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Investors are Idiots E book on personal finance

Table of contents Chapter 1. AMCs should disclose full commission paid to distributors .................... 2 Chapter 2. Is your fund manager making money for you? ............................................... 4 Chapter 3. Analyst downgrade- time to buy .......................................................................... 5 Chapter 4. Be patient and reap the benefits .......................................................................... 6 Chapter 5. Investors will have to suffer downsides if they want to see returns ..... 7 Chapter 6. Become one of them and see the difference .................................................... 9 Chapter 7. The best advice is available at a reasonable price...................................... 10

Chapter 1. AMCs should disclose full commission paid to distributors

It is a well known fact that AMCs (Asset Management Companies) are willing to take a hit on their books for increasing asset base. The AMCs pay commissions that are higher than the management fees charged leading to a loss for the AMC. The distributor is incentivized to sell mutual fund schemes on the back of higher commissions. The investor is sold or pushed products that may or may not be suitable for her as distributors are incentivized to sell the product. The practise of paying high commissions to sell products cannot be criticized outright. AMCs are willing to incur temporary losses for garnering assets, in the hope that the investors stay with them for a while and also invest in other products floated by the AMCs. AMCs paying higher commissions than what they earn on the fund is buying the investor. In an extremely competitive industry where many funds vie for the same investor, such practices benefit AMCs with deep pockets i.e. AMCs that can absorb losses for a while in order to reach a critical mass. The buying of investors by AMCs has its bad effects. The distributors in order to earn high commissions push products to investors. The distributor ignores correct due diligence procedures in cases where the AMC is willing to buy investors. Investors end up investing in products unsuitable for them as they are hard sold the products by the distributors. Investors may not even realise that they are being bought by the AMC and may end up staying invested in poor performing funds. The AMC is also taking a big risk in buying investors. Investors may not stay in the fund if performance is poor or if markets turn against them. The AMC is absorbing losses on schemes floated by them and these losses prevent them from strengthening key areas of functions such as investment management , compliance and operations. The lack of strong front, mid and back office in turn brings down the performance of the schemes floated by the AMC. The entry load ban by SEBI has forced many AMCs to take a hit on their books as they buy investors. If markets continue to remain in doldrums and the investor base does not increase overall, the AMCs will see their money going down the drain. Continued losses by the AMCs will lead to repercussions on the investor in terms of performance, service etc. The investor at the time of investment does not realise the negatives of being bought by the AMC. SEBI should make all commissions paid by AMCs for distributing the products known to the investor. For example if an AMC is paying 3% as commission for selling a product and the total management fee on the product is 2.25%, the investor should know that the AMC is willing to take a hit on its books in order to acquire the customer. The Investor should then decide whether he wants to be

acquired or not. The buying of investors also makes management costs high as AMCs charge full fees to the investor in order to reduce its own losses. Transparency in the commission structure will go a long way in enlightening investors to products being sold to them.

Chapter 2. Is your fund manager making money for you?

The only return that matters to you is the return on your investments. The return on investments is easy to calculate. If you had invested a sum(s) of money at one point of time or over a period of time, the investments should have yielded a) positive returns b) positive returns that have beaten the opportunity cost of investing in a similar asset class elsewhere. Nothing else matters. Now go a take a look at your portfolio. Look at stocks you have invested in, the equity and hybrid mutual fund schemes that you have invested in and the debt funds that you have invested in. Calculate the total returns you have made from investing. If you have made negative returns, you have lost money and have clearly made the wrong investment decision. If your returns are positive, equate the returns you could have received by investing in the equity index (Nifty or Sensex) or in case of fixed income, investing in a fixed deposit of a bank. If your returns are higher than the equity index or a fixed deposit you have made the right investment decision if not you have made the wrong decision. The question of timing arises here. Comparing or judging returns over a short period of time is not ideal as investments do take some time to fructify returns. A too long period of time could mean that all your returns came in one boom period, while other periods could have actually yielded poor returns. A good period of comparison is three years, as there is enough time for investment performance. Once you have calculated your returns, judge for yourself if you are making money on your investments or not. If you are not making money in a stock or an equity scheme, you have to seriously ask yourself whether you should continue holding a stock or the scheme. If you are staying put in your investment it implies that you have good faith in the company or fund manager with whom you have entrusted your money. If you do not have faith, then you are holding on to hope, which can be eternal. Holding on to losing investments is expensive. If it is a stock, the cost is the opportunity of not investing in the index or any other fundamentally good stock. If it is a mutual fund scheme, the cost is the cost of management fees plus the opportunity of not investing in other performing schemes or index or fixed deposits or other fixed income instruments. The choice of a wrong investment can be disastrous. Even if you had invested in a stock or fund at the lowest levels of the Sensex when it fell to 9000 from 21000 levels post the bubble burst in 2008, the stock or fund could actually have 4

delivered returns of 30% to 40% less than the Sensex return of 85%. If you do own such stocks or funds, you have to think seriously on why you made the investments. Hopefully you do not own such stocks or funds.

Chapter 3. Analyst downgrade- time to buy

Brokerages are in a rush to downgrade Sensex and Nifty earnings growth and lower 2011 year end targets for the indices. Earnings growth for Sensex and Nifty companies has been reduced by 1.5% to 2% for fiscal 2011-12. Sensex and Nifty year targets have been reduced by 10% to 15% by analysts. All these downgrades have happened in the last four months, when all hell broke looses. RBI raised benchmark repo rate by 125bps in the last four months even as inflation climbed from 8.3% to 9.3%. Global issues of emerging market inflation and developed market debt came into the fore in the April-August 2011 period. It just did not make sense for analysts to stick to their forecasts made when all things were going along well and the downgrades started happening in a rush. Analysts have not been clairvoyant in lowering their forecasts, the markets have made them to reduce forecasts. For example an analysts with a Sensex target of 20,000 for calendar year end 2011, will have to think many times before retaining the target as the Sensex is at 16,500 levels now and it will have to move up by over 20% in four months time to reach the target. It makes better sense to lower targets now. Lowering targets hurts investor sentiments as fund managers and other institutional investors look to maintain higher levels of cash or become more defensive in their investments in equities. This depresses indices further and provides great buying opportunity for forward looking investors. Investors have to ask themselves, why analysts were bullish on the markets just six months back and have turned around completely now? The issue of inflation in India and other emerging markets was raising its head one year back, but policy makers and analysts failed to judge the true nature of the inflation. As a result, when inflation hit the economies, it hit them hard. India, China, Brazil, Korea are all facing multi year inflation highs. The issues of sovereign debt came into play one year back, when Greece default talks came up. Again analysts ignored the true nature of the debt and continued on their positive forecasts. Debt issues have played havoc on markets recently with equity markets falling by over 10% across the globe. The same is true with analyst forecasts pre 2008 crisis and post 200 crisis. Pre 2008, analyst called for a continued bull run of the markets which saw domestic indices moving up by three times in the 2005-2008 period. The burst of the credit bubble forced them to call for a bear run on the indices. Analysts typically react to what other analysts are doing and what the market is doing. Hence the failure to forecast potential downsides and upsides. 5

Analysts should actually be focusing on what is going to happen down the line and not what has happened in the past. Looking ahead, there are expectations that inflation will come off in India and other emerging markets. The policy actions of central banks in emerging markets coupled with governments in inflation driven countries tightening their belts are positive factors in inflation coming off. In the developed world, debt issues are forcing a cut in government expenditure and this is positive for the debt ridden countries in the longer term. The US fiscal deficit is actually forecast to come off post 2012 on cuts in government spending. Countries with high debts will see growth coming off in the near future and that growth coming off is largely factored in equity prices. Global markets have not performed for the last three years with all the global indices trading in negative territory from highs seen in late 2007. Economies are not in a strong footing at the present, but they are forced into policies that will make then stronger down the line. There are analysts who have called bubbles and depressions at the right time but they are few and far between and usually warnings from such analysts are ignored by most, as it does not suit investors to hear such warnings. Investors should always listen to what can go wrong in analysts forecasts than listening to the forecast itself. This is a time to listen to what can go wrong with downgrading markets at present.

Chapter 4. Be patient and reap the benefits

Investors should look ahead into the first quarter of fiscal 2012-13 for better things to come and buy into equities, bonds and the currency now. It is a good time to put away the negative sentiments prevailing over Indian equities, bonds and currency and look at the positive side of things. The Sensex and Nifty and the Rupee are down over 10% year to date while ten year benchmark bond yields are up by over 90bps. Inflation, rate hikes and global economic turmoil have affected sentiments of investors. Inflation and rate hikes are peaking out while an agreement amongst European union member on resolving the sovereign debt crisis in the Eurozone can alleviate fears on global economic turmoil. Inflation, according to RBI, is still a threat that is not going away soon. The RBI has erected strong fences against inflation through a series of policy rate hikes, including the latest one of 25bps that has taken the benchmark repo rate from 4.75% to 8.5% in over eighteen months. RBI has signalled that its done with its defences against inflation but a constant vigil has to be maintained. Inflation is expected to stay over 9% till end December 2011 before trending down to 7% levels by end March 2012. Until the threat of inflation passes, monetary policy will be tight though there will not be any more repo rate hikes.

Investors will have to be patient till such time the threat of inflation passes. Going by RBIs forecasts inflation is likely to stay at a lower trajectory in the first half of fiscal 2012-13. Inflation staying at lower levels will give the central bank the necessary ammunition to drop its vigil and look at confidence boosting measure such as increasing system liquidity and reducing policy rates. Markets are forward looking. RBIs comment on the last of the rate hikes coupled with a reformist savings rate deregulation measure has enthused a strong rally in equity markets, with the Sensex and Nifty rallying by over 2% each. Bond yields too fell by around 6bps post the policy announcement while the Indian Rupee gained over half a percent against the US Dollar. The markets enthusiasm may not last too long given headwinds of global economic issues, poor government finances and higher interest rates, but there is definitely a sense of relief that rates hikes are over or is on its last legs. The savings bank rate deregulation is reformist. The RBI has allowed banks to determine their own rates on savings bank accounts, which until October 25th was fixed by the central bank. Banks can now compete with each other for deposits and this will both benefit the customer on the deposit side as well as the borrowing side as banking efficiencies will improve. Equity markets have initially started to single out banks with high savings bank accounts to sell (HDFC Bank, SBI, PNB all fell over 2.5% over the day) but in the long run, efficiency will gain over short term sentiments.

Chapter 5. Investors will have to suffer downsides if they want to see returns
Investing in bear markets requires three traits. The first trait in order of rank is to bear downside risk. The second trait is to think ahead and the third trait is conviction. Investors having two out of three of these traits can also invest in bear markets, but of that bearing downside risk is of primary importance. Bearing downside risk Downside risk is the risk of your investments losing money due to depreciation in value. In bear markets investing in equities will have downside risk. The risk varies with the security. The index (Nifty or Sensex) will have the least risk followed by large cap stocks, mid cap stocks and small cap stocks. The levels of equities in bear markets may look good in terms of many factors including valuations, however every level will be tested by the market. For example Nifty may have looked good at 5500, 5300,5000 and 4700. Investors buying into the Nifty at 5500 with a long term point of view will hesitate to buy the Nifty at 4700 as they have already seen depreciation of 15% on their investments. The 15% depreciation is the downside risk the investor is taking when investing in the Nifty at 5500.

Investors unfortunately do not see it that way. The look at it as instead of making money they have lost money and that prevents them from staying invested or investing further sums of money at lower levels. It is a common investor trait and has no rational attached to it. No investment will make money from day one. Markets by nature are volatile and there will be upsides and downsides. In bear markets, investors will have to suffer downside risk when they buy and in bull markets investors will have to suffer upside risk when they sell. Hence investing in todays markets with the Nifty at 4800 levels and the Sensex at 16,000 levels with return expectations of over 25% will come with downside risk in the form of the Nifty and the Sensex going down further by 10%. Investors will have to judge the downside risk they can bear. If they can tolerate higher downside risk they should look at individual stocks but if they can only tolerate lower downside risk they should stick to the index. Bear market investments will always lose money first before giving higher than average returns. Thinking ahead Investors buying in bear markets will have to have a vision of the future and that vision should look bright. If the vision does not look bright then there is no reason to buy stocks in bear markets, as the investment will definitely turn sour before becoming sweet. The sentiment is bear markets are bad and everywhere one looks there will be negative news. Investors will have to filter out negative news to look at the positives, if any, and then take investment decisions. Todays news is all about sovereign debt crisis, fall in rupee, scams, corporate debt burden etc. In all this, sovereigns are pledging to cut deficit, RBI and government is acting against in inflation, corporates are cutting costs and looking to prune debt and become productive and investors are becoming more risk averse. All these are positives out of the negatives as it will strengthen economies and corporates down the line while investors will demand their price for investing. Conviction Bear markets will test ones conviction. Everyday news will be bad, investments will depreciate in value at the blink of an eye and there will be more reasons to sell rather than buy. Bear markets by definition are markets where prices continuously fall and usually one knows one is in a bear market when prices have fallen sharply bringing down sentiments along with it. Investing in such markets require a lot of conviction of how the future will pan out. The Nifty and Sensex are in the fourth year of a bear market and are at least 20% below levels seen in late 2007 and early 2008. Many stocks have lost more than 75% of their value in the last four years. Investors will need to have conviction that this bear market will not last for another four year before investing in such markets.

Bear market turnaround happens without one realising it. Prices will first stagnate at lower levels before trending higher. Oversold markets will see sharp rises from lows at first before stabilising and then again trend up as more investors realise value in stocks. These are actually the first signs of a bull market and investors will have to have conviction to catch this initial bull phase of the market. Bull markets too behave the same way as bear markets. Investors require to stomach loss in profits to sell in bull markets. Investors would have to think ahead of potential risks on sustained rise in prices of assets. Conviction to sell will have to be there to exit bull markets. Thinking back if investors had these traits when the market was peaking out in 2007 a lot of money would have been saved.

Chapter 6. Become one of them and see the difference

The general public should start behaving like capitalists. The idea of investing is to make money, the other stuff like doing good for the nation etc. can come later. An FII investing in the Indian markets does not care two hoots about India, he cares about returns, which he can get. If the returns he gets is good he will invest more and if returns are poor he will pull out money. Investors should think the same way. Put in money when return expectations are high and pull out money when return expectations are low. Investing is a capitalist activity. Investors behaving like capitalists will actually lead to highly efficient market where management delivering returns will benefit and management not delivering returns will suffer. Trying to fight boardroom battles or protest in shareholder meetings or occupy campaigns will not help. India is going to get its chapter of Occupy Wall Street with an Occupy Dalal Street campaign starting Friday the 4th November 2011. The Indian edition of the campaign has political overtones as the sponsor is the CPI (Communist Party of India). The end result of Occupy Wall Street is unclear, as the protestors do not have definitive demands. The Occupy Dalal Street will in all probabilities not enhance any value whatsoever for the general public and in fact will cause more disruptions in the already disrupted city of Mumbai. The underlying frustration amongst the general public across the world is clear. The bankers and the corporate big wigs are getting away despite causing great upheavals in financial markets that are threatening to wipe out economies while the public bears the burden of the aftermath. Central banks from the US Federal Reserve to the Bank of England have bailed out large banks with taxpayers money and there is nothing left to show for it expect a weakening economy and job losses. Post the 2008 credit crisis, economic growth forecasts for the globe have been cut by half a percentage point for calendar year 2012 by the IMF. US unemployment at 9.1% rate is way above the 5% rate seen in January 2008.

In India inflation running at close to double digit levels over the last one year has hit the common man hard, while investors are living with an equity market that has not recovered since the bubble burst at peaks of 21,000 on the Sensex in late 2007 and early 2008. The general public is seeing huge amounts of wealth being amassed through corruption in telecom spectrum auctions, mining and real estate. There is definitely a case for angst amongst the public. The public angst cannot be addressed through a campaign against any so called capitalist institution such as the BSE (Bombay Stock Exchange). In fact the BSE has been swamped by the government owned NSE (National Stock Exchange), which dominate trading volumes in equity, commodity and currency markets. The protest should actually be held outside the NSE, but NSE is an electronic exchange and hence protestors, instead of baking in the heat and dust of BKC (Bandra Kurla Complex) where NSE is headquartered should launch online campaigns in Facebook and Twitter and other social networking site. The BSE and NSE are doing their jobs in facilitating trading in various asset classes. Standing or sitting outside a stock exchange will not get protestors anywhere. Capitalism looks to optimise profits by allocating resources in the best possible manner. In trying to maximise profits some or many of them stray and do illegal things, which cause distress to the public. That leads to protests such as Occupy Wall Street that leads nowhere. The public too must share responsibility. As long as the going is good (read equity and property markets are rising) the public is silent. The public resents losing money in markets, which are inherently risky and in the process losing other comforts as well. If the public had exhibited caution in rising, overheated markets market upheavals will not occur.

Chapter 7. The best advice is available at a reasonable price

The time when the transactor was also the advice provider is over. Investors do not have to depend on the transactor for advice and given that transacting is cheap, she can easily separate the transactor from the advisor. For example an investor can take advice from an independent advisor on what asset class to buy or sell and then transact on her chosen platform. In this way the investor is protected from a transactor's bias (who gives advice for transaction commissions). The choice of the advisor becomes important now. Who can provide the right advice on what and when to buy or sell? Investors can take advice from many sources. Each source has its pros and cons and investors have to weigh them accordingly when listening to advice. The media is the most prominent in doling out advice. Newspapers, magazines, TV Channels, radio shows and web media all proved advice on investments. The media gets in experts from outside or publishes in house research to advice investors on what to buy or sell. However, investors can only take advice from 10

the media and if the investments do go wrong the media does not claim accountability. Investors acting on advice from the media do not have a shoulder to fall back on when the investment turns sour. Investors can take advice from brokerage houses and banks employing their own research analysts. Such research is usually well informed and has a lot of analysis behind it. However, brokerages and banks publish research that is usually biased on the buy side as it makes the investor transact. Time and again investors have been caught on the wrong foot by acting on research given by transactors. Investors can participate in forums on the net or subscribe to any of the advice sites on the web. Investors again have to look at the quality of advice, the expertise of the people behind the advice and whether there is accountability for the advice. Accountability need not be in the form of financial accountability but in the form of accountability for time to listen to the investor when investments turn sour. The best choice for an investor will be an advisor who ensures that he or she is available to the investor at times when the investor needs a shoulder to lean on. It is easy to get advice but it is not easy to get the time from advice providers. Investor should choose qualified experts who will give advice and then be available for the investor after the advice is generated. Such advisors will charge and investors should not shy away from paying for such advice. Who is qualified to give advice? In the hierarchy of financial markets the most qualified are the persons who institutions such as banks, hedge funds and mutual funds appoint to handle money. However gaining access to such experts is difficult unless he or she comes out of institutions to provide advice to average investors. Analysts working for institutional brokers who cater to large fund managers are the next on the hierarchy of qualified persons. Good analysts earn a lot of mileage for brokerage firms appointing them and hence are top of the line in their trade. Average investors cannot gain direct access to such experts unless he or she has come out of the institution to provide advice to average investors. The third in the hierarchy are all the investment professionals working for second and third rung buy side or sell side firms. The fourth in the hierarchy will be the wealth managers or independent advisors who have not really managed money but have trained themselves to give good advice. The last on the hierarchy are so called advisors who do not have any qualification or training but take advantage of bull markets to give advice. Unfortunately for the investor the last on the hierarchy is the most accessible and any investment decisions made on the advice of such advisors will be bound to go wrong. It is easy to spot an investment quack, they will cull out articles, information, analysis etc from books, magazines, newspapers, research reports, blog sites and other information sources and then forward it to their clients. Quacks can never think on their own and will never have an independent opinion. They will also push what sells.

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Investors should look the best for themselves and thanks to the internet many experts from the top of the hierarchy are giving expert advice at reasonable price for the average investor. Investors should look out for such experts and if they cannot find one then they should go down the ladder.

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