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Cyclical and Non-cyclical stocks: How do they differ?

The best offense is a good defense. Just like in military combat or football, investors also need a good offense and defense strategy. In other words, you need to use more than one strategy in order to succeed. As a serious investor, there are many different ways you can do this. You can invest in a variety of stocks, cash, and other securities, you can also diversify your portfolio by investing in securities across various sectors and markets or you can invest in stocks that are at different growth and value levels.

Implementing the right strategy requires a good knowledge of the global economy and how the markets work- if you don’t have a good understanding of this, making decisions become incredibly difficult. As we all know, the economy goes through different business cycles and while we can’t predict the outcome of the cycles we can alter our decisions to keep up with the ever-changing landscape. This changing environment also provides a great way for investors to mix up their portfolio, namely with investing in cyclical and non-cyclical industries.

What are cyclical stocks?

As the name suggests, cyclical stocks are those that move in the direction of the market. That is when the economy is doing well, the stocks go up and when there is a downturn in the economy, the value of the stock goes down too. These stocks are more closely aligned with the broader economy and are more prone to economic activity.

For many investors, the movement of stock in cyclical industries provides a great opportunity to earn revenue on the stock by buying when there is a downturn and selling when there is an upward trend. For a novice investor, this may seem like a fool-proof strategy but be cautious, as it is almost impossible to tell when there will be a downturn in the market.

Cyclical industries usually may include durable goods (that last for a long time into the future), non-durable goods (that have a short shelf life) and services like automobile, construction, and travel.

When the economy is doing good and the people are earning well, they may spend a lot of money on buying a new car, constructing their new house or even plan fancy off-shore travels. However, when there is a downturn in the economy, people may prefer to hold these expenses for another year or two.

Around 75 percent of the stocks listed in the stock exchange are cyclical and follow the market trends. A few examples include Ferrari NV (RACE), Alibaba Group Holding Ltd. (BABA) and Royal Caribbean Cruises Ltd. (RCL).

What are non-cyclical stocks?

While cyclical industries may seem like a good investment, every good offense needs a defense, hence, it is important to balance out your portfolio with non-cyclical or defensive stocks. During a boom, people splurge on goods and services such as travel and cars. But during a slump, people stop spending on purchases that they don’t consider a basic necessity, instead they focus their spending money on food, water, and shelter.

non cyclical industry

During an economic recession or depression, the revenue and cash-flows and share price of non-cyclical companies continue to do well because they are industries that produce the basic needs of life that people will continue to consume.

In addition to basic needs, non-cyclical stocks also include those goods that are addictive such as tobacco or alcohol which can put ethical investors in a tricky situation as these industries do well even during a slump and reduces the number of industries that they can invest in.

Defensive stocks include goods and services in industries that are not affected by market fluctuations such as utilities, food, and medicines. It is basically any good or service that people will buy whether or not the economy is doing well. A few examples of defensive stock companies include Kraft Heinz Company (KHC), Johnson and Johnson (JNJ) and Sysco Corporation (SYY).

Bonus: The top-down strategy

There are two main investing strategies in the market, the top-down approach, and the bottom-up approach. The top-down approach involves looking at the economy as a whole and picking stocks that do well during certain economic conditions. This strategy requires the investor to have a good understanding of the macroeconomy along with its various sectors and industries to know what industry will perform well during the different business cycles. They also need to assess the inflexion points in the economy, that is when a certain stock price is expected to go up or down. For cyclical and non-cyclical stocks, top-down is the most commonly used strategy.

The bottom-up approach, on the other hand, involves looking at the stock individually and making investment decisions based on independent parameters.

When using the top-down approach, there are many indicators that investors can use to study the market. The first and most obvious metric is the GDP (Gross Domestic Product). This is the total value of all the goods and services produced in the economy and gives us a good understanding of the overall economic health.

Another great indicator is the ‘Purchasing Manager’s Index (PMI). This is a survey conducted among the purchasing managers in different sectors and industries in the economy. The PMI provides the investor with information on how the businesses are currently performing and which direction the economy is headed.

A third metric is the Consumer Price Index (CPI). This will give an investor insight into the changing price levels of goods and services in the economy and is a reflection of the state of the economy.

The top-down strategy is considered successful when the cyclical and defensive stocks are in perfect correlation with each other. A 100% correlation would mean that the stocks move in synch with each other while a -100% correlation means that the stocks are still in sync but move in the opposite direction.

During the 2008 recession, luxury goods such as Ford cars faced a huge decline in the value of their stock as people stopped spending on expensive items when the economy was down but at the same time, the stock for beverages such as Coco-Cola continued to do well as people spent money on this regardless of the business cycle.

Also read:

Conclusion

It is important for every investor to have a balanced and diversified portfolio with both cyclical and non-cyclical stocks.

Cyclical stocks include more luxury goods and hence a provide a higher return than non-cyclical stocks. However, the investor needs to study the market carefully and have a good tolerance for risk. Defensive stocks are safer investments but provide lower returns but are better for investors looking for safe investments Remember low risk, low return.

What are Mental Models? And Why Should You Care?

“Like a pane of glass framing and subtly, distorting our vision, mental models determine what we see”- Peter Senge.

Have you ever stopped to question your perception of the world around you? Have you asked yourself: ‘Is the way you view something really how it is in the real world?’ More often than not the answer is NO because our current perception of the world serves us quite well. In fact, we barely question it at all because that’s how limited our view of the world really is.

But have you stopped to think, that in a world so large and complex, there’s more to life than what we see and recognize? For instance, there are so many ways we can look at a problem and at the same time, there’s always more than one solution to the same problem. As humans, it can be a challenge to analyze and understand the vast amounts of information present in this world which is why we need mental models.

What are Mental models?

In its most basic form, a mental model is an image or model a person has of the world around them, that is, how they perceive their surroundings. This view varies by each being and it helps shape their behavior and how they react to the different situations they are presented with. However, many people only have one mental model and try to use it to solve a variety of problems.

In 1994, during a speech to business school students, Charlie Munger summarized this with a quote ‘To the man with one hammer, every problem looks like a nail.’ Possessing just one mental model is equal to having a very narrow perception of the world, which, essentially, is not a great way to operate in the ever-changing world we live in today.

There are numerous mental models that vary by discipline and developing multiple models can help you think more rationally. Here are three mental models used in business, psychology, and economics to help you get started:

Confirmation Bias (Psychology)

Confirmation bias is the tendency of humans to favor the information that aligns with their values and beliefs and ignore everything else that doesn’t fit into our perceptions. A great example would be the Buzzfeed personality quizzes like ‘What Harry Potter character are you?’ Before you even take the quiz, your confirmation bias or the way you perceive yourself has already decided that its Hermione Granger of course!

You have already confirmed the answer to the quiz based on the traits of the character and how they match up to your own personality. This confirmation bias can be applied to our everyday lives as well. Very often we find ourselves making purchases based on confirmation bias and later finding a rational reason to justify the purchase.

A simple way to overcome confirmation bias is to analyze your reasons for buying something, be it a stock or a car- you need to look at both sides of the coin. Make a list of the pros and cons along with the reasons why you want to make the purchase and why you might want to sell it in the future.

Also read: 5 Common Behavioral Biases That Every Investor Should Know.

Moral Hazard (Economics)

A moral hazard is when one party or entity makes a decision on how much risk to take while another party suffers the consequences if things go south. Moral hazard can be dangerous as it can cause the party that does not bear any costs to practice reckless and impetuous behavior.

While in theory, moral hazard can seem unlikely, as society has come to believe that the person making the decision has to bear its associated costs as well, this concept is very much prevalent in the insurance and medical industries. For example, a person taking out a policy on fire insurance has no motivation to protect their home from the risk of fire as they know that any damage caused by fire will be the responsibility of the insurance company. Likewise, in the medical industry, doctors are more likely to prescribe expensive treatment or surgery to their patients if they are covered by medical insurance.

Another great example of moral hazard is during the 2008 financial crisis, where banks and other financial institutions were close to bankruptcy due to their recklessness and poor decision-making. In the end, it was the government that had to intervene and prevent these companies from going under using tax-payers money to bail them out. The consequences of the poor deal-making on the side of the banks was borne by the government.

Network Effect (Business)

A network effect is when the utility you receive from using a product increases as more people use the same product and service and is a common mental model used in business.

A great example is the different types of social media we use today. When Twitter was first introduced, not many people knew exactly what it was and hence not many accounts existed. At this time your motivation to create a Twitter account is not too high as there aren’t many people you can interact with on the platform. But as Twitter gained popularity and more people started using it, you were more inclined to join as the utility you receive from it is now much greater than it was before. The network effect has made Twitter a major source of news today.

The network effect is prevalent in e-commerce sites as well. With websites like Amazon, the value of the platform increases as more people purchase goods and services and leave positive reviews. This encourages more people to use the platform, thus increasing revenue for the company. The network effect is a mental model used in many businesses and is a great way for companies to gain a competitive advantage in the market they operate in.

Resources to read:

Conclusion

The mental models listed above are just three in a long list of models that exist. Mental models can vary by discipline and it can often be a challenge for humans to learn and understand all the models that exist.

However, it is important to master the primary models to gain the wisdom of the world. Charlie Munger refers to these as the ‘Big Ideas.’ Mental models can help you think ‘outside the box’ and widen your perspectives on the world. You can use them to make wise and intelligent decisions!

Is Debt always bad for a company?

While evaluating a company to invest, one of the biggest element to check is its debt level. Ideally, it is said to look for a company with Zero-debt as it means that the company is able to manage its finances predominantly through internally generated cash without any external obligations.

However, is debt always bad for a company? Should you ignore a stock just because it has some debt. Moreover, what if the debt level increases after you invest in a stock? Should you exit that company because the company is adding debts?

In this post, we are going to answer these questions and discuss whether debt is always bad for a company or NOT. Let’s get started.

How a company finances its debt?

A company can raise debt either by issuing debt securities like bonds, notes, corporate papers etc or by simply borrowing money as loans from banks or any lending institutions. However, once the company has taken a debt, it is legally obliged to pay it back based on the terms agreed by the lenders and lendee.

In general, if a company is currently debt free and later starts taking some debt, it might be good for the business as the company can invest that money in expanding its business. However, the problem arises when the company which already has a big debt in its balance sheet, decides to add more. This increasing debt level can negatively affect the shareholders as by norms, debts are to be paid first by the company and shareholders will always be the last in line to receive profits.

When debt is not bad for business?

Although a few matrices like declining profit margins or negative cash flow from operating activities for a consistently long period is considered as a bad sign for a business. However, the same is not true in the case of debts. The debt is not always bad for business.

If a company has a low debt level and decides to take a new debt to start a project which may double or quadruple their revenue, this debt may be good for the business and add more value to the investors in the long run. However, an important question to ask here is whether the company can afford the debt at that point in time. If yes, then it may not be a point of concern for the company or you as a shareholder.

To check whether the company can repay the debt or not, you can look at the free cash flow (FCF) of the company. As a rule of thumb, if the company’s long-term debt is less than three times the average FCF, it means that the company will able to repay its debt within three years using its free cash flow. Of the other hand, consistently negative free cash flow with increasing debt level can be a warning sign for the investors.

Quick note: Also check out this post by Harvard business review on When Is Debt Good?

Debt is cheaper than equity

For growing a business, the management may decide to raise money from investors (equity funding) or they may borrow money from banks as debts. However, an important concept to understand here is that debt is cheaper than equity.

In other words, equity is a comparatively expensive method of financing for a company. Why? Because, first of all, raising money by equity dilutes the ownership and control of the promoters. Second, the cost of equity is not finite. Here, the investors may be expecting bigger returns as they are taking higher risks.

On the other hand, the cost of debt is finite and they are sourced at lower rates. This is because the debt is less risky financing as the firm is obligated to pay it back (unlike equity funding where the company is not obliged to pay any dividends to the shareholders). Moreover, the company has no obligation to the lenders once the debt is paid off.

Further, debt financing doesn’t result in any dilution and change in control. Here, the lenders take no part in the equity of the company and hence the promoters and shareholders can enjoy the benefits.

How to evaluate the debt of a company?

Although checking the liability side of a balance sheet is always the first step to evaluate the debt of a company. However, there are a few financial ratios that you can use to evaluate the debt level. Here are the three most frequently used financial ratios to evaluate the debt of a company:

1. Current Ratio:

This ratio tells you the ability of a company to pay its short-term liabilities with short-term assets. Current ratio can be calculated as: Current ratio = (Current assets / current liabilities)

While investing, companies with a current ratio greater than 1 should be preferred. This means that the current assets should be greater than the current liabilities of a company.

2. Quick ratio:

This is also called the acid test ratio. Current ratio takes accounts of the assets that can pay the debt for the short term. It doesn’t consider inventory as current assets as it assumes that selling inventory will take some time and hence cannot meet the current liabilities.

Quick ratio = (Current assets — Inventory) / current liabilities

A company with a quick ratio greater that one means that it can easily meet its short-term obligations and hence quick ratio greater than 1 should be preferred while investing.

3. Debt/equity ratio:

This ratio is used to check how much capital amount is borrowed (debt) vs that of contributed by the shareholders (equity) in a company. As a thumb rule, prefer companies with debt to equity ratio less than 0.5 while investing.

Also read:

Closing Thoughts

Contrary to the general belief, debts are not always bad for a company but can help it to speed up the growth. Moreover, debts are a more affordable and effective method of financing a business when it needs cash to scale up. The problem arises only when the management does not control its debt level efficiently.

How to learn faster- The Feynman Technique!

As the world around us evolves, we seek to constantly learn and absorb new information every day. Learning new skills and concepts is exciting and can expand your views on the world as you know it, making you a better student and human being. As Benjamin Franklin said ‘An investment in knowledge pays the best interest’.

But there is no denying that learning all this new information can sometimes get tedious and monotonous, there’s only so much knowledge that your mind can take in at any given time. However, thanks to scientific research, there is a method you can use to make the process of studying easier and efficient while increasing your ability to learn- the Feynman Technique. But before we discuss this technique, let me first introduce Richard Feynman to you.

Who was Richard Feynman?

richard feynman

Theoretical physicist and Noble laureate Richard Feynman was born in 1918 in Queens, New York. From a very young age, Feynman quickly took to science and engineering and had a laboratory in his parent’s home where he built various electronic devices.

By a young age, he was self-taught in various subjects such as algebra, trigonometry, and integrals. Eventually, Feynman went on to study at MIT and later Princeton for his Ph.d, where he made numerous contributions in the field of Physics. Some of his accomplishments include:

  • He contributed research papers on the theory of light and matter which earned him a joint Noble Prize in 1965.
  • When the Space Shuttle Challenger disaster occurred, Feynman helped research scientists understand the cause for the crash and the risks involved in flying the shuttle
  • He made a major contribution to quantum physics through the Feynman Diagram. The diagram aimed to visualize the interactions between elementary particles such as electrons and photons.

In addition to the major contributions to Physics, Feynman had the ability to apply his learnings to other fields such as mathematics and biology. He has the ability to comprehend and explain information on a variety of subjects that earned him the title ‘The Great Explainer.’ His vast knowledge led him to give numerous guest lectures at universities such as Cal Tech and UCLA. Many people, including Bill Gates, enjoyed his lectures due to his ability to break down and simplify complex scientific principles.

The Feynman Technique

Say you want to have a good understanding of a really hard concept in a discipline of your choice. There’s a chance that you may find the theory hard to comprehend as the crux of the matter is lost in translation aka with all the business jargon. The ability to understand and communicate these complex ideas in a simple way is what the Feynman technique addresses.

This method was developed by Richard Feynman when he was a student at Princeton. He kept a notebook of concepts and theories that he did not understand and spent time breaking down each process and understanding its parts individually, while looking for contradictory details in the theory. The technique essentially comprises of four parts as follows:

1. Pick the concept or theory you wish to learn

The first step in the Feynman technique is to identify what concept or theory you want to learn and list out everything that you know about the topic in a notebook. This could be any concept, under any discipline.

For instance, if you want to learn more about the game theory, your first step would be to write down all the existing (even limited) information that you have on the topic. Any new information about the theory from various other sources can be added to the notebook. For the game theory, you can start by writing down the definition of the concept and any information about the theory that you may have come across (for example prisoner’s dilemma…).

2. Teach or explain the concept in your own words to someone else

As you approach the second step in the Feynman technique, you would have gathered plenty of information on the subject (in this case game theory). Read through the information you have written down and try to understand the concept as best you can because this step involves teaching it to someone else.

But before you explain the concept, analyze the information in parts, this can also mean re-writing some of the information in your own words to have a better understanding. When explaining the concept, think of it as explaining to a child who has no background in what the concept is about. Hence, you need to use simple words (no jargon) and keep the information concise and to the point- children have a low attention span.

3. Identify any areas in your explanation that you can improve on

Now that you’ve explained the concept to someone else, it is likely that you will find a few areas in the theory that you can learn and improve on. So it’s back to the books to do additional research on certain concepts and breaking the data down further until you understand them completely. The goal is to make the information as simple as possible because that’s what the Feynman technique is all about.

4. Restructure the information and use examples as needed

The information you collected from various sources in the first step of the Feynman technique is essentially a puzzle that you need to solve.

Once you have identified the gaps in your information in step 3, your next move is to fill in these gaps to complete the puzzle. Think of your concept as a story and pretend that you are narrating it to a friend or co-worker.

When you say the information out loud, it can help identify the missing pieces and form new thought processes. Alternatively, you can use examples to simplify your learnings and add an element of creativity.

the feynman technique safal niveshak

(Image credits: Safal Niveshak)

Also read:

Conclusion

The Feynman technique aims to simplify complex learnings by breaking them down into smaller parts.

The technique can help you understand pretty much any concept or theory known to man and it helped Feynman amass large amounts of knowledge at a very young age. The trick is to break down any concept into a form so simple, that even a child would be able to comprehend the information. Albert Einstein famously said ‘if you can’t explain it simply, you don’t understand it well enough.’

How Much Should You Save  - 50/20/30 Rule!

How much should you save — This is one of the biggest questions that comes to everyone’s mind when we talk about budgeting. The importance of smart budgeting cannot be overstated as excessive spending and irregular saving habits can lead to disasters in the future.

If you want to enjoy a healthy financial life, it’s really important to have a balance between your savings and your expenses. And budgeting for individuals helps to align the spendings with savings and figuring out how much to spend on what.

If you are also struggling with personal finance, then this post may be a holy grail for you. In this post, we are going to discuss one of the easiest budgeting strategies to figure out how much should you save. And it is called the 50/20/30 Strategy.

50/20/30 Strategy

This strategy can be extremely helpful for youngsters who are just entering the world of personal finance and don’t know how to manage their spendings. Originally developed by Elizabeth Warren and Amelia Warren Tyagi, this strategy is beautifully described in their book — All Your Worth: The Ultimate Lifetime Money Plan.

50/20/30 is a really simple and straightforward budgeting strategy that can help you to define how much should you spend on your essential spendings (needs), savings and finally on your preferences (wants and choices). According to 50/20/30 strategy, you should allocate:

  • 50% of your monthly income on ‘Needs’ (like rent, food etc)
  • 20% of your monthly income on ‘Savings’ (like your retirement fund, investments etc)
  • And the remaining 30% of your monthly income on your ‘Wants’ (like traveling, dining out etc)

how much should you save 50/20/30 budgeting

(Image Credits: Business Today)

Now, let us understand all these three spending allocations in details.

50% of your income on Needs

As soon as you get your in-hand salary (i.e. your monthly income after deducting taxes), set aside around 50% of this income to pay for the things that are essential in your day-to-day life. The expenses in this category can be spendings on rent, food, transportation, utilities, health care, basic groceries, insurances etc.

Although allocating half of your monthly income in ‘needs’ may seem massive. However, when you look at the items in this list, it makes sense to allocate around 50% of your income on your needs.

Anyways, in case you are not able to manage your needs within 50% of your monthly income, you may have to optimize your lifestyle. For example, instead of living in a fancy house in a fancy locality which is too far from your workspace and adds transportation costs, you may wanna move in an affordable house with walkable distance to your office.

20% of your income on Savings

Once all your essentials are paid, next you need to allocate the 20% of your monthly income on savings. This category includes repayment of debt like a student loan, credit card debt etc along with investing the remaining for your future goals and retirement.

It’s really important that you allocate 20% of your income in this category before moving on to the next one i.e. spending on your ‘Wants’.

30% of your income on Wants/Personal choices

This is the last category in your personal budgeting. Once you are done with your essentials and savings, the final spendings should be on the things that you want. The expenses in this category include spendings on shopping, traveling, entertainment, dining out etc.

This list may also cover a few vague expenses like Netflix subscription, membership to clubs, weekend trips etc depending on your lifestyle. However, make sure that your spendings do not cross the allocated budget of 30% of your monthly income.

Example:

Let’s say that you make Rs 1.5 lakhs per month (in-hand income after paying taxes). As soon as you get your salary, you need to allocate

  • Rs 75k in meeting your day-to-day essentials like rent, food etc.
  • Rs 30k in paying your debts and savings.
  • And the remaining Rs 45k on your personal choice like dining out, traveling, memberships etc.

Using this simple budgeting strategy, you won’t run out of money to meet your daily needs, continuously contribute towards your future and retirement savings, and can also spend guilt-freely on your personal choices.

Also read: 3 Amazing Books to Read for a Successful Investing Mindset.

A few other popular saving strategies:

Apart from the 50/20/30 strategy, here are two other popular strategies that can also help you to figure out how much should you save.

  • 10% rule: This rule says that you should save at least 10% of your monthly earnings, no matter what the circumstances. This strategy is brilliantly explained in the book — The Richest Man in Babylon and works well for the people who are struggling to save money. The basic ideology behind this strategy is to ‘Pay yourself first’ and keep 10% of your savings only to yourself.
  • 100 minus your age rule: This rule tells that you should save at least the percentage of your earnings which is equal to 100 minus your age. For example, if you are 28 years old right now, then you should save (and invest) at least 100–28 = 72% of your monthly income. This rule is based on the principle that the expenses increase as you grow older (like kids, dependents etc) and hence you should save and invest more when you are young.

Also read:

Closing Thoughts:

Although 50/20/30 budgeting strategy may seem a little difficult in the beginning, however, with discipline and persistence — it is followable. Moreover, this budgeting strategy doesn’t depend on how much you earn. Even people with moderate to low salary range can follow this strategy if they are ready to optimize their lifestyle a little.

Anyways, the last thing that I would like to add is that do not take the rule too-damn seriously. I mean, do not freak out if your essential spending crosses over 50% in a month. Sometimes, you may need to review your income and expenses and make adjustments in the budgeting strategy.

For example, if you believe that your needs are less — let’s say you already own a house and hence you don’t need to pay any rent, but your personal desires are more, then you can follow the 40/20/40 strategy {40% spending on needs, 20% spending on savings and 40% spending on wants/personal choices}.

On the other hand, if your essential expenditures are high — let’s say you pay a heavy monthly rent, but your personal wants are low, then you may prefer 60/20/20 strategy {60% spending on needs, 20% spending on savings and 20% spending on wants/personal choices}. Nonetheless, whatever strategy you prefer, try to allocate at least 20% of your monthly income in savings. Remember- ‘A Penny Saved is a Penny Earned’.

Pat Dorsey’s Four Moats for Picking Quality Companies

While picking a quality company for long term investment, one of the key element to check is the company’s sustainable competitive advantage or Moat.

If you are new to the concept of Moat, I would suggest you to first read this blog post. Anyways, in general, the Moat can be defined as something that keeps a company’s competitors away from eating away their profits/margins for a stretched time. And hence the companies with big moats are able to generate economic profits for a longer time period.

Although there may be dozens of factors that may be counted as a moat for a company like patents, management, technology, switching cost, entry barrier etc. However, in the book “The Little Book that builds wealth”, Pat Dorsey, ex-director of equity research at Morningstar and founder of Dorsey Asset Management, described that there are only four moats that really matters while picking stocks.

Rest all are either confused moats or not durable for a very long time period. In this post, we are going to discuss Pat Dorsey’s four moats for picking stocks.

A little Introduction to Pat Dorsey’s Moat

“FOR MOST PEOPLE, it’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that will last longer are typically able to command higher prices, because the higher up-front cost will be offset by a few more years of use. Hondas cost more than Kias, contractor-quality tools cost more than those from a corner hardware store, and so forth.

 

The same concept applies to the stock market. Durable companies — that is, companies that have strong competitive advantages — are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition. This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats. So, if you can identify which companies have economic moats, you’ll pay up for only the companies that are really worth it. 

(Source: Chapter 1 — The Little Book That Builds Wealth)

In his book, ‘The little book that builds wealth’, Pat Dorsey suggested that as a company expands, it attracts more competition. And here, the biggest element that helps the company to remain profitable and beat the competitors consistently, in the long run, is their durable economic moat.

And that’s the reason why a few companies remain highly profitable for decades even in competitive spaces. A few examples of such companies can be Apple, Microsoft, Coca-cola, P&G etc.

Pat Dorsey’s Four Moats That Matters:

Here are Pat Dorsey’s four moats that you should look in a company while picking quality stocks with huge sustainable advantages:

1. Intangible Assets

Intangible assets are those assets that you can’t touch or see. A company can have intangible assets, like brands, patents, or regulatory licenses that allow it to sell products or services at a bigger margin that can’t be matched by the competitors.

For example, Coco-cola. If you look at their products, they are just carbonated sugar water and not much different from any other soda shop that you visit locally to buy cheaply priced drinks. However, when this carbonated sugar water meets the brand value of coke, they are priced way higher than what its competitors do, and still able to make way way more sales and revenue.

Similarly, in the pharmacy industry, if a company has got a patent over a specific drug, it may enjoy high sales without worrying much about the competition. And that’s why Pharmacy companies spend a lot of money on their Research and department (R&D) units.

2. Customer Switching Costs

If the customer has to cost a lot of money, time, efforts or resources to switch from one product to another, it is considered as the switching cost. If the products or services offered by a company has high switching cost (or really difficult for the customers to give up those products) then the firm enjoys a bigger pricing power and profit margin.

A great example of a customer switching cost is MS Excel. Although a lot of better tools compared to Excel are available publicly, however, to make all your employees learn any new tool, the company may have to cost a lot of time and resources.

Similarly, a few other software companies with high switching costs can be Adobe Photoshop, Auto-desk, MS Office etc. All these complicated programs cost a lot of efforts to learn and switching from one to another can be really difficult for the users. Unlearning and relearning these tools demands a lot of time, money and resources like pieces of training, courses etc.

3. The Network Effect

These are those companies whose value increases as their number of users increases.

A few examples of companies with a big network effect in recent days can be social platforms like Facebook, WhatsApp, Instagram etc. People are moving into these platforms as all their friends/peers are using them which makes them more valuable. So even if there are another better social media available, however, if your friends/family are not using them, you might be reluctant to switch there.

A few industries like e-commerce or food-delivery especially enjoy the networking effect. More customers are moving to ‘UBER Eats’ because more restaurants are associated with them. And on the other hand, more restaurants are associating with UBER Easts because more customers are moving into that platform. Overall, the users are inviting the restaurants and vice-versa and the platform benefits from the networking effect.

Another great example of industries with networking effect can be ‘Credit card’ industry. Here, customers are getting attracted to a credit card as they are accepted widely by many merchants. On the other hand, more merchants partner up with the credit cards as they have a bigger customer base. Overall, it’s all about networking effect for these companies.

4. Cost Advantages

These are those companies which are able to find better ways of producing their products or services. They enjoy cost advantages by improving processes, finding a better location, greater scalability, or access to a unique asset, which allow them to offer their products or services at a lower cost than competitors.

In general, the cost advantage is most useful in those industries where substitutes are easily available or for those products/services where the price matters the most for the customers while making their purchase decision.

A few examples of a company with cost advantage can be MacDonald (Standardized, low-cost approach and low-price menu), Walmart (low-cost advantage being scaled up to the massive effect), Vanguard (low-cost index fund that made an enormous impact on the investment world) etc.

Anyways, out of all the different sources to improve cost, Process-driven cost advantage should be carefully studied while evaluating companies. This is because processes can be easily copied. On the other hand, if the company enjoys cost advantages with greater scalability, it can do wonders for the businesses and investors.

Also read:

Closing Thoughts:

In addition to the four moats that matter, in his book, Pat Dorsey also discussed a few other confused moats (things that are not exactly moats) or the eroding moats (the ones which fade away with time) like Technology, Trends, Market Position, and management.

To understand a better picture, I would highly recommend you to read the book “The little book that builds wealth”. It will help you to learn the concept of moat far better while picking quality companies. And moreover, the book is only 210 pages long. You can easily read the entire book within a week.

Finally, there’s one more point that I would like to add before ending this post. A moat on its own is not enough. There are multiple examples of companies with big moats but saturated profits. However, a combination of a moat with strong management, and growth potential is what makes a company a great investment.

3 Dumb Stock Picking Strategies That You Need to Avoid!

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger

Over the last couple of years, since I’ve started investing, I’ve come to know so many strategies followed by different investors. Whether they are- Value pickers (those who buy great businesses at a discounted price), growth picker (those who prefer stocks which are growing at a high pace compared to peers or industry) or income stock pickers (those who invests in stocks which give huge dividends), I have heard of them all.

Apart from them, another category of popular stock picking strategy are the ones who rely on algorithms, programs, expensive arrangements or robo-advisory to pick stocks. And they are also quite successful in making money from the stock market.

However, after interacting with thousands of the Trade Brains’ blog subscribers and also through my personal experience, I’ve also come to know a few dumb strategies that many people use to pick stocks which mostly turn out to be a disaster a few years later down the road. (Btw, I’ve also been a victim of a few such strategies during my rookie days. Therefore, do not feel too bad if you have been using these strategies to pick stocks.)

Now, I totally understand that picking these stupid disastrous strategies are not entirely the fault of the beginners. After all, we are neither educationally trained or psychologically programmed to pick the best strategy that suits our interests. As humans, we generally prefer taking shortcuts and this is one of the biggest reason for the individuals to pick these dumb stock picking strategies.

Nevertheless, knowing the strategies which may turn out to be a catastrophe in the future may help the newcomers to avoid them. Therefore, in this post, we are going to discuss three dumb stock investing strategies that investors need to avoid else it may turn out to be a disaster in the future.

3 Dumb Stock Picking Strategies That You Need to Avoid

1. Investing based on Free Tips/Recommendations.

You are getting consistent stock tips on your phone to buy/sell equities and you finally decided to give it a try. This is one of the most dangerous stock picking strategies. Better you should put that money on a lottery ticket if you are willing to take such a risk.

Moreover, the majority of the free tips or recommendations that you receive on your phone via SMS or WhatsApp these days– are SCAMS. Don’t believe me, then read further regarding the same here: 3 Most Common Scams in Indian Stock Market That You Should be Aware of.

Besides, let’s say you’re discussing the market with a colleague/friend/neighbor and they advised you to invest in a particular stock. Unless they are professionally trained in the market (such as research analyst or investment advisor), most of these recommendations are crap and a definite path for future regrets.

2. Picking a stock because a big investor recently invested in it.

Seriously, this is your strategy? Are you planning to match your investing strategy with that of a big successful investor?

As a matter of fact, you should understand that you can never meet the risk appetite, resources, and exit-strategies of the big investors. There are hundreds of things that may go wrong in this strategy and hence, it’s never a good idea to blindly picking a stock just because a big stock market player invested in it.

Anyways, I agree that following the stock picking strategies and portfolio of big investors can be good learning. However, do your own research before investing and avoid being anchored with big investors’ stock picks.

Also read: Is Copycat Investing Hurting Your Portfolio?

3. Picking a stock because it is continuously going higher

If there is a single lesson that you should learn from this post, then remember this- “Stock prices going upwards is not a reason to buy and prices going down is not a reason to sell.

You should never pick a stock just because it is going higher. Stock prices movement on its own tells nothing.

Here, you need to look into the fundamentals, recent quarterly/annual results, corporate announcements, and other related news to find out the reason of price movement. Always make an informed decision after properly analyzing the company, rather just the price movement.

Bonus

4. Picking a stock because you feel it will go high

Recently, I was talking with one of my friends, Manish, and we begin discussing the equity market. After debating various investing ideas, Manish said that he is planning to buy Tata Motors share because he thinks that its price will re-bounce in upcoming months (Btw, at the time of writing this post, Tata’s share was down by over 57% in last one year).

I knew that Manish didn’t have much investing experience and hence I simply asked why he thinks that Tata Motor’s price will go up. He replied that the price is really down and he’s getting a feeling that the share price will recover and go up in the future.

Now, the share price of Tata Motors ‘may’ or ‘may not’ go up in the future. This is an entirely different discussion which I do not want to start right now. However, the answer that he gave to explain why Tata’s share price may go up is really stupid, right?

If he had talked the stuff like the sales of Tata Motors is going up, or their profit margin is increasing or Tata’s are launching a new vehicle in a segment which may be demanding among the audience, then I might have considered the reasoning. I mean, if someone gives me a factual reason why they believe that the price will go up, then I might discuss it further. However, if the reason is your ‘intuition’ or ‘gut feeling’, I can’t argue much regarding the same.

While investing in stocks, remember that you are not predicting whether it’s gonna rain today or not. Here you are analyzing companies which have fundamentals. There are a lot of pieces of information like the company’s financials, the board of directors talks/speeches, related news etc which are publically available to analyze companies. However, if instead of using these informations, you are making an investment decision based on your intuitions, you should rather be ready for an investment disaster.

Also read:

stock market meme 31

Closing Thoughts:

According to Benjamin Graham, the father of value investing, investment can be defined as “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

If you want to make decent returns from the share market, you need to stop speculating and making decisions based on these dumb strategies. If you are new to investing, take your time, learn and start building your own repeatable strategy by properly analyzing the companies which may produce consistent returns in the long term.

That’s all for this post. I hope it was helpful for you. Happy Investing!!

Why You Should Invest in Balanced Mutual Fund?

The Balanced Mutual Fund is a type of Equity Mutual Fund which combines the feature of both equity and debt in a single instrument. It means that the money pooled from the unitholders are invested both in debt and equity instruments.

However, the equity element in the underlying portfolio of a Balanced Fund should consist of at least 65% of the entire assets under management. The rest portion of the portfolio can consist of debt instruments and cash in hand. In general, the exposure in equity can range from 65% to 85% and is dependent on the market condition and the fund manager’s investing philosophy.

Through a balanced mutual fund, the fund manager tries to achieve portfolio diversification within a single product. The main aim here is to increase portfolio returns by managing financial risks along with maintaining the stability of the fund.

Quick Note: You can read more about Debt Funds and Equity Funds on our website here:

Why You Should Invest in Balanced Mutual Fund?

Risk management:

A Balanced Fund comes with a mix debt-equity portfolio. As stated earlier, a substantial portion of the assets consists of equity instruments and the rest in debts. However, if the stock market returns declines, the loss on equity portfolio can be absorbed by the debts. For example, if the stock market witnessed a drop by 10%, considering your Balanced Fund is having only 65% equity exposure, your portfolio will only get reduced by 6.5%. Moreover, here the debt instruments might help you to constrain the market risks.

Asset allocation:

It takes a significant amount of corpus to create a well-diversified portfolio consisting of both equities and debts. Therefore, if you are looking to create a risk-adjusted portfolio by allocating your savings in both these assets individually, it may demand a huge amount of capital.

However, if you invest in the market through a Balanced Fund, not only your money gets spread across diverse stocks but you can also enjoy a sound equity-debt mix at a lower corpus. Taking positions in equity through Balanced Funds will not only help you grow your wealth but also reduce the fund volatility to a minimum.

balanced funds. market movements-min

(Image Credits: Sanasecurities)

Taxation:

Balanced Funds have a considerable amount of debt instruments in their underlying portfolio. But, they are taxed by the Indian Government as per equity instruments.

So, if you are redeeming your units within a year of investment, short term capital gain tax @ 15% is applicable. Otherwise, for the long-term capital gain, you are required to pay tax @ 10% if the gains exceed Rs 1 lakh. You can learn more regarding mutual fund taxation in India on our blog here. 

Switching Benefits:

Suppose you have a portfolio consisting of equity funds and debt schemes. Now, if you have to rebalance between debt and equity by mutual switching, this would cost you capital gains tax and probably exit load. However, if the fund Manager performs this activity, neither tax nor exit load is attracted on your account.

Overall, it looks relatively profitable to invest in debt and equity through a Balanced Fund than naturally creating a debt-equity mix by yourself.

Things to consider while picking a Balanced Mutual Fund

Your willingness to bear risk:

If you have a moderate risk profile, you can opt for a Balanced Fund. Balanced Fund is meant for providing equity allocation with stability support through debt securities. In case you are looking for a highly aggressive portfolio, you can consider investing in a small-cap or a mid-cap fund instead. On the other hand, if you are a high risk-averse investor, debt fund would be a more appropriate choice for you.

Performance of the fund: 

As a general rule, you should invest in a fund that has consistently beaten its peers and benchmarks over a significant period of time. Although, it may be possible that that fund performed well because it has taken comparatively more risks than its peers. However, you can’t ignore the fact that the fund’s splendid performance has occurred due to the effective asset allocation by its Fund Manager which should be considered as an advantage while investing in that fund.

The expense ratio of the fund:

The expense ratio of a Balanced Fund is the measure of the costs associated with carrying out the operation and management of the same. It is expressed as a percentage and in general, the expense ratio for an active fund can be between 1.5-2.5%. As a thumb rule, a lower expense ratio means more money in the bucket on the investors rather than the fund house. You should choose a particular scheme only after you have thoroughly compared its expense ratio with its peers.

Fund’s underlying portfolio:

As a prospective investor, you should have an overall idea of the stocks and bonds which constitute the portfolio of your fund.  The higher the quality of assets, the more is the probability of earning better returns on your investment. Therefore, always check the fund’s underlying portfolio before investing to understand a better picture.

Fund Manager’s history:

A fund which is managed by a series of Fund Managers over a considerable period of time should be less preferred compared to one which is managed for the long period by a single Fund Manager.

Further, you should also try to avoid a fund whose turnover ratio is on a higher side. Turnover ratio means the frequency of churning the underlying assets of the fund by the Fund Manager in a year. If the turnover ratio is too high, it means your cost of investing will be on a higher side too.

Here are a few other resources to read to get an in-depth knowledge of how to choose a Mutual Fund scheme:

Further, here is the list of a few best balanced mutual fund by Cleartax at the time of writing this article.best balanced mutual fund by groww

(Source: ClearTax)

Closing thoughts

You must have heard the famous dialogue “Mutual Fund investments are subject to market risks, please read all scheme related documents carefully before investing.” The said quote is not a joke but a serious disclaimer which needs to be strictly followed. Before you start off your investment journey, make sure that you have a basic understanding of the Financial Markets.

If you are a fresher in the field of equity investing, it is recommended to start your investing journey with Balanced Funds. Any person who is willing to invest in the equity market but at the same time seeking stability of his/her corpus should consider a Balanced Fund. For example, if you are a middle-aged person who is approaching retirement age, it is safer to opt for equity exposure through balanced Funds.

Investing in a Balanced Fund gives you the scope to enjoy the features of both debt and equity in one product. Moreover, here the job of fund allocation and timing of the market is in the safe hands i.e. Fund Manager of the Asset Management Company. Although, while investing in mutual funds, all you need to do is to simply stay invested and relax. However, here you also need to periodically monitor your portfolio and be active with your investments.

That’s all for this post. I hope you have understood the concept of the balanced mutual fund by now. Happy investing!

21 All-Time Best Quotes by Charlie Munger

Charlie Munger, 95, is a name that doesn’t require any introduction for those involved in the investing world. If you are new to investing, you might have heard Charlie as Warren Buffett’s right hand. However, even individually, Charlie Munger is considered as one the world’s wittiest investor.

Anyways, let me first introduce Charlie Munger to the newbies. Charlie Munger is an American investor, businessman and a self-made billionaire with the net worth of over $1.7 Billion (as of Feb 2019). He is the vice chairman of Berkshire Hathaway, the conglomerate headed by Warren Buffett. And like Buffett, Charlie Munger is also an active philanthropist and has donated millions of his personal wealth for good causes.

Interesting, if you look into his background, Charlie Munger never took any course in investing, finance or economics while he was in university. During World War II, Charlie studied meteorology at Caltech to become an army meteorologist. Later, he earned a degree in law from Harvard Law School.

Charlie Munger and Warren Buffett met in 1959 during a dinner party and got along immediately. Although they knew each other for a very long time, however, they built their informal partnership by investing together only in the 1970s. Later in the 1980s, both started the present structure of Berkshire Hathaway and have been running in profitably ever since by building wealth for themselves and their investors. Here’s what Warren Buffett thinks of his business partner Charlie Munger:

We’ve got an extremely good partnership and business is more fun — just as life is more fun — with a good personal partner and to have a great business partner. You know it’s just — we’ve accomplished more but we’ve also had way more fun.” -Warren Buffett

Charlie munger and warren buffett-min

Charlie Munger’s wisdom is an asset for all the investing community. The knowledge and success that he has gained in the past many decades is quite inspirational.  Therefore, in this post, we are going to highlight twenty-one evergreen quotes by Charlie Munger that every investor should know. Let’s get started.

21 All-time best Quotes by Charlie Munger

Charlie Munger Quotes on investing wisdom

“People calculate too much and think too little.”

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

“What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head. And you’ve got to array your experience — both vicarious and direct — on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and fail in life. You’ve got to hang experience on a latticework of models in your head.”

Charlie Munger Quotes on Wealth Creation

“The big money is not in the buying or the selling, but in the waiting.”

“What are the secrets of success? -one word answer: ”rational”

“It takes the character to sit with all that cash and to do nothing. I didn’t get to where I am by going after mediocre opportunities.”

“To get what you want, you have to deserve what you want. The world is not yet a crazy enough place to reward a whole bunch of undeserving people.”

“All I want to know is where I’m going to die so I’ll never go there.”

Charlie Munger Quotes on Importance of learning

“There isn’t a single formula. You need to know a lot about business and human nature and the numbers… It is unreasonable to expect that there is a magic system that will do it for you.”

I paid no attention to the territorial boundaries of academic disciplines and I just grabbed all the big ideas that I could.”

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero. You’d be amazed at how much Warren reads — and at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”

“Spend each day trying to be a little wiser than you were when you woke up. Day by day, and at the end of the day-if you live long enough-like most people, you will get out of life what you deserve.”

Also read: 31 Hand-Picked Best Quotes on Investing: Buffett, Munger, Graham & More.

Charlie Munger Quotes on Circle of Competence:

“Knowing what you don’t know is more useful than being brilliant.”

“If something is too hard, we move on to something else. What could be simpler than that?” 

I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge.”

“We have three baskets: in, out, and too tough. … We have to have a special insight, or we’ll put it in the “too tough” basket.” 

Charlie Munger Quotes on life rules to live by

“Mimicking the herd invites regression to the mean.”

“Remember that reputation and integrity are your most valuable assets — and can be lost in a heartbeat.”

Just because you like it does not mean that the world will necessarily give it to you.”

“Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much-loved hand — you must learn to handle mistakes and new facts that change the odds.”

Take a simple idea, and take it seriously.”

Suggested Readings on Charlie Munger

Book: 

Articles: 

Why buying a house can be good investment?

As millennials we are often given a lot of investment advice- save early, take advantage of mutual funds and employer savings accounts and get rid of high-interest credit cards. But research has shown that one of the best ways to build up that retirement nest-egg is by investing in a house. According to leading financial advisors, purchasing a home is a great investment because the property is ideally protected from inflation and it is a physical asset that theoretically does not crash or disappear as stocks do.

 Why should you invest in a home?

“Buy land, they’re not making it anymore.” – Mark Twain

Any investment you make comes with its own set of risks so it is important to do thorough research into the advantages and drawbacks before you dive into a single investment. In many countries, especially India, buying your dream home is seen as an important investment as it is the place you create your happiest memories with family and friends.

In other countries such as the US, there has been a dip in home purchasing in recent years due to the volatility of markets and an increase in the cost of living but it is worth noting that the millennial generation represents the largest percentage of first-time homebuyers.

Purchasing a home is a life goal for many and the number of people investing in real estate is slowly picking up as more people recognize its many benefits. Here a few reasons why buying a home is a great investment:

Buying a home is a safer investment

When compared to all other forms of investments such as stock and gold, buying a home is a safe and stable investment. Unlike the stock market, the housing market does not face high volatility. But although it is a safe investment, you still need to be diligent and weigh the pros and cons before you invest in a home.

You can become smarter about your expenses

When you decide to rent a home, all your rent payments go straight into the landlord’s pocket while eating into a large proportion of your income. But mortgage payments or loan payments towards your home are an investment for the future. The monthly payments you make will reduce the amount you owe on the house while your home equity increases. It is a much better solution to make payments towards a home in place of short-term rent expenses that will not provide any value in the future.

It is a great way to save your money

Buying a home these days has become an accessible goal for many young people as salaries have increased and the ability to procure a loan is much simpler. In order to ensure that you are not spending your hard-earned money on unnecessary things, a great option is to invest in a home. Not only does investing in a home lock up all your savings in one asset but it also generates a lot of revenue if you have invested in property in the right location. In India, the Central Government has a PMAY scheme which provides first-time homebuyers with a subsidy of 2.67 lakhs.

The emotional aspect of homebuying

Homeowners are more motivated to form relationships with the people in their community than those who rent. The people in the area you live in can create a dependable support system. Although this may not be a tangible benefit, buying a home brings a sense of pride and accomplishment for homebuyers. Many people view homebuying as accomplishing a milestone in their lives. Moreover, this home can be passed on from generation to generation as a family inheritance.

Buying a home can help augment your retirement income

Due to the high costs of healthcare, funding your retirement is not as simple as it once was. If you choose to buy a home earlier in your life, there is a good chance that your home will be paid off by retirement age. The equity of your home can help supplement your retirement income. It provides a safety net against the rising costs and will give you the added benefit of not having to pay rent every month.

While many people think that investing in stocks is a better way to save for retirement, it is important to remember that any return on stock comes with an added risk. There is a further risk that your stock may lose its value when you reach the retirement age, or worse, it could be wiped out completely. Investing in a home is a safer alternative for funding your retirement as the value of the investment is more stable.

It provides a safety-net

There can be many unexpected twists and turns in your life both professionally and personally. An investment in a home provides a safety net in those instances as you have something to fall back on. In a situation where you lose a source on income or there has been a surge in rent prices or an emergency that requires a lot of money, your property, which is essentially your savings locked up in a single place, can serve as a source of income.

The stability of home-ownership

Owning a home provides a sense of belonging and kinship. Moving houses frequently is often tedious and emotionally taxing, especially for children. As you become older, moving houses becomes more difficult as you begin to form a close relationship with the people in the area you live in. Owning a home is therefore important as it provides a sense of community and helps avoid the emotional discomfort of moving.

Also read: Planning to Invest in Commercial Real Estate? Read This First!

Conclusion

There a many benefits to owning a home and it is one of the best investments millennials can make. However, it is important to study the housing market in the area you decide to invest in and weigh the pros and cons before you make a decision. It is recommended to talk to real estate brokers who can give you more details on the real-estate marker along with a loan officer who can provide information from a financial perspective. Do your homework and play it safe before buying a home.

What is the Prisoner’s Dilemma?

The Prisoner’s Dilemma is a popular two-person game of strategic thinking that is analyzed as part of game theory. It demonstrates how rational individuals are unlikely to co-operate even when it is in their best interests to do so.

The game uses the example of two prisoners being interrogated and how they respond and change their strategy over time depending on the situation.

However, before we discuss the prisoner’s dilemma, let’s first understand what is game theory.

What is Game Theory?

Game theory is the use of mathematical models to identify the reasons for conflict and cooperation between individuals. It helps us understand why an individual makes a certain decision and how their decision affects others.

The application of this theory in non-gaming scenarios is called gamification. The three main branches discussed below are closely related to game theory:

— Decision theory: This can be described as a game of an individual against nature. People’s decisions are based on their personal preferences and beliefs. The decision among risky alternatives is described by the maximization of the utility function. In turn, the utility function is dependent on various factor but mostly the level of money income.

— General equilibrium theory: This is a branch of game theory that deals with a large group of individuals such as consumers and producers. It is used in macroeconomic analysis such as the tax policy, to analyze the stock market or to fix exchange rates.

— Mechanism theory- While the game theory follows the rules of the game, the mechanism theory discusses the consequences associated with each of the rules. The questions addressed include wage agreements, spreading risk while maximizing revenue.

The Prisoner’s Dilemma

Game theory can be described as two players playing a game and listing out the choices and alternatives available to each player.

A famous example of the game theory is the Prisoner’s Dilemma where two individuals who are partners in crime are caught by the police and interrogated in two separate rooms and are given the chance to confess.

Since each prisoner has two possible options (either to confess or don’t confess i.e. remain silent), there are four outcomes to the game as represented in the matrix below:

the prisoner's dilemma 1-min Rules of the game:

  • If both players confess to the crime, they both get sent to jail but they will get a shorter sentence if one of the players is ratted out by his partner in crime.
  • If one player confesses while the other one remains silent, the one who remains silent gets a long severe prison sentence while the one who confesses goes free.
  • However, if both players don’t confess, they both get a shorter prison sentence than if they were to both confess.

 The options in the game (both risks and rewards) are represented as utility numbers.

In the table above, the positive numbers are favorable outcomes while the negative numbers are negative outcomes. However, one outcome is better than the other if the total value is greater. So -5 is better than -10.

In the table above, there are four outcomes, if both players confess, they are blamed equally for the crime (-5,-5). But if one player provides information on the other player in exchange for going free, the individual receives a utility of 3 units. But the other prisoner who does not confess and is sent to prison has a low utility of -10.

The last option is both prisoners don’t confess and sent to prison on reduced terms which results in a very low utility of -1.

Analyzing the Prisoner’s Dilemma

Once the various outcomes in the game are described, the next step is to analyze how the players are likely to respond. Economists make two assumptions when it comes to analyzing this game.

The first is that both players are aware of the total payoffs for themselves and the other player. The second assumption is that both players are looking to satisfy their personal gain from the game.

To analyze the outcome of the game, we can look at the most dominant strategies- this is the most optimal solution for one player, despite the response of the other player. Using the table above, confessing to the crime would be the dominant strategy for both players.

  • It is better for player 1 to confess if player 2 confesses as well because a utility of -5 is better than -10.
  • Player 1 should confess even if player 2 remains silent as 3 is better than -1.
  • Similarly, it would be better for player 2 to confess if player 1 confesses as -5 is more optimal than -10.
  • Player 2 should confess if player 1 remains silent as a utility of 3 is better than -1.

For player 1 and 2, confessing to the crime would be the equilibrium solution to the game.

the prisoner's dilemma 2-min

The Nash Equilibrium

The Nash Equilibrium was developed by mathematician John Nash and it shows the best response strategies in any situation. It is an outcome where one player’s strategy is the best response to the other player’s strategy and vice versa.

As per the outcomes in the table above, if player 1 confesses, it is in player 2’s best interest to confess as well as -5 is better than -10. And if player 1 doesn’t confess, player 2 should still confess as a utility of 3 is better than -1 and vice versa. The best strategies are highlighted in green in the table above.

Note: In case you enjoy visuals, here’s a simplified video on Prisoner’s dilemma:

Also read:

Why has this game become so popular among economists?

There are many reasons why the Prisoner’s Dilemma has become an important tool for economists in developing numerous economic theories.

The strategies to ‘confess’ or ‘not confess’ is used to identify if certain economic theories ‘contribute to the common good’ or ‘behave selfishly’. This is also known as the public good problem.

For example, if the government decides to construct a road, the construction of the road is beneficial to everyone. But, it would be better for the individual if the private sector and not the government built the road. When government spending does not benefit the individuals in the economy, it is known as an externality.

For two competing firms, the outcomes can be ‘set a high price’ or ‘set a low price’. For both companies, it would be beneficial to set high prices to earn higher revenue. But for each individual company, it would be more optimal if they set a low price while their competition set a higher price.

The game also shows how a rational individual should behave. As shown by the dominant strategy, it is best for both player to confess but in terms of utility confessing only results in -5 unit of versus the -1 unit they would receive if they did not confess. The conflict between the individual and the common goal is the basis of many economic theories.

The Prisoner’s Dilemma is an important tool used by economists when making decisions on economic theories and public spending. The payoff matrix can be applied to our everyday lives to find the most optimal solution in any situation.

Why You Should Try Thematic Investments?

Suppose you believe in an idea and confident that it will perform well in future. For instance, let’s say you are optimistic towards the renewable source of energy. Here, you are assured that the grid and other conventional sources of energy will be replaced by the renewable source of energy like solar or wind energy in the future. And therefore, you want to invest in this idea.

However, you are not certain of the best leading company in this segment to invest. Moreover, you also do not want to invest in the entire energy sector through any sectoral mutual fund as you want to focus just on the renewable energy-related companies. How to proceed further with your investments? Enter the thematic investments.

What is Thematic Investment?

As you might already know, mutual funds also provide an option to invest in different sectors via sectoral funds. For example, pharmaceutical funds focus on pharma companies or banking funds focus on investing in companies in the banking Industry. However, thematic funds are different from the sectoral fund.

Thematic funds are growth-oriented equity funds that focus on investing in a set of companies based (or closely-related) to a particular theme. They follow a top-down approach and targets a broader macro-economic theme on which the fund manager has a good knowledge of. Here, the thematic fund investors studies and understand the impact of structural shift in economics, political, technological, corporate or social trends on sectors, demographics etc which may reveal investable opportunities.

For example, electric vehicles (EVs) can be considered a theme. Here, the thematic fund based on EVs do not just need to focus on one automobile industry, rather they can include a set of industries which are a part of the theme. For example- this theme may include companies from the automobile industry, battery industry, Metal companies involved in making battery parts like Graphite, Aluminium, Carbon, etc, auto-ancillaries industry or any other companies related to the EVs.

A few other popular themes in India right now are digital India, make in India, technological progress, Internet of things, blockchain, environmental sustainability, social security etc.

thematic investments approach-min

Mutual funds vs thematic funds:

As I already mentioned above, thematic funds are different from the mutual funds and here are a few major differences between them:

— Mutual funds are over diversified while thematic funds are compact. Mutual funds invest in somewhere between 40–100 stocks. On the other hand, the number of stocks in thematic funds are smaller, typically between 5–20.

— Mutual funds are rigid and not easily customizable. Although there are thousands of mutual funds available in the Indian market, however, they are not customizable. On the other hand, it’s easier for investors to choose their ideas/sentiments and factor their risk appetite through thematic funds.

— The costs involved with mutual funds are high. For managing a popular active fund, the fund house may charge an expense ratio as high as 2.5-3%. However, the fees involved with thematic funds are comparatively cheaper.

Advantages of Thematic Funds

Here are a few common advantages of thematic funds:

—  Thematic funds are potentially more rewarding compared to diversified mutual funds.

— As thematic funds offer a compact theme, they have a concentrated impact because of news or happenings in other non-related industries.

— There are a lot of publicly available popular themes in the Indian market and hence, finding the right investment opportunity is not a tough task for investors. For example, you can use FYER’s thematic investment platform to try new different themes.

— Thematic funds allow strategic exposure to the investor’s portfolio and encourage common sense investing as themes represent the investor’s ideas and thoughts.

The risk associated with thematic funds:

There’s no denying the fact that no investment strategy is perfect. And the same goes to the thematic investments. By making investments in thematic funds, you are preferring a concentrated theme. This portfolio concentration makes these thematic funds comparatively riskier over diversified mutual funds.

Moreover, there’s also a controversy regarding thematic investments which says that investing in a concentrated idea which is still untested and underappreciated, may not be a sound approach.

Also read:

Closing Thoughts:

A major difference between thematic investments and traditional ones is that the thematic investors look into the future and makes decisions based on the predictions on the future trends or upcoming shift in the structure. On the other hand, traditional investors check the history and weights more importance to past performance, market behavior etc.

Moreover, we cannot deny the fact that themes change fast with time. In the last two decades, we have witnessed massive changes in the industrial and technology theme. Therefore, if you are planning to make thematic investments, be observant and careful regarding the entry and exit decisions. Only enter these funds after you have researched the idea thoroughly.

Nonetheless, if you are able to invest in right thematic funds, they are capable of giving huge returns to the investors compared to other index or diversified funds.

6 Common Mistakes to Avoid While Investing Through SIPs

Since the past few years, people are increasingly showing their inclination towards mutual fund investments. However, just an attraction is not enough to invest correctly in the mutual funds. They also need to know how to invest effectively and moreover, what mistakes to avoid.

While investing in mutual funds, people can either opt for lump sum or via SIP mode. For example, if you plan to invest a huge amount of money, say Rs 10 lakh in mutual funds all in one go, this is a lump-sum investment. On the other hand, if you choose to make your investments in chunks, say Rs 20,000 per month for the next 10 years, then this is considered a systematic investment plan (SIP).

In general, the SIP mode can be a little more convenient way to invest in the Indian equity market. It facilitates the people in building long term wealth without putting a lot of pressure of making huge investments all at once. Anyways, if SIPs can make your life more comfortable, it can also add trouble if you don’t use it in the right manner.

Here are some common mistakes which majority of investors do while investing in the Mutual Funds through SIPs.

6 Common Mistakes to Avoid While Investing Through SIPs

1. Choosing an incompetent SIP amount

While investing in a Mutual Fund via SIP mode, you should know the right amount to invest in order to reach your goals/needs.

In general, most people start with a small amount for their SIPs. This may be because they do not have much money to invest at that time or any other reason. However, subsequently with time, one should not forget to increase the size of their investments. On the other hand, there are also a few investors who start investing in SIPs with big amounts without performing a proper analysis of the funds. Moreover, they also don’t monitor their investments and thereby later suffer losses.

While investing in mutual funds through SIPs, you need to find the right size to invest that you can maintain on a regular basis. Furthermore, you need to monitor your portfolio closely in order to make decisions regarding whether to increase, decrease or stop your investments in the underlying schemes.

2. Investing for short-term

Mutual Fund investing is generally meant for generating wealth in the long run. One common mistake that majority of investors make is to redeem their investments in the short term in case their portfolios are unable to earn profits.

A lot of people start their SIPs with an objective to make money in a small time period. However, the fact is that when you opt for a small tenure, you are exposing yourself to a higher risk of market volatility. It is highly unlikely that you will get higher returns in a shorter tenure. Remember, SIP investing works on rupee cost averaging approach and helps in creating wealth in the long run.

3. Picking the Wrong fund

Before you start investing, you need to ensure that you have opted for the correct fund based on your financial aspirations, risk appetite, and liquidity requirements.

If you invest in the wrong fund, your SIP investments might not fetch the expected returns. Furthermore, before finalizing your scheme, you need to check some of the key parameters like its historical performance, underlying portfolio, expense ratio, fund manager credentials etc.

You may have a look at this blog on our website to gain a basic understanding regarding how to pick a right mutual fund.

4. Abruptly stopping SIP investments

Mutual Fund is associated with long term investing and it would be highly profitable if you hold your units for a longer period of time. However, on most occasions, the investors tend to lose their patience when they find their portfolio bleeding in the short run. A similar situation was witnessed by the Indian economy last year (2018) when most investors found their Equity Mutual Fund portfolio running at a substantial loss.

It is understandable that people may start to panic seeing their portfolio in red. However, the risk of market fluctuations drives the majority of the investors to shy away from further investments and this is where they make a mistake.

Also read:

5. Completely forgetting the SIPs after commencing

Ironically, you can find many investors who start their SIP and later forgets it completely. A lot many people have this misconception that long-term wealth creation means it doesn’t require monitoring at all.

However, even the soundest mutual fund which is managed the best fund manager requires monitoring. You need to monitor your mutual fund performances after every 6 months or at least a year.

6. Waiting for the perfect time to start

“Time in the market is better than timing the market.”

When it comes to timing the market vs time in the market, it is said time and again that don’t try to timing the market. You will never find the right time to enter. Here, time in the market is more important as the longer you stay in the market, the better will become your investment return.

Nonetheless, it has been seen that many investors keep waiting for the perfect time to start their SIPs.

The best feature of investing in Mutual Funds through SIPs is that it averages out your costs of investing. And that’s why there isn’t any proper time for you to start your SIP. The earlier you can enter, the higher is your chance to build huge wealth and to enjoy the benefit of compounding.

Quick Note: If you are new to investing and want to learn how to invest in mutual funds from scratch, check out this amazing online course: Investing in Mutual Funds- A Beginner’s course. Enroll in the course now to start your journey in the requisite world of investing today.

Conclusion

Mutual Fund investing through SIPs can help you reach your financial milestones if you invest in the right way. However, investing via SIP requires focus and discipline.

In this post, we tried to cover a few common mistakes to avoid while investing through SIPs. As discussed earlier, while investing in SIPs, always think long-term. Here, you can’t afford to abrupt your SIPs even if the market starts showing a bearish trend in the short duration. The longer is your investment horizon, the higher will be your scope to build wealth from the market.

That’s all for this post. We wish you all the best in your SIP investing journey. Happy Investing.

Planning to Invest in Commercial Real Estate? Read This First!

It goes without saying that investing in commercial real estate is a huge decision. Therefore, it is important that you are well informed before you make any money moves.

Investing in commercial real estate gives you the chance to dip into a new customer base and develop your business interests. It is quite different from investing in traditional real estate and requires some additional considerations. Patience is a virtue when it comes to commercial real estate as the cycle is longer and the investor needs to be well aware of trends in the market and economy.

Here are some key points to keep in mind when investing in commercial real estate:

Location Location Location

It’s all about the location when it comes to investing in commercial real estate. In every city, there are those areas that are in high demand (macro markets) and other micro-markets that are not so favorable.

When it comes to buying commercial property, there are many factors that come into play such as accessibility to roads and public transport, distance to neighboring cities and infrastructure projects currently in development in the area.

But as an investor, you need to be vigilant about emerging markets that are created as a result of the infrastructure developments. These are great areas to invest in because not only will they be in high demand but it also guarantees capital appreciation in the long term.

The property’s marketability

In addition to a great location, it is important for the property to create a steady cash-flow for the investor. The property needs to remain marketable and be able to withstand a large number of tenants and future growth. This means that you need to invest in property that is modern with trendy architecture.

Properties that encourage ‘green living’ and are eco-friendly will add to the attractiveness of the property. Other factors to consider are environment-friendly utilities, maintenance of the common spaces and good building management.

The amenities

The amenities available can add value to the property and these benefits tend to override the cost. Amenities can include many different things that can increase efficiency for the tenants on the property such as extra parking spaces or a food court if the commercial property is used for a campus or office space. These amenities can enhance the space while increasing the marketability of the property.

real estate amenties

While assessing the property, it is important for the investor to ask about who usually does the interior fit outs for the property. Traditionally, the tenant receives a bare space and installs the fit outs such as air-conditioning, lighting and sensors but some tenants may ask the building developers to install such fittings and pay an additional fit out rent.

Tenants who install their own equipment are likely to rent out the space for a longer period of time to cover their expenses.

The property’s risk

The assessment of risk bears a different meaning when it comes to commercial real estate as each property is different. While residential properties that are right next to each other face more or less the same risks, commercial property risks can fluctuate independently. Hence, it is important for investors to understand the potential risks of their investment.

These risks can include a variety of things such as zoning changes that can cause a commercial property to become residential as new suburbs develop in the area. Additionally, having similar commercial properties can create an oversupply in the market, that could drastically reduce demand. Infrastructure projects in other commercial areas can drive potential tenants away from your property.

The market dynamics

Investing is always a numbers game so it only makes sense that you keep up with them before investing in commercial property. It would be helpful to understand trends in the market along with customer’s changing wants and demands. You also need to study the historical market performance over the last three to five years to identify any anomalies or potential for reduced demand in the future.

Along with this, you should plan for the future and map out details about the tenant profile, the rent roll out, the lease contract (expiry date) along with any other information that will provide more clarity on the financials of the property. It would also help to talk to a real estate agent to discuss the details before making any big decisions.

The lease structure

Commercial leases are structured very differently from residential leases. They are either a 3+3+3 or a 5+5+5. This means they could either be a 9 year or a 15 year lease with increments in the rent every 3 or 5 years respectively.

The tenant has the freedom to vacate the property without notice, while the owner of the property cannot ask them to leave until the lease period is complete. They can, however, have a lock-in period in the contract of 3 years, during which the tenant cannot vacate the property. It is important for the investor to understand the lease structure of the property as they are often inherent risks involved. A lease with a long lock-in period is great for the investor.

Documentation

As an investor, it is important to perform due diligence and carefully analyse all title documents, permits and taxes associated with the commercial estate along with the presence of any mortgages. It is recommended to have all documents examined by a legal authority.

If you plant to rent out the space, it is important that the lessee understands their duties and obligations as per the contract. This will reduce the chance for any future errors. In addition to the legal documents of the property, the local area may have local laws that property owners need to abide by. You should have a thorough understanding of all the rules and regulations related to the property and the area it is located in.

Also read:

Closing Thoughts

Investing in commercial real estate can certainly add immense value to your portfolio but it is a decision that needs to be taken after a lot of thought and consideration. You need to conduct a thorough market analysis of the property while taking into consideration the factors listed above.

While the process of investing in commercial real estate is very time-consuming, it is unquestionably beneficial to an investor in the long-run.

Interim Budget 2019-20: The Talk of the Town

On the 1st of February, 2019, the Interim Budget of India, for the financial year 2019-20 was announced in the Union Legislature. Our honorable Finance Minister, Mr. Piyush Goyal, who is a Chartered Accountant by qualification, gave the budget speech, which lasted for around two hours, where a plethora of points were covered.

If you were at home while the budget was announced, you might have got the privilege to watch it live on television. Anyways, I was out on the street when the budget was broadcasted live. And therefore, unfortunately, I missed it. But subsequently, I watched the same on YouTube.

A Union Budget does cover plenty of pointers out of which only a few are those which we, as an individual, can relate with ourselves. This year budget has famously talked about taxation, agriculture, health industry and many other key aspects of our country’s economy.

In this article, we are certainly not going to discuss the entire budget as a whole. Rather, we shall talk a few selective crucial points which you, as an investor, need to know in order to manage your personal finance in the upcoming fiscal year for which this budget will be applicable.

Personal Taxation and Union Budget 2019-20

Income Tax

Firstly, let me tell you that the Income Tax slabs which were for the earlier financial year will remain the same for the FY 2019-20. In other words, there is no change in the tax slab for the people. However, the tax rebate under section 87A has been made applicable for an individual having total income up to Rs. 5 lakhs, (where the previously applicable limit was Rs. 3.5 lakhs).

The tax rebate limit for the ongoing financial year is Rs. 2,500. Nonetheless, the maximum limit of this tax rebate has been raised to Rs 12,500. Therefore, as an individual taxpayer, if you have annual taxable income up to Rs 5 lakh, it won’t attract any income tax.

Note: Currently, the net income falling within Rs 2.5 lakh and Rs 5 lakh is taxed by the Indian Government at the rate of 5%.

Considering this tax rebate, even if your annual gross income goes up to an amount of Rs 6.5 lakh, you won’t require to pay any tax on the same, provided you have made investments in the instruments prescribed u/s Section 80C of the said Act.

Quick Note: Under section 80C, a deduction of Rs 1,50,000 can be claimed from your total income by investing in a few tax-deductable investment options like LIC, PPF, Mediclaim, incurred towards tuition fees etc. This can help you to reduce your total taxable income by up to 1.5 lakhs.

However, if your taxable income exceeds Rs 5 lakh (and you have not made any investment in tax saving instruments u/s 80c), then, unfortunately, you won’t get any rebate in Income Tax.

The table shared below is an example which can help you understand what our honorable Finance Minister has tried to say with respect to the new income tax rebate clause.

income tax rebate

Capital Gains Taxes of Houses

As announced in the interim budget, you will not be taxed by the Indian Government on the notional rent of the second self-occupied house property. Therefore, here the key takeaway is that exemption is made allowable up to two self-occupied house properties.

This exemption u/s Section 54 of the Income Tax Act, 1961 will now be available on your second house property but it has come with a proviso. Your capital gains should either be less than or equal to Rs. 2 crores. Anyways, this benefit can to be availed by you only once in your lifetime. (Read more here).

TDS Relief

Presently, if your interest earning on Post Office Savings and Bank Deposits used to cross Rs 10,000, TDS u/s 194A used to get attracted.

However, the proposed budget has raised the limit from Rs 10,000 to Rs 40,000. In case of senior citizens, the limit has been increased to Rs 50,000. This proposal will surely benefit the individuals who are highly dependent on the interest income from their deposits interest earned on savings deposits, fixed deposits, as well as other deposit schemes in banks and post offices.

Standard deduction and other taxes

In case you are a salaried person, previously you used to get Standard Deduction of Rs 40,000. Now, this figure has been increased to Rs 50,000 which is, of course, going to benefit you financially.

Also read: What are the capital gain taxes on share in India?

Closing thoughts

This Interim Budget will become final unless a new Government comes into power after the Lok Sabha election which is to take place in a few months. However, if indeed a new Government comes into the picture, then this Interim Budget will cease to exist. Such new Government will frame a different Union Budget which will govern the Financial Year 2019-20 in India.

Since the day this Interim Budget was announced, it has created a plethora of confusions on some specific aspects of the budget among the residents in our nation. Out of all such confusions the clause related to rebate u/s 87A has so far seemed to be the most difficult and weird for the majority of the Indians to decode. This is again needed to be said that the tax slab has not been changed at all.

Every February, the new Finance Act (i.e. Union Budget) is declared by the Central Government of India. In every occasion, the budget brings new and/or amended clauses with it which subsequently makes the Indian taxpayers feel puzzled. Therefore, it is expected that even this budget will become clear among the people in India within the next few weeks.

There are people who have shared their negative feedbacks with respect to this budget. On the other side, many people are saying that this is one of the best budgets that India has witnessed since its independence. They have also added that this budget is probably the best budget that our current Government, formed by BJP (Bharatiya Janata Party), has come up with within its current five years tenure.

An Essential Guide to Financial Planning for Non-Salaried

If you are a non-salaried person, you may understand the phenomenon of uncertain earnings. Unlike ‘salaried’ people who earn a regular income from their jobs, ‘non-salaried’ people are those whose expected annual earning is a little difficult to guess.

In general, the non-salaried people are those who earn their living by doing some business, engaging in a part-time profession or carrying out freelancing. They do not receive a monthly paycheck from their company or bosses. Moreover, this irregularity in the income of the non-salaried people is dependent on several factors like demand, workflow, competition, technical innovation, regulations, and technical know-how.

Anyways, when we talk about financial planning, for most salaried people, the health insurances and retirement funds are somewhat taken care of by their employers. However, for the non-salaried people, they need to plan all these by themselves. And that’s why financial planning for the non-salaried person is a must.

In this post, we are going to discuss how non-salaried people can plan their personal finance effectively. Let’s get started.

Financial Planning For Non-Salaried People

Last Sunday, I met my friend Aditi for a coffee. We met after a long gap of three years. She told me that she has been working on a food blog for the last two years and making decent money from it.

After talking on a few causal stuff for some time, we started discussing her finances. She told me that although she was making good money as a freelancer, however, she is struggling a little as her income as they are very irregular in nature.

If we look into her finances, in general, whatever she saves, she deposits the same in her Savings Bank Account. She has also bought a Life Insurance policy and pays her premiums quarterly. Nonetheless, she was feeling a little clueless regarding how to come up with effective financial planning that can help her meet her future financial aspirations.

As a personal finance enthusiast, I tried to help her in my own way. So, we discussed in details regarding the four pillars of the financial Planning- Emergency Fund, Insurance, Retirement Fund, and Passive Income.

Emergency Fund

Firstly, I advised Aditi to build an adequate Emergency Fund. This fund should be big enough to protect her for at least six months in case her income declines or comes to a halt in the nearer term. By Emergency Fund, what I actually meant to say was that Aditi should have sufficient money in her Bank Savings account to run her expenses for a minimum of half a year.

Therefore, Emergency Fund = 6 times Aditi’s expected monthly expenses.

Anyways, these days Bank Savings Accounts do not offer a high interest on the deposits. In fact, the saving interests are not even good enough to beat the current consumer inflation rate in our nation. Therefore, I suggested Aditi to park her savings in a liquid Mutual Fund, which will not only help her in forming a good Emergency Fund but also boost her savings appreciate at around 7 to 8 % per annum.

Insurance

Next, we discussed Insurances. Aditi already mentioned earlier that she has a life insurance policy. However, when we started discussing it in detail, I came to know that her insurance was in the nature of “Term Plan”.

According to me, although Aditi does not have an extremely high standard of living, still her Life Insurance plan should cover a minimum of 15 months’ expected annual income. So, I told her to review her policy once and in case she feels she is under-covered, she should give a thought to take another Life plan.

Another important point that I came to know was that Aditi didn’t have any Medical Insurance coverage at all. For a self-employed person, Mediclaim is an essence. I told her that it should cover a minimum of  5 months’ expected monthly income. Here, please note that many people prefer to go with Life Insurance policies in the nature of the endowment plan. For the risk-averse investors, as endowment plans provide decent insurance plus investment option.

Also read: 6 Reasons Why You Should Get Health Insurance

Retirement Fund

After discussing insurances, I asked Aditi how long she is willing to work as a freelancer. In other words, when does she plan to retire? To this question, Aditi answered that she would like to work at least 25 to 30 more years from now.

When talking about the retirement savings,  I must tell you that it does take an immeasurable amount of time to build an adequate fund. By the immeasurable amount of time, what I mean to say is that you might need to wait for around two to three decades to build a substantial Retirement Fund which could help you maintain a similar (or even better) standard of living after you finally stop earning from an active source.

If you ask me what should be the desired retirement corpus, my answer would be that you need to build a corpus which should be at least twenty-five times the expected annual expenses. Nonetheless, the big question here is how can you build such a huge corpus from around 25-30 years from now.

Don’t worry, the answer is not very complicated. Here, I will suggest you to consider investing in Equities or Equity Mutual Funds. Yes, of course, Equity investing is a little risky in the short term. However, if you opt for value investing, it can aid you in creating a huge corpus in the long run.

retirement fund-min

Passive income

As a non-salaried person, Passive Income can help you to support your basics expenses as your earnings may be filled with ups and downs.

In meaning, passive Income is that income which does not require your active time. Once your passive income mechanism is set up, you don’t need to do anything to earn that income. Moreover, Passive Income can be stable and act as your secondary source of income. A few examples of Passive Income can be your rental income, dividends, and Interests from Equities and Bonds etc.

Apart from your emergency and retirement fund, you need to build a few consistent passive income sources and to add them as other income in your financial planning.

Also read: 11 Best Passive Ways to Make Money While You Sleep.

Closing Thoughts

There is no doubt in highlighting the fact that non-salaried people are subjected to more financial risks compared to the salaried people. For all the self-employed people out there, like Aditi, effective financial planning can help you manage and mitigate the financial risk of your irregular income.

And therefore, as a non-salaried person, you should take your financial planning seriously and start working on your Emergency Fund, Passive Income, Insurance, and Retirement Fund.

That’s all for this post. Today, we tried to cover how a freelancer, business owner or an independent professional, can manage their personal finance effectively. We wish you all the best for your financial investment journey ahead. And Happy Investing!

5 Psychology Traps that Investors Need to Avoid

Benjamin Graham once said that “an investor’s chief problem and even his worst enemy- is likely to be himself.” It is a well-known fact that the human brain is a wonder that is capable of numerous mathematical, problem-solving and communication skills that is unparalleled with any other living species.

However, when it comes to investing, humans have been known to make terrible decisions and often fail to learn from their own mistakes. They go through a ‘roller-coaster of emotions’ as shown below.

Investment process – Roller coaster of emotions

(Image Source: Credit Suisse)

While the human mind is incredibly unique, people still fall victim to the investor traps that can have serious consequences in the financial markets. This has led to the emergence of behavioural finance, a new field that aims to shed light on investors’ behaviour in financial markets.

This post discusses the most common psychological traps investors need to overcome to increase their chances of earning high returns.

5 Psychology Traps that Investors Need to Avoid:

Anchoring Bias

Anchoring Bias occurs when people rely too much on a reference point in the past when making decisions for the future- that is they are ‘anchored’ to the past. This bias can cause a lot of problems for investors and is an important concept in behavioural finance.

For example, if you had a favourable return on a stock when you first invested in it, your perception on the future returns of stock is positive even when there may be clear signs indicating that the stock might take a dive. It is important to remember that financial markets are very unpredictable so you need to remain flexible and seek professional advice when not-sure of making considerable investment decisions.

Herding

Also known as the mob mentality, is a tactic that was passed on from our ancestors and believes that there is strength in numbers. Unfortunately, this is not always the best strategy in the financial market as following the crowd is not always the right move.

Ironically, this herding mentality among investors is the major reason for ‘bubbles’ in the financial markets. Investors often ‘herd’ to secure their reputation and base their decisions on past trends or on investors who have had success with the same stock in the past. However, people are quick to dump stock when a company receives bad press or go into a buying frenzy when the stock does well.

As an investor, you should perform your own analysis and research on every investment decision and avoid the temptation to follow the majority.

Loss Aversion

Loss Aversion is when people go to great lengths to avoid losses because the pain of a loss is twice as impactful as the pleasure received from an investment gain. To put in simple terms, losing one dollar is twice as painful as earning one dollar.

Loss Aversion- How it can ruin your investments

As emotional beings, we often make decisions to avoid a loss, this could involve investors pulling their money out of the market when there is a dip which leads to a greater cash accumulation or to avoid losses after a market correction investors decide to hold their assets in the form of cash.

However, this perceived security of exiting the market when it is unstable only leads to a larger amount of cash circulated in the economy which results in the inflation. During the 2007 financial crisis, there was $943B worth of cash increases in the US economy.

Investors can avoid the loss aversion trap by speaking to a financial advisor to learn how to cut their losses and optimize their portfolio for higher returns.

Superiority trap

Confidence is an asset when it comes to investing in the stock market, but over-confidence or narcissism can lead to an investor’s downfall. Many investors, especially those who are well educated and have a good understanding of finance and in the functioning of the stock market often believe they know more than an independent financial advisor.

It is important to remember that the financial market is a complex system made of many different elements and cannot be outwitted by a single person. Many investors in the past have lost large sums of money simply because they have fallen prey to the mentality of overconfidence and refused to heed anyone’s advice. Overconfidence is the most dangerous form of carelessness.

Confirmation bias

Confirmation trap is when investors seek out information that validates their opinions and ignores any theories that refute it.

When investing in a particular stock that believe will result in favourable returns, an investor will filter out any information that goes against their belief. They will continue to seek the advice of people who gave them bad advice and make the same mistakes. This results in biased decision-making as investors tend to look at only one side of the coin.

For instance, an investor will continue to hold on to a stock that is decreasing in value simply because someone else is doing the same. The investors help validate each other’s reasons for holding on to the investment, -this, however, will not work in the long-term as both investors may end up in a loss. Investors should seek out new perspectives on a stock and conduct an unbiased analysis of their investment.

Also read:

How can an investor overcome these psychological traps?

The human mind is very complex and there are many factors both internal and external that can affect the decisions we make. The pressures we face in society make it easy to feed into temptation and fall prey to the psychological traps listed above. Being overconfident, seeking validation from others and finding comfort in other people who are in the same boat as you are just some of the reasons that can have an impact on the investment decisions we make.

Nobody is perfect and it is only human to fall into a psychological trap. The best way to mitigate these effects is to stay open to new information and think practically about how the investment will affect you as an individual. You should also seek the advice of industry experts to ensure that your investment decisions are based on well-researched information that can help you make unbiased decisions.

6 Best Investment Options for NRIs in India

Since last two decades, India has been rapidly developing as an industrial hub. Day after day, our country is attracting more and more foreign direct investment (FDI). Moreover, these days we can see more and more investments coming from the NRIs to the Indian markets. And this is all happening because the Indian economy and government are offering adequate stability and flexibility to the investors. Not only India is conducive for business growth but our economy is also equipped with an extremely profitable financial market.

The year 2018 was not an immeasurable year for investing in the stocks as it witnessed significant bleeding throughout the year. Nonetheless, a similar situation was observed in any other country across the world. However, if you have a look at the year previous to that i.e. 2017, you would find that India’s stock market yielded around 29% return which was relatively higher than any other economy in the world.

Anyways, financial markets are subject to lots of ups and downs. It goes without saying that you need to undertake end-to-end research before you make your investment decision. Nevertheless, whatever investment option you opt for, it should always depend on your financial goals, liquidity requirement, risk appetite and expected returns.

In this post, we are going to discuss a few of the best investment options for NRIs in India which can provide them with adequate returns depending on their goals and needs.

6 Best Investment Options for NRIs in India.

Here are a few solid investment options in India where you can consider investing if you are an NRI.

— Fixed Deposit

Investing in Fixed Deposit is not only popular among the residents in India but also an attractive investment scheme for the NRIs. Being an NRI, you can open your FD with your NRE, NRO, or FCNR Account. All three of these are the types of bank accounts that an NRI can open in India.

Anyways, how much rate of interest will be applicable to your FD depends on the tenure of your deposit. In general, you can expect to earn interest between 6 to 7% on your account balance. Further, if you are a senior citizen, you would get the privilege of earning an extra interest of one percent. Moreover, this investment option is suitable for risk averse investors as FD is a comparatively safer form of investment.

Note: You can read more about the current Fixed Deposit rates in India here.

— Equity

In case you are an aggressive investor, you can consider investing in the equities listed in the Indian market. If you are an NRI, you can directly invest in the Indian stock market under the Portfolio Investment Scheme (PINS) of the RBI.

As an NRI, in order to invest in the stock market in India, you are required to have a bank account (NRE or NRO Account), a trading Account (with a SEBI registered Stock Broker), and a demat account. However, the maximum amount of your investment in the stocks of an Indian company cannot exceed 10% of its paid-up capital.

Further, this is to be noted that, as an NRI, you are not at all permitted to carry out intraday trading and short selling in India. This implies that you need to own the stocks before you can sell them.

— Mutual Fund

These days AMFI is working hard to promote Mutual Funds among the Indian population. Mutual Fund organizations pool money from their investors and then invest the same in the different financial assets. Mutual Funds have moderate risks as they are neither as risky as direct trading in stocks, nor they are as risk-candid as FDs. Further, mutual Fund investments can be highly profitable. There are a plethora of schemes available for Mutual Fund which can choose depending on your risk appetite and financial aspirations.

Anyways, if you are a person residing outside India, you would, unfortunately, face some limitations in mutual fund investing in India because of some rigid FATCA regulations. You are required to have an NRE or NRO Account for investing in the Indian Mutual Fund industry. Furthermore, you also have to invest in Indian rupees and not in any foreign currency.

Note: If you are new to mutual funds, check out our beginner’s resources for Mutual Fund Investing.

— Public Provident Fund (PPF)

A safer form of investment similar to FD is Public provident fund. PPF is an investment alternative which is backed by the Indian Government. Even if you are an NRI, you can invest in PPF. However, here the maximum limit is Rs 1.5 lakh in a financial year.

You can open your PPF account through a post office or through a branch of any nationalized bank in India. Although PPF comes with a lock-in period of 15 years it is definitely more tax efficient than FD. To know more about PPF, you can read this blog on our website.

— National Pension Scheme (NPS)

If you are looking for another tax-efficient investment option, you can even consider investing in NPS (National Pension Scheme). This is also cost-effective, easily accessible, and tax-efficient way to invest your money.

National Pension Scheme is an Indian Government sponsored pension system. If you invest in this instrument, your entire capital during maturity is treated as tax-free. Apart from that, you are not required to pay even a penny to the government as tax on the amount that you withdraw as pension. If you are an NRI aged between 18 and 60 years, you can open an NPS Account to start investing in this scheme. Click here to know more about NPS.

— Real Estate

It’s a fact that there are a lot of NRIs who stay abroad but look to buy their own house in India. Indian population is ever-growing and this is itself paving way for the advancement of Real Estate business in the nation. Being an NRI you can invest in a house property in India from where you can earn handsomely by letting it out to a third party.

However, this is to be noted that, you have to make any such purchases only in Indian rupee. Furthermore, you can’t buy agricultural lands, farmhouses, and plantations in India. Nonetheless, there is no restriction on you to inherit any such property or accepting them as gifts. Check out more on Real Estate investing in this article.

Closing thoughts

In this article, we tried to cover some of the best investment options for NRIs that they can consider if they are  planning to invest their savings in India from abroad.

If you are a profit-loving investor and looking for a long term capital appreciation, you can choose to invest in the Indian stocks or mutual funds. In case you are having a huge corpus, high risk appetite, and high return expectation, you can invest in the real estate sector. Besides, you can invest in an FD if you have a short investment horizon and looking for a guaranteed return. Lastly, you can opt for investing in PPF or NPS if you are willing to earn tax efficient returns and at the same time not bothered to park your money for a longer period of time.

Overall, nn the basis of your priorities, budget and expected returns, you can make a choice of any investing scheme that suits you in the most effective manner. While making any investment in a financial instrument, ensure that you have gone through the relevant documents and understood the salient features of the same.

Our best wishes on your investment journey. Happy investing!

Warning: Random Walk Theory may change the way you look at stocks

The Random Walk theory is a statistical model of the stock market that shows that stock prices with the same distribution can be independent of each other. In other words, the prices of these securities are not influenced by past events in the market.

The random walk theory was developed by Burton G Malkiel, a professor at Princeton University and was discussed in his book A Random Walk Down Wall Street. The theory applies to trading securities and states that movements in the price of a stock are random and that any research conducted to predict future price movements is a waste of time.

What is the random walk theory?

The random walk theory does not involve the technical analysis of a stock which uses historical data to predict future prices. Nor is it a fundamental analysis to study the financial health of a company. It is, however, a hypothetical theory that states that the prices of the stock move at random. The random walk theory asserts that stock returns can’t be reliably predicted, and stock movements are just like the ‘steps of a drunk man’, which no one can foretell.

This theory is based on the assumptions that the prices of securities in the market moves at random and the price of one security is completely independent of the prices of the all the other securities.

It’s as random as flipping a coin

A random walk down the wall streetThe concept of random walk theory goes all the way back to a book published in 1834 by Jules Regnault who tried to create a ‘stock exchange science’. This was further developed by Maurice Kendall in a 1953 paper that suggested that share prices moved at random. The hypothesis was popularised by Malkiel in his best selling book A Random Walk Down Wall Street.

To prove his theory Prof. Malkiel conducted a test. He gave his students a hypothetical stock worth $50. At the end of the day, he would flip a coin which would determine the closing price for the stock. Heads meant the closing price would be a half point up while Tails meant the price would be half-price down. This meant there was a 50-50 chance of the price going up or down. Prof. Malkiel and his students tried to determine the market trends from the prices.

Using the results gathered from the test, the professor went to see a chartist. A chartist is a person who predicts future movements in stocks based on past trends and believes that history repeats itself.

Looking at the results, the chartist told the professor to buy the stock immediately. However, the coin flips were random and the stock did not have any historical trend. Prof. Malkiel used this example to argue that movements in the stock market were as random as flipping a coin!

What are the implications of random walk theory?

Many people only invest in a stock because they believe that is worth more than they are paying. However, the random walk theory suggests that is not possible to predict the movement in the stock prices. This means that investors cannot outperform the market in the long-run without taking on an inordinate amount of risk. The only solution is for an investor to invest in a market portfolio (such as an index) which is a representation of the total stock market. Any changes in the stock prices in the market will be reflected in the portfolio.

In addition to this, if the short-term movements of stock are random, investors can no longer buy stocks based on the time-value of money theory. Therefore, a buy and hold strategy will be ineffective as stocks can be bought and sold at any point of time.

Criticisms of the theory

One of the criticisms to the random walk theory is that it ignores the trends in the market and various momentum factors that have an impact on the prices. Many critics say that the price is affected by many trends and very often these trends are very hard to identify and it may take a large amount of historical data and fundamental analysis to figure it out. But just because these trends are hard to recognize, it doesn’t mean that they don’t exist.

Another criticism states that the stock market is vast and there are a countless number of elements that can have a large impact on stock prices. There a large number of investors in the market and each trader has a different way of trading. Hence, it is likely that trends emerge over a period of time which would allow an investor to earn a return in the market by buying the stock at low prices and selling at high prices.

Also read:

A Non-random walk

As a refute to the random walk theory, there are a number of technical analysts who contend that the price of a stock can be predicted on past trends and historical data. They believe that traders who can analyze these trends and make predictions have the ability to outperform the market with their superior knowledge.

Then there is the luck factor. The random walk theory states that only way a trader can outperform the market is purely by chance. This is an inaccurate statement, however, because there are some traders such as Paul Tudor Jones who managed to continuously outperform the market. It is more likely that technical analysis of the stock market is in play here and not just dumb luck.

However, it is important to remember that technical analysis can only help predict the probable changes in stock prices and not the actual price.

Conclusion

Choosing to trade based on the random walk theory is based on the preferences of each trader. If you believe that stock prices are random, it would be best to invest in a suitable ETF or mutual fund and hope for a bull market. But if you truly believe that trends and predictable and that stocks can be traded based on historical data then you should use your technical and fundamental analysis skills to actively trade in the stock market.

How Sunk Cost Fallacy Can Affect Your Investment Decisions?

Have you ever been in a situation where you went to watch a movie in the theatre, however, it turned out to be terrible? What did you do next? Did you walked out of the theater or continued watching it till the end because you were afraid that you have already paid for the ticket? If you choose the latter, you have fallen for the sunk cost fallacy.

In this post, we are going to discuss what exactly is a sunk cost fallacy and how it can affect your investment decisions. But first, let us understand what are sunk costs.

What are sunk costs?

Sunk costs are those irrevocable costs which have already been occurred and cannot be retrieved. Here, the costs can be in term of your money, time or any other resource.

For example- Let’s suppose that you bought a brand new machine. However, after using it for three months, you realize that the machine is not actually working as you desired. And obviously, the return period of the machine has surpassed. Here, even if you sell the machine, you will get a depreciated value compared to what you originally bought. This cost is called the sunk cost.

In general, people should not consider sunk costs while making their decisions as these costs are independent of any happenings in the future. However, humans are emotional being and unlike robots, we do not always make rational decisions.

Examples of Sunk Cost Fallacy

Sunk cost fallacy, also known as Concorde fallacy, is an emotional situation where the individuals take sunk costs into consideration while making the decisions.

We have already discussed the example of watching the entire movie (even if it is terrible) just because you, as a consumer, won’t get back the money of your ticket. This is a classic example of sunk cost fallacy.

Another example can be when you eat foods that you do not like because you have already bought that food and cannot revoke that sunk cost. Similarly, overeating after ordering foods in restaurants because food has been already ordered is also an example of sunk cost fallacy.

Further, a typical example of the same fallacy is when you keep attending the miserable classes of your college (that you do not enjoy) because you have already invested a lot of time in that course and also have paid the tuition fee. Besides, salaries, loan payments etc are also considered as sunk costs as you cannot prevent these costs.

A quick point to mention here is that not all past costs are sunk costs. For example, let’s suppose you bought a shoe and you didn’t like it after reaching home. However, as the shoe is still in the return-period of 30 days, here, you can return the shoe and get back your purchase price. This is not a case of ‘sunk cost’.

Sunk Cost Dilemma

Sunk cost dilemma is an emotional difficulty to decide whether to continue with the project/deal where you have already spend a lot of money and time (i.e. sunk cost) or to quit because the desired result has not been achieved or because the project has an obscure future.

Here, the dilemma is that the person cannot easily walk away from the project as he has already spent a lot of time and energy. On the other hand, continuously pouring more money, time and resources in the project also do not seem a good idea because the outcomes are uncertain. This dilemma of deciding whether to proceed further or to quit is called sunk cost dilemma.

For example- Let’s say you started a business and invested $200,000 over the last three years. However, you haven’t achieved any wanted result so far. Moreover, you cannot see the business working out in the future. Here, the dilemma is ‘what to do next?’. Should you bear the losses and move on, or should you invest more resources in that uncertain business?

Another common example of sunk cost dilemma can be a bad marriage. Here, the couples find it difficult to decide whether to save themselves (and their spouse) by splitting up when they are sure that the things are not going to work out. Or should they hold on to the marriage just because they have already spend a lot of time together and breaking up will make them look bad?

Sunk cost dilemma in Investing

Even investors are common people and they face the sunk cost dilemma while making their investment decisions.

For example, let’s say that an investor bought a stock at Rs 100. Later, the price of that stock starts declining. In order to minimize the losses, the investor averages out the purchase price by buying more stocks when the price kept falling (also known as Rupee cost averaging). Here, the dilemma happens when the stock keeps underperforming for a stretched period of time. Here, the investors are uncertain whether they should book the loss by selling their stocks, or should they continue averaging out with the hope that they may recover the losses in the future.

Another example of the sunk cost dilemma is people buying/selling agressively in risky stocks once they have incurred a few major losses in the past to ‘break even’ those losses. However, the losses have already been incurred and investing in risky stocks to cover those losses won’t do any good to such investors. The better approach would be to choose those stocks that can give the best possible returns in the future, not the imaginary aggressive returns that they expect to match up the sunk cost.

As an intelligent investor, people should ‘not’ consider the sunk costs while making their decision. However, this is rarely the case.

Also read:

Closing Thoughts

It is no denying the fact that nobody likes losing and hence the past losses can influence the future decisions made by the individuals. However, one must not consider sunk costs while making their investment decisions.

As sunk costs cannot be changed (recovered), a rational person should ignore them while making their judgments. Here, if you want to proceed, first you should logically assess whether the project/deal is profitable for the future. If not, then discontinue the project. In other words, try to forecast the future and react accordingly.

Anyways, a few methods of solving the sunk cost dilemma is by opting for incremental wins over the big ones, increasing your options (not just to completely quit or go all in) and in the terminal case, cutting your losses. When stuck in this dilemma, try to make minimum losses by looking at the mitigating options.