier. But it seems we all behave that way.

Why?In a cold state

Behavioural economists call this the hot-cold empathy gap. When I was in pain, I swore to myself that I will no longer eat junk food. Or stuff my stomach with lot more than it can bear. I was then in a cold state — a state when there is literally no craving for such food. But after I got better, I occasionally switched to the “hot state” and started demanding sinful food. In that state, I did not really care about the consequences of eating such food.

My inability to realise when I was in a “cold state” as to how I will behave in a “hot state” is what is called as the hot-cold empathy gap. George Loewenstein, a behavioural economist, coined the term after conducted several experiments in this area.

The empathy gap

The hot-cold empathy gap exists because we tend to exaggerate our willpower. Suppose you and your friend decide to visit a closing sale at a mall. In her “cold state”, your friend tells you that she does not intend buying any clothes. She, however, splurges as her “hot state” arouses her desire after she enters the shop.

Her behaviour may seem irrational to you. But remember, it could have well been you in a “hot state”, indulging on clothes instead of your friend. We all succumb to some vices — buying clothes, eating junk food or smoking, for instance.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-06-28T08:21:00.001+04:00

"If you fill your heart with regrets of yesterday and the worries of tomorrow,
you have no today to be thankful for."

Choice irrationality

2009-06-28T08:20:00.000+04:00

B. Venkatesh

Consider this. My friend earns Rs 1.5 lakh per month with a total annual income of Rs 20 lakh including other benefits. One of his company’s clients wants him to work at their office in Europe for four months. He has been promised an income of Rs 10 lakh in lieu of his existing salary. Should he grab the offer? My friend passed it off. Why? Based on his current salary, he will earn Rs 6 lakh in four months. He has been offered Rs 10 lakh, two-thirds more than his current earnings. Classical economics tells us that he should accept the offer, as it increases his total wealth.

So, why then did he reject the offer? Classical economics assumes that all human beings are rational. That is, given a chance, all of us will strive to maximise our well-being. But that is not true in the behavioural world.

Against principle of fairness

Here is how my friend evaluated the proposal. A person of his skill-set can earn Rs 15 lakh for a four-month period in that country. The company offered him 50 per cent less. That went against the principle of fairness. So, he rejected the offer. Classical economists may scoff at his decision. Behavioural psychologists term this behaviour “choice irrationality”.

The same principle works elsewhere too — in factory strikes and job appraisals. Suppose your annual appraisal has just finished and you expect an increment of Rs 25,000. Your boss in a surprisingly generous mood gives you Rs 40,000. You are obviously ecstatic, till you find out that your colleague received Rs 60,000! How will you react? At the extreme, you may quit your job and join another company, perhaps, for a lower salary. Why? You feel that your boss was unfair in paying you less. Your “irrational” choice leaves you worse off. But that is a price you pay to deal with the unfair treatment.

“Choice irrationality” then shows that my friend’s reaction was normal indeed. Would you have reacted the same way?

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-06-28T08:19:00.001+04:00

"Silent gratitude isn't much use to anyone."

Why higher equity allocation is optimal for long-term investors?

2009-06-28T08:16:00.000+04:00

B. Venkatesh

Many investors have carried their exposure to stocks through 2008 in the hope that these stocks would generate positive returns if they hold on longer.

If their hopes have indeed come true, there is a lesson for long-term investors: construct portfolios with higher equity allocation.

But are stocks less risky over the long term?

This article explains time diversification — the notion that the risk of stocks declines as time horizon increases.

It discusses why experts are still divided on the subject. It then suggests why it is optimal for investors to carry higher equity allocation without engaging in time diversification.

Long-term investment is typically an after-thought. Or to be precise, it is usually a short-term investment that has turned wrong!

But does extending the time horizon help? Jeremy Siegel in his book “Stocks for the long run” states that stocks produced positive real returns in excess of both bonds and Treasury bills over longer time horizons.

Intuitively then, extending time horizon makes sense. Suppose a portfolio was set-up in October 2003 with the objective of doubling capital in five years. The portfolio would have fallen short by seven percentage points in October 2008. Extending the investment horizon by a year would have served the objective.

Suppose the portfolio was instead set-up with a strict five-year time horizon. Some experts argue that the terminal wealth then becomes important. That is, an investor should not be bothered about yearly volatility in asset prices as much as the holding-period volatility.

But that may not be true. Suppose the average yearly volatility over five years is 20 per cent while the five-year holding-period volatility is only 7.5 per cent. An investor has to first endure five one-year periods to realise the five-year holding period.

And that could be painful for many. This is one of the reasons critics argue that extending time horizon does not reduce risk.

So, the question remains: Should investors with longer time horizon have higher equity allocations?

Behavioural investing

Suppose an investor wanting to buy a house in five years time constructs a portfolio today with a higher equity allocation.

The investor will regret the decision if equity prices decline at the horizon. Importantly, the investor has to then settle for a smaller house if the portfolio does not generate enough to buy the desired real estate. Extending time horizon in this case moderates the regret.

If equity prices, however, climb up sharply within five years, the investor experiences pride of making gainful allocation, not to mention the joy of buying a larger real estate.

A discerning investor, therefore, wants to balance pride and regret. Making higher equity allocation, hence, assumes importance.

But can investors take higher equity exposure without engaging in time diversification?
The answer lies in constructing the portfolio within a core-satellite framework. It is clear that a strict buy-and-hold strategy will not be optimal in a volatile world.

The investor, therefore, needs to construct a passive core at various price points using the concept of rupee cost averaging. This portfolio will be held for five years, subject to periodic risk rebalancing.

The pain of regret associated with this portfolio could be high, if equity returns trail bond returns.

This pain could be offset with the satellite portfolio, which will be actively traded to take advantage of the high intermediate volatility.

Note that the actual asset allocation policy would be drawn up based on the time horizon and the risk appetite of the investor, a factor dependent on a person’s human capital.

Conclusion

Extending time horizon may not always make stocks less risky. It is true that a portfolio can generate higher returns in 10 years compared with five years.

But risk may also increase with horizon due to high intermediate volatility. Nevertheless, higher equity allocation may be optimal for long-term investors based on pride-regret behaviour.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

How to analyse an IPO

2009-06-28T08:14:00.002+04:00

Bhavana Acharya

The year 2008 was one of drought as far as Initial Public Offers (IPO) goes. But with a revival of sorts in the markets, quite a few of these are lined up, with one — that of Mahindra Holiday and Resorts — already through. Investing in an IPO is a shade trickier than an existing company since not much information about it — financial or otherwise — will be publicly available. This is where, as a rule, the prospectus comes in as the best possible source of comprehensive information on the company.

Since the bulky document may appear a tad intimidating to the new investor, here are a few guidelines on how to pick relevant information, and what to base your investment decision on.

Any issue prospectus will be divided into seven sections — risk factors, an introduction to and detailed information about the company, financial information, details on the issue, legal and other regulatory information. Of these, the company background and business model, the industry it operates in, purpose of the issue, financial performance and risk factors are areas you should concentrate on.

Business

The section ‘About the Company’ gives a detailed description of the nature of the company and its business models; understand how and where the company accrues revenue, and if it is sustainable.

This includes going back to the history of the company, since it explains how the company has developed over the years, acquisitions made, milestones crossed, subsidiary activity, all of which are indicators of the consistency of performance and sustainability.

If possible, compare revenue models with those of existing peer companies to identify if, and where, the company has an advantage. If any competitor is already listed, use it as a comparison for performance, valuations, financials, and strategies.

Also included in the business section is an overview of the industry. Scrutinise it thoroughly to get a grip on the future of the industry and the company’s own prospects within it. As far as financials go, analyse these as you would for any other company.

Strengths

The company will list its ‘strengths’ — what it considers as an edge over peers — again in the business section. Give these a once-over, paying attention to the details only if the said strength stands out — for example, Gitanjali Gems has a diamond sourcing agreement with Diamond Trading Corp, a key strength since the company is ensured of access to good quality rough diamonds which most peers do not enjoy. Sizeable market share (check source of data here), backward integration, and so on, are other factors favouring the company.

Take the strengths with a pinch of salt, since companies sometimes tend to paint a brighter picture than what they actually are. Conclude yourself if the point given in reality works in the company’s favour significantly.

Risks

Risks detailed are wide-ranging, from an economic scenario to company-specific, which must be noted to understand potential downside to your investment. Risks are explained at the start of the prospectus.

Some risks given are general in nature and can be ignored, such as political instability, natural calamities, competition from peers and such, which are usually applicable to all companies, regardless of industry.

Legal issues that have a significant bearing on the functioning of the company, are also given here — for example, Mahindra Holidays has a resort in Munnar, where the land is under legal proceedings since it was said to be agricultural.

Now if the case goes against Mahindra, it will mean closure of a flagship resort and loss of revenue from it.

Understanding such material legal proceedings allows you to skip most of the section on legal issues that appears later in the prospectus. For example, legal issues regarding taxes, labour and such need not be combed through.

Objects

The purpose of the issue is explained in depth, and companies are required to explain the utilisation of funds raised in subsequent annual reports.

Proceeds from the issue can go towards any number of purposes, from repayment of debt to working capital, from capacity expansion to company acquisitions besides covering issue expenses.

Fund utilisation should, as far as possible, contribute to revenue generation and earnings expansion.

For example, companies may raise funds to either ramp up production capacity which may lead to increased sales, or to pay back high-cost debt resulting in lower interest costs and more leveraging capability; or for acquisitions that may add to revenues. However, the time taken to accomplish the stated objectives needs to be gauged.

Check the amount of funds set aside for issue expenses, which include advertising and promotion, printing of the prospectus and so on. Check also whether the proceeds of the IPO go entirely to the company; some IPOs involve a stake sale by the promoters in which case funds raised would not accrue to the company.

Other sections you can glance through are the regulations and policies the company is subject to, the management team and the relevant experience they hold and the instructions to bidders in the section detailing the issue — just to make sure you don’t inadvertently mess up your application.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-06-21T08:27:00.001+04:00

"Make the most of yourself, for that is all there is of you." ~ Ralph Waldo Emerson

Value or growth

2009-06-21T08:24:00.001+04:00

Adarsh Gopalakrishnan

Watching business channels during a bull market is quite a scintillating experience. The investment community quickly put on their smiley faces and go about explaining the rationale for the current market run. Words that get thrown about include contrarian, growth, value among others. Value investing, a style pioneered by Benjamin Graham in the 1930s, involves picking up shares when they are trading below what they are supposed to be worth.

Graham also popularised the idea of stock being represented by a company. What a company is worth can be estimated by parameters such as its book value, replacement cost, and cash per share and so on. Growth investing, the diametrically opposite, involved paying a premium price for a business, perceived as having great growth potential.

Blending styles

Value investing involves buying assets worth a rupee at 50 paisa and selling them when the market acknowledges the underlying asset value. The possibility for such arbitrage exists only for active and informed investors who scour through balance-sheets looking for such stocks, which Warren Buffett referred to as the cigar butt approach to investing — stocks which akin to a used cigar which have a puff or two left in them (indicative that a stock may yet have value left in it).

Such an approach does pay off in a dull market; such opportunities diminish in a bull market or in a market where a large number of investors actively seek such opportunities. With too many people chasing these opportunities, it gets more difficult to find them.

Value investing in its modern avatar has been associated with picking up businesses at low price-earnings (P/E) multiples, price-to-sales (P/S), price-to-book (P/B) or other such ratios. Value investors have traditionally taken a strongly quantitative view of a company. Metrics such as P/E, P/S, P/B values are indicative of cash flows and financial information at a specific point. These values, ‘high’ or ‘low’, are merely a starting point to investigate a prospective investment.

Growth investing has been taken to the illogical extreme of disregard for the price paid, if the prospect for growth looks promising. But if you want to invest effectively, blending these two ‘styles’ may be the right thing to do.

If you pay a ridiculously high price for growth, even stellar growth may not recoup the price you paid. Conversely a low price is no guarantee for success, if the business you invested in goes bust or does not have enough puff left.

In growth investing, success would entail buying part of business which is capable of growing at a minimum cost to investors. The latter is an oft-ignored component. Buffett in his 2007 annual letter highlighted three types of companies:

The company which grows its earnings with minimum capital expenditure;

The company which grows its earnings with capital expenditure, but the pace of earnings growth outpaces capital expenditure;

The company whose earnings growth lags the pace of its capital expenditure.

No prizes for guessing which one of the above makes for the most desirable investment.

Cost of growth

Investors should not confuse increased earnings from increased capital expenditure, with increased earnings from increased efficiency.

The cost of growth is the vital figure. If a company spends a rupee generating a rupee of growth, growth may have no impact on the stock price!

Growth and value may, therefore, have to be put together for effective investing. The environment, economics and management of the business are other components. None of these are independent of the others.

Investing is essentially an act of buying a share of a business and its future cash flows. It involves taking a view of the future cash flows, their sustainability and the cost of generating those flows.

Your call on the sustainability of a business comes from understanding ‘intangible’ aspects such as brand, demand elasticity and institutional culture. The only way to derive value from investing is in understanding how growth happens; this is the point where growth and value cease to be standalone elements.

Sourced from: http://www.thehindubusinessline.com/

Overcoming painful decisions

2009-06-21T08:22:00.000+04:00

B. Venkatesh

Consider this. You go to a restaurant with your family. In a mood to try something different, you order an exotic dish that unfortunately turns out tasteless. Will you waste the food? If you behave like a typical person, chances are you will box it and take it home. Why?

Studies in neuroeconomics have shown that two regions in our brain are activated when we purchase goods. The nucleus accumbens, the brain’s reward system, is turned on whenever you see a product that you desire.

The insula, on the other hand, is activated when you suffer from aversion, like spending money.
You buy a product when the nucleus accumbens overwhelms the insula. But when your purchase decision (ordering food) turns wrong, the insula gets activated and increases your pain. To pacify the pain, you decide to take the food home and “repair” it.

Dulling the pain

More often than not, you shove the food deep into your refrigerator and forget about it. After a fortnight, when the fossilised food turns foul, you (often, your spouse) decide it is time to bury it. So, what did you achieve by carting the food home?

You, perhaps, never really wanted to “repair” the food. But the pain of wasting was especially high when you paid for it. You, therefore, dull the activation in your insula by taking the food home.

After a couple of days, the pain from the wasted food declines. Why? Because the insula is busy getting excited with other wrong decisions you have taken since then!

Fossilising the food and then dumping it is an ingenious way of dulling the pain. But this strategy may not always work. The intensity of pain suffered from a wrong decision may have some relation to the price paid for the product.

Your insula, for instance, may be activated each time you see the frightfully expensive designer dress you outgrew five years ago. That is why it is still buried deep in your wardrobe, waiting to be “repaired”.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-06-14T08:12:00.001+04:00

"No one can make you feel inferior without your consent." ~ Eleanor Roosevelt

Are dividends worth it?

2009-06-14T08:09:00.000+04:00

Adarsh Gopalakrishnan

A friend of mine was gleeful that a 200 per cent dividend had been declared by a company he purchased shares in, a few months earlier. A little while later Rs 4,000 was credited to his account.

He recounted this to me and proceeded to fantasize about a weekend at a hill station or a new mountain bike. He then told me about how the stock had soared by 10 per cent on the dividend declaration.

Being the cynic that I am, I could not stand such joy. So I asked my friend, “How much did you spend on the shares?” “A couple of lakh rupees” was the reply.

He went on to explain how the shares dropped about 40 per cent in the meltdown of the past year, and how the dividend was a shot in the arm. I reminded him, “You do realise the dividend is just 2 per cent of the amount you invested. That barely covers the transaction cost you coughed up on buying the shares.”

He was a little annoyed. Do investors realise how the importance of dividends has waned with stock prices soaring? They probably don’t.

Plunging ‘yield’

Here’s the lowdown. The dividend yield for the Indian markets (as captured by the CNX 500) today hovers at just under 2 per cent!

That is, the “dividend” paid out by an average Indian company hovers at just under 2 per cent of its current market price.

The dividend yield has ranged from 1-2.3 per cent over the last eight years. That shows that investors today buy shares more for their ‘growth’ potential than dividends.

The concept of the dividend has come a long way from being the basis for computing the worth of a share (dividend discount model) and as a means to reward the shareholder.

The dividend was originally thought of as a regular cash incentive for having put your money at risk as a company’s capital.

The inception of security analysis enabled people to ascribe a ‘definite’ price per share. This was based on the value of the underlying assets and other factors. That switched the focus to ‘growth’, how fast a company’s distributable profits grow.

Dividend versus Growth

Companies with hefty dividend payouts are not always the best investments. Certain businesses and situations demand that a chunk of profits be retained to fund expansion and spending.
This may be crucial to maintaining or building a competitive advantage. In such a scenario, the lack of a dividend may not be a ‘minus’ while evaluating a company’s stock.

When looking at the ‘dividend versus growth’ argument, it is necessary to evaluate if retained earnings can generate better returns for you, as an investor, than dividends paid out.

A company’s ability to use the retained earnings (reserves) in ventures which provide an above-average rate of return is the trait to look out for.

What to look for

If you are a conservative investor and do lay much store by dividends, here is what you should look out for:

The dividend yield of the stock at the current market prices. Not the absolute payout. Infosys, for example, paid a 400 per cent dividend on Rs 5 face value (Rs 20). At a share price of Rs 1,600, it works out to 1.25 per cent.

Sustainability. Monsanto India paid a special interim dividend of Rs 120 in addition to Rs 15 annual dividend in 2007-08, out of profits realised from the sale of a business. For 2008-09, it declared a dividend of Rs 12. The sustainability of the dividend is as important as its value.

Companies in cyclical industries may not be able to sustain a consistent dividend. Looking at last years’ dividend to work out the ‘yield’ may be fraught with risk. Metal, automobiles are some of the cyclical industries where dividends could fluctuate with business realities.

It would be prudent for an investor seeking a high dividend return to look at long-term trends in dividend payout as a percentage of earnings or market price, prior to purchasing the company’s shares.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-06-14T08:06:00.001+04:00

"We all have ability. The difference is how we use it." ~ Stevie Wonder

Savings are not equal to investments: Need for financial literacy

2009-06-14T08:03:00.001+04:00

B. Venkatesh

The difference is striking. High net worth individuals take adequate steps to route their savings to optimal returns-bearing assets.

The mass affluent — those aspiring to become high net worth individuals — care more about reducing current taxes. Informal discussions in the marketplace show that the contrasting behaviour is primarily due to the difference in financial literacy between the two groups.

This article provides some reasons for the difference in financial literacy levels. It also shows how these differences act as impediments to the aspirations of the mass affluent, sometimes leading to increase in their portfolio risk.

Investment attitude

The Organization for Economic Co-operation and Development (OECD) defines financial literacy as, “The process by which financial consumers/investors improve their understanding of financial products and concepts … develop the skills and confidence to become more aware of financial risks and opportunities to make informed choices… .”

This definition shows that a need for financial literacy arises if individuals are aware of the importance of making informed choices. And that appears to be the problem.

A typical mass affluent investor is motivated to save, but makes no effort to differentiate between savings and investments.

In an economic sense, savings is the excess of income over expenditure. And investment is the process of routing savings into optimal returns-bearing assets.

The problem is that the mass affluent primarily make investments in March each year to save taxes. The lack of effort to search for optimal investments through informed choices stems from a common complaint — lack of time.

More precisely, the argument is that “the time spent on becoming aware of the investment process can be better spent in the office, generating more income”.

This argument reveals the lack of understanding of the concept of passive income — income earned without being actively involved in its generation.

Investments earn passive income. It, therefore, pays to take time to empower oneself with the knowledge to make discerning investments.

Portfolio tilts

The disinterested attitude towards financial literacy leads to several problems. One, the portfolio is not constructed to achieve a certain investment objective. Research in the US has shown that the vast difference in wealth among households with similar age and income groups is due to the difference in planning. Failing to channel savings into optimal avenues is a failure to plan. And this could lead to lower-than-desired post-retirement lifestyle.

Two, investing to primarily reduce taxes results in a portfolio which is built one asset at a time. This often leads to concentration of holdings. The reason is that each asset is bought without considering its correlation with other assets in the portfolio.

And three, several mass affluent who do invest, engage in naïve portfolio diversification. If they are introduced to four different products (two of which may be similar and the other, not very different), they often choose to divide their assets equally among all the products. Behavioural economists call this process 1/n heuristics. This could again lead to concentration risk if two or more products carry the same investment style.

Conclusion

The lack of informed choices through mid-career could lead to needless risk-taking behaviour towards retirement. This stems from typical tiered behaviour among individuals — hopes for riches and protection from poverty, which is the reason why an individual buys insurance as well lottery tickets.

Behavioural economists have shown that individuals accept lottery-like odds when they are below their aspiration levels and reject such odds when they are above their aspiration levels.

What happens when an individual realises that her “savings” is not enough to help her lead a desired post-retirement lifestyle? She may be forced to make high-risk investments, perhaps, at a time when she needs more exposure to bond-like investments. This problem can be moderated if optimal investments are made through the working life — a process that can be facilitated through financial literacy.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Extortion fee

2009-06-14T07:57:00.001+04:00

B. Venkatesh

Recently, workers from the State electricity board furiously dug up earth in front of our house to repair the underground cables. After they finished work, they forcefully collected some money and then left, leaving the excavated stones on the road. Why do we bribe these workers to do their jobs?

As Walt Kelly said “We have met the enemy and he is us”. In other words, we are the reason why these workers demand bribes. How?

Supporting corruption

Suppose a clerk at a government office offers to attend your case immediately for Rs 5,000. If you agree to pay, you support corruption. The clerk, encouraged by your bribe, may now demand such amount from others as well.

Now, all of us may be willing to pay to save time so that we can engage in more productive work. The clerk, realising that, will expect money from us just to do his job. When bribe is no longer voluntary, it becomes extortion. We are essentially subsidising the government; otherwise, it has to pay a higher salary to these workers.

It is not surprising that we complain about extortion but never take action. Why? The extortion fee is to “To Insure Prompt Service”. The workers will not otherwise attend to our job the next time around.

Lessons from game theory

We can break-away from this habit by drawing lessons from game theory. Consider “Prisoner’s dilemma”. Two prisoners are kept in separate rooms. If they both confess to a crime, they get rigorous imprisonment. If one confesses, he is set free while the other faces heavy sentence. If both keep quiet, they serve a light sentence.

The “Nash Equilibrium” or the optimal solution to this game is for the prisoners to keep quiet. Similarly, if we all stop paying extortion fees, the workers may eventually decide to work without demanding money. But as in “Prisoner’s Dilemma”, there will then be an incentive for each of us to break the rule (bribe) — to insure prompt service! Does it then pay to be virtuous?(The author is a self-styled investment psychologist.

He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-05-03T08:43:00.000+04:00

"To be good is noble, but to teach others how to be good is nobler--and less trouble."~ Mark Twain

Meeting line and separating line

2009-05-03T08:20:00.002+04:00

Yoganand D.

Meeting line and separating line candlestick patterns seem to be related patterns, but they are not. Meeting line is a reversal pattern while separating line is a continuation pattern. The similarity is that both these are two-candle patterns

Meeting lines are formed when white and black candlesticks have the same closing price.

Meeting line is similar to the piercing line candlestick pattern, but meeting line pattern is not that significant as the counter move is relatively weaker in the meeting line pattern, because of which the second candle does not pierce the first candle’s body.

Bullish meeting line

Following a black candlestick in a downtrend, the stock opens sharply lower with a downward gap and then moves up to close at the same level as the previous day’s close. This reflects that there is a balance between the bulls and the bears. A confirmation on the third day is essential in the form a white candlestick with a large gap up or a higher close on the subsequent session.

Bearish meeting line

In an uptrend following a white candle, the stock opens sharply higher with an upward gap and then declines to end the day at the same level as the previous day’s close. A confirmation on the third day is required in the form a black candlestick, a large gap down or a lower close.

Bullish separating line

This pattern is formed in an uptrend. We observe a long black candle during the first day, then the stock gaps up higher. It opens with an opening price equal to the previous black candle’s opening price and closes the day at a higher level, forming a long white body. A confirmation on the third day is essential in the form a white candlestick with a large gap up or a higher close.

Bearish separating line

We notice a white candlestick in a downtrend that is followed by a lower gap when the particular stock opens next day at the opening price equal to the previous day’s opening price.

Later, the stock declines further for a lower closing price, forming a black candle. A confirmation on the third day is vital in the form a black candlestick, a large gap down or a lower close.

Sourced from: http://www.thehindubusinessline.com/

When a discount sale is bad news

2009-05-03T08:15:00.001+04:00

B. Venkatesh

One of my friends recently had an opportunity to buy an exquisite name-brand business suit at a 30 per cent discount. But he passed over the offer because he figured that the discount price reflected inferior quality. You and I may, perhaps, react in the same manner. And yet we always scout for discount buys. Why do we behave so differently to product prices?

Pricing signals

As buyers, we have less information on the product than the sellers do. We, therefore, discern signals from the product pricing. And discount buys do not always signal well. Why?

We typically evaluate the quality of a product from its pricing — more expensive a product is, the better we presume is its quality. And a discount buy offered by a name-brand store signals inferior quality. Here is why.

As the utility of a product is based on perception, we logically derive less satisfaction from a discounted product than when we pay full-price for it.

The reason is that an unexpected discount from an unlikely source (name-brand stores) makes us suspicious. And that subtracts the utility value.

Note that our satisfaction is only bound to be higher when we look for bargain buys and find one. That is why we pass off discount buys at name-brand stores and yet scout for such buys at local stores, which are expected to make such offers.

Expectations and behaviour

Neuroeconomists have been studying product pricing and consumer behaviour for a while. Consider this experiment conducted at Stanford University. A group of students were provided a name-brand energy drink at full-price and another group, at a discounted price.

The subjects were then asked to solve some puzzles. The researchers found that the subjects who paid discounted price consistently solved fewer puzzles than the ones who paid full-price, even though the drinks were identical.

Expectations drive behaviour. The group that consumed the energy drink at discount price, hence, felt it was less effective than the ones who paid full price.

It is also, perhaps, the reason why my friend refused to buy the name-brand suit at a discount.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-04-26T08:21:00.001+04:00

"Do what you can, for who you can, with what you have, and where you are."

Suburban living

2009-04-26T08:19:00.000+04:00

B. Venkatesh

I recently met a real-estate developer who mentioned that people are increasingly moving to the suburbs. He believes that this movement will lead to better lifestyle because suburban prices are cheaper and the air, less polluting. But the move to a suburb is not an easy economic decision. Why?

Suppose you have a choice between buying a small apartment for Rs 50 lakh within the city and building a large house for the same price in the suburb. Which would you prefer?

If you behave like most of us do, you will choose the large house in the suburb. Commuting to work every day through the thick traffic is a small price to pay for luxurious living. Or so you think.

But it turns out that moving through the traffic can be tiring. That is because the traffic is unpredictable. Ironic as it may seem, if you face traffic jams every day, your mind will train itself to accept the wasted hours on the road.

Commuting paradox

Unfortunately or fortunately (I am not sure which one), we do not always get caught in a gridlock. And that means we never really adapt to the suffering of watching the road turn into a giant parking lot. This leads to what economists call as the commuting paradox.

Several years ago, two economists from the University of Zurich conducted a study to find whether people in Germany were happier living in large suburban houses but with additional commuting hours. Their conclusion is startling.

They found that we need to earn 40 per cent more to be happy if we have to travel an hour each way than if we are within walking distance of our workplace!

And that is not all. Social scientists have argued that commuting results in less social connections. The logic appears to be that every 10 minutes of commuting time leads to 10 per cent fewer social connections unless, of course, you take the public transport. Given all this, is the economic decision to move to a suburb so easy?

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from :

Thoughts

2009-04-19T08:44:00.001+04:00

"You can run from your dreams in fear
or
run to your dreams with faith."

Nudge yourself to eat healthy

2009-04-19T08:39:00.002+04:00

B. Venkatesh

All of us frequent restaurants. But have you ever wondered why restaurants have dim lights? Behavioural economics can throw some light on the subject! How?

You may have heard about Richard Thaler and Cass Sunstein and their book Nudge. Nudge, according to Thaler, is a small feature of the environment that captures our attention and alters our behaviour.

Dim lights in restaurants can be a nudge! Research shows that such lights can make us eat more. It is also argued that we eat more if the lighting is very bright! If you and I can be nudged to eat more, can we be nudged to eat healthy food?

Catching your attention

Suppose you are attending a small party. On the dining table, you see some mouth-watering desserts and colourful cut fruits. Which would you prefer?

If you want to choose fruits but end up eating the dessert, do not be too hard on yourself. You were, perhaps, nudged to eat the dessert. You can just as well be nudged to eat the fruit. How?
Experiments have shown that if the fruit bowl is elevated and is kept in such a way as to catch your attention, you will head for the health platter. Remember, nudge is about catching your attention. Sometimes, a printed card on the dining table that states that the average Indian eats more fruits can nudge you towards the colourful platter! The reason is because we like to stick to averages.

Build on positive nudges

It is important that our host does not offer only fruits. If that were so, you and I will be heading for another place that provides sinful desserts.

Nudge instead allows you to make your own decision. Renaming carrots as X-ray vision carrots allows you to savour the richness and nudges you to choose vegetable over a more-tasty less-healthy food that is also available at the table.

We can choose to nudge ourselves to health at home. You can, perhaps, start using small plates that make normal portions look large. And then build on such positive nudges. Healthy eating.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-04-12T10:32:00.001+04:00

"ABILITY is what you're capable of doing. MOTIVATION determines what you do.
ATTITUDE determines how well you do it."

How India Inc. handles currency risks

2009-04-12T10:29:00.002+04:00

Ramesh Kumar

The global financial crisis and the economic slowdown have resulted in a high degree of uncertainty and price volatility across all markets — be it the product, labour or financial markets. The currency market has become more volatile on the back of developed economies trying to correct imbalances in their financial sector. But amidst the challenging environment, the corporate India needs to remain focused on sustaining profit growth. In the current situation, it wou ld be useful to examine how Indian companies handle currency risk.

SMEs rely on banks

Historically, in a controlled environment, India Inc. relied on banks for covering its foreign exchange requirements. But volatility in currency markets now requires better understanding of the currency exposures that arise due to transactions and use of appropriate tools to manage the risks arising from them.

An inadequate understanding of the tools may prove to be extremely costly. It is ‘inadequate understanding’ of companies and the profit motives of banks that had resulted in huge losses on some of the outstanding exotic derivatives contracts last year.

Some of the companies trade actively in foreign exchange and have a separate treasury management unit for foreign exchange transactions. However, there are also large numbers of small and medium enterprises which participate in the currency market passively and depend on commercial banks (authorised dealers) for their requirement of foreign exchange and coverage of currency exposure.

Indian companies usually view their foreign exchange transactions as a part of the credit relationship, and some have not made efforts to understand the implication of the currency exposure. Some companies were aware of the risks, but not of the methods to guard against them.

Tackling currency risk

So how should companies handle their currency risks? The currency exposure has to be understood as accounting (or translation) exposure and economic exposure. Currency fluctuations affect the operating cash flows and income statement, thereby affecting the market share and competitive position of the company. For example, currency fluctuation may affect adversely the price realisation for the exporter and the price of raw materials for the importer.

The company has to have a view of the $/INR rate while budgeting for the year and has to continuously monitor the prevailing exchange rate to ensure stability of rupee cash-flows. A company may budget the annual sales/raw material requirements and cover the currency exposure in the forward market with banks. Currently, they can cover in the exchange traded currency futures market. The futures market provides a transparent platform and offers standardised contracts for companies to cover their foreign exchange exposure.

The balance-sheet exposure to foreign currency affects the value of the firm’s assets and liabilities, accounts payable, accounts receivable, inventory and loans. For example, the borrowings under the ECB and the FCCB routes were attractive for their lower interest rates. But the adverse movement in the $/INR exchange rate has changed the balance-sheet picture on these loans significantly.

Any adverse movement in the exchange rates would result in higher cost of assets that was accounted as ‘capitalising the losses’. Traditionally, banks have advised companies to cover the entire foreign currency exposure, say, for six months forward contracts and roll them over semi-annually. The balance-sheet exposure as a thumb rule can be hedged only if the risk can be passed through pricing/marketing strategy of the ultimate product.

The $/INR market is traded largely in the OTC (over the counter) market dominated by a few multinational banks, large public sector banks and a few private sector banks. The rates are quoted to companies as a mark-up over the ruling inter-bank rate. The prices fluctuate widely when large players cover their positions and there is price differential between large and small players. The bankers undertake proprietary trading and offer various contracts to customers, with the result that conflict of interests cannot be ruled out. In addition, they sell various contracts — such as forward, option, plain vanilla and exotic options — to the customers. The past year saw some companies entering into contracts that were not necessarily in their best interest and eventually seeing losses.

Identify the purpose

Companies must clearly identify the purpose of trading in the currency market. The purpose may be speculative with a view on the future movement of exchange rates or it may be hedging an underlying exposure or making use of the arbitrage between markets or different time periods.

Having identified the purpose, companies must take care to ensure that their trades fit the purpose. A hedging contract must not have any fine-print that will eventually convert the transaction into one which is speculative in nature. Any complex contracts that have embedded options and forwards must be handled separately by a treasury specialist. These should be avoided unless the company is aware of the additional risk and sufficient capital has been allocated to such activity to bear the loss in event of adverse payoffs. The exchange based trading ensures better risk management through margins for VaR (Value at Risk) and daily volatility.

The increased globalisation of trades and services and volatility in financial markets require companies to be aware of the risks associated with currency fluctuations. A focus on treasury functions is needed to protect the company’s cash flows by undertaking specific transactions. At the same time, companies need to ensure that they do not undertake undue risks by entering into inappropriate contracts that may jeopardise the core operations.

(The author is Senior Vice-President and Head-Debt and Currency Markets, Asit C Mehta.)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-04-05T08:24:00.000+04:00

"Ability can take you to the top, but it takes character to keep you there."

Power of social networks

2009-04-05T08:23:00.001+04:00

B. Venkatesh

Several people I know recently switched jobs, helped by their contacts established through LinkedIn. All of them were grateful for the networking that the Internet has come to provide and for the Web sites such as LinkedIn and Facebook. The success of these Web sites rests on the concept of “strength of weak ties”. What is it?

Consider this. Jacob is your close friend while Dianne is an acquaintance. You want to switch jobs and are looking for leads. Who do you think can help you most — Jacob or Dianne?

If your instincts tell you it is Jacob, think again. There is a strong possibility that you and Jacob have a same social network. This is not uncommon if Jacob were your schoolmate or your colleague in the office. Asking Jacob for leads may not be very gainful then because he might know the same kind of people that you do.

Strength of weak ties

Dianne, being an acquaintance, may belong to a different social group. Asking her for leads might payoff, for she might know people whom you do not know — people who could get you a decent job. Dianne is your weak link and a connector to a different network. Networks such as LinkedIn help you apply the “strength of weak ties”. How? You meet a person at a conference and then invite her to your network via LinkedIn. You then request her to introduce you to her social network. Or you could connect with your friends through Facebook — friends whom you last saw at high school!

Economic relationships

“Strength of weak ties” was developed as a social model by Granovetter in the 1970s based on his study in the Boston area. He argued that economic relationships are shaped by and depend on social relations, which he called as “embeddedness”.

He found what we all know intuitively — if you are looking for a job, it is whom you know that is more important than what you know! Granovetter proved it through social theory. People exploit it gainfully these days through social networks.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-03-29T08:21:00.001+04:00

"Everything that irritates us about others can lead us to an understanding of ourselves." ~ Carl Jung

Helping you diet

2009-03-29T08:19:00.001+04:00

B. Venkatesh

One of the difficult things in life is to avoid fatty foods; for such foods are invariably tasty! It was, therefore, quite intriguing when the gentleman with whom I had a business meeting recently said that he was consuming dietary supplements, even though he was not obese. That got me thinking: What can economics tell us about our diet habits?

Consider this. You love to consume potato wafers on a Sunday afternoon watching your favourite TV show. You are aware that the wafers contain more fat than mental satisfaction. What can you do?

Self-control

You can decide not to stock potato wafers at home. Would that help? If you behave like I do, you would hunt for another snack, which may turn out be more sinful. So, you might as well have potato wafers at home!

Or you could try what many neuroeconomists call as “counteractive self-control”. Let us suppose you decide to have your house stacked with potato wafers — more than you can actually chew (literally). Neuroscientists argue that the presence of wafers will trick your brain to delay gratification. That is, the brain diminishes your desire to crave for something that is tempting but readily available.

Delusion with diet foods

But before you try it, be warned that this strategy may not work for everyone and then for every food. Stacking sinful food that you like may defeat the purpose, if you value instant gratification more than the loftier goal of good health.

And then there is the problem of delusion with diet foods. There is a good chance that you may unconsciously consume more sugar-free snack than you would if it had contained sugar! You may, hence, end up with more fat. Studies in behavioural neuroscience have shown this to be true.

So, what then is the remedy? Till the neuroscientists work overtime to find how we can numb our brains to the sight of fatty foods, we should do what doctors have always prescribed — burn calories. Garbage in, garbage out. And that works for classical economists as well.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-03-22T08:37:00.001+04:00

"Love is strengthened by working through conflicts together."

The tipping model

2009-03-22T08:35:00.001+04:00

B. Venkatesh

Consider this. You stop at a restaurant in a small town en route to another city. You are aware that you are unlikely to visit the restaurant for a long time to come. Would you still tip the waiter?

Rationally speaking, you should not, for tips stands for “To Insure Prompt Service”. So, if you are unlikely to revisit, you do not have to insure for prompt service the next time around.

Tipping has become a norm

Yet, you would tip the waiter. Why? For one, this is a one-to-one transaction between you and the waiter. You would not want the waiter to think badly of you — just because you did not tip her. And, two, tipping has become a norm than a voluntary act.

The economics, however, gets interesting when you frequent a restaurant. How then will you tip the waiter? Tipping assumes importance, for the waiter can ruin or improve your experience at the restaurant.

Suppose you decide to leave a 10 per cent tip. After a while, the waiters (assuming a group of three or four waiters take turns to wait on you during your visits) can read your tipping “model”. So, they will “learn” to expect a 10 per cent tip.

The element of no-surprise will prompt the waiters’ to dismiss your tip as just another event waiting to happen. And that could lead to a mediocre service!

Element of surprise

What, then, should be the tipping model? Studies in neuroeconomics have shown that stable payoff combined with a surprise would be optimal. This would mean offering a standard amount (say, 5 per cent of total food cost) plus an element of surprise.

This is, perhaps, the reason why most salaried professionals are offered a base pay with a variable bonus!

For those who are not so arithmetically inclined, leave the “change” if it is more than, say, 5 per cent of the food bill. Or you could simply leave the “change” with an occasional “bonus”. And at the end, do remember to thank the waiter. That would certainly “insure” a prompt service.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-03-18T08:33:00.001+04:00

"Anger is a wind which blows out the lamp of the mind." ~ Robert Green Ingersoll

The emperor’s clothes

2009-03-18T08:29:00.002+04:00

T. C. A. Srinivasa-Raghavan

Is it not quite extraordinary that a discipline which had been preening like a peacock in the monsoon should, all of a sudden, be in such panic-stricken disarray? How gratifying that its leading lights are whispering — as opposed to my loud and uncouth yelling — the equivalent of “emperor has no clothes”.

Consider the following four examples. I could give more but the four men I am citing carry enough intellectual weight to constitute “sufficient proof”.

Paul Samuelson

There are to begin with the superstars, Paul Samuelson and Amartya Sen. And then there are the mere stars Willem Buiter and Gregory Mankiw.

The first two need no introduction. Mr Buiter is a highly respected Professor at the London School of Economics. More importantly, from the point of this article, he was a former external member of the Bank of England’s Monetary Policy Committee. Mr Mankiw is an equally influential professor at Harvard and has been a member of the US president’s Council of Economic Advisors.

Let us start with 93-year-old Paul Samuelson, acknowledged by all as the founder of modern economic analysis and a “Nobel” winner. In a recent interview he says that it was wrong to have believed what Milton Friedman convinced the world to believe, namely, that markets would regulate themselves. “I wish he was alive to witness how his extremism has caused the defeat of his own ideas,” he says.

But it is worth reminding readers that when the free-market types were beginning their jihad, the centrists, as Samuelson calls himself, didn’t or couldn’t match the ferocity of the jihadists’ ideological call. They were content to bleat. Mr Samuelson never fought a “let’s hold the line” battle.

Amartya Sen

Amartya Sen, given his Indian background and Cambridge intellectual provenance, has never been a Friedmanite. He has always thought that you can’t leave it all to the markets.
Even so, in a recent article in the New York Review of Books he takes a shy at Keynes. He writes that though everyone thinks that Keynes was a great statist, “the fact is that he came close to being the guru of a new capitalism, who focused on trying to stabilise the fluctuations of the market economy (and then again with relatively little attention to the psychological causes of business fluctuations)… Even though Adam Smith and A C Pigou have the reputation of being rather conservative economists, many of the deep insights about the importance of non-market institutions and non-profit values came from them, rather than from Keynes and his followers.”

Gregory Mankiw

Come to Mankiw now. This is what he says in an academic paper available on the NBER website.

“The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy…The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering.”

Willem Buiter

Lastly, see what Buiter, until recently regarded as something of a prophet, has to say about monetary policy. The heading of his article says it all.

It is called ‘The unfortunate uselessness of most ‘state of the art’ academic monetary economics’. “Most mainstream macroeconomic theoretical innovations since the 1970s have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works — let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.”

He is also intensely critical of the tendency introduced by engineers-turned-economists to look on the real world as a sort of machine where pressing the right buttons leads to predicable outcomes. “If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear, and that the interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists are brave, but not that brave. So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”

I recently put this to a very vociferous advocate of market design and monetary policy, and, as it happens, an engineer-turned-economist. He said the problem was with the data! This after the same data had been used to validate some of the silliest theories and policies.

Let me end this by quoting Keynes who said in 1931 that “If economists could manage to get themselves thought of as humble, competent people on a level with dentists that would be splendid.”

But that, as Mankiw reminds us, would mean that “avoiding a recession would be as straightforward as filling a cavity.”

And pigs would have wings.

( blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-03-15T09:41:00.001+04:00

"If you don’t like something Change it;
If you can’t change it, Change the way you think about it."

Psychology of cash discount

2009-03-15T09:40:00.001+04:00

B. Venkatesh

Consider this. You walk into a local store and buy groceries. When you dish out your credit card, the counter clerk tells you that will receive a 2 per cent discount if you pay cash. Would you? If you are a typical consumer, you will still use your credit card. Why?

The store understands consumer psychology. That is why it offered you a cash discount. You figure that 2 per cent is a small price to pay for the convenience of using the credit card. So, you use the “plastic”.

But instead of offering a cash discount, what if the counter clerk told you that you will have to pay 2 per cent of the cash bill as additional charge for using the credit card? You may then choose to pay cash. Why?

Framing bias

The reason is because of what behavioural psychologists call as the framing bias. Long back, Kahneman and Tversky, two psychologists, had posed a question to their subjects. The question was about two programs to fight a certain disease.

The subjects chose Program A when the question was framed in terms of saving lives. But the same subjects chose Program B when the question was framed in terms of number of deaths.
The cash discount and credit charge is a similar case of framing bias. Remember, in both cases, the cost of using credit card is 2 per cent. You gain 2 per cent when the store offers cash discounts. You, however, lose 2 per cent when the store charges you for the credit transaction.

Taking pains to avoid losses

Now, you may remember loss aversion effect in behavioural economics. It states that we take great pains to avoid losses. That is, we are more likely to give up gains than accept losses.
It naturally follows that we give up the 2 per cent cash discount to use the credit card. But when faced with a 2 per cent credit charge, we are more likely to pay cash to avoid losses (cost). And that seems to be the psychology behind the cash discount.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from: http://www.thehindubusinessline.com/

Top-line and bottom-line

2009-03-15T09:37:00.001+04:00

Rajalakshmi Sivam

Sift through any business newspaper or equity research report and it is unlikely that you will not come across the two words — top-line and bottom-line. Well, though the jargon may sound complex, it points to two simple things that help comprehend a corporate entity’s performance. Top-line and bottom-line refer to nothing but the sales and profit numbers reported by companies. But, if you are still wondering whose line is it anyway, here goes:

Topline

When reporting performance, corporate entities post the period’s sales number as the first entry in the top-line of the income statement. So, generally, when people make remarks on revenue growth of a company they refer to it as ‘top-line growth’. This figure assumes significance as it brings to fore the company’s business prospects. Breaking up the sales figure to know what helped its growth is essential as it would only aid in deciphering whether the increase is sustainable or not. Higher sales can be a result of either increase in volumes (units sold) or increase in realisation. By ‘realisation’, we mean revenue (selling price) made per unit sold.

Again, there could be two scenarios when a company can see higher realisation. One is when the demand for the specific product goes up and the price shoots up on tight supplies and, two, when the company delivers value-added products that command better price in the market over peer products. Top-line growth speaks of how efficient the company has been in exploiting the opportunities in the market.

Bottom-line

The bottom-line or the bottom figure in an income statement is the ‘net profit’ of the company. This is what the company is left with after paying all its expenses (both operating and administrative) for the period reported. A company’s bottom-line generally denotes the efficiency of the management in controlling costs even as it delivers higher sales.

Higher sales in the period will push up net profits, similar to how reduced expense would. In other words, growth in net profits does not necessarily mean fall in expenses; it could be bolstered by higher sales too. Suppose, ‘X’ company registers a 30 per cent increase in sales and a 10 per cent increase in total expenses, its net profit could be higher despite higher expenditure on higher revenues.

That, however, may be the least of the challenges for corporates, as the real big challenge comes during recessionary times like now when demand slumps and so does sales, making reduced or negative growth. Posting profits in such times is possible only through identifying cost-reduction possibilities and reducing operational inefficiencies. In the December quarter of 2008, only a few companies were seen posting bottom-line growth despite a fall in top-line. Few companies such as Siemens, MIC electronics and Cadila Healthcare managed to grow profits despite a fall in sales. However, here again not all cases were examples of operating efficiencies. Some saw profits soar due to higher other income. What’s other income? Well, that’s a different story altogether.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-03-08T08:46:00.000+04:00

"People never tend to IMPROVE unless they look to some standard or example higher or better than themselves."

Workers’ strike and Ultimatum Game

2009-03-08T08:43:00.002+04:00

B. Venkatesh

My friend’s friend has a problem — workers in his small factory are threatening to go on strike due to disagreement on salary hike. A strike would be lose-lose situation, as the firm will lose revenue during the strike period and workers will not get their salary, leave alone the hike. So, why then were the workers threatening to strike?

Fear of rejection

Experimental economics provides an answer to this question. Consider the Ultimatum Game. In the original version of this game, one subject was given, say, Rs 100 and was asked to share the money with her pair, another subject. Let us call the former, the Giver and the latter, the Acceptor.

If the Acceptor accepts the Giver’s offer, both keep their share. So, if the Giver offers Rs 10, the Acceptor keeps Rs 10 and the Giver, Rs 90. If, however, the Acceptor rejects the offer, both go home empty-handed.

The results of the experiment showed that Givers’ were willing to offer close to 50 per cent. One reason would be the fear of rejection by the Acceptors; for then, both parties get nothing.

Fairness matters

A different version called the Dictator Game was, hence, tested. In this game, a Giver kept her booty even if the Acceptor rejected the offer. Still, 76 per cent of the Givers’ chose to split evenly. Why? Economists argue that the existence of fairness is the reason for the even split. And this, perhaps, is the reason for the agitation at the factory.

A new product launch meant that the firm would push up profits. The factory workers wanted at least 10 per cent share of the profits while the owner was willing to part with only 5 per cent.

Classical economics argues that workers should accept the 5 per cent hike, as they are better off compared with no hike at all. That is called rational maximisation. The workers, however, are driven more by a sense of fairness than by rationality. They are, hence, likely to reject the offer and strike even though it is self-defeating.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

SIPs: It’s about behavioural investing

2009-03-08T08:40:00.001+04:00

B. Venkatesh

This column dated January 11, 2009 had discussed about systematic investment plans (SIP).

We had a rather interesting debate recently with an investor who refused to see the significance of such investing.

He argued that SIP is like rupee-cost averaging and that such a strategy is suboptimal.

This article shows the subtle difference between SIPs and rupee-cost averaging.

It also discusses the behavioural bias that investors suffer from that make it difficult for them to take rational decisions. It finally suggests how SIP helps investors moderate this bias.

Rationally suboptimal?

SIP is different from rupee-cost averaging (RCA). In RCA, an investor has a choice of making a lump-sum investment or a specified sum each month so that a total amount is invested over a period of time.

An investor setting up an SIP does not have such a choice.

Rather, she simply invests a specified sum of money each month, presumably, from her monthly earnings.

In RCA as in SIP, investors will buy more units in a mutual fund when asset prices decline and lesser units when prices trend up.

Research shows that RCA or dollar-cost averaging as it is called in the US is sub-optimal. One argument is that lump-sum investing provides higher returns when the market trends up and better cash returns when market declines.

But what if investors wanting to start an SIP instead accumulate money each month in cash-equivalent account and then invest lump-sum in the desired asset class?

Such an investment will earn sub-optimal returns till the cash equivalents are invested.
Besides, the investor should possess market timing skills to switch from cash equivalents to the desired asset class.

And even if the lump-sum investment plan provides superior returns, there is a strong behavioural reason to set-up SIPs.

Behaviourally optimal

Classical finance assumes that investors are rational.

But evidence shows that investors are normal.

This means that investors are swayed by emotion and cognitive biases which may seem irrational in the world of classical finance.

SIP has to be seen in the light of these biases.

Consider what behavioural economists call as transaction utility.

This refers to the bargain value of a purchase, which corresponds to pride and regret.

A good bargain would mean that pride is greater than regret; a bad bargain the reverse.

Now, there is a strong relationship between regret and responsibility of choice.

Suppose an investor has a wide range of financial products to choose from.

The pain of regret is greater when an investment that she chooses goes down; for the responsibility of choosing and failing rests with the investor.

It logically follows that investors will continue to take investment exposure as long as they can reduce regret.

And they can reduce regret if they can lower their level of responsibility.

Decision made under strict rules reduces the level of responsibility.

SIP is one such rule; for it is an automatic investment plan that buys assets every month with a fixed sum of money.

There is, hence, a strong behavioural reason to set-up SIP.

Setting-up SIP

Suppose an investor wants to set-up an SIP of Rs 10,000 a month on an index fund as part of her core portfolio. Typically, the investor will have a choice of three to five dates to set up the plan.

To ensure that the SIP has exposure to all price points, an investor can break Rs 10,000 a month investment into four units of Rs 2,500 each.

Each unit can be invested as a separate plan spanning four days in a month. So, for instance, Rs 2,500 each can be invested on the first, fifth, tenth and fifteenth of every month.

It is important to set-up the payments through automated debits or post-dated cheques to ensure that the investor does not abandon the plan during market downturns. Remember, if nothing else, that SIP is about behavioral investing.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-03-01T08:40:00.001+04:00

"Hearing is one of the body's five senses. But listening is an art."

Psychology of ‘greatest ever’

2009-03-01T08:38:00.000+04:00

B. Venkatesh

That A. R. Rahman won two Oscar awards is truly commendable. Some have called him the “greatest ever” musician that India has produced. The response is typical. Dhoni was called the “greatest ever” Indian captain after his team beat Australia in the home series. Why do we so generously assign the “greatest ever” label to people after they achieve a commendable feat?

Availability heuristics

Behavioural and social psychology throw some light on this subject. Consider what behavioural psychologists call as the availability heuristics. This is bias that prompts us to make a decision based on events that recently happened. Rahman just won the Oscar. Illayaraja did not, nor did R.D Burman. So, it is easy for us to label Rahman as the “greatest ever”.

It is the same logic that prompts us to state that Tendulkar is the “greatest ever” cricketer soon after he hits a century. It is, perhaps, for this reason that the basketball players are required to wait for at least five years post-retirement before they can be nominated to the US Basketball Hall of Fame.

The feel-good factor

Then, there is the fact that we watched Rahman receive the awards. This creates a personal connection to what he has achieved and makes us feel good about ourselves.

Social psychologists call this “Basking in Reflected Glory” (BIRG). It refers to behaviour where an individual identifies herself with a successful person, whose glory she actually had no part to play!

Robert Cialdini, a psychology professor, documented this behaviour years ago. In one study, he found that undergraduate students were more likely to wear their university logos on a Monday morning if their college football team won a weekend match.

BIRGing is also the reason why soccer fans claim that “we” won after their team wins an important game. This connectedness to the other person’s glory may be a driving factor in concluding that Rahman is the “greatest ever”.

So, until another great musician wins more Oscars, Rahman may, perhaps, enjoy the “greatest ever” label and the economics that comes with it.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-02-22T08:31:00.001+04:00

"Character may be manifested in the great moments, but it is made in the small ones."

Split-strike conversion

2009-02-22T08:28:00.002+04:00

B. Venkatesh

That Bernard Madoff was playing a giant ponzi game is now well known. But what is not that well known is the strategy that he claimed to have implemented.

This article discusses the Madoff strategy called the split-strike conversion. It explains why traders construct such a strategy and the conditions under which it is gainful. It also shows how the strategy can be modified to suit the present market conditions in India.

Split-strike conversion

The split-strike conversion is popularly called as the collar or the fence.

It involves buying stocks that are highly correlated with a tradable index (the S&P CNX Nifty, for instance), simultaneously selling out-of-the-money (OTM) calls and buying OTM puts.
The strategy is sometimes called as the “vacation trade” as it carries limited-risk and limited-return. But why is it called split-strike conversion?

A conversion is a strategy where the trader buys an underlying contract and sells an offsetting synthetic contract. Suppose a trader buys the Nifty futures contract at 2778. She would then sell the March 2800 calls (ATM) and buy March 2800 (ATM) puts. The options-leg of the transaction is essentially a short position on the Nifty at 2800. The conversion employs same strike for calls and puts. In a split-strike conversion, the ATM strike is instead split into two different OTM strikes.

Madoff claimed to implement the strategy for short-term horizons, delivering between 8 per cent and 12 per cent returns regardless of the market conditions.

Option skew

Split-strike conversion is typically adopted to exploit the option skew.

A skew can be understood as a graph that plots the implied volatilities of various strikes of the same underlying for a particular month.

A trader, for instance, can plot the implied volatilities of Nifty March options on a graph.

If the implied volatilities of calls are greater than implied volatilities of puts, a trade can sell calls and buy puts.

But doing so could expose the trader to high risk if the underlying moves up.

When the trader sets up this position against an underlying long position, the strategy converts into a “vacation trade” or a split-strike conversion.

The problem at present is that the implied volatilities of puts are higher than implied volatilities of calls.

The March 2800 puts, for instance, trades at (Wednesday prices) an implied volatility of 47 while calls trade at an implied volatility of 34.

This means that there is no arbitrage available now to set-up a split-strike conversion.

Directional fence?

Traders can, nevertheless, set-up a fence in the following scenario: First, a trader has to hold large-cap stocks that are closely correlated to the Nifty.

Second, the trader has to have a view that the underlying shares and therefore the index will decline in the near term.

The trader can then buy OTM puts and sell OTM calls on the Index for the notional value as the underlying shares.

Suppose the Nifty does decline in value, the OTM puts will generate substantial gains while the calls will expire worthless. This generates income for the trader, even if the implied volatilities of puts are higher than that of calls.

Traders can also adopt this strategy with a single stock or a futures contract. The criterion is that the primary position (the stock or the futures contract) has to be held for the longer term, unlike in the case of typical split-strike conversion, where the underlying is bought to arbitrage price differentials.

If the underlying moves up, the trader can contain the losses on the synthetic position by selling the underlying with the intention of buying it back at a lower price at a later date.

Conclusion

Split-strike conversion is gainful only if the option skew favours the strategy. And even then, traders have to consider the cost of setting up the strategy, as there is two-leg brokerage commission.

A directional fence discussed above may be more appropriate for traders who carry a negative bias.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-02-22T08:27:00.000+04:00

"Great opportunities to help others seldom come, but small ones surround us every day."

Economic prescription from neuroscientists

2009-02-22T08:25:00.000+04:00

B. Venkatesh

The sub-prime crisis continues to claim its casualties. Many firms are shutting shop as a result of decline in consumer demand. One of my friends wonders whether we could go beyond traditional economics to make consumers spend. So, we turn to neuroeconomics and its argument on consumer spending. What does it say?

Neuroeconomics studies how our neurophysiology affects our decision-making. Neuroscientists, hence, have a reason to disagree when we claim that shopping is a pleasant experience. They state that shopping is a balancing act between the pleasure of owning a product and the pain of spending on it.

Neuroscientists conduct experiments that require the subjects to undergo brain scanning, typically with a functional magnetic resonance imaging (fMRI).

Exciting the brain

Scientists have found that when we see a product that we like, a part of our brain called the nucleus accumbens lights up; its intensity reflects the desire for the product. It logically follows that the nucleus accumbens is not excited if we see a product that we already own.

What about the painful side to shopping? When our eyes scan the price, the fMRI catches the action in another part of the brain called the insula. And here is where it gets interesting.

If your craving for a product is overwhelming, the positive feelings triggered by the nucleus accumbens will be more than the negative feelings triggered by the insula.

Likewise, when negative feelings are more, insula overshadows the nucleus accumbens. The fMRI readings help neuroscientists predict whether we will buy or not just before we actually act!

Emotional behaviour

But how can neuroscientists make us buy goods? Studies have shown that our insula calms down when we see bargains such as “Buy one get one free” and “50 per cent off”.

So, if neuroscientists were to take economic decisions, they would play on the emotional behaviour; not peddle the macroeconomic Keynesian models to revive spending. Will it work? We do not know yet but it is at least worth a try, considering that society is today riddled with high negative emotions.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Fiscal deficit

2009-02-22T08:23:00.001+04:00

S. Hamsini Amritha

Picture this. Your company forces you to settle for a lower pay cheque from next month. You have car loan EMIs to pay off and some compelling repair work on your house.

On top of these, you have to meet unexpected medical bills. Though you may borrow from friends, your expenses have clearly gone beyond revenue (your salary).

What if the same happens to the government? This is what the much-talked about ‘deficit’ is all about. Deficits in public finance, are categorised as trade, revenue and fiscal deficits. Of the three, the last category has assumed importance, post-budget.

Meaning

Fiscal deficit arises when the Government’s total expenditure surpasses the revenue it generates. In other words, it is the difference between the total receipts (excluding borrowing) and total expenditure. It is expressed as a percentage of GDP. India’s fiscal deficit is currently estimated at 6 per cent of GDP for 2008-09.

How it happens

Fiscal deficit for the government arises just the way it does for you. The government needs money to meet its expenses — which can be revenue and capital expenses.

Revenue expenses are the day-to-day expenses — salaries payable to the government employees and armed forces, the expenses incurred in running various government departments, and so on — while capital expenses include what is incurred for creating assets and improving infrastructure.

In 2008-09, the major items of expense which overshot budget estimates were the subsidy bill (the government foots a subsidy on food and fertilisers distributed at a concessional rate).

The key source of revenue for the government is the taxes it collects — both direct and indirect. There are also non-tax sources from which the government earns money. These may be revenue receipts (usually recurring in nature) such as dividends received from public sector companies, fees, fines and forfeitures or capital receipts (mostly one-time) — money got through disinvestment of public sector undertakings, recovery of loans, borrowings, and so on.

Why this huge deficit?

Just a year back when the Budget was announced, fiscal deficit was estimated at 2.5 per cent of GDP. Subsequent developments — a higher fertiliser subsidy, the farm loan waiver scheme, implementation of the Sixth Pay Commission, which hiked salaries for government employees with retrospective effect, resulted in the widening of the deficit.

Increased spending on social welfare projects which may yield no immediate monetary benefit to the government may be yet another contributor.

A steep increase in non-Plan revenue expenses and a decline in capital investments also chipped in. While expenses shot up, the last two quarters also turned the heat on the government as tax collections slowed — they contracted by 13 per cent (on year-on-year basis) in October, 15 per cent in November and 25 per cent in December.

Remedial measures

To cover the fiscal deficit, the option usually adopted is to borrow money from the market. Printing more money increases money supply which, in turn, causes inflation. It is a kind of invisible tax that reduces the value of the money you are holding.

Borrowings could be from the Reserve Bank of India or by issuing government bonds to financial institutions.

A long-term solution is, however, to curtail the fiscal deficit. This can be done either by economising on expenses or by raising taxes. Looking at the prevailing recessionary situation, raising taxes may only reduce compliance.

The other option is to reduce spending. This again is difficult, as the government is striving hard to boost the economy by increasing its spending on infrastructure and development activities.

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-02-15T08:20:00.001+04:00

"Sometimes it's better to put love into hugs than to put it into words."

Market timing, a utopian possibility

2009-02-15T08:18:00.001+04:00

S. Vidhya

Timing the market is essentially the art of predicting the future direction of the market through the use of technical and fundamental indicators. Some investors switch between asset classes and funds in an attempt to profit from the changes in their market outlook.

Just within the ambit of equity investing, market timing involves high risk and achieving anywhere close-to-best case outcomes is next to -impossible. Unless of course, an investor gets massive slices of luck.

Let us consider two investors, Mr Happy and Mr Glum — the former investing systematically and the latter based on market timing. The investments are made in Sensex since 1979 and the value is reckoned on December 2008.

The fact is that the compounded annualised returns of both the investors arrive at almost the same value. This clearly shows that the effort taken in timing the market is necessarily a futile exercise; the risks are significant even as returns are almost similar and outcome, to understate the case, is almost unlikely. The risks are only on the downside.

Methodology

Mr Happy: Investment of Rs 1,000 on either the 1st or 5th or 10th or 20th of every month without bothering about any other aspect except personal exigency. His total investment in a year is Rs 12000 on each specific date

Mr Glum: One market-timed investment of Rs 12,000 every year. His investment is made every year on the basis of one of two specific dates in a year: the lowest Sensex value day or maximum loss day of the Sensex.

Investment is made every year since 1979. Each investor has deployed Rs 3,57,000 as on December 2008. Mr Happy ends the year with Rs 54,69,597 (certain outcome) and Mr Glum with Rs 60,23,560 (almost impossible outcome).

When we calculate the compounded annualised growth rate of their investments and take the average of them, we arrive at 15.04 percent for Mr. Happy and 15.41 percent for Mr Glum.
Here we find the average annual returns of both the investors are almost similar. Even after taking the effort of timing the market and investing Rs 12000 in a year, Mr Glum has achieved only a marginally higher return than what Mr Happy has got, by investing Rs 1,000 every month systematically without any exertion.

Though the return arrived is similar for both the investor, the risk taken to arrive at the return is higher in the case of Mr Glum. This shows the risk-adjusted return being low for the Mr Glum.
The probability of correctly predicting each day of every year successfully for 29 years is statistically an almost impossible outcome.

For Mr. Happy, the risk is only in line with the market and no more and since the investment is done systematically the outcome is also certain and is also a very practical approach for every investor

(The author is Head, Products Team, Sundaram BNP Paribas Asset Management. Excerpted from ‘The Wise Investor’)

Sourced from : http://www.thehindubusinessline.com/

Do you self-handicap?

2009-02-15T08:16:00.001+04:00

B. Venkatesh

The CFA Level-I exam results were announced recently. A person whom I know claimed that she would have easily passed the exam but for lack of time! And before you scoff at the excuse, remember that all of us manufacture some defence after an unsuccessful venture. And some provide excuses even before they embark on the venture! Why? Behavioural psychologists call it self-handicapping. Suppose you have an important exam coming up in a week’s time. You think it would be shameful on your part to fail the exam. What do you do?

Self-handicapping…

If you are a typical person, you will start talking about how you have not had enough time to prepare for the exam. At the extreme, your body will unconsciously start troubling you; you may even be hospitalised for a day or two! This provides a foundation for a giant excuse — in case you fail.

Experiments have shown that people indeed regularly engage in such self-sabotage. The important point is that such self-sabotage is not to primarily lower others’ expectations; it is more to protect our self-image.

…leads to self-sabotaging

When you have all the time in the world to pass the exam, you cannot give an excuse as to why you failed. Besides, it is difficult to live with ourselves when we know that we did our best but failed than to say that we could have done better but for…

Self-handicapping, however, has a problem. In one experiment, participants were asked to take a test. Some were deliberately distracted during the test. Those who were distracted and failed were found to be less motivated to prepare for the subsequent exam. Why? These persons thought that they had done well and would have passed the test had it not been for the distracting noise.

Self-handicapping, thus, leads to self-sabotaging. As an experiment showed, students who are self-handicappers often rate themselves among the top 10 per cent in the class even though their grades are poor. So, if you are taking an exam but are suffering from self-handicapping, beware!

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-02-01T08:23:00.001+04:00

"Happiness is enhanced by others, but does not depend upon others."

All about parenting

2009-02-01T08:20:00.000+04:00

B. Venkatesh

Philosophically speaking, children under five years are our best life coaches. You can learn a lot from them about living life. And, then, you can learn behavioural economics as well. Picture this. Your five-year-old child kicks up a fuss to eat her dinner.

You threaten to lock her up in a room. She still refuses to eat. What will you do? Often, you will mollify her so that she finishes at least three morsels of the food.

If you want to change this process, behavioural economics could help you make your child eat better. How?

‘Carrot and stick’ approach

Experiments conducted by behavioural psychologists have shown that even adults do not cow down to “carrot and stick” approach. This approach simply means that a firm will reward employees who do well and punish others who do badly.

The approach does not always work well because of the credibility problem. At the extreme, a firm cannot easily fire an employee until it proves that the person has indeed lagged in his work. And that could take a long time because of labour union. Psychologists have, hence, tried a different tack.

Prison experiment

In an experiment in a prison, inmates were offered good food instead of usual non-edible stuff. Importantly, the inmates did not have to work hard to get the good food; they were provided the food as a default choice.

If a prisoner behaved badly either with the jailor or with fellow inmates, the good food was withdrawn and he was given the typical non-edible stuff.

The prison experiment proved successful in taming unruly behaviour among inmates. Taking away the “carrot” was found to be a better “stick” than wielding the stick itself!

You can, perhaps, adopt a similar approach with your child. Instead of threatening to lock her up, simply tell her that her pizza Saturdays will be taken away or her ice-cream Sundays will be called off if she does not behave properly.

That could prove a better strategy. But only if you sound credible and you do, indeed, have such theme days!

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-01-25T08:28:00.001+04:00

"All people smile in the same language."

Broken window theory

2009-01-25T08:26:00.001+04:00

B. Venkatesh

My friend owns an apartment that is locked through the year, as he lives elsewhere. Sometime back, this apartment was burgled. His wife, an economist, attributed the robbery to the broken window theory. What is that?

The theory was first mooted by criminologists George Kelling and James Wilson in the early 1980s. They argued that a small unfixed broken window could lead to more serious crime! Why?
When vandals see an un-repaired broken window, they think it is alright to break more windows. The next step could well be breaking the door and ransacking the place.

Kelling’s theory was put to practice by the Boston Police in the late 1980s and then by Rudi Guiliani after he was elected as the Mayor of New York City. The crime rate declined sharply, as police came hard on graffiti and other small unsocial behaviour in the neighbourhood.

Steve Levitt in Freakonomics, however, argued that the crime rate in New York fell after abortion was legalised in 1970s — the decline in unwanted births in the 1970s led to lesser criminals in the 1990s.

Fence experiment

Several researchers recently tested the broken window theory. In one experiment, the researchers erected a temporary fence to close a short-cut to a park, allowing only a narrow gap. Two signs were erected — one forbidding people entering through the narrow gap and the other, prohibited chaining of cycles to the fence.

The researchers then created two scenarios. In one scenario, four cycles were parked near the fence but unchained. In the second scenario, these cycles were chained to the fence. The researchers found that substantially more people were willing to take the short cut when the cycle was chained to the fence. That is, one offence led to another.

Broken window theory may be right. Graffiti on the wall could prompt people to violate social behaviour. And appearance that a neighbourhood lacks social control (a broken window) can lead to serious crime. My friend’s wife may be right about the burglary. After all, their living room window was broken.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2009-01-18T10:45:00.001+04:00

"You cannot dream yourself into a character; you must hammer and forge yourself one."

Why we aren’t conscious hypocrites

2009-01-18T10:43:00.001+04:00

B. Venkatesh

My friend, who still holds shares in Satyam, wondered why the former chairman did something so damaging as to bring down a company that he himself founded. Behavioural psychology provides an explanation to what could have transpired inside the head of Satyam’s former boss when he decided to fudge the accounts. And it has to do with self-justification. How?

Suppose it is time to file your Income-tax returns. Will you righteously declare all your income and account only genuine deductions? If your answer is yes, then you are indeed one in a million who are “holier than thou”.

Drawing a moral line

Typically, you may choose not to declare some income that may not amount to much. Or you may debit an expense that is genuinely unrelated to business. Why?

You and I draw a moral line and justify such moves. For one, we say that the income is genuinely small and we anyway donate the proceeds to some orphanage. For another, the government squanders the tax-payers money in wasteful projects. So, why bother?

Self-justification, indeed, starts small. After a while, debiting small unrelated business expense or leaving out some income stream becomes a habit. That is because our self-serving mind makes us believe that what we doing is, indeed, right. Gradually, it blossoms into something big.

One step at a time

Importantly, self-justification works only if it is taken one small step at a time. Initially, it is an income stream that accounts for, say, less than one per cent of total income. Gradually, it adds up until it shaves off 30 per cent or more of our total income!

We, of course, do not know what prompted Satyam’s former chairman to do what he did. But self-justification can well provide an explanation for his behaviour. Perhaps, he cooked the books for some economic reason. And soon it got big, as he took one step at a time to cover the trails.

Interestingly, self-justification is so deceptive that everyone can observe the mistake, except the person committing it! That is why none of us are conscious hypocrites.

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Simpler checklist

2009-01-18T10:40:00.000+04:00

Pore over annual reports, read cash flow statements, check out auditor’s qualifications…. Isn’t all this too difficult for a lay investor to practise? Here is a simpler checklist to filter out stocks that may carry “governance issues” before you buy them:

Promoter Disinterest

A promoter stake of less than 10 per cent may be the sign of a professionally managed company, influenced by no single family or group. But the Satyam episode has proved that it can also show complete promoter disinterest in preserving shareholder value.

Would a promoter who is part of a company’s top management indulge in massive falsification of numbers, if his own personal wealth hinged on the stock’s fortunes? Not if he can help it!

Where’s the Tax?

You cannot avoid death and taxes. So if a company is getting away with skimping on taxes, should you take its reported profits at face value? Maybe not. Measuring a company’s tax incidence against that of its peers in a sector may serve as a check that is as good as poring over its cash-flow statement.

Value Trap

You’ve uncovered this company which has been delivering scorching growth rates quarter after quarter, but its PE multiple remains at a dismal 3. So, have you stumbled upon an undervalued gem which everyone else has missed? Probably not.

When a stock consistently trades at a dismal PE compared to its sector peers it means that the market doesn’t quite take its reported numbers at face value. Or that it perceives risks to the business that will slow down reported growth.

Beware the Outlier

Are a company’s profit margins or growth rates way out of sync with the norm for a sector? That could be the sign of a great business model, an ultra-efficient operation, or… creative accounting.

When you see a company reporting exceptionally high operating profit margins year after year it could be a sign that the company has discovered a business opportunity that others can’t replicate or that it operates in a niche, which rivals can’t easily enter. If you can find evidence of neither… ... treat it with a healthy dose of suspicion.

It’s all in the family

Related party transactions, or a company’s dealings with its promoters, top management, group companies and associate companies are often a clear giveaway on governance issues. Consistent transactions with key management personnel (or their relatives) may indicate that the management is using its position in the company to undue personal benefit.

Sales or income originating from related parties and large loans and advances to group entities may be warning signals on diversion of funds. Collateral and guarantees extended to related parties may turn out to be liabilities at a later date. Interpret these by looking at their size and materiality.

AARATI KRISHNAN

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-01-12T08:24:00.000+04:00

"All personal breakthroughs begin with a change in beliefs."

Self-justification

2009-01-12T08:22:00.001+04:00

B. Venkatesh

The confession by Satyam’s CEO of an accounting fraud led to an intriguing reaction from one of my friends. He commented on how Mr Raju had the guts to confess and that other CEOs who engaged in similar fraud did not muster the courage to do so. If you made a similar outburst after the Satyam incident, it may be because of what behavioural psychologists call as cognitive dissonance. What is it?

Cognitive dissonance

It refers to a state of tension that occurs when the mind holds two conflicting ideas. Suppose you smoke a pack of cigarettes every day. But you also know that smoking damages your lungs. How will you reconcile these two conflicting thoughts?

You may give up smoking. Or you may convince yourself that the benefits from smoking far outweigh the risks of causing lung damage! That is cognitive dissonance.

How does it relate to my friend’s reaction to the Satyam incident? He held shares of Satyam, which he refused to sell last November. And that caused him losses now. So, his mind started playing a game of self-justification. How?

He rationalised that Satyam was a better investment because the CEO confessed to a crime. What is the guarantee, he argued, that the balance-sheets of other companies were clean!

Focus on positives

Research has shown that cognitive dissonance is greater when the decision taken is costly in terms of time, effort and money. And greater the dissonance, greater the need to reduce the effect by concentrating on the positive aspects of the choice made. Or the negative aspects of the choices not made.

Consider this. In an experiment conducted at a racetrack, people who placed bets were more convinced about their choice than the ones who were waiting in the line to place one!
It appears that people become certain about their choice if they cannot undo it without incurring huge costs.

So, the moral is this: If you are buying shares, a bread toaster or real-estate, do not seek opinion from a person who has already bought it!

(The author is an investment strategist. blfeedback@thehindu.co.in)

Sourced from : http://www.thehindubusinessline.com/

Thoughts

2009-01-04T08:22:00.001+04:00

"Footprints on the sands of time are not made by sitting down."

It’s rat race for bonus points!

2009-01-04T08:20:00.001+04:00

B. Venkatesh

My friend holds a customer card at a bookstore that will entitle him to accumulate 1,000 bonus points for certain value of in-store purchases. He can redeem the bonus points for a free book from a list of recent arrivals. He frequented the bookstore at least twice every week during the previous month to accelerate the bonus points from 925 to 1,000. Why did he display such behaviour?

‘Goal-gradient hypothesis’

An experiment conducted in 1930s on rats throws some light on my friend’s behaviour. Clark Hull, the researcher, found that rats run faster as they move closer to the food box. Knowing that the reward was closer motivated the rats to run faster. He called this phenomenon “goal-gradient hypothesis”. My friend, though not a rat, behaved in a similar way!

To appreciate this better, consider an experiment conducted recently at a coffee pub inside a university campus. Each customer was provided a card with 10 slots. The card would be stamped each time the customer had coffee. After 10 such stamps, the patron was entitled to a free coffee.

Closer to the reward

The study found that customers consumed more coffee as they neared the 10 mandated stamps. These customers slowed their speed after they finished the first card and received the second one. Why?

The distance to reward on the second card was now 10 coffees. As the distance narrowed due to normal coffee consumption, they accelerated their visits again!

With coffee, you need to visit the pub several times, as you cannot consume three lattes during each visit. But that is not the case with books. So, why did my friend not buy enough books to gather 1,000 points in just one visit after he collected 925 points?

The reason is that it is difficult to convince the mind to buy books for Rs 3,750 during one visit than to buy books for Rs 750 on five different visits.

You and I experience “goal-gradient” hypothesis as well. Think of it when you use your credit card the next time to gather bonus points.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Ponzi scheme

2009-01-04T08:18:00.000+04:00

Rajalakshmi Sivam

“Ponzi scheme” is a term that has been used to describe many scams and financial frauds — ranging from the failure of large NBFCs in India in the nineties to the recent scam perpetrated by Bernard Madoff on Wall Street.

The scheme is named after Charles Ponzi, who duped people by promising quick returns from trading in discounted postal stamps. In a typical Ponzi scheme, as long as new entrants keep coming-in, earlier investors get good returns. But once that stops, the scheme collapses.

Charles Ponzi promised to double investors’ money in 90 days. The returns, he claimed were from exploiting the exchange rate difference on international postal reply coupons. He convinced people on the kind of extraordinary returns the arbitrage trade could give and amassed money. He then started his own company, employed agents to propagate the scheme and made millions in a short span. But Charles Ponzi kept it in the dark that investor “returns” actually came, not from profits, but from the capital brought in by new investors. The recent Madoff scam has been likened to a Ponzi scheme. Madoff, ex-chairman NASDAQ, founder of Bernard L Madoff Securities LLC was caught in the scam this December.

Madoff was alleged to be running a $50-billion Ponzi scheme through his securities firm. Not just lay investors but many big investment firms are said to have exposure to Madoff’s firms. Bernard L Maoff owned a securities firm (started in 1960) and an asset management firm (launched in 1990s).

His funds were delivering consistent returns every year, even as conventional mutual funds faced declining returns. Madoff claimed that his strategy was investing in blue-chip stocks and buying options simultaneously to limit downsides. Things went on smoothly till money kept pouring in.

The first sign of problem was visible in December last year when some of Madoff’s hedge fund clients wanted their money back. Appeals for withdrawal totalled $7 billion.

Madoff couldn’t arrange for redemption and admitted to a scam. Madoff told the senior employees of his firm on Wednesday, December 10 when he was arrested, “it’s all just one big lie…..basically, a giant Ponzi scheme”.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-12-31T10:24:00.001+04:00

"In every success story, you find someone who has made a courageous decision. "~ Peter F Drucker

Interesting Times @ 2008

2008-12-31T10:21:00.001+04:00

Scams, crises and rescue packages followed in quick succession in 2008. Here's an eventful year in retrospect.

January 26: Jerome Kerviel's derivative trades result in a $7.2 billion loss for his employer, Societe Generale. Until recently, this was the largest fraud in the banking history.

February 22: One of the earliest victims to the financial crisis, Northern Rock Bank is nationalised by the British Government due to sub prime-related losses.

March 17: Bear Stearns, US' fifth largest investment bank is merged with JP Morgan Chase, after fear of bank's failure battered the stock price; which crashed from $172 to $2 in one year. The Federal Reserve provides funds for the transaction.

July 11: IndyMac Bank, US' seventh largest mortgage originator, taken over by Federal Deposit Insurance Corporation. Crude oil soars to its all-time high of $147, marking the last chapter of the commodity boom.

September 7: The US Treasury bails out Government-sponsored mortgage companies Freddie Mac and Fannie Mae as the Government feared a housing market collapse if these companies failed.

September 15: Renowned investment bank Lehman Brothers files Chapter 11 bankruptcy protection making it the largest banking failure, as there were no takers for the bank. Bank of America acquires Merrill Lynch for $50 billion.

September 16: Barclay's buys Lehman's assets; AIG gets a $85 billion loan from US Fed to avert bankruptcy, in return for an equity stake.

September 17: HBOS, the biggest mortgage player in UK, merges with Lloyds TSB in a œ12-billion deal.

September 21: Goldman Sachs and Morgan Stanley shed their investment bank status and convert into banks, to come under regulatory supervision of US Federal Reserve.

September 25: Washington Mutual is taken over by JP Morgan Chase for $1.9 billion.

September 28: Fortis, major European banking and insurance company is partially nationalized after Belgium, Netherlands and Luxemburg come to its rescue by pumping Euro 11.2 billion in the company.

October 3: The US Government announces a Troubled Asset Relief Program of $700 billion (bailout package) for purchase of troubled assets. Wachovia-Wells Fargo merge after Citi backs out from a deal.

October 22: Pakistan gets $5 billion as emergency loan from IMF.

October 28: Iceland gets a loan from IMF

November 9: China announces a $586-billion stimulus package which is to be spent over next two years.

November 25: The US Fed announces an additional $800-billion package to support the financial system.

November 26: China cut key 1-year lending rates by 108 basis points to 5.58 per cent, one of the steepest rate cut in a decade.

December 11: Bernard Madoff, ex-NASDAQ chairman, arrested on charges of a $50-billion Ponzi fraud, making it among the largest in financial history. The Congress rejects the auto bailout package after trade unions turn down wage cuts.

December 16: The US cuts its benchmark Fed rate to near zero. Rates have plunged from 4.25 per cent in January 2008.

December 19: The US Government gives $17.4 billion as loan to GM and Chrysler to avoid failure of these giants. Bank of Japan cut policy rates from 0.3 per cent to 0.1 per cent.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-12-21T08:37:00.000+04:00

"The bow that bends too strictly snaps itself."

Value = perception?

2008-12-21T08:29:00.000+04:00

B. Venkatesh

Consider this. You are holidaying in a nice town and you are tired and hungry. There are several fast-food restaurants, all serving similar food at similar prices, except one. This particular restaurant sells food at a 25 per cent discount. Would you prefer to dine there? If you are like my friend who had to make a similar choice recently, you would prefer one among the full-price restaurants! Why?

Value attribution

The reason is because of what behavioural psychologists call as “value attribution”. This means we assign value to products that we consume based on some preconceived notions than from objective analysis.

My friend attributed value to the food based on its price. His reasoning was that if a restaurant was selling food at a discount, it was because it was not as good. Value attribution can lead to wrong decisions. We do the same when it comes to judging people. Consider the experiment that psychologists ran at the Massachusetts Institute of Technology.

Stunning results

Students in a certain class were told that a substitute teacher would deliver the course that day. The students were also given a brief profile of that teacher.

Unknown to the students, half the class were given a profile that described the substitute teacher as “warm” and the other half, a profile that described him as “cold”. After the class was over, all the students were asked to fill a feedback form. The results were stunning. Students who received the profile that described the teacher as “warm” gave a glowing feedback. The ones who received the profile that described the teacher as “cold” considered him to be serious, cold and uninteresting.

The profile had a major impact on the students’ perception of their substitute teacher. In other words, value attribution kicked-in. Now you may be able to better appreciate why a well-dressed person gets better customer service at a super market than you do. Or why “buy” recommendations from certain brokerage-firms drive up asset prices while others do not. It is all about perception or value attribution.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

You’re stuck with what you endow

2008-12-21T08:25:00.000+04:00

D. Sampath Kumar

It is a facet of human psychology that charlatans of the stock market have exploited to the hilt. Economists have studied it and labelled it the ‘endowment effect’, no doubt with a disapproving shake of their heads. Now clever entrepreneurs have stepped in to take a shy at your purse — this time with the promise of goods at a fraction of the true cost. This is how it works.

You buy a minimum bundle of 30 tickets paying 75 cents (to the US dollar) a piece. Each ticket confers on you the right to put in a bid (the 75 cents is akin to a premium on a call option without the exercise price).

Armed with these vouchers, you can now put in your bids for camcorders, I-phones or whatever it is that catches your fancy.

If your bid is the highest one standing at the end of 15 seconds the merchandise you have bid for is yours, no matter what the intrinsic worth of the product is. Of course, if your bid is upstaged by a better one, and the process is repeated 30 times, you lose all of the $22.50 invested in purchasing those tickets.

Would investors go for it? More to the point, would the model work? Apparently, yes. The Internet based auction site now even has a phone-in facility for its European players. So, what exactly is at work here?

Imagine that you are setting out from home on a shopping errand. You wonder if you should take an auto-rickshaw or a bus. Even as you are reflecting on it you have reached the bus-stop. On an impulse you decide you will take the bus ride after all.

Sticking with it

The fact that engaging a rickshaw also means a tedious process of beating down the asking price from twice what you would have liked to pay and eventually settling for something well above that, makes the choice just that bit easier.

You wait for a while, and nothing happens. A five-minute wait soon becomes 10 and before you realise, it is already shot past the 15 mark. You now begin to fret about the delay.

So, would you decide to chuck the whole idea and choose instead to travel by auto rickshaw? Chances are you wouldn’t. You reason that you have already invested 15 minutes and the bus may be just round the corner. Hence it doesn’t make sense to give up. So you end up waiting a while longer.

The wait becomes almost interminable to the point where you are happy to see even a bus go by in the opposite direction hoping perhaps that sooner or later it would make the trip on your way. No matter how long the wait lasts, you refuse to budge from your initial decision. Each time you are confronted with the question the reasoning remains always the same and no less impeccable.
It always boils down to the prospect of the very next minute that the bus might arrive and not the time you have already invested, which by implication doesn’t count.

You also feel that the choice in favour of an auto rickshaw at that late a stage over a bus ride makes you look absolutely silly to an imaginary crowd of onlookers — a prospect made worse by the fact that as you look back after boarding the auto you might espy a bus turning a bend in the road and coming into view.

Hoping for jackpot

In other words, the amount of time that you have already endowed in favour of a bus ride influences your decision to continue to stick with it — hence, the ‘endowment effect’ in behaviour. So it is with stocks.

You may have bought a dud stock at a fancy price. You stick with it in the vain hope that it will appreciate and any decision to sell in the meanwhile makes you look a bit foolish. Your choice of staying invested is already endowed with the sum of initial money, just like the time spent waiting for the bus in the above example.

The trick is to get the average citizen invest that initial sum of money and the ‘endowment’ effect kicks in.

It ensures that you don’t pull back once you have plonked a few of those chips on a piece of merchandise you bid for, initially. Why would you invest $22.5 in the first place?
A lot of people think that the chance to hit the jackpot of a plasma/LCD TV from Panasonic, or anything else they covet, for just $22.5 is a fantastic deal.

For investors in India, the prospect may yet be unattainable. The game might fall foul of the rules of the Reserve Bank of India, which may not take kindly to Indians charging $22.50 on their credit cards on games of chance.

In case you didn’t know, the Enforcement Directorate is known to go after people other than those belonging to the Anil Ambani Group too!

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-11-02T08:29:00.000+04:00

"To respond is positive, to react is negative."

How the decoy enables an apples-oranges comparison

2008-11-02T08:25:00.001+04:00

B. Venkatesh

A person I know is in the business of selling pre-owned cars. Sometime back, as a witness to a transaction at his shop, I realised how the business owner effectively applied behavioural psychology to selling cars. He used what psychologists call the decoy. What is it?

A couple was shopping for a pre-owned Maruti Swift. The business owner showed them one Swift and one Getz. He explained to them that the Getz was marginally expensive but had some advantages. He and I could see that the couple was confused on whether to buy a Swift or a Getz.

The equation changes

The business owner later showed them another Swift. This one came without insurance and with very old tyres. Suddenly, the equation changed. After two test drives, and more than an hour later, the couple was ready to buy Swift. What happened?

The initial decision to choose between Getz and Swift was very difficult. The couple, perhaps, saw some advantages in Swift and some in Getz. Otherwise, both the cars were not easily comparable.

The business owner’s ingenious strategy to introduce another Swift tilted the couple’s decision in favour of Swift — the car they wanted to buy in the first place. How?

A handle to compare

When a second Swift was introduced, the couple now had a handle to compare. They concluded that the one with insurance and relatively new tyres were better than the one without it. And it did not stop there.

The insurance-less Swift made the Swift with insurance look better than the Getz! Behavioural psychologists call the insurance-less Swift a decoy.

A decoy simply shows the comparable in better light, enabling easier decision. Why? We choose objects that can be easily compared and avoid ones that cannot be.

Publications use this strategy to offer subscription choices. A typical offer would contain a print-only, an Internet-only and a print-and-Internet subscription.

The pricing would be such that the print-only would act as a decoy and print-and-Internet, the preferred choice.

The business owner understood this human response to decoys. He bagged the customer.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Bubble explained

2008-11-02T08:23:00.001+04:00

V. Pattabhi Ram

If you have been wondering how the bubble works, be it in the economy or the stock market, the story of this tiny island which has only three inhabitants, two Re 1 notes in circulation and a piece of land will help. This is what happened to the country between January 1, 2008 and June 30, 2008.

January 1, 2008: Only three citizens lived in that country, Mr A, Mr B and Mr C. Mr A owned the land. Mr B and Mr C owned Re 1 note each. So the country’s total wealth was Rs 3.

Februay 1, 2008: Mr B decided to buy the land from Mr A for Rs 1. So, now Mr A and Mr C have Rs 1 each while Mr B owned the land that’s worth Re 1. The wealth of the country stays at Rs 3.

March 1, 2008: Mr C felt that the price of the land would go up. So, he borrowed Re 1 from Mr A, and with his he bought the land from Mr B for Rs 2.

Mr C is A’s debtor for Re 1. So Mr A’s wealth is Re 1. Mr B had sold the land and picked Rs 2. So Mr B’s wealth is Rs 2. Mr C owns the land worth Rs 2 and with his Re 1 debt to Mr A, his wealth is Re 1. The country’s wealth is now Rs 4; up from Rs 3.

April 1, 2008: Mr A, the original owner of the land, is upset that its price is now Rs 2. He wants it back. So he borrows Rs 2 from Mr B and buys the land from Mr C for Rs 3.

The balance Re 1 is settled by nullifying the Re 1 which was due to Mr A from Mr C. Now Mr A owns the land worth Rs 3. Since he has borrowed Rs 2 from Mr B, his wealth is Re 1. Mr B has given Rs 2 loan to Mr A.

So his wealth is Rs 2. Mr C has Rs 2 with him. So his wealth is Rs 2. The wealth of the country is the total wealth of the three guys, and is Rs 5; up from Rs 4.

May 1, 2008: Mr B decides to get into the act. He buys the land from Mr A for Rs 4. He settles by borrowing Rs 2 from Mr C and by adjusting against the loan of Rs 2 to Mr A. Mr A is free of debt, has the Rs 2 with him and so is worth Rs 2. Mr B owns the land now worth Rs 4 but since he owes Rs 2 to Mr C, his wealth is Rs 2. Mr C has lent Rs 2 to Mr B and so his wealth is Rs 2. The country’s wealth is Rs 6; up from Rs 5.

June 1, 2008: Mr C decides that the land price cannot go up. Ditto is Mr A’s thought. Neither wants to buy the land. So now Mr A has the Rs 2 and his wealth is Rs 2. Mr B owes Mr C Rs 2 and the land which he thought was worth Rs 4 is now only Re 1.

His wealth is Re -1. Mr C has a loan of Rs 2 to Mr. B. But that’s bad debt. Although his wealth is Rs 2, he may not be able to encash it. The wealth of the country is Rs 3; down from Rs 6.

June 30, 2008:Mr B declares bankruptcy. Mr C has to forego his loan to Mr B and in lieu takes the land which is worth Re 1. So Mr A has now Rs 2, Mr B has no wealth and Mr C has the land worth Rs 1. The wealth of the country is Rs 3.

Confused? Good. If you are an accountant, look at each event as a transaction. The changing capital is the wealth of each individual and the sum of the capitals is the wealth of the country.

There are several morals in this. The most important are Mr A won, Mr B lost and Mr C got away. When the bubble bursts, the guy with cash is king.

If you don’t partake in the fun your wealth swings but you don’t lose. Now what we said of this country is true of the stock market.

Caveat: A remarkable story circulating on mail which in part explains the bubble. I have merely tinkered on the margin.

(The writer is a Chennai-based Chartered Accountant)

Sourced from: http://www.thehindubusinessline.com

Thoughts

2008-10-26T08:17:00.001+04:00

"The greatest loss is the loss of self-confidence."

Structured finance for dummies

2008-10-26T08:15:00.000+04:00

V. Pattabhi Ram

Structured finance has been at the leading edge of financial innovation; and of recent financial disasters. At the heart of the transaction is an idea called “securitisation”. Let’s take an example to understand how securitisation works. Assume your company is into providing car loans. Suppose the total loan portfolio is Rs 100 crore and the amount receivable against it across the next three years (loan life) is Rs 150 crore. Let’s now say that you want to raise money. You have two choices.

First, under traditional financing, you could go to a large bank, hypothecate your receivables and raise money. The borrowing would then appear as a liability in your balance-sheet and alter your debt-equity structure.

Financial engineering

Second, you could resort to some financial engineering. Your company (originator) can float a special purpose vehicle (SPV) with a nominal capital and sell these receivables (assets) to the SPV. The SPV will issue tradable securities, called pass-through certificates (PTC) to fund this purchase.

Since these certificates are backed by assets, they are also called asset backed securities (ABS). For you, the advantage is that the receivables are removed from your books as you have sold them. Your transaction does not create a liability in your balance-sheet. Thus, it helps in asset-liability management as also your capital ratio.

So far, so good. But who will buy the PTC? It is here that rating agencies come in. These PTC, also called structured obligations (SO), are rated by rating agencies.

Typically, the originator will like the SO to have the highest rating so that they can be sold easily by the SPV. If the SO does not qualify for such high rating, the agency may require you, the originator, to bring about suitable “credit enhancements” like placing a certain percentage of the receivable as cash margin with the SPV.

As far as you are concerned, once you have securitised your receivables, you are off since you have in effect sold them. But you may still be invited by the SPC to collect the receivables on their behalf for which you are paid a fee. By the way, the assets that can be securitised need not be restricted to car loans; they include property loans, credit card receivables and even future cash flow like property rentals.

Will the buyer gain?

What does the investor, the buyer of the PTC, gain? For him, the attraction is that the return is much higher than similarly rated bonds. On the flip side, there is hardly any secondary market, making the PTC rather illiquid. If these PTCs are parceled out to individual investors, that would be retail asset securitisation, and if you were to have an active secondary market for it in the form of trading, as in a stock exchange, it would be fun. If you asked “where is the complication?” you asked too soon.

The concept of securitisation can be carried further to arrive at a product called collateral debt obligations (CDO). You may group a variety of receivables such as credit card, car loans and mortgage loans and securitise them. You could now create multiple layers of PTC with varying ratings and coupons.

Loans with risks of default

Let me explain with an example. Suppose you have receivables in property loans with varying risks of default. You create a SPV with a pool of Rs 200 crore with an average after tax return of 10 per cent. The SPV could have three tranches of investors. Category A — called first loss tranches — of Rs 10 crore with 30 per cent coupon; Category B — called second loss tranches — of Rs 20 crore with 17 per cent coupon and Category C — called Senior Debt — of Rs 170 crore with 8 per cent coupon.

What this means is that the first Rs 10 crore of bad debts will be borne by Category A, the next Rs 20 crore of bad debts by Category B and bad debts of amounts beyond that by Category C.
Clearly, Category A is the high-risk, high-reward structure. This is generally invested in by hedge funds. Category B is the medium-risk medium-reward structure while Category C is the low-risk low-reward structure. Typically, pension funds invest in Category C are pension funds.

(The author is a Chennai-based chartered accountant.)

Sourced from: http://www.thehindubusinessline.com/

Behavioural pricing is a big deal!

2008-10-26T08:13:00.000+04:00

B. Venkatesh

Last week, I was witness to some interesting human behaviour. Two hawkers had spread out “book shops” on the sidewalk, 100 metres from each other. One hawker was attracting more customers than the other and it appeared that it was because of his behavioural pricing policy. What is that?

Suppose you want to buy a book on psychology. The first hawker — the one having a rather quiet day — tells you it costs Rs 250. You ask for Rs 200 and he replies that the price is fixed. If you are like most of us, you will walk off in a huff, peeved that he is unwilling to negotiate. But suppose you visit the second hawker first — the one who is the crowed-puller. The seller tells you the price for the book is Rs 325. You haggle with him for a few minutes and settle for Rs 250. Happily, you hand him the cash and walk away with the book! What happened?

Negotiating a bargain

More than the buying the book, you derived the satisfaction of bargaining with the seller and winning the negotiation. Of course, the astute sellers know that you and I like to bargain. That is why the clever ones quote more than the actual price to give you the leeway to bargain. If the seller actually wants Rs 225 for the book, he may quote Rs 325. If you end up paying Rs 250, you get the satisfaction of bargaining and he, the fulfillment from extracting a higher price! That is behavioural pricing.

Price of a product

But what if you visit the second hawker after you visited the first one? Even though both offer to sell at Rs 250, you may still stick with the second hawker for two reasons — you invested time in negotiating a bargain, and the second hawker seemed friendlier than the first.

What does this all mean? As buyers, the value we derive from a purchase depends not on the actual price we pay for the product but on whether we arrived at that price after negotiating!

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-10-06T08:07:00.000+04:00

"Most problems are really the absence of ideas."

CDS for dummies

2008-10-06T08:01:00.002+04:00

V. Pattabhi Ram

Samvit Durga

He called them “the financial weapons of mass destruction”. ‘He’ was ‘Warren Buffet’ and ‘them’ was ‘Derivatives’. Boy, the world’s smartest investor could not have been more right.

For proof, look no further. First, the world’s fourth largest investment bank, Lehman Brothers, went belly up and then the world’s largest insurance company, AIG, needed a bailout in the land of market economy. A principal reason: Losses due to extensive exposure to Credit Default Swaps (CDS).

What is a CDS?

We explain with a simple example.

Stripped of jargon, a CDS is an insurance contract. Okay, the high priests of finance would call it a derivative but that is a piece of minor detail. Now, suppose, Bank X has lent money to various entities which are non-A grade (read sub-prime) accounts.

To cover the risk that these accounts may default, the Bank sells the risk to someone willing to buy the risk. Suppose this buyer is AIG. In effect, the bank is swapping the risk of default (hence the word credit swap) for cash. If the borrowers fail to pay, AIG settles. Of course, for buying the risk (a k a swap), AIG takes a fee.

Some numbers will help us understand this better. Suppose Bank X wanted to de-risk loans aggregating Rs 200 crore. Suppose AIG charges Bank X Rs 5 crore to guarantee the Rs 200 crore exposures. Suppose AIG assumes that there is a 3 per cent probability that Rs 100 crore of the Rs 200 crore would devolve, that is, go bad — it provides 3 per cent of Rs 100 crore, namely Rs 3 crore in its books for estimated liabilities. That leaves it with a profit of Rs 2 crore on the transaction.

So far, so good. But competition does strange things to organisations. Someone like Lehman to out gun AIG may assume a 2 per cent risk of default and, hence, it may do the deal with Bank X for a lower price of, say, Rs 4 crore. At 2 per cent risk, it would provide Rs 2 crore (Rs 100 cr x 2 per cent) only and, hence, report a profit of Rs 2 crore. As undercutting turns rampant, assumptions relating to the underlying credit going bad becomes more aggressive, at some point becoming zero!

Now, if in the end, 7 per cent of the debt goes bad it would lead to a liability of Rs 14 crore (Rs 200 cr x 8 per cent) on Lehman who sold the CDS, whereas Lehman would have provided only Rs 2 crore in the books. Phew.

The growing chain

The story doesn’t end there. It is quite possible that Lehman Brothers to de-risk itself may buy a swap from someone else on the same loans.

This someone is willing to guarantee it for an even lesser fee because he makes more aggressive assumptions as to the outstanding going bad.

The result: a growing chain of CDSs on the same asset, with each one guaranteeing the previous one. And when the debt goes bad, the firm that holds the parcel pays through the nose.

AIG reportedly sold around $440 billion worth of CDS, which ended up in losses far greater than it had assumed. The ease with which banks could sell the risk clearly fuelled lending to bad accounts.

After all, you could do a crazy loan and the cover it with a CDS so long as there would be a greater fool to sell the cover. What got missed out in the race was that the CDS seller itself could, under the weight of CDSs, go turtle. And that was exactly what happened in the US.

A useful tool, through its blatant misuse, has shaken our confidence in the global financial architecture. Imagine what would have happened if these instruments had been further parcelled and sold to retail investors. Small mercies.

( blfeedback@thehindu.co.in)

Sourced from: http://www.thehindubusinessline.com/

Why last-minute air travel is costly

2008-10-06T07:59:00.000+04:00

B. Venkatesh

My friend is a last-minute traveller. He ends up paying a premium on his air fare compared to those who purchase tickets in advance. He, however, gets a discount when he buys last-minute tickets to his favourite concerts. Quite intrigued, my friend wanted to know if economics can explain the contrasting price dynamics. Can it?

Maximising profits

All businesses have a simple rule — to maximise profits. Take a movie theatre that has 500 seats. Suppose a particular movie show has sold only 425 seats at an average price of Rs 80 per ticket. The theatre owner can let 75 seats vacant.

Alternatively, he can sell the seats at a discount. If he sells at Rs 50 per ticket, revenue will be higher by Rs 3,750. With low variable costs attached to the seats, the entire amount could add to the profits.

Such pricing could, of course, have some consequences. If the theatre offers such discounts as a policy, fence-sitters or price-sensitive customers could wait till the last minute to avail of the discount. That could bring down the average revenue and profits for a movie show.

Pricing policy

Not considering the consequences of such pricing, receiving a discount at movie theatres and concerts does not seem surprising, given the objectives of full occupancy and optimal profits. The airline companies are equally interested in filling their seats on each journey. And that means they should be willing to offer steep discounts to last-minute customers as well. So, why then is the price dynamics different?

Travellers typically purchase their tickets in advance. They pay a lower price but suffer a huge penalty for cancelling. Often, airlines do not give refunds.

Business travelers are different. Airlines have found that business travellers tend to reschedule their flights frequently and often end up buying tickets few hours before the departure.

Now, these travellers are less sensitive to prices than others. It, therefore, pays to charge a higher premium to the last-minute business traveller, for that maximises profits. Other last-minute travelers simply suffer the consequences of this pricing policy.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-09-28T08:39:00.001+04:00

"Ideas, like time and tide, wait for no one."

Retirement portfolio: Applying human capital for optimal asset allocation

2008-09-28T08:35:00.000+04:00

B. Venkatesh

Retirement planning is a process that enables a person to enjoy the desired post-retirement lifestyle. The retirement investment portfolio is custom-tailored to suit the objectives of the person concerned. Often, retirement planning does not take into account what financial economists call as human capital.

Human capital

This refers to the present value of future income that a person earns till retirement.

The total wealth for any individual is the sum of human capital and financial wealth. During the early working life, the individual has more human capital and less financial wealth.

Suppose an individual aged 25 prefers to retire at 55. She has 30 years of working life.

The present value of the cash flows that she can earn during this period will be substantially higher than, say, a 45-year-old. On the other hand, the 25-year-old will have less financial wealth than the 45-year-old. And that is because she has had less time to save.

Retirement planning is about using financial assets to meet the living expenses after a person passes the age when she can depend on human capital to generate income.

A retirement portfolio, hence, involves both human capital and the financial ability of the individual to save and invest during her pre-retirement life.

It is unfortunate that human capital is often not considered in the portfolio construction process. That leads to high retirement risk — the risk that the portfolio structure will be unable to meet the living expenses of the person, post-retirement.

Earnings risk

The primary factor, which may prevent an individual from enjoying a desired post-retirement lifestyle, is the earnings risk.

This is the risk that the individual may not earn as much income to save for the post-retirement expenses.

Earnings risk feeds into the portfolio structure through two variables — volatility in income and correlation of the income with the financial market, especially the stock market.

Take two individuals, both aged 25. One works as an analyst with an investment bank that has large exposure to the US markets.

The other works as an officer in the Central Government. The earnings risk for both individuals is dramatically different.

The investment bank employee has a higher earnings risk than the one working with the Central Government.

The earnings risk can be thought of as stability of income generation. It is also a function of the flexibility of the individual to adapt to circumstances.

If the analyst can move to an Indian brokerage firm should her current employer run into trouble, the unstable income is reduced by a greater flexibility of labour.

The financial planning process has to consider both variables of earnings risk to construct an optimal portfolio.

Typical portfolio structures would carry high equity exposure for both individuals.
The reason is that both are young and can afford to take risks. The problem, however, comes from portfolio diversification or the lack of it.

Diversification process

The investment bank employee has stock-like human capital because her earnings are unstable and highly correlated with that of the financial market.

An optimal portfolio structure would have substantial exposure to bonds with some exposure to stocks.

The Central Government employee would have a very high initial exposure to equity because of her bond-like (stable income stream) human capital.

The equity exposure would come down with age.

This is because of two interacting factors. One, with each passing year, the human capital declines.

And two, the passage of time increases financial wealth through prudent investments.
Both these factors reduce the need for equity investment and increase the need for bond exposure, as the investor nears retirement.

It is important to note that investors typically suffer from a behavioural bias called Availability Heuristics.

That is, investors typically over estimate the outcomes that they can imagine easily.
This forces them to choose investments within their narrow range of experience — the primary reason why people over expose the portfolio to their employer-company stock.

When Worldcom and Enron declared bankruptcy, not only did the employees lose their income but most of them also lost their retirement investment because a substantial proportion of the assets were in the employer-company stock.

The optimal portfolio structure would have exposure to stocks that have low correlation with the employer-company stock.

Conclusion

Human capital and financial wealth are the primary assets for any individual.
Human capital is high during the initial investment stages while financial wealth gains proportion with age.

Both assets should be combined to construct an optimal retirement portfolio.

Taking equity exposure equal to 100 minus the age of the investor, or considering only financial wealth to construct retirement portfolio will be sub-optimal.

(The author is an investment strategist. He can reached at enhancek@gmail.com)

Sourced from: http://www.thehindubusinessline.com/

Tune your expectations

2008-09-28T08:34:00.000+04:00

B. Venkatesh

You may have observed that stocks of certain companies decline on the day these companies announce their financial performance, even if it is better than the previous quarter. Can economics explain such behaviour? Behavioural psychologists throw some light on the issue. Suppose a footballer meets with an accident. When he regains consciousness, the doctors tell him that he may be confined to the wheel-chair forever.

Enhancing state of mind

A week later, this footballer responds well to medications and is told that he can walk out of the hospital with a minor limp. The footballer’s career is finished. No coach would want a player with a limp, however talented he might be. Yet, the footballer is ecstatic! Why?

Being confined to a wheel-chair affects the footballer’s way of life. When he is told that he can get away with just a minor limp, he regains this mobility. And that greatly enhances his state of mind. In other words, our reaction to an event is not based on how good or bad that event is.Rather, it is based on our expectations from the event. The footballer is still worse off than he was before the accident. Yet, he is happy that he can walk!

Level of expectations

It is the same with the financial markets. If a company continually announces good performance, we raise our level of expectations. Even if the company delivers 40 per cent growth, the market is not satisfied, as it expects more. This leads to a price decline on the day the company announces its financial performance.

The flip side is also true. Suppose the market expects a company to declare losses but it actually reports a marginal profit. The stock may move up sharply, even though the company’s earnings are substantially lower than its competitor.

The key to happiness, it appears, is low expectations! For having low expectations means less chances of disappointment. That way, a bad outcome can actually feel good if we expect something worse. And a good outcome can feel bad if we expect something better.

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-09-28T08:32:00.000+04:00

"The great pleasure in life is doing what people say you cannot do."

Man smart, woman smarter

2008-09-28T08:30:00.002+04:00

FINANCIAL PLANNING

Amar Pandit / Mumbai

“It’s a Man’s world” is an often repeated cliché. However, things have changed to a great extent and urban women are enjoying more economic prosperity now. In the last couple of decades, there has been a tremendous improvement in the ratio of women entering the workforce.

Richa Joshi (name changed) in her thirties is a corporate executive. While she is quite comfortable with managing the day-to-day expenses of the family, she has never bothered to manage her own money. No wonder, she has no idea about the insurance, investment and taxation details of her family’s money. Earlier, the onus was on her father, and now her husband’s chartered accountant does the needful. As a result, she is completely clueless about her investments and joint investments. More importantly, she has no idea about the family’s liabilities.

This is a common story. Not just women, but many men suffer from the same malaise when it comes to managing their own money. They depend on others, like family members and other professionals.

While managing daily money is no mean task, it is important that Joshi takes control, or at least inculcates a strong understanding of her overall financial situation. Of course, there are movies, where it is heartening to see women taking active interest in the Sensex stories rather than the Saas Bahu stories. But most of this interest gets only accentuated when the Sensex is on an upswing.

Typically, most women tend to focus on their family’s immediate or short-term needs such as day-to- day expenses, lifestyle purchases and, at best, vacations. What they lose out is their long-term financial goals, be they retirement, financial security or financial independence. Though it may sound clichéd, it is necessary for a woman to attain these three objectives. Whether married or not, working or not, every woman must plan for the long term.

The following are key questions every woman must ask herself:

What if something were to happen to my spouse today? Will the family be able to live as well as we are doing today?

What are my savings and investments? Are my investments relevant to my financial situation? Are my liquidity, income and growth needs taken care of?

In uncertain times, how long can the family survive? Do we have enough contingency funds?
What would I do in case of an unfortunate incident like a divorce or a separation? Will I be able to maintain the same lifestyle?

Am I up to date with the skills that are required in the job market? As many have found out, after marriage and children, when they come back to the market, they are completely outdated in terms of the skill set required.

As it happens, in case of an emergency, many discover that most of their investments are in tax-savings instruments, earning returns of just 4 per cent a year. Even if there are investments, they were made in a haphazard manner and do not yield great returns. The situation is often worse when there is a loan hanging over their head.

It is imperative, therefore, that women maintain their own balance sheets. This would make them aware of the funds in their name. They should be aware of any joint investments and have access to the necessary documents. Also, if there are liabilities, there should be proper corpuses or insurance plans to deal with such situations. And most importantly, there should be proper medical insurance that will take care of their or their family’s health needs.

Yes, while it’s true that women are looking at everyday needs of the family, it’s imperative as well that they keep a tab on their financial security to ensure a safe future.

The writer is director, My Financial Advisor

Sourced from : http://www.business-standard.com/

Thoughts

2008-09-21T09:22:00.000+04:00

"Happiness is never perfect until it is shared."

Is a concentrated portfolio optimal?

2008-09-21T09:20:00.000+04:00

B. Venkatesh

Modern portfolio management is built on the concept of portfolio diversification. A portfolio manager or an individual investor constructs a portfolio with several stocks to diversify the asset price risk. Hedge fund managers, on the other hand, construct concentrated portfolios to generate alpha returns. We recently received a question from a reader: Should individuals construct a diversified or a concentrated portfolio?

There are obvious benefits and risks of holding a concentrated portfolio. The article discusses these issues and shows why such a portfolio is not suitable for all individuals. It also discusses a model that investors can use to measure concentration in mutual fund portfolios.

Diversifying risk

Long-only managers typically prefer portfolio diversification. The reason is not too far to seek. If a portfolio manager bets on select stocks and they fall in value, the portfolio is likely to underperform. That could prompt the investors to redeem their units, causing a decline in asset under management.

Portfolio diversification is built on the fact that some assets are weakly correlated with each other. So, if one stock declines in value, another may not fall as much.

Constructing a portfolio of such assets enhances the risk-adjusted returns. Empirical evidence has suggested that a well-diversified portfolio can be constructed with just 20 stocks.
But portfolio diversification has become more difficult at present.

The problem is the increasing correlation among assets, which has adverse consequences for the diversification process.

In a recent journal paper, Meir Statman of Santa Clara University has argued that the current market condition requires 300 stocks for a truly diversified portfolio! And that could be difficult to construct for an individual investor, and unwieldy to manage for a portfolio manager.

While constructing a truly diversified portfolio may be difficult, it does not automatically mean that a concentrated portfolio is the right answer.

Benefits from concentration

The Capital Asset Pricing Model advocates diversifying company-specific risks and taking exposure to generate market returns from the beta exposure.

Hedge funds go against the basic tenet of this model. They strive to generate alpha returns — returns that are derived from company-specific risk and are often weakly correlated with the market returns.

Alpha returns are generated from active bets on select stocks. Such exposure carries substantial asset price risk. Suppose a portfolio manager has a positive view on Kotak Bank and, therefore, takes a 15 per cent exposure to that stock. What if Kotak Bank declines 10 per cent while the other sectors either stay range-bound or move up?

There is, nevertheless, an obvious advantage in holding a concentrated portfolio. What if the portfolio manager’s bet turns right? If Kotak Bank moves up 10 per cent instead while the market turns down, the manager has generated alpha returns for her investors. The risks associated with a concentrated portfolio is, however, high. This makes such portfolio attractive only for disciplined traders and risk-seeking investors.

Measuring concentration

A concentrated portfolio is not about the number of stocks in a portfolio. Take two portfolios — A and B. Suppose both portfolios have 10 stocks, but portfolio A has 50 per cent exposure to one stock and the balance in equal weights, while portfolio B has equal weights in all stocks. It is clear that portfolio B carries less concentration than portfolio A.

One measure to capture such concentration is derived from the Herfindahl Index, which measures the market concentration in an industry. The Herfindahl Index is measured by the sum of squares of the market share of each firm in an industry. The number ranges from 0 to 10,000; higher the number, greater the concentration.

The Brandes Institute has modified the Herfindhal Index to arrive at a concentration co-efficient for investment portfolios. The institute defines the concentration co-efficient as the inverse of the sum of squares of the stock weights in a portfolio. So, portfolio A has a concentration co-efficient of 3.6 and portfolio B, 10. One way of interpreting the concentrated co-efficient of 3.6 is that this portfolio is equivalent to an equally-weighted portfolio of 4 stocks. So, lower the co-efficient, higher the concentration risk.

Conclusion

A concentrated portfolio structure would fit well as the alpha-generating satellite portfolio within the core-satellite portfolio framework. Strict risk management rules need to be followed to manage such a structure.

One risk management rule can be stop-loss levels based on technical analysis for direct exposure in the stock market. Investors can also construct a concentrated portfolio with one or two sector funds. The risk management rule in such cases can be based on the investor’s risk tolerance levels.

It is important to understand that a concentrated portfolio in itself is not necessary good. Such a structure enables alpha generation only if accompanied by superior security selection skills.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

Sourced from : http://www.thehindubusinessline.com/

‘Securitisation, a (sub)prime option’

2008-09-21T09:18:00.003+04:00

Rajalakshmi Sivam

We have seen ‘securitised assets’ of poor credibility wrecking havoc in the global financial markets in the past year. So, what is securitisation? In simple terms, it is a mode of raising capital by banks/financial institutions. It is a process where a financial entity converts its assets into securities and sells them to investors. The cash flow from the asset then becomes the return on the investment for the holder of the security.

A win-win situation?

When banks (or other financial institutions) need funds, they convert their assets (advances/loan given) into marketable securities (bonds) by transferring them to an entity (Special Purpose Vehicle-SPV) formed for this purpose. The SPV does the job of detaching these assets from the holder and converting them into securities. Backed by assets, these securities are called “asset backed securities” and are also referred as pass-through certificates (PTC). The banker gets the needed funds, the investor gets the promised returns and the SPV too gets a fee for the service — the difference between the interest the borrower had agreed to pay and the return the investor is promised. Does this look like a win-win situation for all parties? On the face of it, yes. But there are hidden risks. .

Leverage to banks

The entire cycle explained above revolves around the borrower . His promise to repay is the guarantee for return to the investor. . His default will disturb the entire cycle.

A slowdown in real-estate demand in the US and the subsequent fall in their prices completely washed off the mortgage banks that lent to the high risk sub-prime borrowers and investment companies that had put money in those securitised bonds.

Hence, the credit worthiness of the borrowers and the credibility of the instruments in which the banks invest assume significance. Also, any concern on the lower-than-expected return from the investment made by banks (from the money got through PTCs) will impact the return promised to the investor.

If properly structured, securitisation could however give the benefit of leverage to banks and also help higher credit disbursal.

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-09-21T09:18:00.001+04:00

"Courage doesn't always roar. Sometimes courage is the quiet voice at the end
of the day saying, 'I will try again tomorrow."

Why sinful foods come in mini-packs

2008-09-21T09:16:00.001+04:00

B. Venkatesh

One of my friends is calorie conscious because his doctor has asked him to reduce his body weight. Like most of us, he loves eating! He has conceived of a master plan to resolve this conflict. He stocks small packages of high-calorie snacks. His body weight has, however, increased since he started snacking in small portions. Why?

The answer lies in consumer behaviour. You would have noticed that snack foods come in all colours and shapes, but often only in two sizes — small or big. There seems to a reason for this.

Marketers have found that they are primarily two kinds of snack eaters — those who indulge and those who are calorie conscious but would like to taste such food in small quantities.

Tasty pleasure

The problem is that the mini-packs are potent danger to the dieters. These people believe that small packages help them control their temptation and yet allow them to indulge in some tasty pleasure. Often, however, the calorie intake in mini-packs is underestimated. Besides, dieters consume more calories when handed such small packages than when they are dished out large tub of buttered popcorn or bag of chips.

This may seem counterintuitive. Studies in the past have shown that we tend to consume more when offered more. Recent research, however, shows that we tend to apply brakes when offered large portions of high-calorie food.

The reason could be that the world has more self-confessed dieters now than in the past. It is, hence, easier for us to resist large portions of high-calorie food than it is to ward off small portions.

Temptation in mini-packs

We eat a slim bar of chocolate but shy away from a relatively bigger one. Besides, research has shown that some dieters view mini-packs as diet food! Marketers know it only too well. That is why department stores stock these sinful foods in mini-packs.

My friend now believes that the undetected small temptation in mini-packs has led to his weight increase. He is revamping his snack bar. But the marketers could well counter his move!

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/

Thoughts

2008-09-14T08:56:00.001+04:00

"Imagination is more important than knowledge."

Handling uncertainty

2008-09-14T08:54:00.001+04:00

B. Venkatesh

A couple of weeks ago, I was caught in a traffic jam. On inquiry, I was told that the gridlock was because it was an auspicious day, and that had brought large number of visitors to a nearby temple. Why are more people visiting places of worship these days than, perhaps, ever before?
During periods of uncertainty, we become very insecure. This insecurity drives us to become religious and superstitious. We typically visit religious places when we are disturbed — financially, emotionally or physically.

Unfulfilled desires

Our wants have increased manifold. The means to achieve these desires have, however, not kept pace. We are faced with soaring price levels and widening rich-poor divide. Crime rates have increased as well. The unfulfilled desires and tough living conditions have led to uncertainty in quality of life. That has, perhaps, driven us to become more religious, explaining the crowd at places of worship.

Visiting these places is not the only way we counter uncertainty. We also tend to indulge in rituals and esoteric science such as astrology and mysticism.

A certain tribal community, for instance, employs standard fishing methods when working in calm waters but engage in elaborate rituals when fishing on high seas. The researchers concluded that the tribal fishermen engaged in such rituals to decrease the unpredictability of high seas.

Economic downturn and superstition

It is the same with economic uncertainty. During the 1920s, Germany was reeling under hyper-inflation. Two contemporary professors conducted a study and found that newspaper articles on superstition were higher during that period. They found a strong correlation between economic downturn and superstition.

More recently, psychologists from the Tel Aviv University conducted a study in Israel during the 1991 Gulf War. Some cities such as Tel Aviv were in greater danger from scud missiles attacks than others such as Jerusalem. They found that the people who lived in cities such as Tel Aviv were more superstitious than others.

It appears from these studies that being superstitious is healthy, as it helps us cope with uncertainty. It is the traffic gridlock that is the problem!

(The author is an investment strategist.)

Sourced from: http://www.thehindubusinessline.com/