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Path to Financial Independence by Ranjit Kulkarni

This book Simplifies and De-Mystifies Investing.

With the help of humorous real-life anecdotes and practical strategies Ranjit unravels the framework, temperament and wisdom required for successful investing.

Inspired by the wisdom and writings of investment legends Benjamin Graham, Warren Buffett and Philip Fisher, this book provides a balanced and prudent approach towards investing.

It is essential reading for achieving a life time of financial independence.


Ranjit Kulkarni, an MBA from IIM Lucknow, works in the IT and Management Consulting Industry. This book is a result of his deep interest in investing and a passion to simplify it for the individual investor. He lives in Bangalore with his wife and son . For more visit his blog at www.ranjitkulkarni.com

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Path to Financial Independence by Ranjit Kulkarni

  1. 1. CONTENT INTRODUCTION....................................................................13 P A R T O N E : WHAT EVERY INDIVIDUAL INVESTOR NEEDS TO KNOW ....................................................... 17 WHAT IS FINANCIAL INDEPENDENCE AND WHAT FACTORS LEAD TO IT .......................................19 WHY COMPOUNDING IS THE BEST KEPT SECRET OF INVESTING SUCCESS .....................................................22 SIMPLE STEPS TO FOLLOW FOR FINANCIAL INDEPENDENCE .........................................25 WHY IS AGE-BASED ASSET ALLOCATION MOSTLY WRONG .............................................................................30 HOW TO USE DIVERSIFICATION TO REDUCE 3 TYPES OF RISK ..............................................................33 WHAT ARE THE FINANCIAL AND PSYCHOLOGICAL BENEFITS OF REBALANCING ........................................36
  2. 2. HOW TO DECIDE WHICH TYPE OF INVESTOR YOU SHOULD BE ............................................................39 WHAT TO AND WHAT NOT TO LOOK FOR WHILE SELECTING MUTUAL FUNDS ......................................42 IS DIRECT STOCK INVESTING WORTH IT OR SHOULD MUTUAL FUNDS DO .....................................................46 IS YOUR HOUSE AN ASSET, A LIABILITY OR AN INVESTMENT .............................................................49 HOW TO USE LOANS AND PREPAYMENT TO YOUR ADVANTAGE........................................................53 WHY HAVING FIXED INCOME INVESTMENTS IS IMPORTANT .................................................................57 IS GOLD REALLY AN INVESTMENT ...................................61 WHY INSURANCE IS NOT INVESTMENT .........................64 HOW SHOULD I SELECT WHICH STOCKS TO INVEST IN ..................................................67 SHOULD I SELECT STOCKS BASED ON PAST PERFORMANCE OR HOPES OF THE FUTURE............70 THE DEBATE ON MARKET EFFICIENCY: DOES IT MAKE A DIFFERENCE TO INDIVIDUAL INVESTORS ..............................................73 WHY LOOKING AT THE PRICE OF EVERYTHING MAKES ONE UNDERSTAND THE VALUE OF NOTHING..........................................................................77 P A R T 1 : KEY TAKEAWAYS..............................................81
  3. 3. P A R T T W O : WHAT EVERY INVESTOR MUST REMEMBER ABOUT TEMPERAMENT AND BEHAVIOUR .......... 85 WHY TEMPERAMENT AND BEHAVIOUR MAKE A DIFFERENCE......................................................87 HOW TO HANDLE VOLATILITY BY CREATING A MIND-SET.......................................................................89 ARE YOU LOSS AVERSE OR RISK AVERSE .......................91 WHY THE INVESTOR’S WORST ENEMY IS HIMSELF .....95 ARE SUNK COSTS AFFECTING YOUR INVESTING BEHAVIOR ........................................................................99 Mj ds vkxs thr gS - WHY LONG TERM INVESTORS SHOULD NOT FEAR MARKET CRASHES.................................... 102 WHAT RAHUL DRAVID CAN TEACH US ABOUT INVESTING......................................................................106 WHY IT IS IMPORTANT TO TOLERATE BOREDOM IN ‘RANGE-BOUND’ MARKETS....................................110 BREAKING NEWS: PRAY DURING MARKET FALLS! .......112 THE SIX HATS OF AN INVESTOR ......................................115 ARE YOU SUFFERING FROM ATTENTION SURPLUS DISORDER .....................................................118 WHAT TO DO WHEN UNCERTAINTY IS CERTAIN AND NOBODY KNOWS NOTHING ............................121 OF BARBERS AND BROKERS: WHY IT IS IMPORTANT TO KNOW WHAT YOU WANT............124
  4. 4. WHY NO NEWS CAN OFTEN BE GOOD NEWS ............. 128 WHAT’S IN A NAME – WHY NAMES ARE IRRELEVANT IN INVESTING .......................................131 WHAT DO ‘HORN OK PLEASE’ AND ‘MUTUAL FUNDS ARE SUBJECT TO MARKET RISKS’ HAVE IN COMMON ...................................................... 135 NONSENSE GENERATOR: HOW TO BECOME A MARKET EXPERT ........................................................138 LIQUID OXYGEN SYNDROME: A MODERN DAY ILLNESS OF A HIGH PAYING JOB AND A HIGHER EMI................................................................141 HE WHO PAYS THE PIPER CALLS THE TUNE: THE IMPORTANCE OF STRUCTURE ..........................144 THE DILBERT ONE PAGE SUMMARY: ALL THAT ONE REALLY NEEDS TO KNOW ..................................148 BEYOND OPINIONS: THE IMPORTANCE OF DECIDING TO DECIDE .................................................151 ENTRY LOAD AND BUBBLY SODA: LOSING THE FOREST FOR THE TREES......................................154 OF LIFE AND DEBT: SISYPHUS AND THE GREEK TRAGEDY.........................................................................157 RUNNING TO STAY AT THE SAME PLACE: TUM KISLIYE BHAAGTA HAI BHAI ........................... 161 BABA BENGALI AND NIGERIAN SCAMSTERS: HOW BECOMING A FALSE POSITIVE HELPED!........164 FLIGHTLESS BIRDS, CHRONICLES OF DECCAN AND OTHER FLIGHTS OF FANCY ............................. 168
  5. 5. THE BRAZENNESS OF BEING NSEL, AND THE DOG THAT DIDN’T BARK ...................................172 RETAIL INVESTOR ANNOUNCES RETIREMENT FROM STOCK MARKETS...............................................176 P A R T T H R E E : COFFEE WITH JIGNESH BHAI AND SWAMI ......... 181 REFLECTIONS, HUMOUR AND A SLICE OF LIFE ...........183 THE GOOD, THE BAD AND THE UGLY: OBSERVATIONS IN A WORLD OF DIVERGENT AND OPPORTUNISTIC OPINIONS ..............................185 5 STAR RATED ADVICE: DECIPHERING THE S&P US DOWNGRADE.........................................189 WHAT DOES THE US ECONOMY SUFFER FROM? DIABETES OR HEART DISEASE................................... 193 A MATTER OF FAITH: THE ROLE OF REASON AND BELIEF IN INVESTING .........................................197 NOT AN ORDINARY JOINT FAMILY: THE EUROPEAN UNION AND THE CRUX OF ITS PROBLEMS.............200 A GAMBLER’S INSTINCT: THE KNACK FOR TAKING CALCULATED RISKS AND KNOWING WHEN TO TAKE THEM ............................204 ARE YOU WAITING FOR GODOT WHEN IT COMES TO INVESTING................................................ 208 WHY BULLS, BEARS, PIGS AND THE BIG FISH DON’T MATTER, AND COWS AND GOATS DO ..... 212
  6. 6. HAVE YOU DONE THE ANNUAL PERFORMANCE APPRAISAL....................................................................... 216 SAVE ME SUPERMAN: WHY THE BAILOUT BUSINESS DOESN’T MAKE SENSE .................................................220 TRAGEDY IN CLOSE-UP, COMEDY IN LONG-SHOT: A MATTER OF PERSPECTIVE .......................................223 OF QUOTES AND LEARNING’S, FROM INVESTORS AND HINDI MOVIES .....................................................226 CYPRUS, CHEAT FUNDS AND THE COST OF IGNORANCE ...................................................................229 AVERAGE CHOICES FOR THE AVERAGE GUY ...............232 OF NOBEL PRIZES AND IGNOBLE DISGUISES ................236 OF SKILL, LUCK AND THE ABSOLUTE RELATIVE PARADOX ........................................................................239 t+ksj dk >Vdk---/khjs ls yxs............................................................. 246 AN OPINION ON EVERYTHING, A COUNTRY OF EXPERTS ...........................................................................250 A PLAN FOR EXPECTED SURPRISES ..................................255 A CASE FOR BOREDOM ......................................................259 BUSINESS OR PROFESSION, CUSTOMER OR CLIENT: THE FAINT LINE OF TRUST .........................263 P A R T F O U R : WHAT EVERY INVESTOR CAN LEARN FROM INVESTING BOOKS AND GURUS ........................... 267 LEARNING FROM THE GURUS ......................................... 269
  7. 7. BOOK: THE INTELLIGENT INVESTOR............................. 271 BOOK: BENJAMIN GRAHAM, BUILDING A PROFESSION................................................................275 BOOK: MARGIN OF SAFETY ...............................................279 BOOK: COMMON STOCKS AND UNCOMMON PROFITS ...........................................................................283 BOOK: THE MILLIONAIRE NEXT DOOR .........................287 BOOK: THE BOGLEHEADS’ GUIDE TO INVESTING ......292 BOOK: THE LAZY PERSON’S GUIDE..................................297 BOOK: THE COFFEEHOUSE INVESTOR ...........................299 BOOK: THE DILBERT ONE PAGE SUMMARY ..................301 GURU: WALTER SCHLOSS, TRULY CONSERVATIVE INVESTING ...................................... 304 GURU: TIMELESS WISDOM FROM BENJAMIN GRAHAM .....................................................308 GURU: MORE EXCERPTS FROM GRAHAM’S WRITINGS ..................................................312 GURU: FAMOUS QUOTES BY PETER LYNCH .................316 GURU: FAMOUS WARREN BUFFETT QUOTES ..............319 IN CONCLUSION .................................................................322 GLOSSARY OF TERMS .........................................................325
  8. 8. P A R T O N E WHAT EVERY INDIVIDUAL INVESTOR NEEDS TO KNOW
  9. 9. WHAT IS FINANCIAL INDEPENDENCE AND WHAT FACTORS LEAD TO IT So what is financial independence and why is it important? Most people are dependent on their active sources of income for most of their lives. Active income essentially means doing something to earn income to support various expenses in life. In most cases, that means exchanging your time and skills for money – which then determines your expenditure and savings. Most people find themselves in this rut for most of their lives. And while their incomes might increase over time – either fast or slow based on individual circumstances – somehow they never find themselves in a position where they can leave their main source of livelihood/active income. Financial independence is essentially the quest towards removing that dependence on active sources of income, and
  10. 10. 20 :: PATH TO FINANCIAL INDEPENDENCE hence, being able to support your expenses and lifestyle with income generated from financial assets. What are the factors that hinder financial independence? Firstly, Savings is the single most important factor in achieving financial independence. Financially, you are not what you earn but you are what you save out of what you earn. Saving = Earning minus Spending Most people measure themselves by their Earnings – and unfortunately forgetting that it is the saving that matters – for long term financial security. Secondly, Inflation is the second biggest hindrance. Money loses value over time – the reason being inflation. The slow poison or indirect tax – whatever you may call it – inflation is the phenomenon of increasing prices leading to the creeping depreciation in the money earned and saved. Even if they may be saving, most people have no clear sense of the impact that inflation has on their savings as our brains are simply incapable of quantifying long term effects of inflation unless we get there. Thirdly, Education is the third biggest hindrance. While one may appreciate the value of savings and the need to fight inflation, most people don’t have any idea on what to do to put their savings to work. Formal financial education is not included in any of our educational courses – even management and accountancy courses don’t have them, forget about other professional or basic degree courses. I have been unable to find the reason for it – but our education system is focused on
  11. 11. PATH TO FINANCIAL INDEPENDENCE :: 21 providing skills for earning, but not on imparting skills on how to financially manage the earning. Finally, Time and our ability to gauge the impact of time is the last hindrance. The effect that the first three factors above have over long periods of time is astounding any which way you see it. So if you lack in savings, have no ability to fight inflation and have no financial education, and you let these three combine over 25 years, you will find yourself in a reasonably miserable financial condition – without quite realising it – perhaps till you get there. And if you actually have the three factors working in your favour – adequate savings, the ability to beat inflation and the education on how to manage your earnings – and let these combine over 25 years, I can assure you that you will be surprised by the extent of positive results. It is an almost sure shot way of achieving financial independence. That brings me to the magical effects of compounding and its critical role in financial independence.
  12. 12. 22 :: PATH TO FINANCIAL INDEPENDENCE WHY COMPOUNDING IS THE BEST KEPT SECRET OF INVESTING SUCCESS There is a stark similarity between what I reckon to be the driver of success in investing as well as superlative achievement – the single magic phenomenon of compounding. Everyone knows that Einstein called compound interest the eighth wonder of the world. There is also the story of the poor farmer who robbed the rich king in less than three months, when his request for a seemingly small gift of food grains starting with a single grain on day 1, and just doubling the number of grains every day was granted. So the farmer requested that the king add 1 grain today to the first square, 2 grains tomorrow to the next square, 4 grains on the day after and so on, and thus continuing that process to so that he fills all the 64 squares of the chess board. The rich king, irritated by the apparent frivolity of the gift, started the task only to realize by the time
  13. 13. PATH TO FINANCIAL INDEPENDENCE :: 23 he had reached the 32nd square that the task was enormous. That was because for the 32nd square, he had to find 2*32 (2 to the power 32) grains which is ~4.2 Billion grains and that number would double on the 33rd square. Eventually the king gave up on the possibility of trying to fill on the 64 squares of the chess board, realizing he did not have so many grains. That is an example of the power of compounding, and how our brain is incapable of imagining its impact. Most people are taken by surprise when they are told that 99.5% of the current net worth of the world’s richest man Warren Buffett has been earned after the age of 50. For compound interest to work, one needs to give it sufficient runway, which means start early and start with whatever is possible. Starting saving and starting it early are both important. Secondly, for compounding to work, one needs a good rate of return over long period of time. This is not possible, unless one is wired with the right discipline and temperament to go through inevitable ups and downs of the economy and markets, and keep at it. And finally, the real effects of saving, that start looking like investing genius - sometimes simply due to the mathematical magic of compounding – will start showing only when one keeps doing it for a long period of time. So the key takeaway is that there are three drivers: Start Saving Early, Increase your rates of return, and Keep at it for long periods of time.
  14. 14. 24 :: PATH TO FINANCIAL INDEPENDENCE The sad reality is very few people have planned well enough to meet all the three drivers perfectly. That is, perhaps, the reason why we have so few super investors. So what are the steps one needs to follow to achieve this effect of compounding over long periods of time to achieve financial independence?
  15. 15. PATH TO FINANCIAL INDEPENDENCE :: 25 SIMPLE STEPS TO FOLLOW FOR FINANCIAL INDEPENDENCE Alot of individual investors are so interested in getting answers to questions like which stocks to buy, at what price and when to sell them that they do not realize that these are the least important questions when it comes to building long term wealth. Perhaps the single most important decision that influences long term returns has got to do with portfolio policy as it relates to allocation ratio of different asset types. That is – to put it simply - how much of my income after expenses - i.e. savings - do I put in various types of assets across stocks, fixed income, real estate, gold and cash? This is broadly referred to as portfolio asset allocation in financial parlance - and is the single most important decision that impacts long term returns.
  16. 16. 26 :: PATH TO FINANCIAL INDEPENDENCE So why does one need to invest in so many assets? Well the reason is simple – to get different rates of return at different points of time – so that, as a whole, you get a decent rate of return consistently. How is that achieved - one may ask? Well, that has a simple logic due to the nature of the assets. Fixed income (or fixed deposits as most people know them) is essentially loans to someone – a bank, a company or anyone else – with a guarantee to return it with some interest. So it is more or less assured return with little return. Simply because of the logic that whoever is taking a loan from you has probably found some avenue to invest it somewhere to get a better return – else why would he take a loan? That brings us to the second category of assets. Equity or share in a company – which is essentially giving capital to someone who has the enterprise to give you returns. Obviously there is possibility of capital loss, so the expectation of return is higher – else why would someone invest capital in a risky proposition? In between these two categories is real estate. This is sort of an appreciating asset that also gives some return in the form of rent for usage. Generally speaking with lesser risk than equity but with higher return than fixed deposits – primarily because the cost of constructing a new one increases with inflation. Not an exact guarantee – but more or less. And then finally, there is gold, which is sort of a dead asset which neither guarantees any appreciation, nor provides any return, but acts as a currency due to its short supply. Due to
  17. 17. PATH TO FINANCIAL INDEPENDENCE :: 27 historical reasons, it is a store of value – not necessarily a great one to beat inflation – but an asset nevertheless. So those are the four primary categories of assets which – as a whole – promise appreciation in their value over time. Everything else reduces in value and is either a clear cut expense or an expense in the guise of an asset – it will not appreciate in value. That includes cars, jewellery, art, electronics, clothes, food and everything else. Hence, for an investor to achieve the compounding required for financial independence, it is essential to build a portfolio of these four core assets – fixed income, equity, real estate and gold – and find a way of beating inflation together. That brings us to portfolio strategy and the steps. For simplifying portfolio strategy, all the opinions and advice can be essentially reduced to a set of few simple steps that can be followed by an average individual investor. 1. DECIDEYOUR ASSET ALLOCATION BASED ON YOUR LIFE CIRCUMSTANCES: For an individual who does not intend to do investments full time (i.e. has a job or business for his regular income), an allocation of up to 60% in equity, 10% in gold and the remaining 30% in cash and fixed income might be the optimal allocation. It may not give best returns, but is likely to be something if followed over long term.
  18. 18. 28 :: PATH TO FINANCIAL INDEPENDENCE 2. SELECTYOUR CORE AND PERIPHERAL ASSETSWITHIN THE ALLOCATION: For most individual investors, index funds or a collection of actively managed equity funds are the best vehicles for equity participation. 3. REVIEW ONCE A YEAR, AND REBALANCE WHEN ALLOCATION RATIOS GO OUT OF WHACK: That is, if equities have grown and now account for 70% of assets, shift 10% into others by selling; similarly if cash/fixed income or gold value has increased, shift proportionately into equity. 4. SET UP A SYSTEM FOR THIS: Avoid doing this manually, both contributions and rebalancing, so that you do not have to take decisions frequently. 5. KEEP INCREASING ABSOLUTE AMOUNTS OR RELATIVE ASSET ALLOCATION: As your income levels increase or decrease, life circumstances change or ability to take risk alters; make changes to absolute amounts invested as well as relative asset allocation ratios. Do not base them on market levels or projected market direction. This can serve as a framework for deducing a simple investment portfolio strategy for most individual investors. Once
  19. 19. PATH TO FINANCIAL INDEPENDENCE :: 29 this is set up, the investor is likely to realize how unimportant the question of which stock to buy and when to sell really is. So that brings us to the question of how to implement these steps – starting with the first decision of deciding your core long term asset allocation.
  20. 20. PATH TO FINANCIAL INDEPENDENCE :: 81 P A R T 1 KEY TAKEAWAYS 1. Compounding the best kept secret in Investing. What it means is start saving early and give your savings a long time to compound. 2. In allocating your savings, your primary consideration should be to beat inflation and maintain purchasing power. Hence investing in growth assets like equity is very important for the long term. 3. Individual investors must decide an asset allocation plan for themselves. I.e. how much percentage of their savings must go into equity, fixed deposits or debt funds, property and gold and stick to it. 4. Once a year, investors must rebalance their portfolio,
  21. 21. 82 :: PATH TO FINANCIAL INDEPENDENCE so that the percentages decided are maintained so as to avoid unexpected risk to the portfolio. 5. This plan will not necessarily give best returns but it will ensure that it can be followed, as temperament is the most important aspect of long term investing success 6. For the equity component of the portfolio, most individual investors should rely on mutual funds and refrain from direct stock investing 7. If an investor chooses to invest directly in stocks, what kind of stocks to buy depends on whether the investor chooses to be a defensive or an enterprising investor 8. Defensive investors must only buy large established companies using the projection method, while enterprising investors may choose to buy smaller companies using the protection method 9. It is important for investors to have fixed income in their portfolio – both for steady returns and for rebalancing from time to time. 10. Investors must remember that their house is not investment. It may be an asset based on the price you purchase at, the loan component and growth. If not bought correctly, a house can be a liability.
  22. 22. PATH TO FINANCIAL INDEPENDENCE :: 83 11. Gold is not an investment. It is a store of value which is useful only in bad economic conditions. It is useful to have only as a hedge and must not exceed 10% of a portfolio in general. 12. Insurance is not investment. Insurance is a need for all investors to protect their dependent families from unexpected loss of income, so that there is no loss in lifestyle. Investors do not need anything other than simple term insurance if they can follow discipline for their investments.
  23. 23. P A R T T W O WHAT EVERY INVESTOR MUST REMEMBER ABOUT TEMPERAMENT AND BEHAVIOUR
  24. 24. WHY TEMPERAMENT AND BEHAVIOUR MAKE A DIFFERENCE The first part of this book detailed out the steps required for an investor to reach his or her goal of financial independence. The steps were detailed out with insights and views on various aspects of asset allocation, diversification and holding various types of assets in a portfolio. If investing for financial independence was so straightforward, why is it that so few investors are able to successfully achieve it? It is often said that markets give returns, but investors don’t get them. Why does that happen? The reason for that comes down to the investor’s own temperament and behaviour. The second part of the book is a collection of articles on investor temperament and how the various psychological aspects of the vagaries of markets and economy affects investor
  25. 25. 88 :: PATH TO FINANCIAL INDEPENDENCE behaviour, and eventually impacts returns. As this is an area which is best managed by the investor himself, this section is not in the form of step by step guide. Rather it is a set of articles that contains reflections and insights on the various aspects of investor temperament, reading which investors can deduce their own inferences. This also contains articles that are observations on actual events that have happened over the course of the past few years and have temporarily impacted Indian markets. These are meant to demonstrate the value of a balanced temperament in investing.
  26. 26. PATH TO FINANCIAL INDEPENDENCE :: 89 HOW TO HANDLE VOLATILITY BY CREATING A MIND-SET If the fundamentals of investing were so easy, why is it that one finds so few successful individual investors? The reason is clearly temperament and behaviour. For an individual investor whose goal is to achieve financial independence, the toughest thing to deal with when it comes to achieving high rates of return in equity is volatility. And by volatility - though it means fluctuations on both sides, what is tough to deal with is basically crashing stock prices. Financial theories have often equated risk to volatility - which may have some sense when you have a need to regularly evaluate the value of your portfolio, but is perhaps otherwise meaningless for an individual investor. The all-encompassing mind-set of an individual investor has to be that of preparation for crashes. While investing in the stock markets, be it through mutual funds or directly, the dominant mind-set needs to be that of being prepared for at
  27. 27. 90 :: PATH TO FINANCIAL INDEPENDENCE least a 30% cut at any point in time. That mind-set prepares you better to deal with it when it comes. The advantage of such a mind-set is to ensure some degree of rational thinking when the crash happens, even though there may be butterflies in the stomach. Inevitably that happens. In such a scenario, I have found “the Ben Graham corollary of thinking of the stock market as an emotional guy called Mr Market whose moods keep fluctuating” to be most valuable. This moody guy comes up every day and offers you a price for your businesses. You are free to buy from him, or sell to him at that price whenever you want; and best of all, you are free to ignore him if you choose to. He will still come back tomorrow. Getting these two things into your mind-set - that of expecting crashes, and thinking of stock markets as an emotional guy called Mr Market - are the basic starting points in your battle against volatility. Let’s say you manage to do that - the toughest task of all. After that, deciding what to do when stock markets crash becomes easier. And that depends on largely whether you have a plan on why you are in the markets in the first place. If you have, then you are likely to do whatever makes sense according to that plan. If you do not, then this crash could be a good opportunity to make such a plan. In both cases, you are likely to be in a better position to then decide whether to buy from Mr Market, to sell to him or to simply ignore him.
  28. 28. PATH TO FINANCIAL INDEPENDENCE :: 91 ARE YOU LOSS AVERSE OR RISK AVERSE Risk (or uncertainty) in equities is often measured by the degree of volatility. While this is a measure that may have some utility for portfolio management (especially if one has a need to exit positions in case of price drops), for the individual investor, risk in investing is best measured as the probability of “It would appear, Hopkins, that your gut feel was only indigestion”
  29. 29. 92 :: PATH TO FINANCIAL INDEPENDENCE permanent loss of capital. That is because, it is not risk or uncertainty that investors really fear, but losses (notional or permanent) as measured by decrease in capital value that they are afraid of. Any volatility in market prices that does not result in notional losses does not affect the investor emotionally precisely because of this tenet. This is demonstrated aptly by the concept of ‘Loss Aversion’ in behavioural finance - the field of study that analyses the impact of emotions on investing behaviour. The key tenet is that human reactions to the probability of profits and losses are different. We become conservative when faced with profit chances, and take undue risks when faced with prospects of loss. Consider this scenario - where you have Rs.10,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed gain of Rs.5000/- OR (b) Choose to toss a coin - if its heads, you gain Rs.10,000/- and if its tails, you gain nothing. Which option will you choose? Now Consider another scenario - where you have Rs.20,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed loss of Rs.5000/- OR (b) Choose to toss a coin - if its heads, you lose Rs.10,000/-, and if its tails, you lose nothing. Which option will you choose? It is likely for majority of people to choose option (a) in the first scenario, and option (b) in the second scenario. Why is it that in the first scenario, we are not willing to take a chance on more profit, even though we lose nothing,
  30. 30. PATH TO FINANCIAL INDEPENDENCE :: 93 while in the second scenario, we are willing to take a chance to reduce loss, even though we may lose more? That is because, in the first scenario, we have guaranteed profit, so the pleasure we get out of more profit is high, but not as high as the pain we will suffer in case that profit goes away, and we are not fine with the prospect of remaining at status quo. Whereas in the second scenario, we are faced with sure losses, but we are willing to take the chance, even though those losses could actually double, because of the possibility of not having to lose anything. Again the pain of loss is so high, that we take higher risk, just to get back to status quo, even though we could possibly face even higher losses. So in case one is unable to keep emotion out of investing, and unable to handle market declines with a calm and rational mind, this is a key emotional or behavioural takeaway that one will do well to remember. We like profits, but we hate losses even more. So when faced with possible losses, we are prone to take higher risks to avoid the possible loss, but when faced with possible gains, we are prone to lock in our gains without taking risks. Therefore, most investors will end up booking profits early and riding their losses rather than the other way round. Selling losers because the fundamentals have changed is one of the most emotionally painful things for individual investors to do. Well - if you genuinely believe in a company’s earnings prospects and valuations and are able to keep your head, it is prudent to
  31. 31. 94 :: PATH TO FINANCIAL INDEPENDENCE hold and even buy more during falls, but one must be aware that - that is the real reason for one’s actions, and not the loss aversion tenet at play. For normal individual investors, it is almost impossible to differentiate between the two. So, in conclusion, are people risk-averse or loss-averse? It is not that people do not like risk or uncertainty so much, but it is pretty clear that they hate losses a lot, much more than they love profits. Awareness of this tenet will perhaps help investors to decide truthfully on the best way forward especially during price declines when the stomach is churning and the heart in fear, and use their head to take a rational rather than an emotional decision. It is easier said than done.
  32. 32. P A R T T H R E E COFFEE WITH JIGNESH BHAI AND SWAMI
  33. 33. PATH TO FINANCIAL INDEPENDENCE :: 185 THE GOOD, THE BAD AND THE UGLY: OBSERVATIONS IN A WORLD OF DIVERGENT AND OPPORTUNISTIC OPINIONS “Are you a vegetarian or non-vegetarian?” asked the waiter at the hotel to my colleague Swami. This question always confuses him. “I am a vegetarian mostly, but I can eat chicken, except on Tuesday and Friday. So it depends on what everyone else is ordering”, he replied. Such responses always confuse waiters in hotels, who have a simple way of classifying people. According to them, there are two types of people in the world – vegetarian and non-vegetarian. Alas if only it was so simple – my colleague Swami being a case in point. “There are two kinds of people in the world, those with loaded guns, and those who dig. You dig.” Clint Eastwood made this dialogue immortal in the movie “The Good, The Bad and The Ugly”.
  34. 34. 186 :: PATH TO FINANCIAL INDEPENDENCE It seems to me that there are two types of people in India, or maybe the cricketing world, at least for now. Those who think that MS Dhoni was right in calling Ian Bell back (in the Trent Bridge test), and those who feel he was stupid to show such generosity on the English team. Among those who think he was right, again there are two groups – those who think he was a true statesman of the game, doing it to uphold the spirit of the game; and those who think he was just a pragmatist, and hence did it to ensure that the Indian cricket team’s brand value (and hence the money they earn) does not go down. And then there are those types of people (mostly media commentators!) who change their views according to the situation. Those who initially started justifying the morals of “There are some other ‘two types of people’ in the world today too.”
  35. 35. PATH TO FINANCIAL INDEPENDENCE :: 187 how Dhoni was right in appealing for the run out, and how the spirit of the game itself has changed in today’s world of cut- throat professional cricket; and later changed to applauding Dhoni for his generous act on realizing that Ian Bell was walking out to bat again. There are some other ‘two types of people’ in the world today too. Those that think Breivik, the person who fired at and killed 70 odd people in Norway, was an example of emerging, right-wing, ethnic extremism in Europe, and those who think it was not that – that it was just the delirium of a madman. Among those who feel he was an extremist, again there are two groups – those who are shocked by the scale and brutality of the murders irrespective of who did it, and those who are shocked because the killer was not an Islamic terrorist, but a Christian Westerner who hated the tolerance towards multiculturalism. And then, there are those types of people (mostly Western politicians!) who change their views according to the situation. Those who started condemning the killing as another example of ‘acts of terror’, and then called it a madman’s act after realizing that the killer was not an Islamic terrorist. There are two types of people in the markets too. Those who think long-term fundamentals-driven investing is the right way of making money in the markets, and those who think there is nothing like long-term, as all of us are dead in the long-term – so short-term technical-driven trading is the
  36. 36. 188 :: PATH TO FINANCIAL INDEPENDENCE way to go. Those who are long term investors and those who are short term traders. And then there are those types of people (mostly Brokers and people on business channels!) who change their views according to the situation. Those who say investing is the way initially, and then, when the markets go up tell us to become traders. Or those who tell us to make money as traders initially, and then, when the markets go down, ask us to become long- term investors. So it seems the world is made up of two types of people with two sets of clear but divergent views. And then, there is third types who change their views depending on what suits them; but who somehow seem to matter and drive their worlds. And finally, there is a fourth category. That is the type of people who have no view as such, perhaps the majority, and, depending on the arguments, between the first three types, form an opinion. If you are neutral and have no view, your individual view probably does not matter much, and is there for the taking to be influenced. You are probably the common man with no voice, and in the markets, you are probably the retail guy with no choice. Like my friend Swami, you are dead meat even before placing the order!
  37. 37. P A R T F O U R WHAT EVERY INVESTOR CAN LEARN FROM INVESTING BOOKS AND GURUS
  38. 38. PATH TO FINANCIAL INDEPENDENCE :: 271 BOOK: THE INTELLIGENT INVESTOR “The Intelligent Investor” by Benjamin Graham was called the best investment book ever written by Warren Buffett. After close to 60 years after it was first written, one continues to be amazed by its depth and clarity and its relevance even today. It is almost like financial philosophy, akin to the ‘Bhagavad Gita’ of investing and finance for the individual investor - whenever you pick it, you learn a new piece of investment wisdom. If an individual investor must read only one book on investing, ‘The Intelligent Investor’ is the one. It is difficult to pick up the best parts from such a book - it covers everything from definition of investment to specific criteria for stock selection. Here are some of the key takeaways from the book Investment versus Speculation:
  39. 39. 272 :: PATH TO FINANCIAL INDEPENDENCE Investing means any operation that on thorough analysis promises safety of principal and an adequate return. 1. BONDSVERSUS STOCKS IN ASSET ALLOCATION: Graham presents a simplistic 50:50 formula of allocation between fixed income bonds and stocks that works for most investors - giving a leeway of 25% on either side. I.e. at no time should the allocation of either stocks or bonds fall below 25%. The guiding rule is to keep re-adjusting this allocation when one component increases above a certain defined limit, like 60%, by selling the additional 10% of the increased component and buying the other. This does not guarantee the highest returns - but is a mechanical program that is most likely to work - simply because it advises selling and buying when it is counter intuitive, and “chiefly because it gives the investor something to do”. 2. DEFENSIVEVERSUS ENTERPRISING INVESTORS: Graham makes a distinction between types of investors not based on risk taking abilities or age but rather on the amount of intelligent effort that is put into an investment operation. The Defensive investor will place emphasis on avoidance of serious mistakes and losses, and seeks freedom from effort, annoyance and the need to make frequent decisions. The Enterprising investor will be able and willing to put in time and effort in the selection and tracking of securities that
  40. 40. PATH TO FINANCIAL INDEPENDENCE :: 273 may appear to be better valued than the general market from time to time - which may help him achieve better returns than the market over long periods of time. Majority of investors would fall into the Defensive category. To achieve satisfactory results available to the defensive investor is easier than most people realize, to achieve superior results sought by the enterprising investor is harder than it looks. 3. THE FAMOUS MR MARKET: This is perhaps the most valuable part of the book - on how to approach the widely fluctuating markets that an investor will face number of times in his investing life. Treat the market as an obliging, emotional partner in your businesses - i.e. the securities of which you own. Every day, he tells you what he thinks of the value of the share of business that you own, and offers to buy your share at a price or sell you his share at a price. Sometimes his fears overtake him so he offers you rock bottom prices to buy, while sometimes he is excited about the future thus offering you great prices to sell. The best part is he does not mind being neglected - he will come back again tomorrow if you neglect him. Your best interests are then served if you only transact with him if and when you agree with his prices - the rest of the time, it is best for you to neglect him and focus on the operations of your business. In the book, Graham goes on to provide clear stock selection criteria for defensive and enterprising investors - with
  41. 41. 274 :: PATH TO FINANCIAL INDEPENDENCE great examples to help stock evaluation practically. But more than those, the clear framework based on the above - definition of investment, asset allocation, the decision on type of investor, and the attitude towards market fluctuations - are most valuable for an individual investor to go about his investment operations. Graham’s advice and wisdom are unlikely to make anyone rich in a hurry - perhaps only when one gets old. But the principles are timeless and practical.

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