Avoid Recency Bias

Recency bias hurts the most when a bull market ends. We tend to buy investment ideas which did very well in the recent past. This happens across the board. The stocks in favour remain the ones which hit recent highs and gained the most in the past year. We tend to mechanically buy the dips. Market leadership remains the same and money continues to disproportionately be allocated to stocks and mutual funds with good past performance. We continue to use the recent performance to justify our investment choices. But, that logic is only optically right most of the time. Stock prices know more than we do. When bull markets end, we need to think afresh.

Mr. Market will not continue to react the same way he did in recent corrections. Mr. Market will change his investment preferences and priorities. But, Mr.Market will always shift slowly. And, we mostly fail to read that change even when it is slow. We end up seeing it only when it is too late.

More money is lost chasing investments driven by recency bias. This is a time to shed recency and build a portfolio designed to perform in the future.

Validating Advice

Podcast Transcript

Every portfolio often needs validation. Our ideas are constructed in a particular context and we find that soon thereafter the market context changes dramatically.

My own experience from previous bull runs is what comes to mind. When we come out of a bull market, we tend to think our portfolio is strong given that we built it in good times. But, on the contrary, portfolios built in the best of times almost always carry serious weaknesses. The reasons are simple.

When valuations are very high our choices are not adequate. We tend to rush into decisions which later look very ordinary. Bull markets also tend to raise the tendency to imitate. And most importantly, decision-making speeds tend to trip the quality of our investment process.

Then, when we land in bear markets, we begin to regret what we did. Often, we think we could have done things very differently. Choices suddenly grow wider. We start seeing better opportunities.  And, we tend to have little or no money.

I recall that every bear market threw this challenge at me. But what is interesting is how I learnt to face that challenge. I would take a fresh look at my portfolio. And, I would seek peer validation. So, this let me draw up a fresh list of ideas. Induce fresh thinking and put together a new line up. This gave me the choice of changing my fortunes. I would get my thought process validated by a smarter peer before rushing into action. This helped to be sure that the remedial actions delivered.

If you are an investor in shares or mutual funds, this is a time when the market context is changing rapidly. Your portfolio constructed to an earlier context needs expert review and corrective action. Merely staying put with past decisions may not end well. You need to validate that you are doing the right thing.

A review with someone who can give an objective view can be greatly helpful. Choosing the right person to advise holds the key. My own learning is that this choice can make or break your investment performance.

A review needs to happen in competent hands. I strongly believe in that. I hope you reach out to your advisor and do the right thing quickly before it is too late.

If you don’t have a competent advisor, it is the time to find one.

Debt Note: A New Stance

Investment Strategy:

The RBI’s stance of calibrated tightening indicates that rate hikes are possible but not mandatory. As investors, it is important to capitalize on rising yields to structure a layered portfolio. The spread between the repo rate and the 10 Year Government Security is nearly 1.5%. This presents a compelling investment opportunity as it is normally 0.5% to 0.75%.

 

The Background:
The last two months have been eventful for financial markets. September witnessed tight liquidity conditions, the default from IL&FS, a new milestone in the NPA resolution process, new lows for the rupee, and much more. All these factors have made bond investors wary of the bond market. Recent volatility and correction of financials in equity markets has raised investor concerns across the board.

Defaults have risen from “asset-liability mismatches”. This is when companies borrow money for long-term projects using short-term instruments to reduce the cost of borrowing. The capacity for these assets to generate cash in the short-term is limited and could trigger defaults and destabilize the financial system.

The RBI Policy:
Market consensus indicated that the RBI would raise the repo rate by at least 0.25% in its October meeting. However, they left the repo rate unchanged and modified their stance from neutral to calibrated tightening. This surprised participants, since rate hike expectations were already factored into the bond prices.

Interest rates are not the only way the central bank can stabilize markets. To address illiquidity, the RBI conducted OMO purchases and reduced the SLR [Statutory Liquid Ratio]. Inadequate liquidity creates panic and reduces financial stability.

Recent inflation prints have been below the targeted 4%. However, rising oil prices, the upcoming festive season, and increased liquidity could push it up.

The Way Forward:
It is important to note that the rupee has not been as severely affected as its peers. Domestic macroeconomic indicators remain promising. Growth has exceeded forecasts and inflation is largely contained. The real concern is to protect this stability and build resilience towards global threats. By controlling inflation, remaining fiscally prudent, creating appropriate capital and liquidity buffers, and continuing structural reforms, economic resilience can be sustained. A stable economy attracts investments and promises growth.

Concentration Risks Return

The crack in US markets was long coming. Lest we forget, this is America’s longest bull run in history and their economic problems are far from over.

So, what caused this euphoria? Liquidity has been at the core of America’s economic problems and solutions. For a decade, America has been grappling with how to deal with the liquidity tiger and euphoria has become the unintended outcome.

Sadly, the cause of euphoria is ETF investing. This was a way of investing that was supposed to mitigate risks.  Instead, it seems to have done exactly the opposite. ETF investing created a massive concentration of capital in a basket of stocks. As money kept pouring in, a bubble was created. Now, it seems to be unravelling.

But, Indian markets had a reason of our own to correct. We had too much concentration of financials in our indices. This will need to be fixed and our markets will do so in the coming quarters. In the interim, some pain is inevitable.

We are back to learning basic lessons on concentration risks.

When Greed Bests Fear!

The stock markets capitulated this week. The fears were largely overdone. The sharp dip in OMCs clearly indicates the symptom. The markets are clearly gripped by the fear of loss. And, investors dump every stock where they fear further loss. And the very risk aversion they display is causing huge losses to investors.

The disconnect between decision making and value is stark. Large caps losing almost 30% in just two trading sessions is now becoming a regular feature. The most valuable index bellwether lost 12% in just two trading sessions. The cracks are widening and sentiment could well capitulate unless something calms nerves and eases the fears. Results of the better-performing companies can do their positive bit. But, even that may not last for too long.

Not everything is lost yet. Contrarians will definitely show up in this market. The coming weeks could well be their best outing. A year later, this phase will be part of folklore. But, standing out and counting on conviction is not going to be easy. The time when greed bests fear was never meant to be easy. The coming weeks will prove that for the umpteenth time.

Happy investing!

The Opportunity in Crisis

 

Podcast Transcript:

Clearly, our markets have walked into a crisis we could have avoided. It was in good measure… our own making.

Too much liquidity chasing stocks had made markets way too expensive. But, investors kept pouring money into SIPs. And the markets refused to correct despite FII’s selling through the year. The sharp spike in oil prices and the crisis in the financial sector spooked what seemed like a never-ending party. Within a week, the markets look to have lost all their resilience. From a time when nothing could spook our markets, we have swiftly transitioned to a point where no news is viewed positively by the markets. Sentiment has a way of swinging towards extremes very quickly. The current swing is not unusual. We tend to overdo our greed and fear alike. Now, it is the turn of fear to overplay itself.

Nobody talks of buying equities now when supply of good quality stocks at moderating valuations is rising. When we should be shopping for equities, investors are running scared. The sharp fall in financial stocks has greatly shaken up the index, and investor sentiment has been mauled. Public mood is despondent.

But is the situation so dark as the markets are making it out to be?

Probably not. While oil prices present a real risk to our macros, the situation is unlikely to prolong for too long. Trade deals and oil deals between US-China and US-Iran will probably give India much needed relief on the macro front.

But, it is difficult to predict when this uncertainty will end. So, there is no option but to wait. But waiting to undertake investment actions does not make sense.

A sharp fall in our markets presents a very attractive long-term buying opportunity. This opportunity must be selectively bought into. It is a good time to refocus investment portfolios towards the future. Deep contrarians can bet on the reversal of oil prices. Even risk averse investors can dip into defensive themes, which looks far more attractive now than a few weeks ago.

Mutual fund investors are in a bigger crisis than the equity investor. They had focused heavily on mid and small cap themes in 2017 & 2018. These are showing negative returns. Many investors are also wondering how to deal with their balanced funds which they wrongly bought to replace their fixed deposits.

A proper review of investments and a timely restructuring of portfolios is the need of the hour. Investors must now seek forward-looking advice. And, swift rejig may not work going forward. For instance, the financials theme may see rough days ahead. A new market leadership is in the making. An investor must clearly be forward-looking in his approach and be willing to walk out of mistakes. Given that most investors are fully invested now, fresh monies must be created within their portfolios itself. This can be done only by selling the weaker ideas and betting more on the stronger ones.

Crisis is always clearly an opportunity. Stocks get thrown away in a crisis. This makes it a good time to invest in mutual funds too. When more monies are invested during crisis hour, we give ourselves a better chance to leverage the opportunity. Crisis hour always tends to gradually reach their end. Then the market swiftly put the crisis behind and moves on.

A smart investor must use the crisis hour to buy cheap and then hold onto his investments for long periods of time. Buying into a crisis is the current opportunity. It clearly is too good to pass.

 

Systemic Shocks Return

The markets saw heightening volatility this week. The stress was very visible in financials, small caps, and midcaps. The sharp cut in valuations of companies in this place has come as a nasty surprise. What went wrong?

Firstly, investors assumed that growth would last for a long time. Secondly,  they believed profitability would hold steady. Third, the assumption was that valuations would remain stable. All three assumptions went into a tailspin when oil, the dollar, and liquidity went out of control.

While all three variables will stabilize over time, market confidence in financials and small caps will not return anytime soon.

This is going to be a big worry for markets in 2019. Indices need new drivers that can replace financials. Investors can’t exit small caps and midcaps. Mutual funds will struggle to hold onto assets when faced with aggressive redemption pressures. This will compound valuation concerns in this space.

Overall, markets need to walk out of their excesses of 2018 with as little damage as possible. This is not going to be easy.

Reverse Mortgage Loans

What would you ideally need to retire? A steady flow of income, a sizable corpus, and a sense of financial security. Imagine you saved consistently but invested predominantly in real estate. Upon retirement, you would find that while you were still well off you might be strapped for cash. Today, young people aspire to own their own homes and buying a house is easier with higher disposable incomes and better access to home loans. So, rental income may not be as lucrative or reliable as it was before. Investments in property are capital intensive and they tend to skew asset allocation in their favour. While owning real estate imparts a sense of financial well-being it does not offer liquidity. But, financial independence is integral to a financial security. So, could a reverse mortgage be the solution for someone who is heavily invested in real estate?

 

What is a Reverse Mortgage?

Think of it as the opposite of a home loan. Under a reverse mortgage, you pledge your house to the bank, who in return offers to pay you in regular intervals over a period of time. The advantage of a reverse mortgage is that you and your spouse own the house through your lifetimes.

This means that you remain responsible for the upkeep, insurance, and taxes due on your property.

Depending on the payment structure you use, you may receive an inflow for a fixed term (Regular Reverse Mortgage Loan – RML) or throughout your lives (Reverse Mortgage Loan Enabled Annuity – RMLeA).

Reverse mortgages are typically offered only to senior citizens.

 

Structuring Income

Banks allow you to structure your payments regularly or as a lump sum. You can also do a combination of both through either a normal reverse mortgage loan (RML) or one that is converted to an annuity (RMLeA). It’s important to understand the features of each option.

RML: The RML offers payments for a fixed term. You would receive no income if you survive the term of the loan. The maximum term that RMLs offer is twenty years but it could also be lower depending on the bank. The payments made by the bank are linked with the principal borrowed. The income you earn from the bank under an RML is currently not taxable.

RMLeA: In the RMLeA, the bank transfers the loan payment to an insurance company who would purchase an annuity on your behalf. You would continue to receive annuity payments (pension) until your death. The income you earn from the annuity is taxable.

The Fine Print

For starters, the loan issued will not be equal to the value of the house. Banks issue a loan based on the LTV (loan to value) percent, and not the actual market value of the property. The LTV depends on various factors such as the location of the property, the borrower’s credit history, the bank’s policies, etc. The LTV normally ranges between 40 per cent to 60 per cent of the value of the house.

Additionally, RMLs have higher interest rates (11 per cent per annum currently) than housing loans (8.3 per cent-8.7 per cent). Since the title is never transferred to the bank, at the time of settlement, the tax liability will fall on to the legal heirs.

The RML can be settled in two ways. Either your legal heirs buy back the house by settling dues with the bank (principal and interest payment). In this case, they would be eligible for only one year of tax benefits (at present the maximum deduction is Rs. 1.5 Lakhs of principal and Rs. 2 Lakhs of interest) on the home loan payment. Or, the bank could sell the property. The legal heirs would be entitled to any profits but would be liable to pay capital gains on the sale. This is applicable to both RMLs and RMLeAs.

There are restrictions on what you could do with the lump sum that the bank pays you – for instance, you cannot invest in equities. Over and above this, you would have to pay a processing fee and there may be other associated charges.

Reverse mortgages are expensive financial products. They limit your investment options considerably and are tax inefficient. They could also be cumbersome for your legal heirs.

 

What Are Your Alternatives?

If you are keen on financial independence, you could liquidate your real estate assets and downsize to a smaller apartment. Contrary to popular belief, renting makes more financial sense than buying real estate. The problem with annuities is that you don’t have access to your entire capital. If you like the concept of a reverse mortgage, you could directly enter into an informal agreement with your children instead of using an intermediary like a bank. Financially speaking this might be a better solution for the family.

 

This article was also posted by SilverTalkies

 

Time To Be Proactive

A relatively insignificant event triggered a massive scare in Indian financials on Friday. But, the story does not lie there. It lies in the institutional imperatives clashing with individual investor interests. When there is a problem, either of solvency, liquidity or of risks, it is the bigger investors who bail out first.

The US 64 crisis is a classic example of this behaviour. Retail investors had to wait for years to get their capital back. The loss of opportunity was significant, and strangely, retail investors bore it quietly. The current crisis in a leading infrastructure lender is many times bigger than the UTI crisis. Importantly, it comes with the same symptom of US 64. The lenders run a potential risk of getting stuck without receiving monies for an indefinite period. This is going to make corporates who have parked surplus with such lenders to rush for the exit gate.

It is fair to extend that the debt mutual funds are going to struggle to meet bulk redemptions in an already illiquid market. This was what we witnessed on Friday. While the focus was intensely on which paper got sold and for what reason, we have not got any whiff of which large investor caused this panic. That is where the challenge lies for all market participants and by extension the regulator, as well as the Finance Ministry. We need a strong proactive mechanism to provide liquidity in such situations.

Memory may be short, and most would have forgotten how the RBI and the Finance Ministry reacted to avert a crisis the last time this happened. But, we are going to need much stronger effort and heavy lifting from both in the near future. These are interesting times.

A Decade After Lehman

 

“Prophecy is a good line of business, but it is full of risks.”
~Mark Twain
 

 

These words ring a bell as we approach the end of a decade after Lehman. Predicting almost never brings glory to the person doing it. Even if, by the twist of fate, the prediction is spot on, there will be enough people who will find ways to negate its veracity. Nobody likes accurate predictions as they are glaring reminders of what we failed to do about them.

So, we don’t even hesitate to lie to ourselves. We embark on an elaborate exercise of self-deception, by distorting the sequence of past events, altering narratives, and creating a new spin around inconvenient facts. But history remains objective.

Financial history has an indelible empirical trail. Numbers don’t lie. New narratives surrounding Lehman are mostly excessive personal indulgences. In a nutshell, the world got greedy, American capitalism lost its way, and that led to the meltdown. America can ill afford to simplify macroeconomic risks once again. The pervasive thought process that America needs to save, invest, and borrow sensibly still seems a long way off.

Today, we need to recognise that we can have another meltdown if we refuse to learn from history. Uncontained speculation makes real business look uninteresting. A stock market simply shouldn’t look better than businesses.

Prophesying that good times will last forever is never sensible. With that sombre prophecy, here is a solemn moment to the ghost of Lehman.