Investment

Posted on by Devesh Deepak Asset Allocation, Equity, Investment, Macro-economy, Personal Finance, Prudent Investment, Sensex, Valuation

Valuation: Cyclically adjusted PE Ratio

P/E Ratio is one of the simplest valuation multiples and that is also its main shortcoming. The ratio of current price to recent last four quarters earnings is a simple but very effective tool to evaluate a stock, portfolio or market since the beginning of the stock market. The lower the PE, the less you are paying for future earnings. It’s quick and easy, hence popular. The criticism for P/E ratio is that it doesn’t account for the cyclical nature of a business or the different phases of the business cycle. Thus, P/E ratio can’t be extrapolated as price and earning of one era can’t be compared with price and earning of a different era.

The famous value investors Benjamin Graham and David Dodd, in the early 1930s in the book Security Analysis, argued that a single year’s earnings would be too volatile to evaluate a company’s real value in the marketplace. To control for cyclical effects, Graham and Dodd recommended dividing price by a multi-year average of earnings and suggested periods of five, seven or ten years. Based on that idea, Robert J. Shiller and John Y. Campbell in 1998 developed a cyclically adjusted price-to-earnings ratio (CAPE), which puts the current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year observation period is to ensure that the profits are averaged over more than one earnings cycle. Shiller and Campbell’s research found a negative correlation between the CAPE ratio and the stock market performance over the next ten years. A high current CAPE ratio meant poor future stock returns.

cape

The cyclically-adjusted price-to-earnings (CAPE) ratio of a stock market is one of the standard metrics used to evaluate whether a market is overvalued, undervalued, or fairly-valued. This metric was popularized during the Dotcom Bubble when Robert Shiller, a Yale University Professor of Economics and Noble Prize winner, correctly argued that equities were highly overvalued.  For that reason, it’s also referred to as the “Shiller PE”, meaning the Shiller variant of the typical price-to-earnings (P/E) ratio of stock.

Does the Shiller PE predict the future returns? In his book “Irrational Exuberance,” Shiller shows that CAPE is correlated to the subsequent 20-year annualized return after inflation. A low P/E bodes well for the next 20 years of investing, whereas a higher ‘PE 10’ suggests a lower expected return.

The GuruFocus.com has a nice article on Shiller PE – A Better Measurement of Market Valuation in which they write:

If we assume that over the long term, the Shiller PE of the market will reverse to its historical mean of $mean, the future market return will come from three parts:

  1. Contraction or expansion of the Schiller P/E to the historical mean
  2. Dividends
  3. Business growth

The investment return is thus equal to:

cape1

cape2

We don’t have much Sensex data prior to 1990 hence can’t compare our finding with the US data. Still, the above graph shows a remarkable correlation close to 80% between implied return and the actual 3 years return. For calculation, the business growth is taken as average annual GDP growth since 2000. We believe the real earning growth of composite or large-cap index tends to align with GDP growth over long-term.

Despite its value in projecting future returns over long periods of time, the Shiller PE is often misused when applied to any periods other than long ones. The elevated Shiller PE is in no way an indication that investors should sell their equities. In reality, the Shiller PE has almost no predictive value in determining where the market will go in the next year or other shorter term periods. We must emphasize the fact that valuation metrics are not a market timing tools.

In terms of shortcomings, Shiller PE is based on the false premise that earnings can be normalized using inflation only. Population growth, productivity growth, interest rates, and dividend payout ratios are all key ingredients in earnings growth and they are neglected by this ratio.

No valuation ratio is ever going to explain the market fullest. Every multiple has some positives and some negatives but the Cyclically Adjusted Price-to-Earnings ratio or “CAPE” has shown remarkable ability at least in the US market for assessing long-term future returns. However there are situations when the earnings growth is higher for reasons other than inflation, Shiller PE may give a false reading, and it will show much higher value than the reality.

Posted on by Devesh Deepak Asset Allocation, Investment, Personal Finance, Prudent Investment, Risk, Valuation

The Market Valuation: A Primer

“A cloud does not know why it moves in just such a direction and at such a speed, it feels an impulsion…this is the place to go now.

But the sky knows the reason and the patterns behind all clouds, and you will know, too, when you lift yourself high enough to see beyond horizons.”

A quote by Richard Bach

The market valuation is a topic which creates a great divide among the academician, practitioners, and investors. The market is a collection of a great number of companies, engaged in a different sector of the economy, having different financial size and their business cycles are not calibrated. We all know the stock market does not follow a pattern, the stock price movement is random and still, we want to put a number to summarise it.

Valuation is not about pricing and certainly not about market timing. But it’s equally true whatever is valued can be priced and vice versa. And the price is a factor of value and time. Valuation multiples tell you a story in numbers and how you interpret it is certainly up to you.

The valuation multiples what we are going to discuss in this blog are well-known and you will find plenty of reading materials over internet and publications. The idea of this blog is to summarise those ratios in the context of Indian stock market.

Price-to-Earning Ratio

PE ratio is simply price divided by earnings. There are a number of ways to define the ratio. It is all based on how the price and earnings are defined. Here, we defined the price as the current price of BSE Sensex and Earnings as the weighted EPS (earning per share) of the Sensex companies in most recent four quarters. Thus the ratio we are talking about is better known as trailing PE ratio.

The PE Ratio is the first and still the foremost valuation tool. The history of PE is as old as that of the markets. When the first stock exchange starts working, the market PE multiple was born. PE is based on the present value of future cash flows from companies. In non-financial terms, the inverse of PE is earnings yield, the amount you are expected to receive by investing Rs.100 in the market. Higher the PE ratio, lower the earning yields.

When we look back across the last three decades of BSE Sensex, we see a rollercoaster cycle of the market PE—vacillating from peaks above 50 in during Harshad Mehta time to troughs just above 10 in October 1998. Since stock price movements are random hence PE cycles are not symmetrical, but they are pronounced and recurring. One aspect is very clear higher the PE; lower will be the forward earning. Historically, the cut-off is 23x, beyond that even your 3 to 5 years forward returns is very dismal.

Blog_val_1

Price-to-Book Value Ratio

Price to book value is a financial ratio used to compare a company’s book value to its current market price. The book value of an asset is the value at which the asset is carried on a balance sheet and calculated by taking the cost of an asset minus the accumulated depreciation. Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.

Value investors were always looking for low P/B ratio. Low P/B ratio not only shows low valuation but together with Return on Equity (ROE) become a potent indicator of market valuation. The ‘B’ in P/B ratio and ‘E’ in RoE are the same. You can calculate ROE by dividing net income by book value.

Return on equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. The high P/B ratio does not necessarily indicate high ROE but on an index level, the weighted average value shows a positive correlation.

Blog_val_2

A market with a high P/E and a low P/B would be a rare combination. On an aggregate basis, the book value of the Sensex companies has risen almost twice since March 2010, whereas the total earnings of the Sensex companies have risen by only one-and-a-half times. It shows the credibility of Indian market and Economy among knowledgeable investors is high and that increase its stock price before this is reflected in quarterly earnings reports. This somewhat strange combination of ratios may indicate a still undervalued stock in the Sensex that will enjoy a substantial price run-up going forward.

BEER Ratio

The Bond Equity Earnings Yield Ratio (BEER) is a metric used to understand the relationship between bond yields and earnings yields in the stock market.

BEER = Bond Yield / Earnings Yield

Bond Yield is the yield of 10 years G-Sec and Equity yield is the inverse of the Sensex price-to-earnings ratio.

The thumb rule is to invest in stocks when BEER is less than 1 as equity yield is more than bond yield. Similarly, if BEER is more than 1, invest in bonds. Thus, a BEER of one would indicate equal levels of perceived risk in the bond market and the stock market.

Blog_val_3

The Bond Equity Earnings Yield Ratio above 1 is not necessarily because of low earning yield from equities, it might be because of high bond yield owing to high inflation and other macro factors. In the Indian context, the bond yield is always higher than the equity yield except during the period 2002-04 and briefly in Oct 08-Apr 09, and we all know what phenomenal returns it has generated thereafter.

Blog_val_4

The high bond yield is not just an Indian phenomenon, even in the US from 1982 till 2004; the US bond yield was above the earning yield of S&P 500.

Blog_val_5Source: CNBC

Market Cap to GDP ratio

Market Cap to GDP ratio was made famous by the legendary investor Warren Buffet. According to him, it is probably the best single measure of where valuations stand at any given moment.

This ratio in the Indian context is very nascent. Though the Bombay stock exchange has published market capitalization data since FY 2001-02 it was just end of the year value. The monthly/daily data was published only from FY 2013-14. Similarly, the quarterly GDP data is only available from FY 2004-05.

It is assumed that the price movement of stocks reflects the future earnings of the companies. Similarly, consolidated earnings of the companies reflected in the growth of country’s GDP. Hence this ratio gives an indication whether the stock market is running ahead of the curve or it is lagging behind. The fair value of this ratio is one. Any value near one is considered to be fair value.

Blog_val_6

The average value in last 15 years is 75 pct and in last ten years, the market remains in the 60-100 pct band.

Conclusion

The major criticisms in using these multiples for valuation of a stock, asset or market are:

  • They are too simplistic and they hide more than what they divulge.
  • There is no standardization. It is defined in different ways by different users.
  • The numerator and denominator are not at the same time and space. Though price data is recent there is at least a lag of a quarter in earning, book value and GDP data.
  • No multiple captured all the four prime factors – Price, earning, interest rate and inflation.
  • These multiple are relative in nature and it has to be interpreted not with its own historical value but also in relation with other macro factors especially the fundamentals which drives these multiples.

As we said in the beginning, Valuation multiples tell you a story in numbers and how you interpret it is certainly up to you.

Lastly, as Burma born British writer H.H. Munro, better known by his pet name Saki, in his short story “Clovis on The Alleged Romance of Business” has said, “a little inaccuracy sometimes serves tons of explanation”.

 

Posted on by Devesh Deepak Asset Allocation, Diversification, Investment, Mutual Fund, Risk

Diversification – A lesson from Cricket

Indians treat Cricket not just a game but we eat, sleep and breathe cricket.  Cricketers are as popular as a movie star and every victory in the field is a festival for the masses. Since cricket is so much entrenched in our psyche that we think there is no better way but Cricket to explain the benefit of diversification in your investment portfolio. The cricket is the most watched sports in India and every other Indian claim to be the bona fide expert of the game. Even the youngster will tell, “I know my cricket as my mamma knows her household.”

But for few tyro, Wikipedia explain the game as – Cricket is a bat-and-ball game played between two teams of eleven players on a cricket field, at the centre of which is a rectangular 22-yard-long pitch with a wicket (a set of three wooden stumps) at each end. One team bats, attempting to score as many runs as possible, whilst their opponents field. Each phase of play is called an innings. After either ten batsmen have been dismissed or a fixed number of overs have been completed, the innings ends and the two teams then swap roles. The winning team is the one that scores the most runs, including any extras gained, during their innings.

So what are the basics, there are eleven players on the field for each team during a match and every member of the team has an assigned role to play. The top order players are the batsman, the middle order consists of wicket keeper and all-rounders and lower order players are bowlers. The team has to score runs and restrict the opposition team to score as many runs as they have scored to win the match. The players who score runs are called batsman and the players who restrict the opposition team to score are called bowlers. Hence the reward is to score as many as runs you can and risk is the rival team can score more run than what you have scored.

If scoring the runs is the most important aspect of the game then why we can’t have a team with eleven specialist batsmen to maximize the rewards or eleven specialist bowlers to minimize the risk? If you ask this question even to somebody who wasn’t a big cricket fan, they could probably tell you that everyone has a job to do during any given match. If you don’t have a bowler in your team, your risk will magnify and it would be difficult for your team to restrict opponent to score more run than your team. Similarly, the team consisting of only bowlers can’t expect to score many runs and thus lose out to the opposition. This exactly explains the reason for having a diversified portfolio – as in cricket, every asset class has a specific job to do within the portfolio.

So if you are an investor trying to build a portfolio, let see what Cricket can teach you.

Go for Diversification

Holding several investments in a single asset class doesn’t mean a portfolio is well-diversified. Generally, diversification may lower risk when investments are negatively correlated, meaning their prices typically move in opposite directions. Your portfolio should be diverse enough to weather all sorts of markets – a mix of aggressive and defensive assets, such as stocks and bonds, may reduce the general risk of investing in the market. Dividend-paying blue chip stocks or mutual funds could be the core of your portfolio, while smaller growth stocks can give your portfolio speed and agility.

Diversification doesn’t mean sacrificing return

A well-balanced cricket team with six specialist batsmen and five specialist bowlers will have greater chance to win. A good all-rounder only adds the strength. Similarly, diversification may boost returns while lowering risk when compared to a single asset class. It’s possible at times that a portfolio holding separate asset classes produces a total return greater than the respective returns of each individual asset class. Since the portfolio is not subject to the volatility of a single asset class and covariance among the assets also lower the portfolio risk.

Build a core for Long Term Success

A team works best when they are built for a long period of steady success rather than a single, brilliant season. The best teams build a talented core group of players and only make changes when they need to address weaknesses in the team. M S Dhoni and Saurav Ganguly was the most successful captain of the Indian cricket team and both back their players to the hilt and gradually built a core which remains constant throughout their captaincy.

It’s the same in your portfolio. Rather than constantly rebalancing your portfolio and guessing the next winner, find some mutual funds that you like and plan to hold them for long time period. You should not obsess over whether your portfolio is up or down on a given day. Plan for the long-term; it’s better to have your portfolio perform above average over years than to have a few big years but performing sub-optimally in most of the other years.

Identify and stick with steady Manager

In the first decade of this century, we have two very successful coaches – John Wright and Gary Kirsten. In between, we also have Greg Chappell. The records of these coaches speak for themselves. Rather than firing the players after disappointing performances, the successful coaches kept faith in their long-term ability to win and stuck with them, even in the bad times. Whereas, Greg Chappell’s firing policy proves a disaster for Indian cricket team.

An investor should do well to analyse the performance of the fund house instead concentrating on a single scheme. One should not quit a fund if it is going through a rough patch. A steady, successful fund management team always pull out of rubbles and steer the fund back to its winning way by adhering to winning strategies, putting up good numbers in the long run. The track record matters and investing in a hotshot new manager with no track record can be risky.

Conclusion

The great team doesn’t build in a jiffy; it takes years and load of patience. Even the best team loses sometime hence one should not lose sleep if your portfolio gives negative returns when market capsizes. We all are well aware of the history of US stock market crash of 1929. Some investors must have first-hand experiences during market meltdown in 1999 and 2008. The reality is that some market crashes are so sudden that even the most diversified portfolios suffer. Risk can only be minimised, can’t be wished away. However, portfolio diversification may stabilise risk to help lower a portfolio’s sensitivity to market volatility.

 

 

Posted on by Devesh Deepak Bonds, Investment, Macro-economy, Yield Curve

Yield Curve Primer

A yield curve is a graphical representation of the current interest rates. The interest rate varies across the maturity.  The yield curve shows the rate of return that can be locked in now for various terms into the future. The left, vertical Y-axis of the graph shows the YTM that is currently available in the marketplace. The bottom, horizontal X-axis shows the G-Sec maturity. The yield curve is the line connecting YTM across maturities and looks something like this:

YTM000

A yield curve can be created for any specific segment of the bond market, from AAA-rated corporate bonds to single-B rated corporate bonds. The G-sec yield curve is the most widely used because G-Sec has no perceived credit risk, which would influence yield levels, and G-sec and T-bill market includes securities of every maturity, from 3 months to 40 years.

As the investor in the Bond, we all know that Yield to maturity reflects the total return an investor receives by holding the bond until it matures. But why the yield curve is important and does it has a predictable power?

The information contains in the yield curve is valuable for the prediction of business cycles, inflation, and monetary policy; the response of the yield curve helps to understand the extent of transmission of monetary policy and, it is also the barometer to measure the impact of any surprises on the macro economy. The importance of Yield curve can also be gauged by the fact that it represents the relationship among short, medium and long-term yield and most of the pricing activity taking place in the bond markets centres around it. The Yield curve is also called Term Structure of Interest Rates. To understand the shape of the yield curve, we must understand the variables of yield curve – level, slope, and curvature.

Level = Average yield of Short Term (3mnths), Medium Term (2years) and Long Term (10years).

Slope = Spread = Difference in the yield of Short Term (3mnths) and Long Term (10years).

Curvature = [2 x Long Term yield (10years) – Short Term yield (3mnths) – Medium Term yield (2years)].

And examine the theories and hypotheses that explain the yield curve and the relationship of short, medium and long-term interest rates:

  • Pure expectations: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk.
  • Liquidity premium: long-term rate is the sum of current rate and future expected short-term rates, adjusted for risk, plus a premium for holding long-term bonds, called the term premium or the liquidity premium.
  • Preferred habitat: In addition to pure expectations and liquidity premiums, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their “preferred” maturity, or habitat.
  • Market Segmentation: postulates that the yield curve is determined by supply and demand for debt instruments of different maturities.

The Yield curve has five major characteristics:

  • The change in yields of different term bonds tends to move in the same direction.
  • The yields on short-term bonds are more volatile than long-term bonds.
  • The Long-term yields follow the short-term yields.
  • The yields on long-term bonds tend to be higher than short-term bonds.
  • At a given level, yields are mean reverting.

The pure expectations hypothesis explains the first three characteristics; the liquidity premium theory explains the fourth characteristic and the market segmentation explains the last one.

The Shape of the Yield Curve

There is a dynamic relationship between fiscal and monetary developments – government debt and the budget deficit, real output, inflation and the monetary policy rate– and the shape of the yield curves.

Normal Curve

A normal, upward-sloping yield curve suggests the economy will grow in the future, and this may lead to higher inflation and higher interest rates. No one will buy longer-term securities without a higher interest rate than those offered by shorter-term securities. A normal yield reflects the easing of monetary policy and easy liquidity. And the economy expected to expand. The upward sloping normal yield curve is the most common shape of the yield curve.

YTM002

Inverted Curve

When the long-term yields fall below short-term yields, the yield curve becomes inverted. An inverted yield curve indicates the economy is to slow or decline in the future and this slower growth may lead to lower inflation and lower interest rates across all maturities. An inverted yield curve typically indicates that central banks are ‘tightening’ monetary policy, limiting the supply of money in the banking system and thus control credit availability. An inverted yield curve has indicated, in the past, the slowing down of economic growth and even recession.

YTM001

Flat Curve

When the short-term bond yields increases and yields on long-term bonds decrease, the yield curve flattens or appears less steep. A flattening yield curve can indicate that expectations for future inflation are falling and thus the demand higher long-term bonds fall. Since inflation is less of a concern, the long-term premium shrinks. A flat yield curve indicates a slower economic growth.

YTM004

Humped Curve

A humped yield curve is a kind of flat yield curve or reflects uncertainty about specific economic policies or conditions, or it may reflect a transition of the yield curve from a normal to inverted or vice versa.

YTM003

Posted on by TeamGenus Asset Allocation, Investment, Mutual Fund, Risk

White Paper – Investment Plan

One of the parts of developing a comprehensive financial plan is the development of an investment plan. Investment Planning is the process of finding the right mix of investment option based on your future goals, time horizon, and risk profile. There are six steps that you should follow when you are developing your investment plan.

The Means to Invest

In order to even begin this portion of your financial plan, you must determine that you are ready to invest. In this step, you will determine if you are going to use the money for some good or service (spend it), or if you will invest or save the money.

Investment Time Horizon

In this step, you will be determining how long you plan to invest and when you will need the funds to meet your financial objective(s). You must decide, based on the time horizon of your objectives, among short-term investments, long-term investments or some combination. In this step, you are going to be determining what you will be saving for, which should give some indication of your time horizon.

Risk and Return

You will need to determine what your level of risk tolerance is. As the level of risk tolerance increases so does the potential for higher returns as well as larger losses.

Investment Selection

Based on 1, 2 and 3 above, investments should be selected to meet your goals. These investments must satisfy your time horizon and your risk tolerance.

Evaluate Performance

Once investments are chosen and expectations are established, the performance of your investments should be determined by comparing the actual realized returns against the expected returns. The returns should also be compared to a benchmark, such as the Sensex or Nifty index. In addition, the investments should be reevaluated to determine if they continue to meet your investment criteria.

Adjust Your Portfolio

Your portfolio should be adjusted to maintain your goals and your investment criteria. If your goals change, your investments should be reviewed to determine if they continue to meet your objectives.

Benefits of Investment Planning

 Investment planning helps you:

  • Generate income and/or capital gains.
  • Enhance your future wealth.
  • Strengthen your investment portfolio.
  • Save on taxes.

Investment Strategies – Passive vs. Active Strategy

Passive

Passive strategies do not seek to outperform the market but simply to do as well as the market. The emphasis is on minimizing transaction costs and time spent in managing the portfolio because any expected benefits from active trading or analysis are likely to be less than the costs. Passive investors act as if the market is efficient and accept the consensus estimates of return and risk, accepting the current market price as the best estimate of a security’s value.

A buy-and-hold strategy means exactly that – an investor buys fund or stock and basically holds them until some future time in order to meet some objective. The emphasis is on avoiding transaction costs, additional search costs, and so forth. The investor believes that such a strategy will, over some period of time, produce results as good as alternatives that require active management whereby some securities are deemed not satisfactory, sold, and replaced with other securities. These alternatives incur transaction costs and involve inevitable mistakes.

Active

An active strategy involves shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better and avoid or de-emphasize those sectors that are expected to do relatively worse. Investors employing this strategy are betting that particular sectors will repeat their price performance relative to the current phase of the business and credit cycle.

Most of the Mutual funds in India are actively managed. The goal of active management is to beat a particular benchmark. Because the markets are inefficient, the anomalies and irregularities in the capital markets are exploited by the active fund manager. Prices react to information slowly enough to allow skillful investors to systematically outperform the market.

Building an Investment Portfolio

Asset Allocation

Investors often consider the investment decision as consisting of two steps:

  1. Asset allocation
  2. Fund selection

The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in other words, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, money market assets, and so forth. Each weight can range from zero percent to 100 percent.

The asset allocation decision may be the most important decision made by an investor.

The rationale behind this approach is that different asset classes offer various potential returns and various levels of risk, and the correlation coefficients may be quite low.

Portfolio construction involves the selection of securities or mutual funds to be included in the portfolio and the determination of portfolio weights. The Modern Portfolio theory provides the basis for a scientific portfolio construction that results in efficient portfolios. An efficient portfolio is one with the highest level of expected return for a given level of risk or the lowest risk for a given level of expected return.

Asset Classes

Portfolio construction begins with the basic building blocks of asset classes, which are the following major categories of investments:

  • Cash (or cash equivalents such as money market funds)
  • Stocks
  • Bonds
  • Real Estate (including Real Estate AIF)
  • Commodity, bullion or others

Each investor must determine which of these major categories of investments is suitable for him/her. The next step is to determine which percentage of total investable assets should be allocated to each category deemed appropriate.

Risk Reduction in the Portfolio

Diversification

One has to remember that no investment is Risk-free. Every investment has the potential gain as well as losses. The diversification is not a guarantee against any potential loss. Based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.

A diversified portfolio is built by a judicious mix of assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction, and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio, hopefully, is growing. The intention of using this strategy is that the loss incurred due to the negative performance of a particular asset class is partially or wholly offset by gains via the positive performance of another asset class. Another important aspect of building a well-diversified portfolio is that you try to stay diversified within each type of investment.

Modern Portfolio Theory

Covariance is a measure of the co-movements between securities returns used in the calculation of portfolio risk. We could analyze how security returns move together by considering the correlation coefficient, a measure of association learned in statistics.

As used in portfolio theory, the correlation coefficient is a statistical measure of the relative co-movements between security returns. It measures the extent to which the returns on any two securities are related; however, it denotes only association, not causation. It is a relative measure of association that is bounded by +1.0 and -1.0, with

Pi,j = +1.0, perfect positive correlation

Pi,j = -1.0, perfect negative (inverse) correlation

Pi,j = 0.0, zero correlation

With perfect positive correlation, the returns have a perfect direct linear relationship. Knowing what the return on one security will do allows an investor to forecast perfectly what the other will do.

With perfect negative correlation, the securities’ returns have a perfect inverse linear relationship to each other.

With zero correlation, there is no relationship between the returns on the two securities. Knowledge of the return on one security is of no value in predicting the return of the second security.

Rupee Cost Averaging

The systematic investment with mutual funds, along with consistent periodic new purchases of the mutual fund, creates risk reduction by creating a lower cost per unit owned over time. This is known as rupee cost averaging. This strategy allows one to take away the guesswork of trying to time the market. You invest a fixed amount of money at a regular interval, regardless of whether the market is high or low. By doing so, you buy fewer units when the prices are high and more units when the prices are low. Because rupee cost averaging involves regular investments during periods of fluctuating prices, you should consider your financial ability to continue investing when price levels are low. However, this approach reduces the effects of market fluctuation on the average price you pay for your shares. Additionally, it helps you maintain a regular investing plan.

Conclusion

Even the best-laid investment plan will fail if you can’t control your behaviour.  That’s one of the biggest reasons for keeping your disciplined investment strategy as simple as possible.

It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend.  And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.

There is enough statistical evidence to suggest that if you invest regularly for a long term, your money will grow on a consistent basis.

References

  1. Investments: Analysis and Management by  Charles P. Jones

  2. US SEC
Posted on by Teena Gera Budget, Tax

Union Budget 2017

Major Highlights of Union Budget 2017:

  1. IMF estimates world GDP will grow by 3.4 per cent in 2017.
  1. Oil prices, rising dollar and volatile commodity prices seen as risks to Indian economy.
  1. India is seen as engine of global growth, have witnessed historic reform in last one year.
  1. Total Budget of ₹ 21.47 Lakhs crores for 2017-2018.
  1. Agriculture sector is expected to grow at 4.6%, agriculture expenditure targeted at ₹ 10 lakh crore.
  1. 36% increase in FDI flow; forex reserves at $361 billion in January, which is enough to cover 12 months needs.
  1. Allocation under MNREGA increased to ₹ 48,000 crore from ₹ 38,500 crore. This is highest ever allocation
  1. Total allocation for rural, agricultural and allied sectors for 2017-18 is ₹ 187223 crore, which is 24% higher than last year.
  1. One crore houses for poor by 2019.
  1. Safe drinking water to cover 28,000 arsenic and Fluoride-affected habitations in the next four years.
  1. 133-km road per day constructed under Pradhan Mantri Gram Sadak Yojana as against 73-km in 2011-14.
  1. For senior citizens, Aadhar cards giving their health condition will be introduced.
  1. 3500km railway lines to be put up.
  1. Service charge on rail tickets booked through IRCTC to be withdrawn.
  1. Rail safety fund with corpus of ₹ 100,000 crore will be created over a period of five years.
  1. Foreign investment promotion board (FIPB) to be abolished.
  1. Allocation for infrastructure stands at a record ₹ 3,96,135 crore.
  1. 25 crore people have already adopted Bhim App for digital payments.
  1. Aadhaar Pay- an app for merchants- to be launched; 20 lakh aadhaar-based POS by September 2017.
  1. Government is considering introduction of new law to confiscate assets of offenders who escape the country.
  1. Defence expenditure excluding pension at ₹ 2.74 lakh crore.
  1. Fiscal deficit for 2017-18 pegged at 3.2 percent of GDP.
  1. Fiscal deficit target for next three years pegged at 3 percent.
  1. India’s tax-to GDP ratio is very low. We are largely a tax non-compliance society, when too many people evade taxes burden falls on those who are honest.
  1. Out of 3.7 crore who filed tax returns in 2015-16, only 24 lakh persons showed income above ₹ 10 lakh.
  1. Of 76 lakh individuals who reported income of over ₹ 5 lakh, 56 lakh are salaried.
  1. Increase in Direct Tax collection by 34% after demonetisation.
  1. Holding period for LTCG for Land & Building reduced to 2 years.
  1. Small firms with turnover up to ₹ 50 crore to pay 25% tax now, instead of 30%.
  1. Carried forward of MAT Credit for 15 years instead of 10 years.
  1. 6% presumptive tax for turnover upto ₹ 2 crores.
  1. Change in period of limitation for scrutiny assessment.
  1. Black money SIT has suggested no cash transaction above ₹ 3 lakh. The government has accepted this recommendation.
  1. Jaitley reduces income tax rate from 10% to 5% for tax slab of ₹ 250,000 to ₹ 500,000.
  1. Surcharge of 10% for those whose annual income is ₹ 50 lakh to 1 crore.
  1. 15% surcharge on incomes above ₹ 1 crore to continue.
  1. One page Income Tax return proposed.
  1. No major changes for Indirect taxes due to GST implementation.
  1. Base year for indexation now 2001 instead of 1981 for long term capital gains.
  1. Maximum cash donation any party can receive will be ₹ 2000 from one source.
  1. Political parties will be entitled to receive donations by cheques or digital modes.
  1. An amendment being proposed to RBI Act to enable the issuance of electoral bonds for political funding.
Posted on by TeamGenus Asset Allocation, Black-Litterman Model, Reverse optimization

White Paper – Asset Allocation

“Don’t Put All Your Eggs in One Basket”. It means don’t risk everything all at once. If you had a certain number of “eggs”, it would be safest to put those eggs in different “baskets” and not “put them all in one basket”. To “put all your eggs in one basket” would be to risk losing all of your “eggs” in case you drop that one “basket”.

Even if you are new to investing, this old adage explain you the most fundamental principles of sound investing. If that makes sense, you’ve got a great start on understanding asset allocation and diversification.

Studies have shown that proper asset allocation is more important to long-term returns than specific investment choices or market timing. Asset allocation means diversifying your money among different types of investment categories, such as stocks, bonds, and cash. The goal is to help reduce risk and enhance returns.

The process of determining asset mix in your portfolio is a personal choice. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.

Time Horizon – Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.

Risk Tolerance – Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. Check your risk tolerance here.

The two most commonly used terms when referring to asset allocation are strategic and tactical asset allocation.

Strategic (or neutral) asset allocation refers to the neutral asset allocation that aims to achieve the investor’s long-term investment objectives. It is based on the longer-term risk and return outlook for the asset classes.

Tactical (or dynamic) asset allocation aims to take advantage of perceived inefficiencies in asset pricing in the short-term. The deviation from the Strategic asset allocation is done with the aim to enhance returns in the shorter term. The decision rule that defines how the Tactical asset allocation is implemented could be different for each investor.

Every investor or portfolio has a Strategic asset allocation that is used to model the returns that the investor is likely to achieve in the long-term.

Based on data since 1997 and Risk Tolerance level, we have created five model strategic asset allocations using reverse optimization process through gradient quadratic programming method of Nobel laureate William F. Sharpe.

  1. Conservative Asset Allocation – Equity: 1.6%, Debt: 79.1%, cash: 19.3%
  2. Moderately Conservative Asset Allocation – Equity: 6.4%, Debt: 93.6%, cash: 0.00%
  3. Moderate Asset Allocation – Equity: 23.9%, Debt: 76.1%, cash: 0.00%
  4. Moderately Aggressive Asset Allocation – Equity: 33.9%, Debt: 66.1%, cash: 0.00%
  5. Aggressive Asset Allocation – Equity: 44.0%, Debt: 56.0%, cash: 0.00%

You can check these models here.

We use another reverse optimization model – Black Litterman model to arrive at the tactical asset allocation. Though Nobel laureate Harry Markowitz’s mean-variance optimization is one of the cornerstones of modern portfolio theory and has become the dominant asset allocation model. However,

  1. Mean-variance optimization is very sensitive to the estimates of returns, standard deviations, and correlations. Of these three inputs, returns are by far the most important and, unfortunately, the least stable.
  2. Input sensitivity indicates that the model’s output (the asset allocations) changes significantly due to small changes in the input (the capital market assumptions). Input sensitivity causes mean-variance optimization to lead to highly concentrated asset allocations.

The Black-Litterman model was created by Fischer Black and Robert Litterman. The Black-Litterman model enables investors to combine their unique views regarding the performance of various assets with CAPM market equilibrium returns in a manner that results in intuitive, diversified portfolios. More specifically, the Black-Litterman Model combine the subjective views of an investor regarding the expected returns of one or more assets with the CAPM market equilibrium expected returns (the prior distribution) to form a new, mixed estimate of expected returns (the posterior distribution).

The CAPM market equilibrium returns are calculated using the reverse optimization technique described by Sharpe. You can see the tactical asset allocation area graph based on risk tolerance here.

Our five-step asset allocation process:

  1. Establish a Strategic (long term) allocation
    1. You need to know the Risk Tolerance Score
    2. And to align with one of the five Market Portfolios based on risk tolerance
    3. Market portfolios are your reference point for monitoring deviation from your risk profile.
  1. Shift your asset allocation away from strategic allocation only when there are “valuation” opportunities:
    1. When one asset class is extremely undervalued relative to competing asset classes
    2. When we can make high-confidence assessments of the impact of cyclical factors that might enhance or detract from such opportunities
  1. Analyse and choose actively managed mutual funds, and in some cases Exchange Traded Funds (ETF), to implement your asset allocation. Use the Fund Screener to select the top-rated Schemes. Choosing more schemes leads to greater diversification, but avoid unnecessary diversification. Eliminate any schemes you do not want to own for any reason; however, you should keep at least 20 schemes in an effort to properly manage risk.
  1. Hold for at least One year – For better Tax Efficiency
    1. In our opinion, it is a better idea to keep your investment for approximately one year. This to maximize your after-tax returns; therefore, holds the gains for more than a year to become long-term, and book any losses before the one year holding period is reached.
  1. Go Back to Step 1
    1. Once you have sold any gains and any losses, select and purchase a new portfolio by following step 1 to 3.

Conclusion

The greatest asset allocation strategy won’t work if you can’t control your behaviour. That’s one of the biggest reasons keeping your disciplined investment strategy as simple as possible. The truth, that long-term investing after fees and taxes beats active wealth management, is hard to accept.

It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend.  And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.

Attachment

  1. Reverse Optimization aa_gradient_tgblog
  2. Black-Litterman Model aa_bl_tgblog

Acknowledgment (For idea, content, formula and calculation)

  1. http://www.blacklitterman.org and the reading list published on the website.
  2. Macro-Investment Analysis by William F. Sharpe

  3. Financial Modeling by Simon Beninga

Posted on by Devesh Deepak Bonds, Mutual Fund, Risk

Deciphering Bond – 2

In a country like ours, the bank fixed deposits and government sponsored products like Tax-free bonds, PPF and Post office schemes created an illusion that Debt is risk-free. This is a bit surprising because there were numerous defaults in NBFC FDs, Company deposits, RNBC deposits and chit funds in last two-to-three decades but every such default only strengthens the views that the government sponsored product are high in security and returns and what’s the need to invest in other debt products.

There is another counter view which is gradually catching the imagination of investor is Debt mutual fund. The AUM (Asset under management) of Debt schemes in the Mutual fund industry stands at over Rupees Ten lakh crore as on September 30, 2016. Often there is a great deal of discernment about an investment avenue that brings clueless investors down the wrong path. Investors also have such beliefs for Debt funds that could be partly true at best and misleading at worst. Here we will try to decipher risk associated with investment in Debt, which is equally true for debt mutual funds.

No market-related investment is risk-free, be it equity or debt. While debt funds are not as risky as equity funds, they are not without risks either.

The two prime risks in a debt instrument are the interest rate risk and credit risk.

Interest Rate Risk

Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds generally rises. Conversely, when interest rates rise, the price of bonds tends to fall.

Let’s assume you purchase a bond from Company ABC. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, call option, and other characteristics of the bond.

One common way to measure a bond’s interest rate risk is to calculate its duration.

In general, short-term bonds carry less interest rate risk; less responsive to unexpected interest rate changes than long-term bonds are. This implies that short-term bonds carry less interest rate risk than long-term bonds.

Credit/Default Risk

Credit risk is the likelihood that a bond issuer will not make the interest payments or principal repayment to its bond-holders. It means the issuer may default. All bonds, except for those issued by the government, carry some credit risk. This is one reason why corporate bonds almost always have a higher yield than government bonds.

While the definition of credit risk may be straight forward simple, measuring it is not.  Many factors, like a business loss, poor cash flows, change in business environment, country’s socio-political situation etc can influence an issuer’s credit risk and in varying degrees.

Rating agencies like CRISIL, ICRA, Moody’s and Standard & Poor’s analyse bond offerings in an effort to measure an issuer’s credit risk on a particular security. Their results are published as ratings that investors can track and compare with other issuers.

These ratings range from AAA (the most secure) to D, which means the issuer is already in default.

Rating downgrades generally come from rating agencies. A downgrade from any one of them is a major signal that an issuer is more likely to default on its debt. If a bond is downgraded to a level below investment grade (aka, “junk”), there is often a serious sell off of those bonds, because most institutional investors are forbidden from owning junk bonds.

Ratings have a large influence on the demand for a security. Downgrades (or even rumours of downgrades) tell investors that a security is now believed to be riskier, which may have a negative impact on the security’s price. In turn, downgrades often lead to less trading activity and lowered liquidity.

Other Risks

a) Reinvestment Risk

Reinvestment Risk is the likelihood that an investor won’t have the opportunities to reinvest income streams from the Bond at a rate equivalent to the Bond’s present rate of return

For example, consider a Company ABC bond with a 10% yield to maturity (YTM). In order for an investor to actually receive the expected yield to maturity, she must reinvest the interest payments she receives at a 10% rate. This is not always possible. If the investor could only reinvest at 8% (say, because market yield fell after the bonds were issued), the investor’s actual return on the bond investment would be lower than expected. This risk becomes more pronounced if issuer has the call option to retire the bond before the maturity.

b) Inflation Risk

Inflation risk also called purchasing power risk, is the likelihood that the returns from the Bond won’t be worth as much in the future on account of changes in purchasing power because of inflation.

For example, Rs.1,00,000 in bonds with a 10% coupon might generate enough interest payments for a retiree to live on, but with an annual 5% inflation rate, every Rs.10,000 produced by the portfolio will only be worth Rs.9,523 next year and about Rs.9,070 the year after that. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.

Inflation-indexed bonds were designed to provide a hedge against rising prices or inflation. They attempt to address this risk by adjusting their interest rate for inflation to prevent changes in purchasing power.

c) Liquidity Risk

Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction. Liquidity refers to how deep or liquid the market is for a particular security. If the market is deep, an investor can purchase or sell a security at current prices.

The risk that investors may experience issues finding a purchaser when they need to sell and might be compelled to sell at a significant rebate to market value. Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.

Posted on by Devesh Deepak Bonds, Risk

Deciphering Bond

In the annals of Investment folklore there is an old saying, if you want to make the most money, you should invest in stocks. But if you want to keep the money you made in stocks, you should invest in bonds.

We always consider Bonds as the most important asset class though it also has the lowest expected rate of return. Bonds are largely regarded as being lower-risk investments than shares, which is why they’re so popular with big institutions such as Banks, Provident Funds, Insurance and pension funds.

Bonds are important as they are a better indicator of wider macro signals and risk measures, rather than shares. Bonds and especially government securities tend to react very quickly to the macroeconomic signals and risk measures. Equity markets try to remain ahead of any earning and the economy uptrend; that is, they’re probably about six months ahead of any data indicating an economic recovery. Equities, in particular, can be very volatile and sometimes share prices are moved by factors that have nothing to do with interest, inflation or GDP growth rates, or economic/business cycles.

Basic Things to Know About Bonds

A bond is a type of investment that represents a loan between a borrower and a lender. With bonds, the issuer promises to make regular interest payments to the investor at a specified rate (the coupon rate) on the amount it has borrowed (the principal amount) until a specified date (the maturity date). Once the bond matures, the interest payments stop and the issuer is required to repay the face value of the principal to the investor.

Because the interest payments are made generally at set periods of time and are fairly predictable, bonds are often called fixed-income securities.

Maturity

The maturity date of a bond is the date when the principal or par amount of the bond will be paid to investors, and the company’s bond obligation will end.

Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years.

 Not all bonds reach maturity, even if you want them to. Callable bonds are common: They allow the issuer to retire a bond before it matures. Call provisions are outlined at the time of issuance of the bond itself.

Coupon

A bond’s coupon is the annual interest rate paid to the bondholder, generally paid out annually or semi-annually on individual bonds. The coupon is always tied to a bond’s face or par value and is quoted as a percentage of par values. It is also referred to as the coupon rate, coupon percent rate and nominal yield.

Bonds that don’t make regular interest payments are called zero-coupon bonds. As the name suggests, these are bonds that pay no coupon or interest. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the most commonly used yield measurement. The yield to maturity (YTM) is a very meaningful calculation that tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will receive (assuming you reinvest these interest payments at the same rate as the current yield on the bond), plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium) on the price of the bond. YTM is useful because it enables you to compare bonds with different maturity dates and coupon rates.

Coupon vs YTM

Fluctuations in interest rates usually have the biggest impact on the price of bonds – interest rates can be affected by many things, including a change in inflation rates. Generally speaking, bond prices move inversely to interest rates because the coupon rate usually remains constant through to maturity. If current interest rates are higher than the coupon rate, the bond is less attractive to investors and drops in value, since investors aren’t willing to pay as much for a series of lower coupon payments. Bond prices increase when the coupon rate is higher than current interest rate levels. To an investor who holds bonds through to maturity, price fluctuations may seem irrelevant.

Let us assume that a bond has a face value of Rs 100 with an 8% coupon rate. A coupon rate or nominal yield indicates that if you hold a bond from issuance to maturity, you are expected to receive the amount equal to the coupon rate every year and par value at maturity. This means that the investor will earn Rs 8 per annum on each bond he invests in.

Scenario1: Interest rates rise to 10%. Even so, the investor will continue to earn Rs 8 that is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 80.

Scenario2: Interest rates fall to 6%. Again, the investor will continue to earn Rs 8. This time the price of the bond will have to go up to Rs 133.

Duration

The maturity of the bond matters. The greater the maturity – the longer the life of the bond – the stronger the effect with regards to gains and losses is of interest rates in the economy.

To estimate how sensitive a particular bond’s price is to interest rate movements, the bond market uses a measure known as duration.

Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid.

If you know how to calculate the present value of the future cash flows, you will very well calculate the duration of the bonds. As an investor, it is good to know the calculation but it is better to understand the relationship among price, yield and modified duration of a bond.

            ΔP = – MD * ΔY

where,

Modified duration = Duration / (1 + yield)

P = Price

Y = yield

Let’s assume that modified duration of the bond is 3 years. So if the yield fell by 0.5%, the price would go up by 3 x 0.5% = 1.5%. If the yield rose by 0.5%, the price would fall by 1.5%.

Modified duration is a standard risk measure in bond fund management but it is important to remember that it is used only for small movements in yield.

Conclusion

Many people including legendary investor Warren Buffett has argued that bonds fail to protect investors’ purchasing power. When taxes and inflation are subtracted from bond returns, investors fail to gain wealth.

This is true if you hold your entire portfolio in cash or bonds, you run the risk of losing out to inflation. This is particularly a threat in the low-interest-rate environment. We don’t think bonds should be shunned. When held to maturity, bonds provide a consistent return of capital. Bonds also have low long-term correlations with stocks, making them a good diversifier. Bonds and shares are two important component of asset allocation and you can’t wish away any of them.

Posted on by Devesh Deepak Risk

Are we Loss averse or Variance averse?

How many times you have compromised on return and invested in a relatively safer instrument; or fretting about the potential loss before making an investment, or worst sold the investment whenever there was the slightest dip in the value of the portfolio. This impulse to protect you is called the safety first principle or “loss aversion.”

The influence of emotions on decision-making is widely accepted. Neurophysiology evidence suggests that loss aversion has its origins in relatively ancient neural circuitry (e.g., ventral striatum). This evidence also helps us to understand while modern finance theories tend to see risk as related to variance in expected returns; the psychology literature tends to link risk to probability or size of potential losses.

The assumption of modern portfolio theory about the efficiency of market and rationality of investor is long been nullified. Individuals do not tend to act rationally when making decisions in a risky environment. Most of the times individuals have little information, process such information using simplified routine, and are influenced by the way in which information are presented to make a decision.

Before the advent of Modern Portfolio theory (MPT), the investment risk is measured in terms of absolute loss or relative loss vis-à-vis of a market index. Variance as a measure of Risk was first introduced by Economist Harry Markowitz in MPT in a 1952 essay, for which he was later awarded a Nobel Prize in economics. This idea of variance as a measure of Risk is so new that it never percolated in the psyche of investors, despite the fact that all the subsequent development in Risk Management – Risk-adjusted return, Value at Risk, EWMA, Downside Deviation or GARCH – uses variance as a building block.

The significance of standard deviation (the square root of variance) can be gauged by the fact that 68.2% of the time your return of the investment will lie between one standard deviation above and one standard deviation below the mean value, 95.4% of the time your return of the investment will lie between ‘2’ standard deviation above and ‘2’ standard deviation below the mean value and 99.7% of the time your return of the investment will lie between ‘3’ standard deviation above and ‘3’ standard deviation below the mean value.

We don’t have empirical evidence to conclude whether individuals are loss averse or variance averse but our experience in the field of investment suggest that individual is more loss averse than variance averse.

Dan Ariely, James B. Duke Professor of Psychology and Behavioural Economics at Duke University, and the author of ‘Predictably Irrational’ and ‘The Upside of Irrationality’, both of which became New York Times bestsellers opined that “People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.”

The asymmetrical behaviour of the individual under the fear of losing money tends to make these common mistakes:

First, they ‘overweight’ the lesser probability and ‘underweight’ the higher probability and sometimes totally ignore a minor event.  Their response to a loss is more extreme than the response to a gain of the same magnitude. Instead of cutting loss, they try to recoup the loss by liquidating their profitable assets—that could run counter to their long-term investment goals.

Secondly, they often increase their risk-taking in order to try to escape losses and fall victim to the sunk-cost fallacy. The sunk-cost fallacy is behaving as if more investment alters your odds, believing the more you put in, the more it will pay off.

Third, they fail to distinguish between a bad decision and a bad outcome. Individual regrets bad outcome of a good company like a weak quarterly result or low returns over a period, even if they have chosen the investment for all the right reason. In such case, regret can lead them to make a decision to sell. This means selling at the bottom instead of buying more.

Lastly, they justify holding the safe investment by comparing the alternatives with respect to a specific point of time, that is, they always evoke Internet bubble of 2000 or Lehman Brothers collapse of 2007 to justify not investing in stocks – thus losing the chance of potential return.

It is interesting to note investors – amateurs and professionals alike, regardless of intelligence or skill level – act intuitively under risky and uncertain condition forgetting that today’s uncertainty won’t likely last forever.

Risk aversion is important. This is natural check and balance – keep us away from financial fraud and also keeps our expenses in control, and helps us to save for a rainy day. But loss aversion is short-sightedness. It happens when we lose sight of our long-term goals, and focus too much on short-term events.