Ouch! That hurt!

Most of us who have invested in securities (stocks, bonds) this year have seen deep red splashed all over our portfolios. It’s been one harrowing ride after another, all this year. This, after a fantastic 2017, where the markets went only in one direction, that is up. Investors grew very complacent after they were lulled into seeing day after day of low volatility, with markets globally trudging ever higher. Almost everything went up, not just stocks… bonds, bitcoin… you name it. Even stuff like “Tulip Coin” and “Dogecoin”, were able to skyrocket in value. The Tulip Coin was literally referring to the Dutch Tulip mania and the Dogecoin was a joke currency based on Shiba Inu from the “Doge” Internet meme. Talk about irrational exuberance!… The saying “a rising tide lifts all boats” couldn’t have been any truer.

2018 has been a whole new ball game. Volatility is back with a vengeance. The indices have been whipsawing violently with a +/- 2-3% gyration almost on a daily basis. Most of the major world indices are in bear market territory (-20% from the top). The crypto currency space has bitten dust as I predicted. Bonds are threatening to go into a protracted bear market after 3 decades of bull run. The adage “all good things come to an end” has proven itself to be true again in 2018. What should one do in such a scenario? Ordinarily, I would have said “nothing … just stick to your investment plan through thick and thin” and this is exactly what I am doing. But I think there is a more fundamental issue to be addressed before I just say “stick to the plan”. I think the key issue here is the “plan”, which in my case means the asset allocation plan. Let me explain…

Over the past year, I have been helping out a few individual investors to come up with an asset allocation plan. When I asked, before I started with the plan, almost everyone said they were very risk tolerant and wouldn’t lose sleep even if the losses were up to 50% of their portfolio value. I took their word for it and derived an aggressive stock heavy asset allocation plan. Now that they are seeing real losses, not 50% but just 5%, they are losing sleep and want to change the strategy to a more conservative one. I learnt a valuable lesson, never ask people how much risk they can take, as it would be very difficult for them to quantify, especially given that there hasn’t been a real bear market since 2012-13, in India, and most individual investors have pumped in huge amounts of money into the stock market only in the past couple of years. They simply don’t know what it feels like to see their portfolio suffer 20-25% loss in value.

Where there is a lack of experience, people tend to overestimate their ability to endure pain. This has a real base in psychology as well – the Dunning–Kruger effect is a cognitive bias in which people of low ability have illusory superiority and mistakenly assess their cognitive ability as greater than it actually is. I think this same effect is applicable to risk taking ability as well. People without actual experience tend to say that they have more risk taking ability than they actually do. Only when they are really hurt do they realize how much risk they can actually take.

Given this, when one starts investing, how does one arrive at one’s real risk appetite? Especially if one hasn’t suffered painful losses before? The only alternative I can think of is based on an honest appraisal of one’s risk appetite with the aid of risk attitude assessment models. The “Assess your attitude to investment risk” is an assessment model developed by Oxford Risk, an independent team of leading psychology academics originating from Oxford University. There are many such models available on the internet.

So, to every Investor, even before attempting to create an investment plan, please do asses your ability to take risk and use that as an input to derive your asset allocation plan. Things also change as time passes by, so, do assess your risk appetite once in 5 years and course correct your asset allocation plan accordingly.

I would like to end this topic by reciting an incident out of J.P. Morgan’s life, as it relates to seeing losses in one’s portfolio. When a friend complained, to Morgan, of restless nights, worried about his stock holdings, Morgan’s advice was to “sell down to the sleeping point.” This is very sage advice.

Lastly, I’d be remiss if I didn’t say “do nothing … just stick to your investment plan through thick and thin”… you’ll come out fine on the other side. Also remember, don’t bet on individual stocks, finding winners would be like looking for a needle in the haystack. It’s better to buy the whole haystack, i.e. the market, you are bound to have many needles in it. Also diversify geographically if possible.

With that said, I wish all my readers a very happy new year, may your investments touch new highs in 2019.

Let the good times roll!

Ka-ching! Is that the ringing of your money registers?
All over the world, the major stock indices are on an upward tear. Most people invested in the stock market before Trump’s election would be sitting on substantial gains. No amount of bad news seems to deter the market for more than a couple of trading sessions. All the losses are recouped in no time at all. In fact it has been a nightmarish market for short sellers, who have had to cover their shorts or risk losing their shirts (pun intended), as the markets seem to shake off all bad news and grind on ever upward.

The below chart shows how the stock markets across the world have performed year to date.

The complete report is available here.

As you can see, all the markets have moved up pretty much in lockstep. Ray Charles, in his 1959 Grammy winning album “The Genius of Ray Charles”, sang the famous song “Let the Good Times Roll!”. And the Good Times are indeed Rolling …. but sadly, all the Good Times must always come to an end.

There is a famous stock market saying that “Trees don’t grow to the sky.” Something which has gone up must reverse course and fall back down.
Are we all in a ginormous asset bubble? When is it going to deflate? What do we do about it? The answers to these questions are almost impossible to give. The legendary Jack Bogle says

“After nearly 50 years in this business, I do not know of anybody who has timed the market successfully and consistently. I don’t even know of anybody who knows anybody who has timed the market successfully and consistently.”

If investing legends, with their armies of analysts, cannot predict what the market will do, should mere mortals like us do something? The answer to this is “no” and “yes”. No, you shouldn’t do something based on your fantastic intuition, tips from business news channels, sure things from colleagues, and dare I say anyone. Yes, you should stick to your asset allocation strategy and re-balance on a periodic basis, pruning your winning asset classes and shifting the money to your losing asset classes.
Do I hear you say, what the heck are you saying, shift money to your losers? Yes, remember what goes up must come down and what comes down must go up.
This is the best you can do when you cannot time the market and, in the long run, this provides you with the best returns with reduced volatility. I am not talking about individual stocks here…. I am talking about broad asset classes, like re-balancing between stocks, bonds, cash and real estate.

Fads, Bubbles and Manias will always we a part of the financial markets. Be it the Tulip Mania or be it The South Sea Bubble or, more recently, be it the Japanese Real Estate bubble. There is a fascinating book by Charles P. Kindleberger & Robert Aliber called Manias, Panics, and Crashes: A History of Financial Crises. This book is a must read for all serious investors. The authors chronicle the way that mismanagement of money and credit has, time and again, led to financial explosions over the centuries.
Did you know that at the peak of the Japanese Real Estate bubble in the mid 80’s, the ground under Tokyo’s Imperial Palace, which was about the size of Disneyland, was assessed at a value greater than the entire state of California. In hindsight, this looks ridiculous, but if you were in the mid 80’s, the biggest of financial institutions, with the greatest of intellectual fire power, were investing lock, stock and barrel in Japanese real estate. Adjusted for inflation, the Japanese real estate market has still not recovered, after 30 years, to the pre-crash levels. This gives further credence to what Jack Bogle says…. no one can time the markets consistently. Suffices to say, super starts of a few years ago, David Einhorn, Bill Ackman, et al., have under performed the broad S&P 500 index the past couple of years. You could be a one hit wonder by pure accident… can’t you? Its the long run record that matters.

It pays to be cautious when all the cash registers are ringing simultaneously. The party cannot go on for ever. Consider the crisis Trump is going through, the markets took a nose dive when Watergate happened under Nixon and Monica Lewinsky happened under Clinton. Why is it different this time? I don’t know the answer to that. May be the collective wisdom of the market is better than my individual wisdom. May be this crisis will blow over and the US administration will get to reforming the tax code for corporations. Markets this time don’t seem to be reacting to the uncertainty, or maybe everyone is in an illusion.

Illusion is the first of all pleasures

– Voltaire

Talking of illusions, one only needs to look at the way cryptocurrencies have rallied in the past couple of months and the volatility they have displayed, having huge swings on their way up, I can’t fathom why. People have made money ….. and dare I say, lots of money. How are people valuing cryptocurrencies? Shares entitle you to get the stream of profits from a corporation, bonds enable you to get the stream of interest payments and real estate enables you to get a stream of rental payments. What is the asset backing cyptocurrencies? Isn’t printing of currencies the sole domain of sovereign governments? If so, will the governments give up this right so easily and defer to a cryptocurrency which is not issued by them? How can there be such wild swings in the value if cryptocurrencies are a store of value akin to gold?

Is this all smoke and mirrors? The illusion of everything being hunky dory. Are there invisible fault lines developing in the markets? I don’t know the answers to these questions…. If I knew, I would be in my 200 foot yacht, docked in Monaco. Since I am doggedly sticking to my asset allocation strategy, almost mechanically, even if things take a turn for the worse, I wont be left groping for my pants. I will use Buffet’s inimitable way of conveying this in a folksy way….

“Only when the tide goes out do you discover who’s been swimming naked.”

I can safely say….. let the good times roll, but, I will come out OK even when the shit hits the fan…. can you all say the same?

 

Read the disclaimer here.

Where’s my free lunch?

Most of us have heard the popular adage “There’s no such thing as a free lunch.” This was made popular by one of the staunchest proponents of free-market economics, Milton Friedman, when he wrote the book bearing this phrase as the title, in 1975. What most people don’t realize is that this phrase was not “invented” by Milton Friedman but by Robert A. Heinlein, who used it in his 1966 science-fiction novel The Moon Is a Harsh Mistress.

Harry Markowitz, in his seminal paper “Portfolio Selection”, published in 1952 by the Journal of Finance, laid out a theory for portfolio construction which minimizes the expected risk and maximizes the expected returns. He called it “Modern Portfolio Theory” or MPT for short. More about MPT in a later post. His ideas were so much ahead of their time that it took a few decades for them to gain traction on Wall Street. Finally, the Nobel Committee recognized the significance of his work and he was awarded the Nobel prize for economics in the year 1990. He once famously said that the only free lunch available to investors is diversification. Many notable economists such as Bill Sharp, Merton Miller, Eugene Fama, Burton Malkiel & Jack Bogle have used this as a basis for their own work.

Most cutting edge research & intellectual output, in the past 200 years, has come out of a few top universities in the US. The work done by the above mentioned economists is no different. They have all been nurtured and paid for, at least partially, by the universities. Have you ever wondered how these universities find the money to fund so much research? Do I hear “the tuition fee paid by the students”? The answer is no, the tuition fee doesn’t even scratch the surface. The government funds a lot of research where the output has implications on defense or public good. Many private firms too fund university research. In fact, a lot of Wall Street banks provide research grants in areas which might have a real impact on the business the firm is doing. But, for most work which doesn’t fall under either the government or the private bucket, there is one more source of funding, especially in the top universities. This hidden treasure is called the university endowment. This is the money people, typically alumni, have donated to the university. The endowments of some of the universities are bigger than the GDPs of most countries. Here are the top 10 US universities in terms of the size of their endowment chests.

University name	Endowment size (2015)
Harvard University	$38 Billion
Yale University	$26 Billion
Princeton University	$22 Billion
Stanford University	$22 Billion
Massachusetts Institute of Technology	$13 Billion
University of Pennsylvania	$10 Billion
University of Michigan—Ann Arbor	$10 Billion
Texas A&M University—College Station	$10 Billion
Columbia University	$10 Billion
University of Notre Dame	$9 Billion

These numbers are mind boggling. In fact, the Harvard endowment is bigger than the GDPs of half of the countries in the world. Does this mean that all the money these Universities have has been donated? The answer is no, the universities hire endowment fund managers to invest this money and generate meaningful returns for the university. That is how the pot has grown to such gargantuan sizes. These endowment fund managers seldom make the headlines or have their faces plastered all over CNBC or Bloomberg even though most of these managers have a better record than the Wall Street Hedge Fund managers… who seem to be dime a dozen nowadays…. constantly hankering for media attention and investor money.

One of the most legendary endowment fund managers is David F. Swensen, the Chief Investment Officer of Yale University. He has managed the Yale endowment for the past 30 years, generating a return of ~15% on an annual basis for this period. This record is unparalleled in the world of endowment fund managers. This record is all the more enviable given that Yale University imposes some restrictions on how much risk the fund manager is allowed to take. Most universities have similar restrictions. This limits the universe of investment options the fund manager has at his disposal.

David Swensen chronicled his approach in a couple of books: Unconventional Success: A Fundamental Approach to Personal Investment and Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, the first of which is good read for individuals like us.

If I were to boil down his investment mantra into a bunch of easy to remember/ implement points, they would be

1. Don’t try anything fancy, especially if you don’t understand it or have half baked knowledge… this is a recipe for failure
2. Stick to a simple diversified portfolio….with exposure to various asset classes…. he also says that asset allocation/ diversification is the closest you would ever get to a free lunch in the investment world
3. Keep your costs down…. be it the management fees charged by funds or the brokerage charges levied on trading or the taxes owed due to realization of capital gains
4. Re-balance periodically to keep your asset allocation in line with your long-term goals… no more than twice a year though, to keep the costs low

Sounds very simple and intuitive doesn’t it? Most people fail to make good returns in the market because they fail consistently to do one or more of the above “simple” things. I have used Swensen’s model portfolio and adopted it to the Indian situation with examples of possible asset candidates. Click here to see his original model portfolio.

1. Stock – 55%
   • Domestic equity – 30% (Nifty, Sensex, Nifty Junior, Midcap 100 ETFs)
   • Foreign developed equity – 15% (NASDAQ 100 ETF, Developed Market mutual funds)
   • Emerging market equity – 10% (HangSeng ETF, China or Emerging Market mutual funds)
2. Bonds – 30%
   • Corporate bonds – 15% (Too many options …. choose a wide basket of AAA, AA bonds)
   • Sovereign or Quasi Government Bonds – 15% (RBI Bonds, Bonds issued by companies where GoI is the majority owner … SBI, NTPC, NHPC, PFC, REC, IRFC etc.)
3. Real Estate – 15% (REITs… will be available in India soon…. and Property investments)

This is not a silver bullet allocation… one needs to modify the allocation suggested by Swensen to suite his own individual circumstances.

As a part of his Financial Markets course, Bob Shiller, another Nobel laureate and professor at Yale University, always has one guest lecture session by David Swensen. Anyone interested in serious investing should definitely watch this lecture …. and indeed the whole course, which is available on YouTube. The link to the full course playlist is here. If you don’t have the time to listen to all the lectures, but only want to “sit in” on David Swensen’s guest lecture session, the video is below

One becomes a successful investor not by executing trades suggested on CNBC… but by coming up with an analytical framework and sticking with it under thick and thin. The surest way to lose money is to change ones investment philosophy when things start going south…. In fact, I feel that in times of distress one needs to be more committed to ones philosophy. The markets will test your patience, and reward the one who perseveres through the tough times. Having said that, the analytical basis for the investment framework needs to be sound and backed up by historical performance…. An example of a philosophy I would call flawed would be to say I will blindly buy everything that Porinju Veliyath buys….. because he has done well and is suddenly the talk of the town. By all means do take his advice, but don’t substitute it for your own thinking and framework.

You must realize that there are always 2 parties in any trade… if you are buying, the person on the other side of the trade has the exact opposite thesis to yours and is selling…. and if you are selling, the person on the other side of the trade has the exact opposite thesis to yours and is buying…. one must clearly be able to articulate why he is right when the person on the other side is doing exactly the opposite thing…. What makes you think that you are more “intelligent” than the other person…. and hence it is you who is poised to win? Especially given that you don’t know who the other party is … for all you know it might be a fund manager who has an army of analysts whose daily job it is to find investment ideas.

Do you think there are other free lunches apart from diversification and asset allocation? Isn’t “free lunch” food for thought? Do share your observations/ thoughts.

Addendum:

1. Harvard endowment performance – click here to read

Read the disclaimer here.