Investing logic

The road to financial prudence is straightforward: invest systematically and don’t get carried away by emotions. Unfortunately, like many well-known rules, this one too is observed more in the breach. In fact, so influenced are investors by emotion and sentiment—of the general market kind as well as those sparked by social interaction—that investment decisions are usually dependent on emotion hotspots. But as investors have often found, it is at their own expense.

Now with the global financial crisis having dipped confidence levels to a new low, even a slew of stimuli has failed to lure edgy investors back to the stock markets in large numbers. In such circumstances, 50 Psychological Experiments for Investors reveals valuable insights into investor behaviour. A compilation of research exercises conducted across the world, the book deconstructs the effect of biases, interaction and emotion on investor activity. Using a question-answer format, author Mickäel Mangot draws conclusions from experiments conducted by researchers of behavioural finance. Even though the studies have been carried out mostly in western countries, the learnings are for everyone to pay heed to.

Beginning with momentum investing, the book highlights a number of fallacies in human behaviour. For instance, investors turn optimistic when the markets are bullish and become pessimistic in bear markets. If a particular asset class generates positive returns for some time, investors increase their exposure to it. This, says Mangot, is due to momentum bias. “Increases of 15% in real estate or of 30% in the stock market are extreme phenomena that are much less probable than more modest changes confirming to historical averages. Betting on them is like betting on snow in Beijing in October,” he notes.

He also points to a weekly survey conducted by the American Association of Individual Investors during 1987-1992 to understand how past performances determine investor expectations. The study found that investor expectations are more directly linked to the performance of the index in the week prior to the survey. Coming to an investment conclusion based on immediate past results, instead of more concrete historical data, can be less than fruitful.

Another behavioural aspect that is more applicable to current times is the disposition effect. Investors tend to keep loss-making securities for a longer period than the winning ones. The popular tactic is to book profits in winning stocks and hold the loss-making ones, a strategy that has proved expensive for retail investors.

A study of 6,380 investment accounts of individuals from 1987 to 1993 by Odean for the book Are Investors Reluctant to Realize their Losses? found that the investors tend to sell gaining stocks more than the losing ones. The study also found that the winning stocks which were sold, outperformed the market on an average by 2.3% in the following year, while the losing stocks which were retained, underperformed the market by 1.1%.

“Thus, if the investors studied had kept the securities sold and sold the securities kept, they would have increased their annual performance by 3.4%,” points out Mangot. The author calls this a “sunk cost fallacy”. This fallacy induces the investors to go right till the end, that is to keep the stock until it reaches the break-even point.

Another discovery is that psychologically, owning a home increases selfesteem and autonomy in investment decisions. Also, children of homeowners tend to be more successful than the children of renters.

The studies also track the gender difference in financial behaviour: women are found to be fiscally more prudent than men because of higher risk aversion. They also prefer bonds to stocks and change their portfolios less often compared with men.

Even the effect of the lunar cycle on human behaviour is dealt with, albeit in a realistic manner, by taking inferences from studies conducted during these periods.

While most of the results and outcomes cited in the book make for an interesting perusal, readers could get bogged down by the number of references for each question. But for the sheer width of psychological insight into investment behaviour patterns, this book is probably unmatched. It’s a very useful tool to introspect one’s investing history— and to correct the way i n which one makes investment decisions in the future.

BEHAVIOUR DECODED

How we choose information on fallacious criteria

Q. Why do you think you have to invest in the stock market when prices have skyrocketed?
A. Investors think that what’s occurred in the recent past can recur, but it is necessary to observe phenomena over a long period to get an accurate picture.

Q. Why do you buy stocks when the market has gone up, and bonds, when it goes down?
A. The better the recent performance of stocks, the more they attract investors. When the market goes down, investors turn pessimistic and invest in bonds.

How loss and regret aversions inhibit our behaviour

Q. Which stocks do you sell quickly and which are the ones that you retain?
A. The stocks that are gaining are sold more easily by investors than those that are losing. Studies show that the stocks sold subsequently outperformed the market, while those that were held, underperformed.

Q. Why do you reinvest in losing securities?
A. Investors put time, energy and money in investment decisions, so they try and average out the purchase price by buying more of a losing stock. All this increases the overall risk to the portfolio.

How purchasing real estate affects financial performance

Q. Do owners live more happily than renters?
A. Research shows that ownership of real estate produces satisfaction. Owners, therefore, enjoy better psychological health than renters.

Q. Are children of homeowners more successful than those of renters?
A. Studies show a positive impact of ownership on the present and future behaviour of children through geographic stability and a better living environment. They also tend to be more successful in school.

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How to profit from losses

The Income Tax Department is more often than not seen as the cloud; seldom is it the silver lining. In a rare exception, it provides muchneeded succour to those ravaged by the stock markets. So, if you are among the thousands of investors who lost money in the market collapse last year, there’s some solace. Any short-term loss suffered in the last financial year can be adjusted against profits made in subsequent years. What’s more, this loss can be carried forward for up to eight financial years.

Short-term losses are the ones you incur when you sell shares or equity funds within a year of buying them. But calculating these deficits is not an easy task. The sale of stocks and funds are on a first-in, first-out basis. This means the shares you bought first will be considered to be sold first. So, if you bought some more shares of a company that you already owned and subsequently sold some, the shares you bought first will be deemed to have been sold first.

One needs to be cautious while making the calculation because what you assume to be a short-term loss could actually be a long-term one, which cannot be offset against any other gain or carried forward. Just as there is no tax on long-term capital gains from equities and equity-oriented mutual funds, there is also no provision to set them off against any other gain.

You can carry forward losses (both short- and long-term) for other investments as well. But keep in mind that you can do so only if you file your return by the due date. If you file after 31 July, you will not be allowed to avail of this benefit.

What can be carried forward
Short-term losses from equities and equity-based mutual funds.
Short- and long-term losses from debt-based funds and gold funds.
Short- and long-term losses from real estate, gold and silver.
Losses in business and selfemployment.

When it comes to real estate, the losses resulting from a sale can be carried forward. However, there is another type of loss that does not come from selling property. The interest paid on a home loan is considered a loss. Taxpayers can adjust up to Rs 1.5 lakh a year on this count against any income, including salary and business income, if the house is selfoccupied. If a property has been given out on rent, the entire loss (interest paid) can be adjusted against the income. However, the interest paid on a home loan cannot be carried forward.

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16 incomes that are not taxed in India

Although the taxman has been vested with the task of collecting taxes on the incomes of the citizens, he has deemed certain kinds of incomes as 'not included in total income'.

Thus, if any earning that you receive falls under these incomes you don't have to treat it as income or pay tax on it!

Now, let us take a look at the different incomes that are not taxable incomes. . .

1. Agricultural income: Any income which you receive as income from any agricultural activity is deemed as not included in total income. If your father is into agriculture and he gives you a part of the income as a gift, then you don't need to pay tax on it, provided, your father files his tax returns.

2. Income for being partner in a firm: If you receive any income for being a partner of a firm which has already been assessed separately, then the income need not be included in total income. Thus any share in the profits that you have in a firm according to the partnership deed is not taxable.

3. Travel concession/assistance: Any monies that you receive from your company for the purpose of travel to any place in India along with your family for the purpose of leave. The claim can be made two times in a bucket of 4 years.

Family includes wife and children and also parents, brothers or sisters if they are dependent on you. The only check being that you have to maintain original bills to prove travel if the income tax department asks for it.

4. Rs 5,000: An amount of up to Rs 5,000 which you receive for any reason -- other than as prize money and is not a recurring amount -- can be excluded from your total income. It seems to be a very small amount, but sometimes this could be the difference between being in a higher slab and a lower slab.
5. Retirement/death gratuity: Any payment received under a pension or death-cum-retirement gratuity scheme by an individual or his widow, children or dependents.

The gratuity should not be more than the number of years in service multiplied by half month's salary based on a ten-month average. For example, if the average salary for the previous ten months prior to receiving gratuity is 10,000 and years in service is 15, then 15x5,000=75,000 will be not included in total income.

6. Leave salary: Any cash amount received as compensation for earned leave which is encashed at the time of retirement. (This applies only to employees of central/state government).

For employees other than government employees, the leave salary can be encashed up to a limit of ten months worth of earned leave. It also specifies that the entitlement to earned leave should not exceed 30 days for each year of service.

For example, if you have 76 days of earned leave and total years of service is two years, then, only the cash equivalent of 60 days of earned leave is not added to income.

7. Retrenchment: Any compensation received by a workman due to the closure of his company or change in the management of the company if new terms are less favourable than what was previously applicable.

8. Voluntary retirement: Any amount up to a maximum of Rs 500,000 paid at the time of voluntary retirement in accordance with and scheme of voluntary retirement of the company. But, the company paying the VRS should have a framework for VRS as prescribed by the government.

9. Life insurance policy: Any amount received as benefit from a life insurance policy, including bonus payment, is not included in total income. The only exception is the amounts paid as part of keyman policies.

10. Provident Fund: All payment which is received from a provident fund to which the PF Act applies or any PF fund of the government, is not included in total income.

11. Superannuation: Any payment made from a superannuation fund on the death of the beneficiary or as a refund of contributions or if the employee becomes incapacitated before retirement.

12. Payment of rent: Any allowance paid by an employer to an employee to meet expenditure actually incurred on the payment of rent for accommodation. But this is not allowed if the house is owned by the employee or he has not incurred the rental.

13. Income from government securities: Any earnings from interest, premium on redemption or other payment on securities, bonds, annuity certificates, savings certificates and other instruments issued by the central government and also deposits taken by the central government.

In case of Non-Residents, if the bond have come to you by virtue of being a nominee or survivor of the Non-Resident, or if the bonds have been gifted to you by an NRI -- who purchased the instrument in foreign exchange and if the principal and interest will not be taken out of India by the recipient of the gift, the amounts will not be added to income.

14. Scholarships for education are not included in total income.

15. Awards and rewards: All payments receive in cash or kind as an award given by the central or state governments or by a body recognised by the central government to give such awards, will not be included in the total income.

16. Relief funds: Any amounts which are received by an individual as part of the Prime Minister's National Relief Fund or the promotion of folk art fund or students fund or foundation for communal harmony will be treated as not included in income.

Thus we see that although the taxman is mostly portrayed as a villain, he has been liberal enough to give us the benefit of income tax free income from so many sources.

The above learnings can be applied to our personal lives in two ways:

Try to increase the income, if any, coming under any of the above heads; and
Invest in any of the tax-free avenues given above so that we may get the benefit of the investment as well as tax free income when it comes to our hands later on.

RBI warns public against fictitious fund offers

Cautioning public against fictitious offers of large funds from unknown entities, the Reserve Bank of India on Thursday advised them again to not get carried away by such offers.

"The Reserve Bank of India, has today once again clarified that remittance in any form towards participation in lottery schemes is prohibited under the Foreign Exchange Management Act, 1999," RBI said in a release.

Further, the RBI said that restrictions are also applicable on remittances for participation in lottery-like schemes functioning under different names.

The central bank clarified that it neither maintains any account in the name of individuals, companies or trusts in India to hold funds for disbursal nor does it allow individuals to open an account to deposit money with the Reserve Bank.

"The Reserve Bank has advised the public not to remit or deposit money in such accounts in response to fictitious offers/ representations. The public may immediately bring the details of such offers to the notice of local police authorities for booking the culprits," the release added.

The warning comes in the wake of many people falling prey to such tempting offers and losing money in the recent past. The central bank has also cautioned the public in the past asking them not to make any remittance towards participation in such schemes or offers from unknown entities.

The Reserve Bank further said that in addition to making offers through letters, e-mails, mobile phones, the fraudsters have now resorted to issuing certificates, letters, circulars on letter head that looks like that of the RBI's.

"The fraudsters also convince the victims by impersonating as senior officials of the Reserve Bank," it said.

The central bank said that many fraudsters have even opened accounts with banks in India and advised public to deposit money in these accounts.

"Once the money is deposited in their account, people mailing such offers withdraw the money and then vanish. The victim thus loses the money already paid," RBI said.
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Avoid these 2 mistakes and become rich!

There are two big mistakes most investors make.

The first is following the crowd and not trusting their own intuition. Doing what everybody else is doing is often okay in the short run but in the long run it's usually wrong. Take five steps back and look at the big picture.

Is there a general market trend up or down? Has there been a shift in the trend? Are we really in a growth time frame or is this a time when companies are laying off people, having a difficult time increasing prices, holding off on capital investments, etc? What is your personal experience or experience of family and friends? What is your intuition telling you? You may believe that intuition has no value in investing, but how many of you knew the stock market was overvalued and yet in-vested because everyone else was making money and you felt left out of the game? Try to understand your motivation and create some belief of what the future is going to look like.

The second common mistake is not looking enough at history and understanding history and market valuations. People may understand the past twenty years at most, but they don't really study and understand the last one hundred years. You can see patterns when you're looking at the whole twentieth century. You look at the last twenty years and the stock market has done extremely well, but you look at twenty years before that and stocks did very poorly. So you have very long periods of time where the markets don't do anything.

History helps you see that. Markets tend to get greatly overvalued. You have extreme greed and extreme fear. What you see when you review long-term history is that when you have extreme greed, markets become very overvalued and bubbles occur, and, when you have extreme fear, markets become very undervalued - and, therefore, present a very valuable opportunity to buy.

It's very useful to understand these big cycles up and these big cycles down - what some people call regime shift. Ben Graham said something that was extremely valuable in his classic book, The Intelligent Investor. There used to be a belief - because of our traditional market allocation models and modern portfolio series - that you should hang in there for the long haul. Ben Graham, who is one of the best value investors of all time, said that in a normal 50 / 50 portfolio, when markets are greatly overvalued, you go 25 per cent in stocks, and, when markets are very undervalued, you go 75 per cent stocks.

You're really going against the crowd when you do that so it's very hard, but that keeps you from getting caught being greedy. You look at the markets and say, "Is the market overvalued or undervalued, and how much risk am I willing to take?"

In 1999, for example, valuations were very high, so it was time to start lowering stock allocations even though the share prices were still going up, and everybody was euphoric about the market. In hindsight, it certainly proved to be the right rule, but it was a difficult thing to do at the time. You want to be heavily invested when things are cheap and very cautious when things are expensive. You have to avoid saying that it's different this time and that markets are going to keep going up because of technology or whatever.

When you alter your strategy as valuations become very cheap or very expensive, do so gradually. In 2000, for example, the average investor in Japan had about 3 per cent in stocks, whereas the average recommendation in the United States had about 68 per cent in stocks, according to Barron's.

In the late 1970s, the average recommendation was between 25 and 30 per cent in stocks, and that was the time just before the beginning of the bull market. It just shows that we tend to see the very short past and not look at valuations and the big picture.

Major trends are very slow to change, so the investor doesn't have to do something every week. Once or twice a year is often enough to rebalance your asset allocation in order to reset it to your original allocation. Yes, it's very hard to take money off the table when things are going up, and it's very hard to add to equity portfolios when things are cheap, but this is exactly how you grow wealthy over the long-term.

A golden rule to remember is that greed and fear control the market in the short run. If you can understand greed and fear as the central short-term components, you can see what's going on and realize the pattern. Investment valuations at the time of purchase determine long-term returns. When people are more fearful, great values are created; when people are greedy, bubbles are created.

So, don't pay attention to short-term noise. It doesn't matter what the market does in the short run. You have to understand the basics - what's going on in the big picture - and not worry about missing some of the upside. In other words, let neither let greed nor fear hold you in their sway, indeed, it's in times of pervasive fear that great values are available.

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