Investment blunders of the rich and famous

I've just finished reading a book on Investments, named "Investment Blunders of the Rich and Famous...and What You Can Learn From Them".

Some of the important advice the author of the book gives to investors, and some of his comments in the book are:

- Beware of cheerleader advisors.

- If you have a clear picture of your preferences for the future and what you need to accomplish them, you simply pick the investment alternative that best meets your needs. However, the person with unclear preferences doesn't pick the alternative that fits the goals; he or she picks the option that looks best compared to the alternatives.

- The willy-nilly approach of most investors gives them a lack of solid foundation from which to make decisions. As a result, investor allocations and stock picks are frequently not aligned with their goals. One consequence is that the typical investor spends time moving money from one investment to another, trying to meet an obscure goal. Investing without a plan, or road map, leads to a lack of discipline. The lack of discipline allows your psychological biases and emotions to invade the process

- The more active the investor, the worse the net return. Cost of trading eats away a big part of the investment. Active trading magnifies your emotions and psychological biases that cause these bad choices.

- Investors don't like to sell losers, only winners. They sell when the stock is going higher and hold on to the stock when it is going low. This is not a good strategy.

- Investors have fixed their sights on the purchase price. This is called anchoring. Investors frequently anchor their hopes to fixed prices. The purchase price is one anchor. The highest stock price the investor has seen also becomes an anchor. Investors typically wait for the stock's price to reach these anchors before making a trade.

- Gamblers tend to treat winnings as if the money is not quite theirs yet. Their behavior seems to suggest that the profits are still the casino's money. Specifically, the feeling of betting with someone else's money causes you to accept too much risk. Similar behavior could be seen in the stock market, too.

- Many investors have realized the alluring trap of frequent trading and using debt to buy stocks. People have gone bankrupt when they borrow to trade.

- In order to earn a high return, you must take market risk. We want to take market risk while avoiding firm-specific risk. This is because we are compensated for market risk, but not for firm-specific risk. If you own just one stock, you are taking both types of risk. In fact, most of the risk you are taking is firm-specific risk. However, if you add one randomly selected firm to the firm you hold, you reduce the total risk in your portfolio by 24%. This risk reduction is completely due to the reduction in firm-specific risk. Add two more randomly selected stocks and the total risk in your portfolio is only 60% of the risk of holding just one stock.

- It now makes sense to reduce the firm-specific risk in your portfolio further by holding over 20 randomly selected stocks. In fact, a 30-stock portfolio is optimum.

I found the book title a misnomer since the book was about general Investment theories and not about investment blunders of the rich and famous, but it was an interesting read.

Gambler's Fallacy

There are people who see patterns in random data and try to predict the future based on such patterns. Probability theory states that for an unlimited set of trials, the numbers in a game should come up equally or the same number of times.

For example, a coin when flipped a given number of times, should have equal number of heads and tails. So, if the coin has been flipped 5 times and the outcome have been head, head, tail, head, head, the outcome has not been what was perceived. A person might assume the chance of the next outcome being tail is more as it has only occurred once in the last five tosses. The reality is that the next toss has equal chance for tail and head, both have 50% chance. The past events don't mean anything for the future outcome. But, the person thinks there'll be an unknown self-correction that will skew the results in favour of tail to make it more balanced as per probability theory. This belief is known as the gambler's fallacy.

There are similarities in such beliefs with trading. Predicting the price change at any time is like flipping a coin. Most of the patterns that are found are a result of the random data searched. These patterns are not likely to repeat in the future. They can't be used to make predictions. But people often make such predictions and others fall for them.

Rule of 72

Here's a simple rule of thumb to quickly calculate compounding interest in your mind. It is called the rule of 72.

To calculate the annual compounding interest required to double your money in a fixed number of years, or conversely, given an annual interest rate, to calculate the number of years it would take to double your money, divide it my 72.

For example, if the rate of interest is, say 9%, it would take 72/9 = 8 years approx. to double your money. Similarly, if you want to double your money in, say 6 years, you'd need an annual
compounding interest rate of 72/6 = 12%.

This rule gives good results for upto 20 years or 20% rate, and very good results at typical compounding rate between 6% to 10%.

The same rule can also be applied to find out the number of years for the value of money to get halved at a certain inflation rate. For example, for an inflation rate 6% it would take 72/6 = 12 years for the value of your money to get halved. This means the money which gets you a certain commodity now would only buy half of that after 12 yrs. In other words, you'd need double of this money to buy the same thing after 12 yrs.

How double indexation works for FMPs

My last post discussed FMPs and why they are better than FDs because of Double indexation benefits. I'll discuss how double indexation works for FMPs against FDs, for the same amount of investment:

Let's say you invest Rs 1000 in FDs and Rs 1000 in an FMP in March this year.
The maturity value in May next year for both FD and FMP = Rs 1100 approx.
Assuming inflation of 6%, the cost price of your investment after March this year = 1000 + 1000*6/100 = Rs 1060
Cost price of Rs 1060 after March next year = 1060+ 1060*6/100 = Rs 1123.6
For FMPs the maturity value of Rs 1100 is less than the cost price of Rs 1123.6, that is you are at a loss in paper. This happen because the effect of inflation in case of FMPs is calculated twice, at the end of March this year (that is the financial year end) and also at the end of March next year. This results in capital gains tax = 0. This is double indexation benefit.

For FDs, the cost price = Rs 1060 ( it is calculated only once ).
Maturity value of Rs 1100 is more than cost price, so you have to pay capital gains tax on the interest earned.

This results in FMPs giving a post tax return of about 8.5%, where as FDs give about 5.5%. This is for a period of about 13 months of investment that started in March and ended in May.
FMPs don't work for you in case you want to withdraw the money invested before the maturity period. Then FDs might be a better choice.
If one is sure they can remain invested for the period, then FMPs are a good choice over FDs.

Fixed Maturity Plans ( FMPs )

Recently, I read about Fixed Maturity Plans or FMPs as they are commonly known. These plans are of about 13 months duration and give better returns than Fixed deposits (FDs), normally. FMPs manage to do that because of Double Indexation benefits. Double indexation basically is - showing the effect of inflation on your investment for two years even if the investment is for only slightly more than a year. Since the financial year ends in March, FMPs show the period of investment from March of the year of investment to May of next year. This results in showing on paper the final value of investment as being much less than what it is in real. This results in less tax to be paid and more net return to the investor. FDs in banks, even if they give the same % return like FMPs don't have such double indexation benefits and so the investor ends up paying more in taxes and gets less net return.

In effect, while FDs manage to just beat the inflation, FMPs manage to grow the investment. FMPs, thus, are a better choice if one has money they are sure they can invest for at least 13 months.
One thing I haven't found yet is if FMPs are available all year around, or just around March. Would they be available in May? According to a relationship manager, they should be.

Feed aggregator

I was a latecomer in the area of feeds. I used to read all the blogs I liked by individually opening them in new tabs in my Firefox browser. This posed some problems. I had to remember each of the blog addresses I wanted to read. This meant I would often miss some recent blog entries by my favourite bloggers. This is not a very serious problem as blogs can be bookmarked. But still I had to open all the blogs one by one going through bookmarks. Now I read about 25 blogs religiously and wouldn't want to miss any new posts. That would mean 25 tabs in Firefox. As much as I like Firefox, it is a resource hog and opening 25 tabs would often make my computer less responsive.
Enter Feeds. A simple but powerful technique to arrange all your favourite blogs. Now I have installed a Feed reader called Sage. Whenever I want to read blogs, I just click on the Sage icon on the toolbar and all the blogs I have subscribed to show up on the left pane of Firefox. If I want to see if there is any new post I can just click an icon on top of the pane called Check Feeds and it automatically looks at every blog for new postings and updates the pane accordingly. If I go to a new blog that I like, I can just click Discover Feeds icon and it automatically discovers the Feeds in the blog and I can then add it to Sage. Two kind of feeds are popular: RSS and Atom. I wanted to make it simple for me by choosing only one of them, so I chose RSS feed reader but Atom is good as well. Many blogs don't have obvious Feed icons, but there are almost always hidden ones, for example in blogger/blogspot. Discover Feeds will discover them all.
It has made reading blogs a breeze. Just click any blog you want to read in the left Sage pane and start reading. Sage blog aggregator for Firefox can be downloaded from here.

Business and trademarks

A couple of days back I was discussing about Google with friends when one of them mentioned that Google has become such a well known brand that it has entered into Merriam-Webster dictionary as a word. I told them this is actually not a good thing for a brand. They didn't believe what I was saying. Having done a trademarks course I know a thing or two about it and explained it thus:
Google has created a unique product for search which is widely acknowledged as the best online search engine. It has a unique advantage over competitors now. Anyone wanting to search online would first think of Google search. This is because the brand differentiates it from competitors such as Yahoo or MSN. Users are well aware of it and so they prefer Google search over other engines. But if it becomes a generic dictionary word then it lose its value as people would start using the term Google or worse 'googling' for online search. It wouldn't matter to users then which engine they use. Google for them would mean online search. The differentiating factor that was Google's brand then lose its advantage. One could as well go to Yahoo search and say he is googling.
In the history of brands there has been many a cases where companies lose their valued trademarks because they become generic nouns. It is for this reason that companies tend to use their trademark always as an adjective. Google search, for example. It is almost always followed by a noun. It is for this reason that Google wouldn't be amused if someone tries to make a word 'googling'. Companies protect their marks for the fear of it becoming generic, sometimes even launching PR campaigns.
Some brand owners didn't protect their marks well enough and they have become generic nouns and some are almost on the verge of becoming one.
Some examples of tradmarks that became generic and hence lost the advantage over other products are:

Aspirin: The product name became generic noun and now companies use it just as synonym for a particular medicine.
Escalator: Was a brand, now a generic English word.
386 : This was Intel vs AMD case which Intel lost and also lost the advantage of brand 386.

Some trademarks on the verge of becoming generic are:
Kleenex : Tissue paper.
Xerox : People have begun using Xerox word as a generic word for photocopy. Xerox is fighting to prevent its term from becoming generic by launching PR campaigns.