The Actively Lazy Style; Of Life, and Of Investments

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Blaise Pascal, the famous French physicist of the 17th century, had once said “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”

Understandably it is not easy to extol the virtues of laziness, or even of selective inaction. However, if laziness is resorted to consciously, with full control over oneself, in many situations it can work wonders towards attainment of goals and achievement of happiness. It can be of immense value for people in fields as wide ranging as sports, investments, science, archaeology , human relations, medicine and business management. Being comfortable with status quo, with environment, and with oneself can at times be crucial for flow of creative juices, for revitalization of thought process, for avoiding disasters, and for action later with renewed vigor and enhanced focus.

Why float like a butterfly; Just rope- a- dope, and sting like a bee

In one of the most eagerly awaited boxing matches in history – the “Rumble in the Jungle” in 1974 in Zaire, the bone-crunching power of the undefeated reigning champion George Foreman was pitted against the timeless agility, stamina and technique of former champion Muhammad Ali. The fight delivered one of the biggest upsets in boxing history as Ali went on to knock out Foreman. Ali’s win was attributed mainly to his makeshift strategy dubbed as “rope-a-dope”.

Ali was a nimble fighter with great footwork and stamina, and had a knack of scoring points with his lightning fast punches and jabs. However he realized early in this fight that his famed ability to “float like a butterfly, and sting like a bee” would come a cropper due to Foreman’s diagonal movements blocking his “floating space”. Ali instead came up with an improvised strategy –to lean against the ropes effectively luring Foreman to have a go at him. In all these rope-a-dope acts Foreman helped himself to a barrage of 20-30 punches over bursts of 15-20 seconds attempting to blast Ali out of the ring.

Spectators thought after seeing the first such instance that Ali was finished and it was a matter of minutes if not seconds before he was floored. However Ali was mindfully playing a patient game – deciding to do nothing except for closing the access to his face and head, thus avoiding any meaningful damage and inviting Foreman for the elusive kill. In doing so Foreman boxed himself out of the fight – he was sapped of energy and eventually knocked out in the eighth round.

The ant behavior on our part

So why are we unable to sit quietly without disturbing our limbs or vocal chords? Craving for action or to be seen doing something, bubbling energy, attempt to be in control, and the perception that doing more means getting more and that one will look smarter by doing so often push people towards perennial action mode. In many professions, we are expected to have an opinion on everything and cannot be seen as saying “I don’t know”.

Lack of skin in the game can transform into incentive-caused bias

There are instances where there is a misalignment of interests and outcome for the actor is different from outcome for the person experiencing the end results. Such incentive caused bias is often seen in investment management industry if fund manager’s compensation has low correlation with the investor’s portfolio returns.

Feedback loops not closed

In a situation where we have not done enough work to understand a problem, it is quite likely that we may yield to peer pressure, or may follow system 1 (the fast, associative, spur of the moment, intuitive and emotional part) of the brain to be spurred into action even if it’s not required.

Actively lazy in investments and life

Doing nothing – when market has leapt, or it has tanked, or a favorite stock in the portfolio has collapsed, or a stock has jumped quite fast though is still at less than price objective – is not easy even if often preferable. Selling too early, getting into a bad investment, excess portfolio concentration, high cost of doing business are some of the undesirable outcomes of high adrenaline activity in the field of investments.

Less number of decisions means less chances of wrong decisions This sounds counter-intuitive but the amount of discipline this can instill in an investor, and hence the benefit it can have for the portfolio, is amazing. Ace investor Warren Buffet goes to the extent of saying that investors should assume that they have only 20 stocks to buy during their life time and make their investment decisions accordingly.

Don’t try to jump over seven-foot bars; Look for one-foot bars that can be stepped over – With a lazy (actively, though) style an investor is able to steer clear of a stock, or some strategy that is out of her circle of competence. Actively lazy investors are comfortably able to avoid unnecessary bravado and temptation to stray into unchartered territories.

In Indian mythology Lord Krishna is also known as “Ranchhor” or “one who deserted the battle field”. Jarasandh, the powerful but evil king of Magadh, being hell bent on obliterating Krishna and his Yadav clan had once invaded Mathura. Mindful of the possibility of certain destruction of the city if there were to be a war, Krishna decided to lead the Yadav’s away from the battlefield to the faraway Dwarka where eventually the erstwhile dwellers of Mathura prospered after setting up virtually a new city. Thus, there are some situations where instead of grabbing a problem by its horns, a better solution can be found via a less active and seemingly even an inglorious route – possibly aided by an outside view, or by inversion. Or better still, not every battle in life is worth fighting.

Busy-bee investing is injurious to wealth – As investors we may face a situation where a stock we hold has fallen by 20-30% for some reason and there is an extreme urge to sell. Very often the reason for this decline is temporary in nature with low long-run relevance. Here, while the analysis should obviously be thorough it is important to be actively lazy in responding to the behavioral demons (that make us hyperactive and induce us to go for the elusive stock bottom).

Pulling out the flowers? – If a stock spurts by 50% then a high adrenaline strategy will call for selling the stock even if it, as per earlier high-conviction analysis, is set to grow by another 5x. This mistake is committed repeatedly due to investor’s inability to take a break from watching the stock prices continuously.

Stop chasing stocks; instead, buy when market offers them – If good stock buying opportunities are not there it is better to keep the powder dry and wait for opportunities to emerge rather than buying at any price.

The world would have been a very different (in fact, much worse) place had Adolf Hitler stuck to his original plan of pummeling all the western European powers into full submission before invading the Soviet Union.

WWII had been going very well for Germany in mid-1941. Entire continental western Europe was under its occupation. Britain, with its geographical advantage of being an island, had unleashed fierce resistance but it seemed like a matter of time before it would be down on its knees. USSR would not intervene as it was overawed by Germany’s might and also due to its non- aggression pact with Germany, and USA was largely out of the picture.

Amid a stalemate with Britain, Hitler somehow concluded that time was ripe to roll-out the next leg of his plan to conquer the world. He decided to attack USSR despite being advised against doing so by his best military minds, and being fully aware that USSR with its limitless depth, seemingly unending steppes and long, harsh winters had for centuries been the proverbial graveyard for invaders.

Haste to reach for the goals quickly in defiance of existing environment drove Hitler towards this fatal mistake. The ferocious resistance, followed by aggressive counterattack, by USSR’s red army led to the downfall of Hitler and his Nazi dreams.

Play to win, not to the galleries – Whether in investment or in some other walk of life, most of us fall prey to this fallacy where-in we work more to convince others – or even ourselves- that we are putting our best effort. Many fund managers churn their portfolio rapidly due to this behavioral bias.

Goalkeepers in soccer often succumb to this behavioral vice. In football penalty kicks often decide the fate of a match. Here speed of the ball after the kick is so high that the goal keeper can’t stop the ball if he waits for the penalty taker’s foot to hit the ball before making his leap. Instead he tries to read the body language and mind of the penalty taker to guess the direction of the kick – to his left, to his right, or at him as he stands in the middle – and makes his jump accordingly. As per a study of penalty kicks (source – Little Book of Behavioral Investing, by James Montier) roughly one third each of the kicks go to the left, right and centre. Further, the goal keepers leapt to the left or right on 94% of the kicks. Thus only in 6% of the shots the goalkeepers were standing in the middle – without jumping-even though 33% of the shots came at that position. Indeed the temptation to act overrides the commonsensical understanding that even if he rightly guesses the direction of the kick the goalkeeper does not stand more than 40-50% chance of stopping the shot in his left or right. On the other hand, if he were to keep standing at his position he would be able to stop 80-90% of the shots that came his way.

So, how to follow actively lazy style in investment

The key is to be aware of our predilection towards action. It is important not to confuse activity and results.

  • Reduce external stimulation of the mind – Cut off news, do not consume information with low shelf life, avoid newspapers and TV.
  • Practice and exercise – Read, analyze, discuss and gather evidence so that there is enough confidence to be lazy.
  • Recognize that most things are random, and generally have false causality – Then effort for control looks futile and refraining from high adrenaline action seems the better approach.

 

Trees Don’t Reach the Sky; Perspectives on Regression to Mean

Success = Talent + Luck; Great Success = a little more talent+ a lot of luck

This is how Daniel Kahneman, Nobel laureate in economics, responded on being asked for his favorite equation. Napolean Bonaparte had once quipped “I’d rather have a lucky general than a good one.”

Regression to mean (RTM) is one such phenomenon which in a sense is manifestation of luck. Understandably RTM provides the philosophical underpinnings for many decision-making systems. It can be the savior especially when we are tempted to extrapolate current trends into the future – nudging us towards better decisions.

Tomorrow is another day

Natural systems offer the best and most explicit examples of regression to mean. Trees stop growing at some juncture because the rate of growth after remaining above average for a sustained period has to regress to the mean – in this case zero growth. It has been scientifically established that children of very tall parents tend to be less tall (and vice versa).

In practical term RTM suggests that performance in any area is unlikely to go on improving or growing worse indefinitely. We swing back and forth in everything we do, continuously regressing towards what will turn out to be our average performance. Perhaps this is what explains the lack of consistency in performance of fund managers. Similarly, it is rare to see the progeny of top cricket players, or Bollywood super stars to reach the heights achieved by their parents. When inflation in an economy hits extreme levels it is only a matter of time before it starts moderating.

“Tomorrow is another day” (asserted by the gritty, main protagonist Scarlett O’Hara when she is a in a miserable condition, in the US civil war era novel “Gone With the Wind”) is amongst the most powerful and immortal words in literary history. It rehashes what most religious and philosophical scriptures say that times – whether good or bad, always change.

Parents, offspring and correlation

Regression to mean had been so counter intuitive and seemed so strange to the human mind that as a concept it was discovered two hundred years after the discovery of differential calculus.  Francis Galton, the high-bred British scientist and explorer had first observed this effect during his experiments on size of seeds in successive generations. He found irrefutable evidence that the offspring did not resemble the parent seeds in size. Instead the next generation would always move towards mediocrity. It would become less large if the parent seeds were large, and larger than the parents if the parents were small.

Indeed, it was Galton’s analysis which eventually led to the concept of correlation which measures how closely two series vary relative to one another. The two series here can be movement in value of rupee and stock price of Infosys, or rainfall and crops, economic growth and stock index changes, or inflation and interest rates.

As he proceeded with these experiments and as he involved some prominent statisticians of the era Galton hit upon the notion that regression to mean occurs whenever the correlation between two measures is imperfect.

It exists even if we are oblivious to it

So often, experts on business news channels dish out something like “US Fed rate hike” as a reason for  “the xx % decline in the Sensex this week’’ when a much better explanation can be that “the Sensex fell since it had risen by yy% last week”.

The issue is that we dislike, and fear our inability to explain an event as much as we hate admitting the significance of luck in our life. The associative memory in human mind with its urge to dig up causal explanations is the prime mover here. This is the reason why we are at times unable to apply RTM and this is why it took so long for RTM to be discovered.

Stock markets and RTM

If the P/E (Price/Earnings) multiple of a stock has been growing rapidly, to levels substantially ahead of historical averages, then even a layman can guess that the stock may face a correction. Or vice versa- if some stock has seen its valuation multiple get crushed to abysmally low levels then the stock may be ripe for a sharp uptick. Of course there are many market participants who are unable to read the tea leaves, extrapolate the current run up or decline in a stock well into future, and thus end up burning their fingers.

In the field of investment management there are two strategies that are rooted in RTM. Many investors follow regression to mean as the main driver for their forecasts of economic growth, industry trends, company earnings, valuation multiples, or of the stock prices directly. On the other end of the spectrum, there are momentum investors who work with expectation that the stock price or valuation multiple will defy regression to mean in near future and place their bets accordingly.

The Academic Evidence

In 1985, economists Richard Thaler and Werner DeBondt analyzed the three year returns of more than a thousand stocks from 1926 to 1982. Stocks that had risen more than or fallen less than the market average in each three-year period were categorized as winners. Similarly stocks that fell more than or grew less than the market average in a three-year period were termed as losers. Then the average performance of each group was calculated over the subsequent three years. The results demonstrated regression to mean at work in the stock markets in unambiguous terms. Over this period of 1926-1982, the loser portfolios outperformed the market by 19.6% three years after portfolio creation. Winner portfolios on the other hand trailed the market returns by 5%.

The above results remarkable as they are, do seem logical if seen in light of the fact that stock markets – which are effectively melting pots of human brains – due to their inherent behavioral idiosyncrasies tend to overreact to any new information in the short term. As a result, once the new information reveals its full imprint and after market participants have done proper impact analysis the stock moves much lesser than it did when the initial set of information came up.

Handle with care

Spare a thought for some investors who during the great crash, after seeing US stocks slump by 50% between second half of 1929 and early 1930, put serious money to work in the stock market assuming that RTM would take center stage soon, only to see 80% of their investment vanish into thin air over next three excruciatingly painful years.

So why is it not easy to use RTM to become rich by investing in markets?

First, RTM itself can be predicted but it is difficult to predict the timing of the beginning of regression. Thus, before the regression happens the gap from mean can widen causing debilitating losses. Remember what Keynes had to offer ‘Markets can remain irrational longer than one can be solvent”.

Further, mean regression often drives extreme movement on the other side. Thus P/E multiple of a stock when retracing from a level of 21x towards its long-term average of 15x may keep on sliding down till 8-9 x instead of settling at 15x. In addition, it can continue fluctuating randomly around the mean for a long time.

Finally, the mean itself can keep changing and may even have some subjectivity. If recent data points are settling towards one extreme then mean can shift over time to present a new normal replacing the earlier norm. For an investment professional a dilemma can be as to which mean to take – over 3 years, 5 years, 10 years or 20 years?

Practical reasons are that vs natural systems man made systems become complicated due to presence of too many neural drivers and hence RTM does not work systematically. Human psyche as we all know is less dependable than the nature, despite all the latter’s vagaries.

RTM is a good tool and a logical starting point in many situations but is must be looked at in context of changing realities versus history. Peter Bernstein in his famous book “Against the Gods” quoted Galton as urging us to “revel in more comprehensive views than the average”.

 

 

 

 

 

 

Escape from Freedom; The Glenn McGrath Model of Investment

Escape from Freedom; The Glenn McGrath Model of Investment

In his widely-acclaimed book “Escape from Freedom” (published in 1941) the German philosopher Eric Fromm extolled the virtues of reducing our own options – something that goes against the tenets of basic economics and even militates against common sense. He argued that lack of freedom represented by social or biological determinism made life easier. In this case with limited number of options, life has a well-defined structure with less requirement for decision making, low chances of confusion, enhanced commitment, and even lesser possibility of regret in hindsight.

Burning the Boats

Life in the ancient era was hinged largely on the above framework. There was this incident where a Chinese general called Xiang Ji set his army’s ships on fire on the night preceding an important battle with a formidable enemy – the Qin armies. As his troops watched the boats go up in flames they  realized that their rations also had been burnt down with the ships. From there-on they had only two options left – fighting their way out through the enemy ranks, or perishing in this self-imposed pursuit of glory. Armed with clear focus and absolved of fear, Xiang Ji’s heavily outnumbered army emerged victorious after a protracted set of battles defying heavy odds.

Even in the current era there are many instances where lesser number of options makes life less complicated and improves the average happiness levels. The tenacity and vigor that comes from shutting all doors save one can often lead to unexpectedly positive results.

More Options Better Than Less Options?

However in real world a rational human being (the “econ” in economics parlance) always prefers more options than less. A student is likely to be happier if she has admission offers from the three Indian Institutes of Management (IIM) at Ahmedabad, Bangalore and Kolkata than she is when she has just one offer – only from IIM Ahmedabad, even if the latter is considered to be much better than the other two IIM’s. Here the student gets more satisfaction if she has admission offers from Bangalore and Kolkata also since it adds to her self-esteem even though the latter offers are redundant in the face of the offer from Ahmedabad.

A football club manager wants to have 8-9 defenders in his squad of 25, even if he knows that 2-3 of them will never be used, even if he is convinced that the latter 2-3 defenders are not good enough to be in the first team, even if he knows that other 6-7 defenders are capable to carry through the season assuming the normal injury rates and form reversals. This is a case of over designing which eventually curtails the manager’s ability to rotate strikers as the season progresses. The manager, with his economically rational approach, gets more satisfaction in the knowledge that he has 4-5 additional back-up defenders versus the back up strength of 2-3 players that he may actually need.

Another example – an investment manager feels constrained if all his fund schemes are based on the same investment style. Most investment managers enjoy using discretion especially the one that comes with being in a position to apply various models and styles of money making. In this case the larger number of options add to the feeling of excitement, level of active involvement and sense of being in control which often act as emotional drivers for higher level of satisfaction.

However over-designing, or keeping all options open till end may not necessarily lead to the most desired outcomes.

Same line, same length, same height, same speed – ball after ball, over after over, spell after spell

Cricket lovers fortunate enough to have witnessed the great Australian test cricket teams of the nineties in action, would recall whom does the above description refer to. Glenn McGrath, arguably amongst the best fast bowlers of all times, will always be remembered for his persistent accuracy which led to his spectacular feats on record books and to his domination of the game in the nineties. He rarely tried variation, novelty or deception in his deliveries nor was he a speed merchant. McGrath used to surprise- even the best players of fast bowling- with his irritatingly repetitive but exceptionally accurate bowling spells. Most of his deliveries would be a couple of inches outside the off stump, would be of good length and at a pace of around 130-135 kmph.

McGrath had deliberately curtailed his armory and instead focused on perfecting one kind of delivery. He sent down similar deliveries over long spells and waited for batsmen to commit a mistake. This enabled him to curb his own mistakes as a bowler (as evidenced in his top class bowling averages and economy rates) as well as in reducing the need to make too many split second decisions (regarding what type of ball to deliver) before releasing the ball form his hand. Cutting down on options is what differentiated him – and fetched him spectacular success and provided elegance as a fast bowler – versus some other top class fast bowlers of his generation.

Where do investors stand

Admit it – when the friendly wealth manager suggests instruments like derivatives, commodities, cash equities, real estate, arbitrage fund etc doesn’t it feel like that the best way to go about it is to distribute the corpus amongst all these asset classes and instruments? Similarly, the freedom and the mandate to invest in any geography, in any asset class, and in any portfolio proportion is amongst the most alluring factors for a professional fund manager. Indeed, there are many fund managers who manage more than one fund schemes based on meaningfully different investment styles.

Consistently Strong Returns -Over Long Term- Demand Consistency in Style too

History is replete with examples that suggest that sticking to one style offers better success rates for investors. Warren Buffet (quality, margin of safety, buy and hold) and Charlie Munger (quality, buy and hold), Phil Fisher (quality, buy and hold), Ben Graham ( margin of safety), John Templeton ( contrarian), Peter Lynch (quality, bottom up), George Soros ( global macro, arbitrage), Howard Marks( margin of safety, arbitrage), Jim Simons ( quantitative strategies), Ray Dalio ( Arbitrage) etc are some legendary investors who have led the investment world with consistency and scale of their performances over long periods.

While they have different styles and philosophies for investment, one factor that separates these names from the “also rans” is that they stick to their styles, philosophies and principles with extreme diligence. Even as their styles have evolved over time they have never spread themselves thin by chasing too many ways of money making. Keeping down the number of fundamental options in terms of styles and philosophies at a minimal level has helped many of these super investors reduce the number of decisions they take thus shrinking the odds of mistakes, stay within their circle of competence, avoid procrastination, and remain focused.

There are Always Exceptions, But Not Many

Of course, Phil Fisher’s saying that “There are exceptions to every rule; though not many” is apt here too. There are some investors who have delivered good returns even with a medley of investment styles in action. However, such investors are much less in number as compared to the prophets of consistency named above.

Alignment of Philosophies of Life and Investments

Perhaps among the most important drivers of an investors’ performance over long term is if her investment style is aligned with her philosophy and perspectives on life in general. If one has done enough introspection then one will be clear on one’s basic value system, principles and philosophy of life. There can-not be a multitude of value systems and philosophies that a person can hold and follow in life. Accordingly, the investment style too must have some core, non-negotiable factors which are aligned with the person’s perspectives on life, and which if practiced with diligence over time can fetch healthy rewards. It is very important for an investor not to try to be someone who she is not.

Lessons From a Crash

It was the year 1987 AD. Berlin wall still stood tall in all its sadistic glory. Developed world was using computers of 386 vintage as a force multiplier in many fields. Back in India a new car called Maruti had recently been launched to challenge the duopoly of Ambassador and Premier Padmini.This was also the period when a certain Diego Maradona was setting football grounds on fire with his brilliant individual skills.
For the US stock markets,1987 was turning out to be another spectacular year. By August the benchmark Dow Jones Industrial Average (DJIA) index had registered about 40% gains for the year. In fact the five year bull run since 1982 had catapulted the DJIA 3 x.US economy too was dashing ahead having registered five straight years of expansion.
The tragic developments that were to follow – particular in October – would leave more than a hole on market psyche. Many large financial institutions received a big jolt, some smaller ones faded into oblivion, a large number of investors lost sizeable amounts in the markets, and many a promising career was cut short after this event, dubbed as the black Monday.
Unfortunately the financial world moved on post the 1987 crash without taking the lessons properly. Not surprisingly some avoidable though extreme disruptions, with some similarity to that of 1987, have been hitting the markets with remarkable regularity. Lessons from 1987 could have cushioned the impact of events like ASEAN crisis (1997), the LTCM disaster (1997), Tech boom and bust (1997-2002) and global financial crisis (2007-2009) – if not prevented them altogether. For the 1987 disaster the culprit was the same, eternal one – unfettered greed that throws caution to the winds. However this was the first time when the folly of greed was riding the dragon of derivative instruments. The latter inflicted the main damage once lust for easy money had blindsided market participants.

The Learnings First

Why did the markets fall precipitously on 19th October, 1987 ? To say gravity, won’t be an oversimplification.The markets had risen too high too fast and hence they were ripe for a rout.
The lessons for market participants (especially equity investors), financial institutions and regulators were quite clear if one analyses the events of that fateful period of October’87 –
1. If some profit seems too good to be true then chances are quite high it is so. It is important for investors to steadfastly refuse invitations for free lunches in markets.
2. At any point in time, inability to justify a course correction for markets in future does not guarantee continued momentum, or even status quo. For example, if market frenzy takes a stock to price/earning multiple of 45x – say, substantially ahead of historical and peer group valuations – then the stock is best avoided even if one cannot pinpoint even a single reason for potential correction.
3. Even simple looking derivatives should be handled with care. People with less than perfect, understanding of and, experience in these instruments should treat derivatives as nothing but weapons of mass destruction
4. There is another and deeper issue with derivatives. Superficially the outcomes and methods look as simple as they seem compelling. Thus slowly people get sucked into the cauldron lured in by specter of easy profits. After some time the application of a particular derivative instrument becomes so widespread that contagion risks grow exponentially and uncontrollably. Now one seemingly innocuous mistake by an untrained hand is what it takes to bring down the entire edifice. Even people who understand and are experienced in these instruments find themselves helpless once the genie has been set free.
5. Quantitative models, even if they are mathematically rigorous and practically simple, are unable to capture emotions and hence can become irrelevant precisely when they are needed the most.
6. A quantitative strategy based on assumptions on correlation – among certain assets – derived from intricate data from past can often fall flat on its face when markets turn irrational. These correlations can in no time swing from a sizeable negative value to a meaningful positive one. An asset supposed to hedge another one may end up doubling the exposure in reality thus piling in the misery.

Anatomy of a stock market crash

On Monday, October 19th, 1987, DJIA nosedived by 22% – the biggest ever single day fall. The index remained extremely volatile for the week though it closed the week above Monday’s closing.

The solid trailing performance over preceding five years had layered a lot of froth over the markets and was also converting investors into reckless risk takers. On October 14th, and 16th the index had fallen by 4% each. Interestingly, news flow leading into the disaster was not too conspicuous even in hindsight. Some examples –
* Surprisingly high trade deficit
* 30 year bond yield rose above 10 percent level for the first time in two years
* US treasury secretary warned that the US might stop providing support for the dollar
* Legislation was coming up in the congress to tax greenmail

However, a chart showing an eerie similarity between 1987 and 1929 crash had been doing the rounds since early 1987 which had prompted some prescient (and/or lucky) traders to go short on the market.

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For the majority though the developments came as an avalanche from which some took a long time to recover.

The Mindset and The Protagonists

While psychological seeds for this disaster were sowed by widespread greed for easy money, by poor memory of market trends prior to 1982, and by an uncontrollable urge not to be left behind peers, there were three sets of protagonists in the mayhem around the black Monday. The three protagonists had one thing in common – they all were based on sophisticated strategies that seemed simple, elegant and practical. The three protagonists were –
1.       Risk arbitrageurs: Risk arbitrage (arb) desks at various financial institutions were thriving on betting on who would take over whom in the takeover boom of those days.The weapons for takeovers were high yield bonds which provided capital for a raider to make a run on the target company.
2.       Portfolio insurance buyers: Portfolio insurance is effectively a dynamic hedging strategy designed to prevent a stock portfolio dipping below a predetermined floor. As the portfolio value rises hedges are reduced. Hedge is increased as portfolio value declines and as that latter slips below the floor the portfolio is fully hedged. Thus the instrument looked like a remarkably simple way to enjoy best of both the worlds – participate in the upside if portfolio is moving up and limit your downside if the markets are tripping. The strategy was based on the now famous Black-Scholes equation for option pricing.
3. Cash – future arbitrageurs

The snowball …..

On October 14th, the Street realized that there was a bill in the congress that intended to tax greenmail. This would dim the prospects for many takeover in the works. As a result risk arb firms started a broad liquidation which in turn weakened the markets.
The drop in the market was felt by portfolio insurance hedgers who were forced into their own programmed selling which continued through 16th October, Friday.

…..Gathers Momentum….

Over the weekend – after running their models on Friday closing prices – many more portfolio insurers got ready to make adjustments to their positions to increase their hedges by liquidating stocks. It still seemed business as usual at portfolio insurance desks as models appeared to be in control and nothing had gone beyond the script.
However mutual fund clients of these portfolio insurers were panicking and giving sell orders. Redemptions on Friday and on weekend meant that a commensurate amount of their equity positions had to be sold.
On Monday, 19th October even before the markets opened portfolio insurers had sold S&P futures worth 500 m, about 30% of public volumes. Futures prices dropped precipitously – and stock markets had not even opened.
Now, as the chasm grew between cash and future prices, cash- futures arb teams waded in to gain from this widening gap. With market yet to open on Monday – 19th October, cash price was being assumed at Friday closing and as futures had dipped pre-market there was a seemingly big opportunity for cash – future arbs. However risk of gap down opening of stock markets that had somehow been overlooked, was to play out soon- and, painfully.
Here in futures market the cash – futures arb traders were the other side of portfolio insurance hedgers .These traders in turn were depending on stock market for their other side of the trade. Effectively the cash-futures arb traders were taking the market impact from the futures and transmitting it back to individual stocks on NYSE. In this normal link up between cash and futures markets the weak link was the difference between the time frames to transact in the stock markets, and in future markets. The latter was much more quicker. Further, liquidity in cash market was much lesser than in futures market. This proved to be calamitous that day for traders who had been lured in by the siren song of cash versus futures arbitrage.

…..Finally turning into an avalanche

Finally when the cash market opened it was at a breath taking discount to Friday closing. Due to this gap down opening of stocks, sell orders started building up and potential buyers, even the long term players, panicked effectively closing a liquidity tap that could have provided succor to markets. Thus stock prices started falling sharply prompting portfolio insurers to throw more sell orders into the futures markets. Dipping futures, in turn, pulled down the stock prices too.
The cascade in stock prices wreaked havoc on cash – futures arbitrage traders ( gap down opening of stocks turned their arbitrage opportunity on its head), who started limping to the sidelines thus depriving the markets of another source of liquidity. Meanwhile the portfolio insurers continued their selling spree even as liquidity was drying up. The result was that the DJIA saw the worst ever single day decline of 22%.

Shrug off  – the post script

The disaster with its genesis in unbridled greed, herd mentality, inability to raise even basic questions, and unrestricted application of derivative instruments by untrained hands – should not have come as a surprise. What was remarkable was the resilience post the disaster. The index retraced the losses in less than 18 months in a sense paving the way for the next disaster in mid -nineties.

Watch Out;The Surface Is Slippery

Someone is driving from Mumbai to Goa to usher in the new year. What is the risk of meeting with a road accident? What is the chance that it will rain on a September afternoon in Mumbai? Should one venture out with or without an umbrella? What is the risk that BSE Sensex will plummet by 50% in next five years?

In daily life we all come across various kinds of risks and often effortlessly take measures to control them without even feeling the need of a formal process. At the same time it can’t be gainsaid that people whose risk management systems are more systematic and evolved tend to take better decisions. Indeed it is difficult to overstate the role of understanding, assessing and controlling risks for a happy life.

As human beings we abhor risk to the extent that we don’t mind scaling down our ambitions if bigger goals imply more uncertainty. However it doesn’t prevent people from living with, or even accepting some risk if the pay-off is favorable. Alan Greenspan, ex-Chairman of US Federal Reserve Board, had commented in 1994 that ” The willingness to take risk is essential to the growth of a free market economy. If all savers and their financial intermediaries invested only in risk free assets the potential for business growth would never be realized”.

It is also quite pertinent to note here that we human beings typically have an exaggerated belief in our ability to spot and address risks perhaps due to facing, understanding and managing risks over thousands of years – and due to the fact that we, unlike any other life form, can figure out that something is dangerous even without experiencing it.

Risk: Uncertainty and consequences

So, how can risk be defined? The most obvious point that risk alludes to is uncertainty. Generally, there are many events, not all of them palatable, that can play out in future. This is best expressed in words of Elroy Dimson “Risk is more things that can happen beyond what we have planned”.

In addition, impact or consequence of these events too contributes to the risk. For an event to be bad we need to know how bad it is. An innocuous event, even if it has a very high probability does not add to risk. Thus risk, if not quantified, is better termed as uncertainty. In a way risk can be construed as a product of probability of failure, and consequence of failure.

Keeping in mind that Investment essentially is all about dealing with future it is difficult to miss out the relationship between investments and risks. It is impossible to know with certainty about future and hence risk is inescapable in the process of investment. Managing risk is very important to reduce the element of luck in investment performance.

More risks = higher expected returns

A rational economic agent seeks higher return from an investment if she is taking higher risks in those investments. A large part of modern finance theory is based on this basic concept which can be seen in the below exhibit in the shape of the so called capital market line which suggests that returns increase proportionately with risk taken.

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Taking a step further, investment performance of a portfolio of assets should be seen not just on the basis of returns and instead, should also be looked at in context of risks taken. For example a return of 35% from investment in a small market capitalization, commodity stock may not necessarily appeal to every investor versus a return of 20% from investment in a large market capitalization, consumer staples stock. A small cap stock in the commodity sector has typically a higher possibility (versus a small cap stock in consumer staples sector) of decline in price. Of course the possibility of higher returns too is higher. Thus returns must be adjusted for risks taken in the portfolio for an apple to apple comparison.

More risks do not necessarily mean higher actual returns

As the concept that returns have to go up proportionately with risks makes sense, at least directionally, shouldn’t – as a corollary- people who take higher amount of risks make more money? No. If this were to be true everyone would load on riskier instruments and record solid returns which in turn would suggest that those instruments were not risky in the beginning.

The exhibit below, from Howard Mark’s book titled ” The Most Important Thing” gives the relationship between risk and returns a better perspective.

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As seen in the above exhibit, as higher risk is taken the outcome becomes less certain as evidenced in widening probability distributions.The reality is that investors who take more risks may or may not get better returns even as they expect better returns. Expected returns increase with higher risks but the latter also increases uncertainty.Riskier investments have higher probabilities of making higher profits but they also have higher probabilities of lower profits and may even have some probability of making some losses as seen in the fourth normal curve in the above exhibit.

Imprecise for future, vague for past

One cannot be definitive about risks. Risk is difficult to quantify ex-ante but interestingly it is equally difficult to measure with precision even ex-post facto. Even after a stock has moved in one direction we do not get any new information – versus what we had prior to its movement – regarding the risk involved. Let’s say we bought a small cap commodity stock which jumped by 35% in 12 months. Does this – or for that matter, a scenario where the stock declines by 20% – add anything new to our assessment of risk involved in the stock? Not really. It’s only after we have observed statistically significant number of relevant data that we can draw some conclusions.

The situation is quite similar to a forecaster who predicts that there is a 65% probability that the stock will go up by more than 20% in 12 months. Let’s say the stock actually rises by 23% in 12 months. Now, was the forecast right? Since he had a forecasted probability of between 0 and 100 it can’t be said with precision if he was right or wrong (even though directionally he can be said to be right since he had predicted more than 50% for the event which eventually took place).Had he given a probability of 0 or 100 the verdict could have been precise.

In real life there are very few situations with probability of 0 or 100 and obviously they are quite simple to deal with. Such situations do not pose any risk.

Beauty lies in the eyes of the beholder

Not surprisingly, in keeping with his credo of keeping things simple Warren Buffet says ” My definition of risk is the possibility of permanent erosion of capital”. This brings us to another very important feature of risk – it is not absolute and instead depends on the protagonist.

Risk is a matter of opinion, is difficult to pin down in an equation and differs even in perceptions of different people. One investor may see capital loss as risk while some other investor may see poor returns as risk. Someone may see poor portfolio performance over one year as risk and some other person can say that for her risk means bad returns over five years.

Demonetization: Can Pandora’s Box Contain Goodies?

The scheme for demonetization of Rs 500 and 1000 notes announced on 8th November, 2016 and aimed at curbing black money (BM) in India has opened the proverbial Pandora’s Box. Apart from stiff opposition from most, if not all, political parties the scheme is also facing tremendous logistical issues. While the level of preparedness of the government leaves a lot to be desired, ultimately the course from here will be determined by ratio of outcome, and inconvenience for the common man.

Here it is important to recognize that large cash in hand, or cash transaction, may not always be black (or bad). The term black money ( BM)refers to money that has been accumulated by corruption or by tax evasion. There is a sizeable proportion of India’s economy that is clean-cash based due to logistical and legacy reasons and that is perfectly legal. Now, before forming views on the scheme and its feasibility it is important to understand what does it intend to do, what does it not target, and what are its limitations.

What does this scheme intend to do

  1. Dampen the purchasing power of people with unaccounted wealth
  2. Cleanse the system of fake currencies
  3. Demolish a key financing element of terrorists and Maoists.

What it is not aimed at

  1. Turn India into a cashless economy

People who can explain the source and trail of their cash should be able to get their cash exchanged from banks in next 4-6 weeks. In fact people who deposit less than Rs 250,000 won’t face any questions. After some inconvenience over next 3-4 months clean-cash based economy too should be able to reach required levels. As an unintended but favorable consequence there will definitely be some move towards increase in cashless transactions in future.

What it may not be able to achieve

  1. Wipe out black money altogether
  2. Eradicate the plague of fake currency forever

What can it achieve

  1. Restore faith of honest citizens that the welfare state has not abandoned its duty to be fair to all its citizens. Here the key is that black money must be made to lose its value.As per this scheme people with large chunk of unaccounted cash have to pay applicable taxes and a hefty penalty. Government will be able to raise a sizeable amount as tax.
  2. Provoke fear of law amongst the dishonest – This event will for a long time weigh in their minds possibly as a deterrent to corrupt activity and tax evasion.
  3. Reduce inflation which can give ammunition to RBI to cut interest rates that in turn may help economic growth by spurring an uptick in credit demand.
  4. Improve liquidity and credit availability in the economy. The hoarded money that had been lying idle so far can now be deployed more productively by banks, or by the people themselves after withdrawing from banks.
  5. Induce trust in the system –As many cash transactions are replaced by cheques, online payment gateways and other modes of non-instantaneous payment, economic agents will need to trust each other more which can over the long term augur well for all economic activities. Perhaps this can turn out to be the biggest advantage to emerge from this exercise.

What are the factors that are prompting opposition to the scheme

  1. This scheme won’t be able to prevent generation of fresh black money – i) True since here the focus is on penalizing those who have been enjoying undue benefits – so far. It is naïve to expect generation of black money to be annihilated in one shot. Had there been a magic wand, governments in the past would have definitely used it. At the same time it is not illogical to demand from the government equally stern measures to control the black money menace in future too. ii) Black money generated in next 2-3 years may only be a fraction of what is being sought to be unearthed by demonetization. iii) In future tax evaders and the corrupt will need to devise new ways to cheat. However the fear induced after this action may provide some deterrence.
  2. Not all notes will be tendered – Yes – A large chunk of the cash may be destroyed by the hoarders but it does not change the outcomes. Either way the dishonest will lose their ill gotten wealth while relative buying power of the honest Indian will be boosted.

Destruction of notes is a sort of poetic justice and at the same time helps in redistribution of wealth away from the corrupt. Notes that are not tendered may add to one time profit of the RBI in practical terms which in turn can be passed on to the government as dividends. Even if RBI does not book this as profit and keeps this amount under the head of other liabilities in its balance sheet it will be owing to conservative accounting. RBI can use it as a large buffer to fight currency fluctuations and liquidity issues later.

  1. This is causing inconvenience to general public – This is the most potent and relevant argument against the scheme. In the first week of the scheme the government has been caught on the wrong foot. Now, the long queues at bank and ATM’s can perhaps be entirely explained by lack of new notes. When almost 85% by value of currency in circulation, ie about Rs 14.5 lakh crore, is sought to be demonetized the level of preparedness should have been much higher to say the least. The government should have been ready with fresh stock of at least 25-30% of the demonetized amount on 8th November. If secrecy was the concern, and rightly so, then a war chest of Rs 100 denomination could have been kept ready.

So far the lure of the outcome (blow to black money) is what has kept emotions of the man on the street from spilling over but situation may worsen if bank queues do not shorten and if cash availability does not improve in next two weeks.

  1. Barking up the wrong tree; Cash as a vehicle to store black money is peanuts as compared to gold and real estate – Even if Rs 2 lakh crore (equivalent to about 35%of India’s fiscal deficit, or about 80% of defense expenditure, or 3 x of India’s education budget) black money is unearthed in this exercise it will be worth the effort.BM in gold and RE can be tackled by other measures in near future.
  2. This did not work in the past – Demonetization schemes in the past were very different from what is being done now since i) In 1978 the quantum of high denomination notes was just about 1.5%of total currency in circulation. In 2016 it is 85%, ii) In 1978 the notes that were demonetized were Rs 1000, 5000 and 10000.Thus demonetization exercise of 1978 was much narrower in its targeting and hence passed off without even a whimper from hoarders of black money.
  3. Reintroduction of Rs 500, 2000 will negate the potential gains –The idea is not to kill the cash economy – even though some shift towards cashless system may happen as collateral gain.Where ever commerce/trade etc are done in cash due to some honest constraints, denominations of Rs 500 and Rs 2000 will be required.
  4. Cost of the exercise is too high – Cost of printing new notes to replace the existing ones can be about Rs 10,000 crore. If seen in proper context (about Rs 80 per Indian, or just about 0.7% of demonetized notes, or equal to fake money stock in circulation) this seems quite reasonable especially in the backdrop of the targeted gains.
  5. People with black money will game the system – Manipulators are trying their best to bypass the government’s dragnet even as the latter remains in hot pursuit. However as of now it does not seem that more than a small proportion of black money can escape detection.
  6. Bad for economy – It is true for short run but in 2-3 quarters the economy should bounce back. Once the gains start kicking in, trade, commerce, agriculture and industrial activities will look much stronger starting 4-5 quarters from now.

In any case, sizeable long term improvements often need disruptive, instead of incremental, initiatives and this is one of the few disruptive efforts seen in India for a long time. It must be given a fair chance.

Perhaps Janet Yellen, US Federal reserve chair, had some such event in mind when she said “Productivity growth, however it occurs, has a disruptive side to it. In the short term most things that contribute to productivity growth are very painful”.

US Elections and Markets:Much Ado About Nothing?

As US presidential elections have come close business news channels and pink newspapers are hysterically discussing scenarios for equity markets. Stock prices have been swinging based on the latest predictions.In fact as Donald Trump has gained in opinion polls in last week or so, Dow Jones in the US has been trending down.

Fear, greed but above all …excitement

We all hate uncertainty and the impending elections are creating fear understandably amongst investors. There will be some who will be waiting for some stock mispricing to appear post the election results so that they can tap the opportunity. Most of us are waiting with bated breath for the outcome. It is quite an obvious question – what should an investor in Indian equity markets do at this juncture?

One way is to take the problem head on. As the first step one needs to figure out how will the policies of the two main candidates Hillary Clinton and Donald Trump affect the markets.This should not be difficult as market strategists and economists have been generously commenting about various scenarios in detail. After that, what is left is to predict who is winning. Here too, agencies conducting opinion polls continue to publish their updated expectations. Finally position the portfolio as per the stated policies of the winning candidate. Simple ! Not really, as we shall see below.

Deep and wide top-down analysis may not always add much value

Selecting sectors and stocks, based on which candidate is wining and what are his/her policy statements does not sound difficult. Additionally it gives one the satisfaction that one is working hard to make money.

However this approach is difficult and futile due to three problems –

a) Forecasting the winner, especially in a seemingly closely fought election is never easy. History is replete with examples where opinion polls have gone horribly wrong – who can forget the opinion polls of Indian general elections in 2004 ?

b) It is not easy to predict the way the new president will act – just on the basis of his pre election claims and promises.It is not easy to guess what is going on in his/her mind.Then, where is the guarantee that the new president will stick to the stance that he/she has publicized so far. In any case over the next four years the president of United States will be fed so much new information that there may be sharp changes in his policy stance in future.
c) Finally, even if we are able to pinpoint the future policies accurately, how are we to predict the company performance and stock performance based on that. Aren’t there other, often more important, drivers behind the performance of a stock ?

Taper tantrums, Daesh, Rexit, Brexit

Let us also take an outside view – how has Indian stock market behaved after some hotly debated political or macroeconomic events in the past.

I) Taper tantrum – In May 2013 when the US fed announced that it was going to reduce its bond buying activity, even after giving ample guidance earlier, the markets – globally as well as in India, had taken a severe beating. BSE Sensex dropped by about 10 % through the coming 4-5 months. However it didn’t take too long for the markets to shrug off the impact of this event. By May,2014 the Sensex was up by 20% versus its May, 2013 levels. For someone with two years investment horizon, at least in hindsight, this event provided a good point to add to his stock positions.

II) Daesh – Early victories of Islamic State in the Middle East in 2H2014 had unnerved many market observers. In fact some commentators had started discussing possibilities of Indian army getting into a face off with IS in near future. The fears turned out to be exaggerated and IS success on the battlefield started fizzling out soon.

III) Rexit – In 1HCY2016 a public debate was raging regarding the need and likelihood of RBI’s then governor Raghuram Rajan getting a second term.There was absolute consensus that Governor Rajan had been doing a great job and a vast majority felt that he must be given an extension.
Most market participants were of the opinion that if he was not given an extension Indian market would nosedive and would see a sharp derating medium term.Media started discussing with amazing regularity,and some respected global newspapers published articles and op-eds highlighting,the potential damage that Raghuram Rajan’s exit would do to India’s image and to investments in India.
In June,2016 the governor dropped a bombshell by announcing that he would not seek a second term and would instead head back to his first love i.e academia. Many market observers, business news anchors and newspaper columnists were dismayed and aired their views highlighting the dent this would make on prospects of Indian equity markets. However in a matter of weeks (or rather, days) it became clear that markets were thinking otherwise. The impact was minimal and short lived.

IV) Brexit – This was another event which had been followed closely by investors in 1HCY2016. Opinion polls, TV interviews and newspaper columns kept people on tenterhooks. Finally when the British voted on 23rd June to exit the EU global, including Indian, markets were hammered for a couple of days.Surprisingly the impact was negated- soon.

Make no mistake, political or macroeconomic economic events do matter for markets.However all headline hogging events may not be so earth shattering as they seem initially.As investors we should avoid forecasting events that are almost impossible to forecast and where no amount of sincere hard work can give us an edge.

Active Inaction:Need of the hour

Now, a word about the type of investment psychology that is required for this. If we have investment horizon of 2-3 years or more, if we are not using borrowed money, and if we are not employing derivatives this inaction may save time and intensify our focus on more important aspects of investment process.

Conscious and well thought out inaction can at times be the best friend of a diligent, hardworking investor with time on his side.Perhaps Blaise Pascal was thinking of investments and markets when he had said “All men’s miseries derive from not being able to sit in a quiet room alone”.