Finance and the Treachery within

Of all the Industries, the one that is loathed despite its laudable achievements is the world of finance. If not for the inventions in finance, most of us would still be bartering stuff around and hoping that you have what I need and you need what I have.

While inventions in other industries are lauded, in the world of finance, invention in recent years has made one wonder as to whose good these instruments of finance really are.

At its simplest level, finance is all about money changing hands from one who has more than he wants (for now) to one who wants more than he has (for now). Every business is build on its ability to finance its investment from one source or the other.

Directly or Indirectly, most of us are participants of every nature of business there is. While investing in Equities or Bonds is a direct way, when you lend your money to the bank and they lend  to a business, its a indirect way wherein your money is channeled to the business with the risk being spread across.

Mutual funds are one way of participating in the business with the main logic being that the fund manager knows better than others. But does he really know any better?

Every month, reports go out on what funds bought and sold and the list is large enough to wonder as to why fund managers need to trade so much even as they hold in disdain any form of short term trading / investing. HDFC Equity Fund for example (picked up at Random) has a turnover ratio of 34% which means that the whole portfolio is literally turned over every 3 years and yet, we have fund managers who shout from the roof tops the advantages of holding for the very long term.

Since 2000 if not earlier, there has been reports of how monkey’s have been able to beat professional money managers (at least the vast majority of them). While there is no monkey out there with ability to pick the best stocks, the reason behind their success lies in the fact that markets being random, everyone has a chance at hitting the jackpot once in a while.

Some time back, the book 100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities by Thomas William Phelps started to make waves in the financial circles. I myself have not been able to read it though thanks to the world of Blogs, was able to get detailed reviews of it.

The thing is that no one, not me, not you, not the hot fund manager right now or the wise wizard next door has a clue about which business will click and provide tremendous gains over the next 10 / 20 / 30 years and which won’t. This means that one really cannot buy a few selective number of stocks and hope for the best.

In fact, right from Warren Buffet to the value investor down the road prefer to reduce risk of the portfolio by diversifying the same. Mutual fund advisers advise one to invest into not just 1 fund but 4 – 5 funds to reap the benefits. But if you were to total up the stocks, you may very well find that you own nearly 70 – 80% of market capitalization ranked stocks.

Much of the financial world is made of monkey’s who offer to provide the service of sharing their cake. As you would know the story by now, its the monkey who stood to gain from the cat’s misfortune. There is literature after literature, all backed by data going back decades and even centuries about investing in a simple index fund being way better than in any mutual fund. But we are told that India is different and Indian fund managers are really able to generate Alpha – something that even Warren Buffet is finding difficult to achieve these days.

The solution to every problem and goal you have in mind is now easily achievable by doing a Systematic Investment Plan we are told. No amount of words or data seems to change the beliefs of the non believers, so let me try and tackle the issue in another way.

What are the Primary reasons for Investors to invest using SIP. Based on my discussions, I could come up with the following

1. Unlike in the past, we are told that youngsters these days don’t save much even as they draw mouth watering salaries. Unless some part is taken off and invested, they may not have much by the time retirement comes calling. Also since they are butter fingered when it comes to money, they cannot accumulate money to buy when markets are cheap.
2. Most investors have no clue about investing and aren’t prepared to make efforts to learn the same. Hence investing directly in stocks is too risky for them since they cannot understand the difference between say a Jet Airways and a Kingfisher.
3. By investing every month regardless of valuation (which they cannot perceive anyway), they can hope to benefit by long term averaging (in fact, the other word for SIP is Dollar Cost Averaging).

So, any alternative to Systematic Investing has to be one where no grey matter is strained and its simple enough for execution.

One of the ways to generate wealth on the stock markets is to buy Good companies and hope that they continue to grow for decades to come. Easier said than done as evidence has shown that even companies that are part of Indices can come to naught.

Buying the blue-chip of today may provide you with a decent return but nothing extraordinary while if you can buy a stock before market start to believe in it, you may have a real wealth generator out there. Its similar to investing say in Kohli before he started notching up his Centuries. His price (even say in case of Sponsorship) would have been way lower than what after market recognized his abilities.

But identifying such companies is not easy – not even for fund managers who prefer to buy the safe stock than risk (and rightly so) on companies that may emerge to be the next big thing. Most mutual fund portfolio’s are hence full of stocks that are similar in nature (and hence more the funds, more the over lapping).

What if instead of putting X amount of money per month into a scheme you invested the same into a random stock. A stock that was chosen by anything but skill, how do you think that would play out?

Well, I tested out the same. Using a survivor free database, I selected stocks every month randomly and assumed to have bought the stock for the money I was investing (10K per month). Every month all I did was throw a dart and buy the stock it picked.

The negative of the strategies would be

1. You will have a lot of bad apples. After all, not every company will thrive on the long run.
2. Your demat statement will run into pages after a few years as you keep adding more and more companies over time.

The positives of the strategy are

1. Since you invest only a small sum every month, the maximum risk would be losing one month of investment. On the other hand, if you can over time get even a single 100 bagger, it would ensure that 99 other bad apples are taken care of
2. Cost is small for executing this strategy. These days with brokerage firms offering Zero brokerage for Cash Delivery, the net cost would be way smaller than any other comparable investment (even Vanguard is beaten).

So, how did my test turn out?

I selected 120 stocks from Jan – 2005 to Dec 2014 and invested 10,000 into them. I did not add for Dividends which over time can turn out to be a good enough amount and one that will take care of the costs (Demat / Exchange costs) and more.

So, how did it turn out? A 10K investment per month for 120 months meant a principal investment of 12,00,000. At the closing prices of Friday, the current sum would have been 74,13,875.35 and since the investment was monthly, our XIRR return comes to 29.40%.

Of course, this is just one streak of many (given the randomness) and you may actually end up either better or worse than the above number. The intention of this post is to provide you a view on how you can build a large kitty without having to wonder if you have picked up the right fund manager and if the fund manager is making the right bets.

Much of the finance industry is about making grandiose statement without providing the data to back them up. They say that if you SIP for say 10 years, you returns would be great, but is there is no possibility of having a loss after 10 years? Not even 1%, Zilch? Really??

Hundreds of thousands of Crores change hands from investors to those with the ability to market themselves as being the savior of your savings with no one being the wiser. As a adage goes, “The fool and his money are soon parted”.

When the financial crisis hit in 2007 / 08. thousands of investors lost money, many bankrupted. As to those who sold them such products in the first place? Well, most of them are well off and many are in a better position than during those turbulent times.

As I repeatedly emphasize, every one is after you money and its up-to you to safeguard the same. If you fail, you cannot have anyone to blame but yourself.