Testimonial on www.amazon.in

 

 

“Amit takes us down the memory lane and re-caps the previous rallies and the turmoils. It is very interesting when he says that markets do fall because they do rise. The book is punched with interesting observations from similar books and mixes a good bunch of humour in between. This is a good read to set our expectations as an investor. Very good guide when we need help to learn the right behaviour in the market, as an investor. I enjoyed reading & learning.”

Rohit Shah on http://www.amazon.in

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Why understanding investor psychology is important – 2

Continuing from yesterday’s post:

While the various assets would generate various kinds of investment returns, be it current income (in form of rent, interest or dividends) or capital growth over the years, it entirely depends on the behaviour of the investor as to how much of it one takes home.

This gap between what an investment generates and what an investor gets depends on costs (transaction costs, holding costs, maintenance costs, etc.), taxes and investor psychology. To some extent, the former increase due to unstable mind of the investor.

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Why understanding investor psychology is important

he subject of behavioural economics, or behavioural finance, or plain simple investor psychology has been around for decades. However, it came into limelight only in last few years. Today, more number of people are talking about this subject.

This is not new. The role of emotions in our daily life has been explained by our Upanishads. As the famous Amrit Bindu Upanishad says

its-all-in-the-mind

(The mind alone is the reason of our bondage or our freedom.)

The fact is, ever since humans started dealing with other humans – even before money was invented – the relation between price and value has always been a subject of debate. There have been opinions justifying the price for the value and there are opinions questioning the price with respect to the value. Probably trade happens only due to such differences in opinions.

However, when cold logic is applied, it is often difficult to arrive at a decision. Add a pinch of emotions and you are able to arrive at a conclusive decision and act on it.

However, emotional decision making has its own flaws.

It is important to understand the role of emotions in our life and the flaws associated. These emotional flaws reduce the upside in case of our financial decisions or they increase the costs and the risks.

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A short intro …

The book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget” is a story of various events that took place in the history of financial markets. More than that, it’s a story of the fickleness of the human mind.

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Easy money

When easy money becomes available, investors tend to take more risks with money that would otherwise lie idle.

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The enemy in the mirror

Recently, I came across a brilliant article on mistakes that many investors make.

It talks about the common mistakes many investors make and there are psychological reasons behind these. Investment decisions are taken more often based on biases like these rather than the economic ones.

This is very similar to what I have written in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

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Why are markets taking a nasty ‘U’ turn? – an article wrote years ago, but still relevant

Why are markets taking a nasty ‘U’ turn?

The financial markets have borrowed certain terms from Physics, e.g., leverage or gearing, equilibrium, momentum, etc. Those who understand the concept of leverage or gearing as in Physics or as in real life as an application of Physics can easily understand what can happen in case of financial leverage or financial gearing.

What is Leverage & when is it used?

Levers are used to enhance the effect of limited power available with a person. In other terms, levers are used when one needs more work done but has limited power. In the same manner, leverage is used when one has limited capital, but needs to get higher returns on the same capital. We have the facility to borrow money from those who have surplus; in most cases it is the bank. This borrowed capital added to one’s owned funds allows one to take a bigger position (invest more money) than one could take with only the owned fund. Now we know in levers, if the direction of the force is reversed, the result would be exactly opposite, but of the same magnitude. In financial leverage also, similar thing happens. Let us elaborate this.

Financial leverage is a double-edged sword

An investor has capital of Rs. 5 lacs. He goes to the bank and borrows Rs. 20 lacs. Now he has Rs. 25 lacs at his disposal. Let us say, he invests this amount where he earns 10% on the investment (10% of Rs. 25 lacs is Rs. 2.50 lacs). The profit of Rs. 2.50 lacs is 50% of the investor’s own capital. Although the investment gave a return on 10% on the amount invested, due to leverage, the investor could earn 50% on his capital from the same investment option. And that is the power of leveraging. However, what happens if the money is invested in stock market, which is volatile by nature? Some times, the stock prices move up, but there are certain occasions when the direction changes. Let us assume in the same example that the investment depreciated by 10% instead of appreciating as before. Now the current value of the investment stands at Rs. 22.50 lacs, which is less by Rs. 2.50 lacs than the amount invested. However, out of this, Rs. 20 lacs belongs to the bank (or the lender) and hence, the investor, if he gets out of the market, would get only Rs. 2.50 lacs, which is 50% of his original investment. As seen here, leverage can work both ways.

How do banks (or lenders) assure safety?

Normally, as a matter of safety of their own money, the banks (or lenders) insist for some security against the loans. In the above example, the money that the investor invested is called margin money and the bank has the first right over all the stocks bought for the Rs. 25 lacs. That is the security of the bank. If this is the norm, in banking parlance, the bank has kept a margin (Rs. 5 lacs) of 20% of the value of purchase (Rs. 25 lacs) – margin of 20% is mentioned only as an example; in reality, the margin may differ from lender to lender. In other terms, the bank has restricted its exposure to the investment to the extent of 80% (Rs. 20 lacs of loan in the total investment value of Rs. 25 lacs). When the prices appreciated, the bank was fine since the value of the investment was Rs. 27.50 lacs whereas the bank’s exposure in the investment was Rs. 20 lacs (72.73% – Rs. 20 lacs divided by Rs. 27.50 lacs), which is lower than 80% of the value.

However, when the prices declined, the portfolio value stands at Rs. 22.50 lacs, out of which the bank’s exposure is 88.89% (Rs. 20 lacs divided by Rs. 22.50 lacs), much in excess of 80%. The bank now calls some money from the investor (known as margin calls) to restore its exposure back to 80%. If the investor is unable to meet the margin call, the bank is left with the only option of selling some of the shares in the market. How many shares does the bank have to sell to restore the exposure level to 80%? The answer is surprising (in fact, this also is a result of leverage). The bank has to sell shares worth around Rs. 10 lacs so that the value of the investments is now Rs. 12.50 lacs and the bank’s exposure is Rs. 10 lacs (80% of the investment value – Rs. 10 lacs divided by Rs. 12.50 lacs).

As discussed earlier, the bank calls for margin when the prices decline, and if the investor is unable to pay the margins, the bank is required to sell some shares in the market. This causes the prices to fall further and the bank requires more margin money. Add to this the fact that most of the loans also happen to be for buying the shares where the investor interest is the largest. That means when the banks need to sell shares to safeguard their own positions, most would be selling the same stocks. Eventually, the rally stops and the markets takes a nasty “U” turn leaving many investors shocked with the steepness of the decline.

If one understands the behavior of the markets as per the above discussion, the decline or its steepness is never a surprise. This was set up when the prices were moving up. And every uptick was only increasing the risk level in the market.

Are we suggesting that loan is a bad thing?

Not really. A loan is a good thing as it allows those with limited resources to acquire assets beyond reach. However, as is said about many other things, anything could be good if it is within limits. Loan for buying a house property is generally a good thing as long as one has enough earnings from other sources to pay the installments and that the ability to continue the income in future is good. Taking loan for business is also a good thing as long as the profit margins from the business are higher than the interest cost.

It is important to understand the nature of the loans and the asset / property one acquires. If the asset price is very highly volatile and not generating any income, taking loan for acquisition of such property is a good idea only if, (i) one has other sources of income and other assets to a bankruptcy and (ii) in the short term one has the ability to pay margins to the lenders.

Meeting the above conditions means that the amount of leverage gets capped to a certain extent.

There have been many examples in the history of large institutions and experts completely getting wiped out due to excessive usage of leverage. Those interested in knowing more about the devastation leverage can cause may read a classic called “When Genius Failed” written by Roger Lowenstein.

Amit Trivedi

This article was written when I used to work with Franklin Templeton

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