8 Feb 2024

Back to my roots

I grew up reading magazines at home. Political news commentary, children’s magazines, lifestyle magazines, science magazines, computer magazines, and whatnot.

Somehow the reading stopped once I moved out to live on my own. Now I am trying to go back to my roots.

One of the magazines in the picture is a brand new subscription; I have no idea how enjoyable and insightful it’s going to be. But I can’t know until I give it a try, can I?

3 magazines: Mutual Funds Insight, Wealth Insight, and Swarajya

20 Jan 2024

Temporal correction of market-linked securities

A “correction” in the securities market is when the price of assets fall.

The market often gets overenthusiastic about securities and the prices go up more rapidly than justified. Once the market participants realise this mistake, the prices come down. Sometimes prices come down sharply, within a few days. Sometimes prices stay more or less stable for many months: this is known as a temporal correction. Or a “sideways market” (vs bull market and bear market).

The chart below is an example of a temporal corrcetion.

You’ll notice that from about early 2020 through the end of 2021, the asset value (current balance in the chart, the blue region) has gone up rapidly. Since then, the balance has been falling and rising. By the end of December 2023, the balance is back to where it was in December 2021.

Essentially, 4 years worth of appreciation was realised in just 2 years, between January 2020 and December 2021. Instead of sharply correcting the price, the market has been tepid throughout 2022 and 2023. This temporal correction brings the asset prices back to a reasonable range.

It’s anyone’s guess where the prices will go from here. If 2024 also remains tepid, then we’d say the temporal correction continues. If the prices go up, then we can say that the correction is over.

15 Jan 2024

My progressive disillusionment about direct equity investing

My desire to dabble in direct equity investments is not new. I also know that direct equity investing is not a good fit for me. Despite knowing this, the desire for direct equity investment hasn’t fully vanished.

Rather than fighting the urge, I decided to give in. That’s usually how I roll. I just give in to the temptation and see for myself. Either I end up liking it or I come away with the understanding that it’s not as attractive or beneficial as it once looked.

If I am going to invest in direct equity, well, I might as well learn about it first. So I subscribed to Value Research’s Wealth Insight magazine. A part of me was afraid that I may end up risking too much of the family money in this direct equity experiment, but I marched on anyway. I have been reading the magazine for a few months now and learning.

Contraty to what I was expecting, I am picking up more and more signals and reasons for not investing in direct equity! Jan 2024 edition of the magazine has a story listing common mistakes investors tend to make. The following screenshot is one mistake from the list:

Screenshot from Wealth Insight magazine with this text: "This tree will grow to the sky: No trend can continue without a stoppage. Something or the other will always play spoilsport. It could be the entry of new competitors, a change in the economics of the product, changes in tastes and preferences, poor decisions by the management, etc."

The moment I read this, I remembered my bias towards holding on to my employer’s shares. I was (and still am to some extent) of the belief that holding on to my employer’s RSUs—which have grown much more rapidly than S&P 500—will make me rich. “No tree will grow to the sky” is the advice I had to see to remind myself that no one company is going to be infallible forever.

A few months of learning has not made me give up on direct equity, but I am not madly in love with that idea anymore. Learning about direct equity investing has made me more aware of the risks and nuances involved. I am in a better place than I was a year ago.

12 Jan 2024

A cluttered portfolio is not a problem—it’s a symptom

Let’s say you have bought a ticket for a 4pm movie show. When you arrive at the movie theatre, you notice that there is a 7:30pm show of a more interesting movie. If you had known about this screening earlier, you wouldn’t even have bought tickets to the 4pm movie—the 7:30pm movie is just better.

What do you do after your 4pm movie is over? Do you stay at the theatre and watch the 7:30pm show too? While some may do that, most people don’t. Despite the 7:30pm movie being good, most people don’t have an uncontrollable urge to watch it. Why? Because people know that it’s just another movie. Yes, every movie is unique, but that doesn’t mean you have to watch every movie out there to be entertained. You can afford to miss even really good movies.

Now replace movies with mutual funds. You have been investing in a flexi-cap fund for a few months. You see a media report that praises a certain mid-cap fund for its stellar performance. You fear you’re missing out, so you invest some money in that mid-cap fund. A few months later, maybe you invest in a thematic fund because the theme sounds so wonderful. Later you invest in a contra fund. If this goes on, you’ll soon be holding a dozen or more mutual funds in your portfolio.

Why does this happen? Why is it so easy to say No to a movie, but so very difficult to say No to a mutual fund? Not just mutual funds—accumulating clutter is true with pretty much any investment asset. People who invest in equity want to add gold to their portfolio. Then some REITs. Then some global equity. Then some InvITs. Then something fancy, say invoice discounting. When it comes to investment assets, many of us have a hard time saying No. Why?

I think I have an explanation.

We know that we don’t miss much by not watching a movie. We are able to control or ignore our desires and urges. Most of the time, it’s not even an issue because we know beyond doubt that it’s just a movie.

But we are not able to say No to investment assets because we lack that confidence. We have no confidence in our ability to make the right decisions. This lack of confidence makes us nervous every time we come across something new. Diversifying into different assets gives us a sense of safety. We hope that at least some assets will bring in profits. This lack of confidence inevitably leads to a messy and cluttered portfolio.

A cluttered portfolio is not a problem in itself, but it’s a symptom that tells us that the investor lacks confidence. The investor has no confidence in their ability to pick the right investment asstes. Nor do they have confidence in the assets they currently hold. They readily make room for new assets because they don’t know if their current assets are sufficient or whether they need the new asset. They err on the side of caution.

Conversely, a confident investor will have a simple, uncluttered portfolio. They are comfortable not having every interesting asset in their portfolio because they are confident about the prospects of the few assets they already hold. They don’t get FOMO (fear of missing out) because they know that it’s just another asset.

6 Jan 2024

How safe are “too big to fail” banks?

When conservative investors ask for “safest banks” to keep their money in, a popular answer they get is to stick to the D-SIBs—the list of banks that the RBI has declared as domestic systemically important banks. These banks are considered “too big to fail”. People assume that if such a bank were to fail, the government will intervene and save them. But is that really true?

What are “too big to fail” banks?

To understand this better, we need to start from the origins of the idea of systemically important banks. During the 2008 financial crisis, many governments had to bail out big banks in their respective countries. The governments were pretty much forced into this bailout since these banks were “too big to fail”. If such a bank was allowed to sink, the ripple effects would have been so severe that a significant chunk of the economy would have fallen with the bank! So the governments didn’t have much of a choice but to distribute cash to bail these banks out.

This is a moral hazard. A moral hazard is defined as a situation where one party takes excessive risk because they know that another party will rescue them if the risk were to realise. Big banks now know that they can lend recklessly in a pursuit to maximise their profits. If the low quality loans they give out are repaid, the banks get to keep the profit. If the lenders fail to pay, well, the government will bail the banks out anyway. So the big banks have no reason to be prudent about their lending. This is a problem.

To mitigate this moral hazard, a framework was brought up, called the G-SIB Framework. Essentially, banks that are too big to fail are identified and they are held to a higher bar than other banks. If a big loan they give out goes bad, the onus of recovering from that loss is placed on the bank itself.

The D-SIBs list, or the “domestic” systemically important banks is the same framework applied to Indian banks. The Reserve Bank of India (RBI) determines which Indian banks need to be held to a higher bar and sets them that bar.

What does it mean to be a D-SIB?

To understand D-SIBs, we need to first understand how the RBI prevents Indian banks from sinking. The RBI does this by prescribing a Capital Adequacy Ratio (CAR). Read this tweet thread by Kirtan A Shah to learn how CAR works, but in short, banks are required to have “risk capital” of at least 11.5% of their loan book. Risk capital is capital the bank can use to make up for any loss arising from bad loans.

An oversimplified example may help. A bank that has lent ₹10,000 crores needs to have risk capital of at least ₹1,150 crores. If the bank loses ₹200 crores to bad loans, the bank will dip into the risk capital to make up for the loss. Now the available risk capital is only ₹950 crores while the bank has active loans of ₹9,800 crores. The bank will need to raise additional ₹177 crores to bring the risk capital back to the required 11.5% level.

That 11.5% captial adequacy ratio is for “ordinary” banks. Since the nation cannot afford to have a D-SIB fail, the D-SIB banks have a higher CAR requirement. HDFC Bank and ICICI Bank need to maintain a CAR of 11.7% while SBI needs to maintain a CAR of 12.1%. That’s pretty much it.

In essence, neither the government nor the RBI is committing to bail out the big banks. These banks are classified as D-SIBs only to reduce the likelihood of them needing a bailout tomorrow. Assuming sovereign guarantee for these banks is a mistake.

Should we stick only to D-SIBs?

While any additional CAR doesn’t hurt, it is up to each investor to decide for themselves what protection an additional of 0.2% or 0.6% CAR is going to give them.

The RBI has been very proactive in regulating banks and preventing bank failures. Depositors have lost capital from the failures of PMC Bank and some small cooperative banks. But there has been no loss due to other bank failures. Yes Bank and Lakshmi Vilas Bank customers suffered some temporary liquidity issues, but no one lost their deposit.

I personally don’t consider a CAR of 12.1% to be significantly better than 11.5%, so I consider all domestic banks to have similar amount of risk. Choose any bank that you are comfortable with, but know that “too big to fail” is not a guarantee of bailouts.

What if I want more safety?

Some of us may find the banks’ capital protection measures unconvincing. The additional protection from the D-SIBs is not significantly better, either. If you seek even more safety for your capital, you have a few other options.

  • If you are okay with volatility, you can buy gilt mutual funds. The bonds are isssued by the government; the government can pay its loans off much more easily than any bank can.
    • What’s the downside? There will be volatility and the returns will be unpredictable.
  • Park your money in post office savings schemes. This money is essentially lent to the government, so it’s very safe.
    • What’s the downside? Working with the post office is not as convenient as working with a bank.
  • If you are savvy enough, find mutual funds that have less duration risk and invest predominantly in gilts. Quantum Liquid is one such fund, but there likely are other options too.
    • What’s the downside? You need to keep an eye on the mutual fund’s portfolio to make sure that the fund management team is not exposing your money to excessive risk.