Is it a time!?

This could be the best time to invest equities. Share prices have fallen to such extents and P/E rations are in lower single digits for many companies.

Financial goal - calculate the rate required

The author of the book described in my previous post gave a very simple method to calculate the interest rate required to achieve a financial goal in the long term. As an investor knows very well, one should always have a financial goal in mind when he starts investing. Otherwise, his approach won't be a systematic one and the returns not as good. Most investors have a retirement goal.

To start, you must compute a variable called Investment Capital. This is an estimate of the amount of money you have invested and will contribute in the future. The equation to compute this Investment Capital is:

Investment Capital = Value of Current Investments + (1/2 * Annual Contributions*Years to Retirement)

From this equation, compute the Capital Fraction as:

Capital Fraction = Investment Capital ÷ Financial Goal

For example, if I have a goal of 20,000,000 that I want my investments to grow to in 25 years. If my current investments are of worth 400,000 and I contribute 100,000 every year to my investment.
Then,

Investment Captial = 400,000 + (1/2 * 100,000 *25 ) = 1,650,000

The Capital Fraction variable would then be computed as 1650000/20000000 = 0.0825

Now, there is a chart with years and Fraction variable matching the compound interest rate required. It is given in the chart below.


From the above chart it is clear that if I want my investment to be worth 20000000 in 25 years, I have to match 0.0825 in the column '25' i.e. my investments have to grow at about 11.0 to 11.5% every year to achieve that. I find this calculation to be very useful. Just create a long term financial goal, calculate the rate your investment has to grow every year and work towards achieving it.

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.

Are Index Funds better than other Mutual Funds ?

I have read at some places that index funds are better than other mutual funds. An example is this blog. Index funds are investment schemes that invest in representative shares of a particular stock market. For example, a fund can have Index fund for BSE or NSE or some other exchange. These funds try to replicate the behaviour of that particular market. For this reason the NAV of these funds rise and fall with the market they are trying to replicate. The main advantage of these funds is that these are automated with no active management needed. So the entry load (the charges paid when you buy a MF) and exit load (the charges when you sell your units) and other charges are low. So, it is generally thought that Index funds earns an investor more profit as compared to other funds like equity diversified mutual funds. I decided to check this yr's results for the Indian market. Hardly 4 index funds have managed to beat the market in 2006. This is called tracking error when automated calculation misses the market behaviour by some points. The best performer has a growth of 49.8% in 2006. On the other hand, about 30 equity diversified mutual funds beat the markets with growth of the best performer being 61.6%. Even after deducting the charges, it is clear than equity diversified funds managed to beat the index funds hands down. Even after assuming that the total number of index funds available to investors is less than the total number of equity diversified funds, it is clear that Index Funds are no better performers than other funds. At least 2006 proved that. The same is true even if we compare last 2 or 3 yrs results.
Check the performance of Index funds here and the performance of Equity diversified funds here.

How do Mutual Funds calculate dividend

MFs normally pay dividend periodically if they are dividend based (D). Growth based mutual funds (G) pay dividends rarely. (D) type mutual funds pay dividend when they make a profit by the trading they have done in the market. It depends upon the fund managers how much percentage of the profit they want to reinvest and how much they want to give back to investors. That money being given back to investors, minus any taxes etc, divided by the number of Units is the dividend per unit. MFs give it a fancy percentage by calculating it from the face value of the unit which is 10. So even if the book value (that is present unit price) is, say 100, the dividend percent is still calculated based on 10. So a 25 dividend per unit would be called a 250% dividend, although it is only 25% of its present price, since it is calculated based on the face value of 10.
Growth oriented MFs pay dividend sometime if the fund has made profit and fund managers find extra cash which is not likely to be invested.

Mutual funds - what if they don't pay you dividend ?

I've mentioned in the earlier posts how Mutual Funds (MFs) pay dividend, and why it doesn't matter as far as your net wealth before and after getting dividend is concerned. In short, dividend is just your money that was in MF which is returned to you. The price of the MF unit comes down after the MF pays dividend. So, overall net wealth is same for you. It is just that the part of the money you had invested in MF is now in your bank. This could lie there if you are not careful. Which is not a great idea. For this reason, unless you need cash, dividend isn't a good option.

So MFs pay dividend which is good if you need money. What if you need money and your MF is not paying you any dividend? In that case you can sell some of your MF units. This is like paying yourself a dividend. The effect will be same as if the MF has paid you dividend! This is called Capital Gain. Funny how the terminology changes for same thing. It is your money in MF that you have invested. If MF gives some back to you, it is dividend. If you withdraw it is capital gain.

PS: I'm trying out a few online money making ideas I found on net and have given the links to the right side of this blog. I will evaluate them time to time and remove links I found aren't worth wasting time, or will add links that I find interesting. Two days ago I found myLot which pays for each message you post in the Forum. So far it seems to be working. Paying rate per message is low though. For about 50 messages sent they pay you $1. It is fun to try, but don't expect to earn a lot of money!

Stock market rebound and mutual funds you must own

The stock market has finally rebound nicely after sliding down for a few days. Investors who bought at the peak when BSE was 14,000 and NSE was crossing 4,000 but sold when market started going down would have lost substantially. That is one of the reasons longs won't be affected by such short term trends or corrections. The market always goes up in the long term and they make money. That's a reason why buy and hold strategy works better in favour of more investors. Similar is the case with Mutual Funds.

Talking of mutual funds, the last issue of Outlook money had a list of 10 you must own. Here's the list in no particular order:

DSP ML Opportunities Fund
Franklin India Flexi Cap
HDFC Equity Fund
HDFC Top 200
Prudential ICICI Dynamic Fund
Reliance Vision
SBI Magnum Contra
SBI Magnum Global 94
Sundaram BNP Paribas Leadership
Sundaram BNP Paribas Select Midcap

Is it wise to own all 10 MFs? Is it possible that a few of them have matching portfolio and hence it wouldn't matter if you buy this or that. Having similar portfolio makes them behave the same with the money invested.
I don't own any of them, but if the Outlook guys have done the research right, some of them look tempting.

Some Mutual Fund jargons explained

Mutual Fund : It's a fund by which people can indirectly invest in the market. These funds normally invest a part of total capital into equity market. You invest into the fund and share its profit/loss. The fund managers look after the money so there's less hassle for individual investors. But it comes with a some fee you have to pay the fund for managing it for you. This means that if you invest directly in the market and hold the same portfolio of shares as the fund, you can make more as there's no fee. There are other factors to affect investments. MFs normally enjoy lower taxes on returns on investment than direct traders. Also, fund managers are experts in their fields with a large capital so they can chose a very diversified portfolio that results in growth over a period.

NAV - Net Asset Value : It represents the value of one unit of a fund. If there are 100 investors each holding say 10 units in a fund which has a total value of Rs 10000, then NAV would be 10000/100*10=10

Dividend option : The fund pays divident periodically to its investors. This makes the NAV go down but the investors get some cash. Overall wealth of an investor remain same before and after getting dividend.

Growth option : In this option the fund doesn't give dividend but reinvests the capital periodically. The goal of this kind of fund is to increase the wealth of the investors by long term investment in the market.

The same fund scheme can have both Dividend and Growth options mentioned by (D) and (G) respectively after the scheme name.

Online trading

Looking at the market dive my enthusiasm to try out online trading has kind of worn off now. :)

Stock market correction?

Hmm, my invested worth came down by more than 1k in the latest market correction (?) in the last few sessions. But the mutual funds I've bought are long term plans. There's a mandatory three year lock in period for tax saver funds which I bought. A good lesson to invest in a systematic investment plan (SIP) so that the gains and losses get even out over the investment period. Otherwise, you may buy MFs during the high times and lose money in the shorter period. Long term investors don't have to worry with such fluctuations in the stock market though, as it will definitely go up in the long term.

I've no idea what's causing the market to go down now, and I've not watched or read news for the last couple of days.

Online trading or Mutual Funds?

To follow up on my last post, a friend told me that ICICIdirect has good online trading service. But now I am in a dilemma. Would it be worthwhile for me to jump into online day trading? Mutual Funds (MFs) seem much safer in the expert hands of fund managers even though they have some fee associated with them. I've read somewhere that MFs have to pay less tax than traders and so in the long run MFs could yield better return. Need to chose MFs which are diversified.
Guess I will wait for a while to learn more about the pros and cons of Online trading vis a vis MFs.

Looking for a good online trading site

I'm looking for a good online trading site. I've heard of a few like icicidirect, kotaksecurities, sharekhan and 5paisa. Unfortunately, most of them seem to like only IE as a browser as clearly mentioned in their site. Now we don't use Windows at office where most of my weekdays are spent, and from where I'd have to do the trading. Are there any good sites which go beyond Windows IE? I'm specifically looking for one which can be used with Firefox.

Looking at the Gateway account info at kotaksecurities, they ask for a margin of 20,000. Does it mean I've to invest at least 20,000 to begin with? I didn't get any info there about what it means.
20k is a bit too much for trading for a newbie like me. I am looking to start with an amount below 5,000 to learn the tricks of the trade. If anyone has knowledge and experience with a good online trading site, I'd like to know more. Thanks!

Real Estate investment

A couple of my friends are taking loans from bank to buy an apartment in Bangalore. One of them is planning to take a home loan of Rs 2,000,000. He plans to live in a rented apatt and put his newly bought apartt on rent. So I believe he's taking the house as an investment.
The doubt I had in mind was if it was a better option than other forms of investments where he doesn't have to take loan and still could invest enough over a period of 20 yrs. Of course, the value of his apatt will increase with time. Still, I would be uncomfortable in such investments. I have no idea about how real estate works. Only time will tell how wise the investment is.

Eight Indian mutual funds among world's top 10

Interesting news item. For a period of last 10 yrs, 8 Indian MFs are among top 10 in the world! For 5 yrs period 7 Indian MFs among world's top 10 performing. Interestingly, in the short term period of last one yr there is not a single Indian MF among top 10. Strange as it has seen the big run in the Indian stock market. Does it mean Indian MFs had the long term horizon in their mind and didn't actively trade when the market soared?
Times of India article here

Which insurance to take!?

There’re many options to chose from in insurance. I’ve always thought of insurance as something that we take away from savings periodically and get most of it back when the insurance period ends. It could be 10 or 20 or any number yrs when the policy terms expires.

Recently I came across another kind of insurance which I think is the best one to take up. It is called term insurance. The idea is that you invest some amount every yr in this insurance. In the event of any eventuality, which basically means if you die before the policy term expires, your dependents get the money you’re insured for. If you outlive the term of the policy, you get nothing.

For an example, for a 28 yr old person, under the popluar LIC, in the 20 yr moneyback policy, if you want to get 1,000,000 moneyback 20 yrs from now, you have to pay a hefty premium of 62,360 per yr for 20 yrs. That comes to a total investment of 62,260*20 = 1,245,200 over a period of 20 yrs. He gets 200,000 back every 5 yrs and the remaining amount plus bonus at the end of 20 yrs. LIC premium calculator

In case he invests the 200,000 he gets every 5 yrs in MFs, at the end of 20 yrs the amount would have grown to 3081400 + 1238340 + 497660 = 4817400. Adding the remaining 400,000 plus bonus he gets at the end it would go upto 5500000 at most. Still much less than what he can grow the money with term insurance and MFs from the beginning.

If the person takes a term policy instead for 20 yrs for insurance of 1,000,000, he has to pay just Rs 2890 a yr. Over a period of 20 yrs, the total amount he has to pay is 2890*20=57,800. He loses this amount if he outlives the policy. It is just a cover for his dependents who get a sum of 1,000,000 if the person dies within 20 yrs.

So what can the guy do? Well, let’s take the difference in the amount he has to pay over 20 yrs for the two policies discussed above : 1245200- 57800=1187400

So he can invest the amount 1187400 into some growth based mutual funds over a period of 20 yrs. He has to invest Rs 59,370 every yr ( or Rs 4948 every month ) for 20 yrs. At the end of the period at the average rate of return of 20% (for long term funds are known to increase at 20% ), his savings from this turns out to be a Rs 12,067,460. That is 1 crore and 20 lakh plus! magic of compounding

So, it seems the best option is to take a term insurance for 20 yrs and invest the rest of money in such funds or other schemes with a good growth history. If anything happens to him in these 20 yrs, he will leave 1000000 for his dependents. Also, the amount he has invested until now would also have grown to some extent. If he outlives the policy, his investments have grown upto 12067460 while he only paid a total of 57800 for term insurance, so he can be sure of a comfortable life for himself and his family whether he lives or dies in 20 yrs!