Where to Invest My Money ?

Almost anyone who has some amount of surplus capital is faced with this question. More so with youngsters who have just started their careers, and have fewer responsibilities to cater to. But there never seems to be a very convincing answer that can be found. In this article, let's take a deep look and find out where we get to in our quest for figuring out the best possible choices when it comes to parking our money.

Investing is Personal

There is no one size fits all approach when it comes to investing. One must understand that just because something worked for someone does not mean that the same will work for someone else. On these lines, it is important to emphasize that there are notions people have about replicating the investments of the most successful investors, which are almost certain to fail. Why? 

1. Do you have access to the quantum of capital like the investor you are trying to follow?
2. Do you know the complete list of investments that he is making? What if you only have access to the list of his lowest-performing assets?
3. Do you get to know when he is entering or exiting his investments?

As you will easily notice, the answers to most of these questions are negative. Therefore, even if it was a good idea to simply replicate the investments of successful investors, there is clearly no access to sufficient information. But wait, the idea is not good. Simply because every investment has an objective and this objective varies with every individual.

Every Investment Must Have an Objective

You must not invest anywhere unless you know what you are expecting out of that investment. Every investment must have at least one desired outcome. For example, the most common being, capital appreciation. Other goals are the protection of capital, tax savings, keeping up with inflation, saving for a life event etc. But that is only a part of the story. These words have no meaning unless you attach a number to them. How much capital appreciation are you looking for? What is the maximum drawdown you can accept? Does preservation mean "no erosion" or are you okay with the erosion of capital with dwindling currency values?

Once you have an answer to this question, you'll be faced with the other side of the coin. What are you willing to pay to get your desired outcome? For capital appreciation, how much risk are you willing to take? For the protection of capital, are you willing to lose the opportunity of capital appreciation? Or maybe, are you willing to lose your access to liquid cash, should there be a lock-in period for some insurance plan? For a retirement plan are you willing to commit to paying a premium for a given period of time?

Yes, like every other thing in life, investment is always a tradeoff. We must pay something to get what we want. But the point here is, we must know what exactly we want before we commit our money. 

Once we are able to answer these questions, it will be very easy to notice how different we all are in terms of our investment goals. Evidently, our choice of investment options will also differ. More importantly, you will be well aware of your expectations and will know what to ask for when a broker tries to sell you an investment product. 

Money is Not Cash

Why you must rack your brains to invest your money somewhere is a question you might have. Please remember, that the money you are willing to invest did now walk into your bank account out of nowhere. You and your family members toiled countless hours to earn that money. You spent almost two decades of life in formal education, with all its rigour, costs and effort, in order to become qualified for the profession that you have today. so the money you have today, is not to be treated like another piece of paper. It is your toil, in hard copy. Value it, and value it highly. 

When you need to keep it somewhere, you will have to be aware of where you are keeping it. Would you send your child to an unknown place just because someone asked you to do so? Treat your money similarly. If you're not, probably you are not valuing yourself enough. 

You Will Change, So Will Your Priorities

Something we all know, but often forget to align our investments with. Why not create a simple matrix of financial priorities for yourself? Not only will you be able to plan more wisely, but also be clear about what you really want to achieve with your financial resources. Priorities keep changing as we progress in life and therefore a rigid plan is sure to fail. While priorities decide our investment objectives, one thing that is always necessary is safety. In exploring financial products that align with your objectives, be sure that you are making choices that are safe to the extent you want them to be. Make sure you read our article on the pitfalls of financial products before you decide on your next move.

Returns Can Be Non-Monetary

Investing in assets that generate income is fine. But it is not necessary that the return on investment will always be monetary. Based on your priorities, and the stage of life you are in, you will need to invest in education, skills, fun and relationships. All of it will cost money. You will need to buy books. you will need to buy tickets to a concert, and you'll need money when you want to buy something nice for the person you care about, to make him/her feel happy. Yes, and each of these is an investment. 

The Most Important Investment

Money is a resource and is renewable. What you spend today can be earned again. But investing is not always about money. We invest our resources, money being one of them. The most valuable resource we have is time. Because it cannot be earned back. While we are busy thinking about growing our money, we must also think about where we invest our time. In fact, that should be a bigger concern for us given the nature of the resource.

We must invest our time in activities that add meaning to our lives, that add to our purpose, that spread smiles and help us grow. After all, we want to earn money for a reason. And we cannot let that reason slip out of our mind.

How to Save Yourself from Being Wiped Out of the Market

We have seen several "experts" predict stock market prices with their impeccable analysis and forecasting tools. We have seen them value stocks with their seemingly infallible techniques. We have seen them claim their own glory in beating the market 85 % of the time. And those who have observed them for long enough have seen them fail miserably. Which brings us to the question - is it really impossible to predict stock prices?

With whatever I have observed, I tend to believe that it is impossible to do so. Not because people lack the ability to do so; we have enough brains and enough computing power to accurately determine anything that can be determined. It is because the market is not an exact science. And in such cases, it is wiser to use a probabilistic model. When we say that there is a 90 % chance of something happening, we are also saying that there is a 10 % chance of it not happening. Strangely, humans are wired to ignore the latter. We confuse a 90 % probability with certainty and that heralds our doom.

There have been innumerable cases where people have invested huge sums on a particular bet and it just so happened that the 10 % chance of the event not happening prevailed. Consequently, large sums of money were lost. This is the very reason why we must learn one very important lesson in our investing journey - position sizing.

Having said that, it is noteworthy that when things are uncertain, it is prudent to be open to change. In an uncertain environment, nothing is etched in stone. Not even the size of our positions. Whether the stock moves in our favour or otherwise, we must keep recalculating our bets and add/reduce our position accordingly. We will look through a very detailed example and understand how to get a hold of this technique.

We derive our formula from the famous Kelly Criterion. For those having an inclination towards mathematical research papers, I recommend this book that will explain the concept in ample detail. The Kelly Criterion is a precise tool to calculate the size of our investment in a given trade. While it has its applications in other areas as well, we will confine ourselves to its use in investing in the stock markets and other asset classes. 

The formula is given as follows :


f * is the fraction of our entire funds that can be invested
b is the winning multiple, i.e. the factor by which our initial investment will be multiplied
p is the probability of winning
q is the probability of losing, which is 1 − p

As a simple illustration, let us consider a simple investment in a CFD issued by a company which has a 5 % chance of going bankrupt and not paying out its commitments. We assume the CFD to pay a 5-year return of 8.75 % which means our b is 1.0875, p is 0.95 and q turns out to be 0.05. Kelly suggests that we wager 90.402 % of our funds in such a scenario. However, things get far more complicated when we trade stocks or derivatives since we cannot determine the odds of our winning in any situation. In fact, we are not even sure of the winning multiple in such cases because we never really know for certain how far the stock price will move even in the case of a favourable move. In order to discount this uncertainty, we will use a 50 % probability of winning.

Obviously, the winning chances are higher in every trade, which is why we enter the trade in the first place. Had it not been so, trading in stocks would be akin to a gamble. Traders use their judgement and select a particular stock from a sea of available options because they have some justification in that choice. Which explains why the chances of a win are certainly higher than 50 %. But since we are never sure of the exact return that trade might deliver, we bring down the win chance to 50 % in order to account for this uncertainty. On the other hand, we will use a multiplier that reflects our expectation of where prices might reach in the ensuing move. 

In the above example, let us say we buy at 57.50 with an expectation that the price will reach 70.35. The emphasis here is not on how we figure out the target price. That varies widely depending on the analysis technique used. What we are trying to look at is the multiplier that we shall consider for our calculation. In this case, the winning multiplier will be 1+ {(70.35 - 57.50)/57.50} which is 1.2234. Using the Kelly equation, we see that the suggested investment size is 9.13 % of our corpus.

Talking of the long term, let us take a look at what this seemingly simple formula does for us. Here are some equity curves that we must look at.

We simulated a sequence of 1000 trades where the win/loss is decided at random and two scenarios are evaluated. One equity curve is drawn assuming the investment size is determined using the Kelly Investment Criterion while the other is drawn assuming that the investor uses 30 % of his corpus for each trade. We have considered that each winning trade delivers a return of 5 % and each losing trade delivers a loss of 95 %. This again is the worst case scenario since no investor would invest where the risk is equal to the reward. Surprisingly, it is observed that for a non-Kelly investor, it takes less than 100 trades to wipe out his capital. If we use 50 % of our corpus each time, the wipeout will occur even sooner. On the other hand, by the use of the Kelly Factor, the investor successfully retains all of his capital even in the worst sequence of trades. In this simulation, we have also assumed that the probability of our winning the trade is just 50 %, which means we go wrong half the time. This simulation gives us a picture of the margin of safety this formula gives us even in the worst of cases.

Evidently, it makes enough sense to use this tool in all our investment decisions. Whether it be the capital markets, forex trades, or investments in projects, the Kelly Investment criterion is the first tool one must use. The tool seems to work best for asset classes where the loss of capital erosion is very high in the case of a losing trade. For example, trading in naked options. Here is a link to download the spreadsheet and play around with the figures, should you want to experiment with some more scenarios. Feel free to share your findings with us in the comments. Happy investing!

6 Facts that Refute the Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) is an investment theory whereby share prices reflect all information and consistent alpha generation is impossible. Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns, or alpha, consistently and only inside information can result in outsized risk-adjusted returns. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
Source : Investopedia.com

While there are three forms of the Efficient Market Hypothesis, namely the weak, semi-strong and the strong form, all of them seem to be far from the truth. Proponents of the theory claim that the market will immediately and effectively reflect all available information in a stock's price. This essentially means that it is virtually impossible to outperform the market. Whether technical or fundamental, any analysis will be futile and there will be no discrepancy in the prices of a stock and the underlying value of a security. A corollary of this theory is that since all information is already discounted in a stock's price, there are no other factors that can affect market prices of stocks. Here are six facts that contradict this theory and lays the foundation of a large opportunity, which we will discuss shortly. 1. Security prices, in the short term, are governed by supply and demand and may have no relation to the intrinsic value of a company. There is a multitude of investors participating in the market at any given moment. And often there are imbalances in supply and demand of a given security, which drives price. heavy buying or selling both can drive prices to a large extent. In fact, this is the very reason why circuit filters are in place in any regulated market.

2. Motivations for buying or selling shares, for a large pool of investors is not the underlying value of the stock. Investors transact in shares for a wide variety of reasons. The expectation of dividends, capital appreciation, speculation and arbitrage are few of these. Since the underlying value of a company is not the only reason why investors participate in the markets, it is obvious that information is not the only reason behind a price change.
3. A stock that is a part of some index will be bought by an index fund irrespective of its underlying value. Here is a list of Nifty 50 funds
If any of these funds decide to pump in money, each of the Nifty 50 stocks will be faced with buying pressure which will drive prices up. The converse also holds true in case the fund wishes to divest. This again, is an instance where prices are not driven by the intrinsic value of a company, thus creating a divergence between price and value.
4. Funds often are bound by several restrictions in their operations. For instance, at a given point, if the investment criteria of the fund are not met by a particular stock, the fund will liquidate its positions in the company irrespective of the prospects of growth. This has no relation to the value of the company whose shares are being traded. 5. Retail investors are governed by margin requirements by their brokers. For a given investment size, they are required to fund their account with only a portion of the investment size. However, if the value of the investment reduces over time, then the investor is required to fund his account further and mitigate his risk. There are times when an investor is unable to meet a margin call. In such cases, he is left with no choice but to liquidate his position. 6. A pool of investors buy shares solely by focusing on the earnings of the company. Such investors may liquidate their positions if the earnings for a quarter are disappointing. There is a popular article written by Warren Buffet titled "The Superinvestors of Graham-and-Doddsville". Here is a link to the article. In this article, Buffet talks about a group of investors who have repeatedly demonstrated how differences in price and value have led them to churning huge returns on their investments. Given these facts, it is reasonably safe to admit that the markets are far from efficient and presents several discrepancies between price and value. How can you benefit from this? By realizing that stock prices do react to information and that there are deviations in their prices from underlying value, we learn something. That the market often presents opportunities to buy stocks at a discount, which essentially is the objective of value investing. It is important to understand the factors that cause prices to diverge from or converge towards the underlying value and it is in the identification of these factors that the potential investor will find opportunities for profit. The prudent investor will certainly try and find such opportunities not only for the potential profits. There is another huge advantage of this method over other techniques of investing. Value investing is the art of identifying undervalued stocks which have certain characteristics. In fact, in any investment, the first objective should ideally be the minimization of risk, followed by an examination of the profit potential. Value investing achieves exactly this. For stocks that are undervalued, the potential downside is virtually the lowest possible. Hence, the risk of capital erosion is at its lowest. Once we understand the fallacy of the Efficient Market Hypothesis, aptly demonstrated by the facts mentioned here, it is easy to believe that prices do not always reflect all possible information about a company. As a consequence, investors are presented with a big opportunity, that of mitigating risk and finding worthwhile securities to invest in.

7 Secrets Your Broker Hides From You

They Hide Facts That Could Reduce Their Revenue

Let me start with a short story. I was a small investor then. One day, I discovered an article that spoke about a Basic Services Demat Account. On further research I found a circular issued by the Securities and Exchange Board of India, that described the entire facility. To my awe, I realized that had my broker told me about this, I would have had to pay a reduced fee for maintaining my account with them. Here is a snap of the circular.

On asking my broker convert my account they said that I would have to sign a form, which I agreed to. They handed me two forms. One was the BSDA account conversion form and the other was an ECS mandate. On asking why an ECS mandate was required, the broker mentioned that it was their policy get it signed along with the BSDA application. I questioned that and asked them why they would need access my bank account for an account conversion. They were rigid and I had to escalate a complaint to finally get my account converted.  The first thing to notice here is that the broker never ever spoke of this kind of account. Secondly, they presented some unnecessary baggage when I insisted on the conversion.

Many years passed and I turned from a trader to an investor. I executed only a few trades every year and held long-term positions. One fine day I received an email from that same broker stating that my account was being converted to a dormant one because of my inactivity. Whenever I wanted it back,  I would have to reach out to them and they would try to get my account activated within one business day. This could mean a lost trading opportunity for me! This time I wrote to them asking whether their business policy was only to entertain traders who generated enough commissions for them and whether they were unwilling to entertain long-term investors. I asked them to state this clearly in a reply which I would certainly take forward to the regulatory authorities. After the exchange of some emails, my account was reinstated. I did not expect this from one of the leading broking houses in our country and since this event, my faith in them has certainly diminished. 

They Need Commissions, Not Your Prosperity
It is easy to notice how often brokers will encourage you to trade on their recommendations. Please bear in mind that whether you make a profit or not, they earn a commission from each trade you make. And so, it is in your best interest to judge whether to execute a trade or not. Brokers will also discourage withdrawal of funds from your trading account. You withdrawing your funds means a reduction in their account size, and a reduction in capital available for trade, which translates to lesser commissions. They will want you to reinvest your profits and will show you a huge corpus, all on paper. What is the use of funds which you cannot spend?

The Motive Behind Their Recommendations Might Not Be Transparent
It is easy to notice that most of the recommendations offered by brokers are on the buy side. Many brokers are subsidiaries of investment banks and it is obvious that it is difficult to write negatively of a company who might be their client, or possibly a prospective client. Secondly, there is another advantage to buy recommendations. Anyone who has money can buy a stock, but not everyone can sell a stock. You will need to own a stock in order to sell it. Therefore, at any given point of time, the pool of prospective buyers is far larger than the pool of sellers. Which is one more reason why we see more buy recommendations than sell. There could also be other vested interests behind their recommendations since financial institutions, banks and corporate bodies maintain close ties.

They Recommend Funds That Feed On Your Money
Ever wondered how mutual funds finance their operating costs? Where do they get the cash if you sell your holdings? Do they have to sell your portion of stocks? If not, then they have to pay it from their cash reserves, which is funded by your money. Who pays for all their advertising? Yes, all of this is discounted in the NAV which is the price you pay for one unit of the fund. Let me explain with an example.

Let's say the fund wants to buy shares of company A which is currently trading at Rs 100 per share.

The fund has a corpus of Rs 1,00,000 and therefore will buy 1,00,000/100 =1,000 shares of company A. The fund issues 50,000 units to the public for purchase and therefore each unit will be priced in the following way :

Price of 50,000 units = Rs 1,00,000

Price of 1 unit = Rs 1,00,000/50,000 = Rs 2.00

But then they have to cover their expenses. So they factor these in, and the NAV, which should have been Rs 2, can be dropped to Rs 1.50, leaving out 50 paise for every 2 rupees you invest to cover their costs. Assuming that is the price you are willing to pay for their expertise, let us look at the next question.

Their Interests And Yours Might Not Be The Same
What is the assurance that the fund manager's only intent is to outperform the market? We rarely see them outperforming though. Moreover,  is performance alone a good indicator of a fund manager's skill? What risk is he exposing us to ? Where do they show the risk calculations? It's all about returns, returns and returns everywhere.

In many cases, the compensation of the fund manager is not a function of his performance, but a function of the value of assets under his management. Therefore, it is in his best interest to demonstrate returns of his investments to potential investors, masking the risk component that is applicable to those same investments. This poses a greater cumulative difficulty. As the corpus of his fund increases, it becomes increasingly difficult to manage them.

It is wise to realize that though the entire equity market comes with a share of risk, the quantum of risk is not equal across the spectrum of stocks. And therefore, investing the same amount of money in two different stocks poses the investor with two different risks. An awareness of this fact will help an investor choose his stocks not by looking at return alone, but in conjunction with the risk it carries and therefore helping him to evaluate the return per unit risk across his investments. It is true that the risk of an entire portfolio is also a fair estimation of the risk that the investor accepts when investing in a fund, but that information is also not highlighted for the awareness of the investor. It is usually found in some corner of the fund prospectus and stated in technical terminology when it should have been made available to the lay investor, highlighted and well explained.

They Aim For The Wrong Thing

The next hurdle is the relative performance trap. Typically, funds are compared against an index and/or against other funds. This is a blatant example of misleading potential investors. The only reason why an investor should trust a manager with his money should be the potential value of the stocks that the fund is invested in. In trying to outperform an index or another fund, it is easy to lose sight of the value of the stocks being chosen as investments. Other fund managers are also doing the same and therefore, the situation ends up with a group of fund managers each trying to outperform the other. As a result, everyone ends up with mediocre returns and the economy suffers. It is only the brokers who benefit from frequent churning of the portfolio.

Their Opportunities Are Limited

There are many value stocks available in the market which cannot be picked up by any mutual fund. This is because of the sheer size of their investments. In keeping with their restrictions, funds are unable to invest in relatively illiquid stocks, even if their potential upside is huge. Let us look at another example.

Say the corpus of the fund under management is Rs 300 crores. The fund decides not to allocate more than 5 % of their corpus in any one stock. That leaves them with a maximum of 15 Cr to invest in one stock. The next restriction they face is that they have a cap on the maximum percentage of outstanding shares of a company they can buy. Which means if the cap is, say 3 % and a company has 15 lakh shares being transacted in the market, they can buy a maximum of 45,000 shares. So in this case, the company has 15 Cr to spend, and a max of 45000 shares to buy. Which means each share will have to cost Rs 3,333.00 in order to exhaust the entire corpus of the investment. Value stocks come for a far lesser price which leaves the fund handicapped. Either they have to invest a minuscule amount, or they have to forsake the opportunity.

In contrast, an individual investor, who knows how to find value stocks would easily be able to transact in these shares on a personal capacity. There could be minor liquidity issues, but given the size of average investment in one stock, there would not be much difference in the price at which a trader would complete his purchase.

It is therefore in the best interest of the investor to be aware of the complete picture of what he is getting into, before investing his hard-earned money. It should be our endeavour to educate each other so as to make the most of the opportunity of investing.

Do you have another experience to share? Do you know of any more pitfalls? Let us know with your comments!