The Crash of January ‘08

The headlines screamed “Melt down”. Was it really a melt down in India? The market came down from incredible bubble valuations to reasonable valuations. Is this a crash? It seems the media is a spokesperson for idle gamblers who view the markets as a perpetual money-printing machine. To call Monday “Black Monday” and Tuesday “Terrible Tuesday” is irresponsible journalism. And if ignorant adults called “small investors” lost, why should the rational world shed any tears? They were blinded by greed and made incredibly irresponsible punts in the first place.

The power of compounding – Time, Return, Amount

There is this story about the man who invented chess may years ago. It is said that the king of the land was so impressed that he summoned the inventor and asked him to take a gift from him. The inventor thought for a while and said that he wanted 1 grain of wheat for the first square, 2 grains for the 2nd square and 4 grains for the 3rd square, and 8 for the 4th square and so on – doubling the number of grains every square till he reached 64 squares. The king was offended at what he thought was a very small request and he ordered his staff to attend to it. Many hours later he was surprised to learn that his staff was still calculating. After many more hours he was told that the demand was such that whole planet would not be able to fulfill.
The monstrous number of grains required was 18,446,744,073,709,600,000 !!! That amounts to trillions of tons of wheat, which is more than what the world has produced in the history of the planet.
That is the magic of compounding. What looked like an innocuous 31 grains after 5 squares had built up to this monster figure by the time the 64th square was reached. The secret to making money also lies in using the power of compounding effectively.
Albert Einstein is supposed to have said that the most powerful force in the universe is compound interest. And it's true. Compound interest describes how investments can snowball over time. Just as a snowball gets bigger and bigger and rolls faster and faster as it tumbles down a mountain, the same can be true with your investments. Due to the power of compounding, the value of your portfolio can grow faster each year because you earn interest not only on what you invested, but also on the interest you earn. The money you make will depend on three factors:
How much money you invest
How much time it spends growing
Its rate of growth
To illustrate the above points, let’s look at a few examples. We look at three investment alternatives – Rs 10,000 per month, Rs 15,000 per month and Rs 20,000 per month. In terms of returns, we will look at three examples – 10% pa, 15% pa and 20% pa. In terms of time frame, we will look at 10 years.
What will be the final value of the investments? For starters, the simplest thing to calculate is the amount invested in each case, which will be Rs 12 lakh, 18 lakh and 24 lakh respectively. What will they amount to after 10 years? Take a look below –
· 10,000 per month at 10% pa return will amount to 20 lakh. At 15% pa it will amount to 26 lakh and at 20% pa it will amount to 34 lakh.
· 15,000 per month at 10% pa return will amount to 30 lakh. At 15% pa it will amount to 39 lakh and at 20% pa it will amount to 51 lakh.
· 20,000 per month at 10% pa return will amount to 40 lakh. At 15% pa it will amount to 52 lakh and at 20% pa it will amount to 68 lakh.
You would notice at once that the returns do not vary linearly. The difference between amount invested and returns for the best case (20,000 at 20% and 10,000 at 10%) is a huge 36 lakh. When you look at the other dimension time (just compute the above figures for 15, 20 and 25 year time horizons) the differences will compound even more.
Remember that not all growth rates are the same. If your bank is paying 6-8% interest on your savings, that's safe and guaranteed money. The stock market, however, is not a sure thing. Stock market returns fluctuate. There are good years, great years, and terrible years. Over long periods of time, though, the stock market tends to go up. Over many decades, in India, it has averaged an annual 20% return.
In general, the more certain the growth rate, the lower it will be. The more risky it is, the higher it will be.
The lesson here is that discipline in terms of amounts invested and the time invested s to be combined with risk in terms of returns to get great overall long term results. Risk alone will not do much and discipline alone will take you some way but not too far.

Nifty Volatility

Volatility is critical to risk measurement. Generally, volatility refers to standard deviation, which is a dispersion measure. Greater dispersion implies greater risk, which implies higher odds of a price erosion or portfolio loss - this is key information for any investor. We often estimate future volatility by looking at historical volatility.
The volatility of CNX Nifty is shown above.

The volatility presented above is for 30 days. It is computed using the following method
a) Ln (Closing Index value/ Closing Index value of previous day) is computed for every day = X
b) Volatility = Standard Deviation of 30 days values of X multiplied by square root of 250 (it assumed that there are 250 trading days in a year)
Just before the crash of May ’04, the volatility had soared to levels of 55-60% and it came down to levels of 20% by July. The Nifty corrected from a peak of 1833 to 1504. During the summer of 2006, the volatility again rose to 50% and above and a sharp correction followed as the Nifty went down from an intermediate peak of 3754 to 2633. The smaller fall in August this year was also preceded by higher volatility. The volatility is seen to be rising again and is pushing the 30% mark.

Human Behavior and investment

"Recently we worked on a project that involved users rating their experience with a computer. When we had the computer the users had worked with ask for an evaluation of its performance, the responses tended to be positive. But when we had a second computer ask the same people to evaluate their encounters with the first machine, the people were significantly more critical. Their reluctance to criticize the first computer 'face to face' suggested they didn't want to hurt its feelings, even though they knew it was only a machine."
Bill Gates in The Road Ahead

"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."
Robert G. Hagstrom, The Warren Buffett Way

Most financial theory is based on the idea that everyone takes careful account of all available information before making investment decisions. It is assumed that human beings are rational. Behavioral finance -- which examines how people's emotions, biases, and misjudgments affect their investment decisions -- is one of the less discussed and understood areas of investing. Yet, this is perhaps what impacts markets the most.

Researchers in behavioral finance have come up with some interesting theories, which are briefly presented below:

Prospect theory - People respond differently to equivalent situations depending on whether it is presented in the context of a loss or a gain. They become considerably more distressed at the prospect of losses than they are made happy by equivalent gains. This 'loss aversion' means that people are willing to take more risks to avoid losses than to realize gains. Even when faced with sure gain, most investors are risk-averse, but faced with sure loss, they become risk-takers. According to the related 'endowment effect', people set a higher price on something they own than they would be prepared to pay to acquire it. Tversky and Kahneman originally described "Prospect Theory" in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain.

Regret theory – This theory is about people's emotional reaction to having made an error of judgment, whether buying a stock that has gone down or not buying one they considered and which has subsequently gone up. Investors may avoid selling stocks that have gone down in order to avoid the regret of having made a bad investment and the embarrassment of reporting the loss. They may also find it easier to follow the crowd and buy a popular stock: if it subsequently goes down, it can be rationalized as everyone else owned it. Going against conventional wisdom is harder since it raises the possibility of feeling regret if decisions prove incorrect. Professor Statman is an expert in the behavior known as the "fear of regret." People tend to feel sorrow and grief after having made an error in judgement. Investors deciding whether to sell a security are typically emotionally affected by whether the security was bought for more or less than the current price. Many money managers and advisors also favor well known and popular companies because they are less likely to be fired if they underperform.

Anchoring - Anchoring is a phenomenon in which, in the absence of better information, investors assume current prices are about right. In a bull market, for example, each new high is 'anchored' by its closeness to the last record, and more distant history increasingly becomes an irrelevance. People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with long-run averages and probabilities

Over- and under-reaction - People show overconfidence. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on bad news and rise too much on good news. And in certain circumstances, this can lead to extreme events

People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Researchers found that at the peak of the Japanese market, 14% of Japanese investors expected a crash, but after it did crash, 32% expected a crash. Many investment experts believe that when high percentages of participants become overly optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur.

People often see order where it does not exist and interpret accidental success to be the result of skill. Tversky is well known for having demonstrated statistically that many occurrences are the result of luck and odds. One of the most cited examples is “Tversky and Thomas Gilovich's” proof that a basketball player with a "hot hand" was no more likely to make his next shot than at any other time. Many people have a hard time accepting some facts despite mathematical proof.

Two psychological theories underpin these views of investor behavior. The first is what Daniel Kahneman and Amos Tversky (co-authors of prospect theory) call the 'representativeness heuristic' - where people tend to see patterns in random sequences, for example, in financial data. The second, 'conservatism', is where people chase what they see as a trend but remain slow to change their opinions in the face of new evidence that runs counter to their current view of the world.

The bad news is that you cannot escape these patterns by giving your money to an expert to manage. The ideas of behavioral finance apply as much to financial analysts as they do to individual investors. For example, research indicates that professional analysts are remarkably bad at forecasting the earnings growth of individual companies. Evidence suggests that forecasts for a particular company can be made more accurately by ignoring analysts' forecasts and forecasting earnings growth at the same rate as the average company. The underlying reasons for the abject failure of the professionals are classic behavioral finance: they like to stay close to the crowd; and their forecasts tend to extrapolate from recent past performance, which is very often a poor guide to the future.

Release pent up demand

A college scene in TOI had a senior student pointing something to a fresher, while still talking on the mobile. Nothing unusual. At the airport, at shopping complexes, even inside theaters people are on mobile. How much can people talk?

Looks like there is no limit. And all this is new found love for talking, because just 10 years ago the same set of people were spending less than 1/10^th of the current time span in talking.

This is a classic case of supply at reasonably low prices stoking pent up demand to humungus proportions.

Wonder what will happen if ………………

The government decided to eat less in the form of taxes on petroleum products and petrol sold for about 40% lower values ………. The earth for sure would heat up faster

Or any other product for that matter.

However, there is a lesson for the government here. There is a particular segment which is very small and heavily taxed – food processing. The taxes price the processed food out of the market and these can really be articles of mass consumption. Why do people make their own curd, for example? Because packaged curd is too expensive. Ditto for ready to cook and ready to eat food, processed chicken and other articles of mass consumption. There will be no revenue loss for the government, because these segments are so tiny, that there is hardly any revenue.

No one in his right mind would like to make these things at home. No one makes pickles at home any more, for example. It is just the price point which is constraining demand.

The Key Energy Sources

The diagram below depicts the world’s marketed energy by type.

Crude oil consumption continues to rise, though its share in the world marketed energy sources is on the decline. In 2000, global crude oil consumption accounted for 39 percent of world marketed energy source at 155.9 quadrillion British Thermal Unit (Btu). By 2010, the share of crude oil in world marketed energy source is likely to fall to 36 percent or 185 quadrillion Btu.

The period depicted above shows that the overall demand for energy has grown at a CAGR of 2%. Nuclear energy has been the fastest growing segment growing at 4.6% CAGR (starting from a much smaller base), while crude oil has been the slowest growing segment growing at 1.2% CAGR(albeit from a very high base). Natural Gas and coal have grown at 2.7% CAGR and 2.1% CAGR respectively. Consequently, the share of crude oil in the energy basket has dropped from 46.6% to 36.4% over the 30-year period. It is interesting to note that the share of coal has remained virtually unchanged in the energy basket, over 30 years.

The trends suggest that while the share of crude oil will continue to decline, it will remain the most important energy source for the next few decades at least.

The following charts, based on the past data of over 30 years illustrate the trend further.

Source: OECD Factbook

The energy mix has changed significantly between 1971 and 2003. Nuclear energy, which experienced an annual average growth of 10% since 1971, increased its share of production from 0.5% to 6.4%. Renewable energy also experienced a high growth rate over the 32 years, but its share was very low in 1971, making this growth less meaningful. The share of natural gas in total production increased from 16.0% in 1971 to 21.0% in 2003, and the share of oil has fallen from 44.9% to 35.3%. The share of coal production remained at around 25%.