Fortune Watch

Investing is so fascinating because it’s just as much about people and their emotions as it is about the raw numbers. Sure over the shorter period – and especially over the past 4 years – everyone’s an expert. It’s critical that ALL investors have a sound investment process.

It’s good to be confident, or so all of us were told when we were young. Confidence will make whatever you want achievable. So it must be very good that I’ve been meeting a lot of very confident investors these days. I met a man who started investing in stocks only three months ago and whose investments have returned more than 25 per cent during this period. That’s an annualized return of more than a 100 per cent a year, as he proudly-and accurately-informed me. Someone else I ran into started investing in February 2004 and have more than doubled his money. He has made a very confident projection that showed how fabulously rich he was likely to be in about five years’ time.

Of course, this is not just amateur hour-professional investors too are sounding like the gentlemen above. I met the marketing chief of a mutual fund company who had many megabytes of marvelously entertaining PowerPoint slides about how his fund managers had generated great returns over the last three years. I did ask him about what their returns had been like before that but the response I got made me feel that I had said something very rude.

Welcome to the land of investing geniuses, no one in this world has made any mistake on the stock market for as long as they can remember.

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The pain of investors is enormous. People have lost a lot of money and not only are the losses continuing, but it’s clear to me that they are going to continue. What is worse is that the boom and the hype around it evolved in such a way that the worst pain is faced by those who are least prepared for it.

The worst real losses are those of investors who got attracted to the stock markets around the time when the markets were booming. Typically, these people have made a series of bad choices. Instead of investing steadily, they have put in large chunks of money at one go. Their mutual fund investments are in untested new funds and their stock investments are in rumor-of-the-day type of stocks that were being pushed by brokers. The more recklessly adventurous have already lost large chunks of their investments to repeated margin calls from brokers and lenders.

Of course, the question that everyone is asking is when will the markets turn upwards and resume what we’ve come to believe is their normal course. After all, as the logic goes, there is nothing wrong with fundamentals. Firstly, the fundamentals corporate’ financial future are somewhat less rosy than the general hype would have us believe. The rising cost of money and distortions produced by the huge liquidity glut are a serious issue.

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Personally, I’ve never had much respect for the stock market. In fact, on some days, the news of the stock markets are the chief source of amusement that I and some colleagues of mine have. I hardly ever pay any attention to the Stock Indexes except when I am feeling bored. When I feel the need for some light relief, some of us open the day’s live Dow Jones graph on finance, point it out to each other and laugh heartily, as if it were some great joke. We never feel there’s anything strange about this behaviour except when we end up doing this in front of a visitor who, in turn, starts looking at us as if there is something strange about our behavior.

Now I know this sounds heretical coming from someone whose vocation appears to be linked to the stock market, but I really do feel that there is something funny about the daily curve of the stock market graph. Or more precisely, about the deep meaning that so many people are trying to derive from it.

Am I saying that the stock market is a meaningless circus then? No, far from it. The stock market, along with the stock prices of all listed companies and the levels of the various indices are extremely important to the countries and to many of us’ economic well-being. What is a meaningless circus is the minute-to-minute hyperventilate tracking of these things. Let me explain it this way. Tracking and predicting the weather is an important function but lying on the ground and trying to draw meaning from the changing shapes of clouds being chased by the wind is madness.

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Let’s talk about rats. Rats are mammals, they are intelligent, and have a remarkable behavioral and biological resemblance to humans. These are the reasons that they are often used not just for biological but psychological experiments as well.

Here’s an amazing experiment that I once read about. A group of rats were divided into two groups. Both groups were conditioned to expect food at a certain spot in the complex of cages where they lived. Apparently, rats learn this sort of a thing very easily. At set times of the day the rats would turn up at this feeding station and find food waiting for them. However, immediately after eating, the rats were subjected to electric shocks through the floor of their cages. The shocks were strong enough to be very unpleasant but not lethal.

But the two groups were treated differently. While one group was given an electric shock after every meal, the other one was given the shocks after only half of the times. However, for the second group, the actual instances when they would be subjected to the shocks were chosen randomly. After some of their meals they would get the shocks and after some they wouldn’t and they had no cues to help them figure out what would happen on any given instance. The effect of this pattern on the behaviour of the two groups was interesting. The group that got the electric shocks every time quickly adjusted to what was happening and basically got on with life. They would show up for food, eat it, brace themselves for the shock and happily continue with their ratly routine after getting the shock.

The other group did far worse. They just couldn’t get used to the randomness of their ordeal. Many of them started avoiding food and would eat only when they were on the verge of starvation. All of them became significantly weaker. Get this clearly: the group that got fewer electric shocks fared far worse than the ones who were given electric shocks every single time. It was the sheer meaningless unpredictability of their lives that did them in.

From this point on, this article could be about almost anything. But since investments are my brief, I’ll just talk about how legions of investors are abandoning equity and rushing towards debt.

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Do you ever wonder where your spending money goes or how you can spend so much on practically nothing in so little time? In the old days people brought their paychecks to the bank, deposited most of the money and pocketed the rest in cash. The cash was supposed to last until the next check. If it didn’t, it was an obvious cue that too much money was being spent.

Fast-forward to these days when paychecks are deposited electronically and we stuff our pockets with debit and credit cards. Beaten-up dollar bills and heavy coins never dirty our hands. It’s so much nicer than the old days. Unfortunately, it makes it too easy to bust the budget.

Without that dwindling pile of cash it’s harder to recognize how much is being spent. Sure, you can log on and look at your bank account every day, but most people probably don’t. When they finally see their balance they think, “no way!” More than likely it’s not the mortgage that’s killing them; it’s the daily money drain. If that scenario fits your life, the seven-day money challenge may help you get on track.

Use this challenge to give yourself a wake-up call to those who don’t realize how much they’re spending. I ask some of my clients to guess to the best of their ability how much cash they’ll need for a week’s worth of spending. It’s just the day-to-day stuff like gas, groceries, going out for meals. The usual outcome is they’re out of money by Wednesday.”

Learn your weaknesses. “I was trying to go from Monday to Monday, I carried a little notebook and would write it down if I stopped for coffee or went to the drugstore. Wednesday night I went to buy gas and I didn’t have enough cash. I had to resort to my credit card to get me through the rest of the week. I was shocked and a little disappointed.” Thats what some of them say.

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It takes time, sacrifice and consistency to join the million-dollar club

Quit fantasizing about marrying a millionaire, winning the lottery or walking off with a TV-quiz-show jackpot. By making your money work harder and smarter now, you can become a millionaire by the time you’re ready to kick back and trade work for play.

There’s no magic involved in reaching the million-dollar mark. If you set goals, do the research and start investing now, you can hit your wealth-building target on schedule. And you don’t have to be a financial whiz! What are needed are time, sacrifice and consistency.

Time is most significant: The longer you invest, the smaller the amount you need to put away each month to reach $1,000,000. Thus the younger you are when you start investing; the younger you’ll be when you join the million-dollar club. Many of the estimated 8 million millionaires began investing in their teens, and always with a long-term goal. Let’s say you’re 28 years old now, with no money saved or invested and would like to have a million-dollar portfolio of investments by the time you turn 60. You will need to invest $300 a month in stocks or stock mutual funds that have at least an 11 percent annual rate of return. If you increase your monthly investment to $500, you’ll hit your mark by age 54.

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The other day I read about someone who claimed to have doubled his investments every month for more than a year now. If I do the math’s it turns out that this man must have multiplied his money to more than 4,000 times what it was. That’s 4,000 times, not 4,000 per cent. The interesting part is that not only do such people expect to be believed; there are those who believe them. If you ask a random collection of people whether they think it possible that somewhere in the world there exist investors who can go on doubling money every month, then you’ll get a surprising number of yeses. This sounds like believing in anything you hear.

No one who invests in the stock markets ever loses any money. Or at least, that’s what I will have to believe if I take at face value whatever someone says about their personal performance in managing their investments. I’m serious. It’s amazing, actually. The markets fall. Dubious stocks shoot up and people keep buying them and then when the markets fall and stagnate and no one admits to having lost any actual money. To be fair, there are some who admit to holding investments that are way under water from their purchase price, but claim that this is not a loss but a temporary dip.

That’s a point of view, I suppose. Not only does this undying faith in the existence of supernatural rates of return persist, it does a lot of real harm.

The refusal to admit to wrong investing decisions means that we miss the opportunity to learn from them. I know these sounds like a slogan from one of those motivational posters, but failure really is a very good teacher. Provided one makes the effort to learn from it.

And at least in the case of investments, it isn’t all that difficult to learn from bad investments. What one has to do is to honestly think of the reasons why one bought that investment and then resolve not to repeat that reason without any further refinements.

Let me illustrate with a couple of examples.

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There is inflation every year. You cannot stop an increasing in living expenses as prices of consumer goods increasing all the time. Saving money becomes an extremely difficult task to do. Here are some solutions for saving a little so that you can still meet your needs and still find ways to trim off a little for the future.

Budget – Get one and stick with it! And set aside at least a small portion for savings while you’re at it; savings for your future, your retirement, your education, your vacation, whatever. Head to your local office supply store for planning workbooks or budget sheets to use. Or head to your favorite search engine and type in, “budget planning” for hundreds of sites with articles, free downloads, tips, ebooks and other resources to help with your budget setup and follow up.

Plan Ahead – Make sure to plan for emergencies and the unexpected, like an appliance break down or garage door malfunction. Even if you can only set aside $100 or so each monthly, place it in an account and earmark it for this “Miscellaneous” fund. Then when things go wrong, and they will – nothing is perfect – you’ll be better prepared.

Monthly Items – Work out a monthly payment for items that you don’t pay monthly and set this up in your regular monthly budget. For example, for items like annual home owner or renter insurance, quarterly water bills and life insurance payments and annual trash bills, take the amounts and determine what they would be monthly. Then list the items on your budget log and pull these amounts aside, saving them in your account for those purposes. This way, when the bills hit, you won’t be caught off guard and have to scrounge for the payments.

What works well, instead of handling multiple savings accounts for each company owed, is to use index cards and one savings account. Create one index card for each bill. Then simply log the amount you’re setting aside on the card and deposit it into your savings account. Keep the index cards with your savings passbook to remind you what the balance covers. The total of all your index cards should equal the balance in your savings account. Make sure to create an index card for your regular funds that you are saving each month in step one above and a card for your Miscellaneous fund in step two above.

Both short term and long term trading can be effective trading strategies, however, long term trading has several significant advantages. These include the effect of compounding, the opportunity to earn from dividends, reduction of the impact of price fluctuations, the ability to make corrections in a more timely manner, less time spent monitoring stocks.

Compounding: Time can be investor’s best friend because it gives compounding time to work its magic. Compounding is the mathematical process where interest on your money in turn earns interest and is added to your principal.

Dividends: Holding a stock to take advantage of payouts from dividends is another way to increase the value of an investment. Some companies offer the ability to reinvest dividends with additional share purchases thereby increasing the overall value of your investment. Additionally, dividends are more a reflection of a company’s overall business strategy and success than volatile price fluctuations based on market emotions.

Reduction Of The Impact Of Price Fluctuations: In the long term investment the persons is less affected by short term volatility. The market tends to address all factors that keep changing in the short term. So a person involved in long term investment or trading will not be affected as much by short term instability due to factors such as liquidity, fancy of a particular sector or stock which may make the price of a stock over or undervalued. In the long term, good stocks which may have been affected due to some other factors (in the short term) will give better than average returns.

Long-term investors, particularly those who invest in a diversified portfolio, can ride out down markets without dramatically affecting his or her ability to reach their goals.

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When it comes to building your nest egg, the most important strategy is to minimize loss. The best way to minimize this risk is through the power of diversification. By diversifying your portfolio, you are ensuring that your nest egg is spread across different baskets. Diversification helps to strengthen and protect your portfolio.

Your chances are increased that if one area falls another area that you have invested in will remain strong, and your assets will be protected..

I define risk as the probability of things going wrong. Once things have gone wrong, they cannot go right. Older investors will remember this feeling they have after their losses, of wanting to turn the clock back. It is the same feeling you get after losing a loved one, when you want to reach out and touch the person after she or he is gone.

The preventive part is all about ‘diversification’, almost the only way to manage risk as defined in financial markets. Both risk measurement and diversification lend themselves to mathematical and statistical analysis, giving classical finance its biases. .

Value investors do the opposite. They add to their positions as a scrip goes down, playing to be the ‘last man standing’, i.e. trying to buy the last falling share as sellers depart the stock. The more of these ‘last’ shares they can pick up, the better their returns, provided of course, they have bought a safe, steady business at a great price, and the business recovers subsequently. .

In this strategy, you should try to trade a correlated pair as part of your diversification strategy. Like buying the market leader and short- selling the market laggard. A caution here is that if you are buying at the bottom of the cycle, then the laggards gain more than the market leaders. In a bull market, buying the market leader and short-selling the laggard may be a good trading strategy. Make sure that you don’t make a mistake in reading the market for example, is this a bull market or a bear?. Across the world, the cost of capital will soon start to drop. That would suggest a very shallow bear market, if we see one at all. Even a normally ‘bearish’ person like me is not willing to take a stand.

Statistically one thing is clear – traditional means of diversification won’t save you. Remember one common mistake: mindlessly diversifying into, say, 100-200 stocks, which then go unmonitored for entry and exit points. Since the investor no longer knows enough about these businesses, he is prone to fall prey to rumors. In effect, the act of ‘diversifying’ will actually increase the probability of losses rather than reduce it.

True diversification includes far more investment choices than just stocks and bonds. It includes other non-correlating asset classes that don’t intrinsically involve either speculation or timing. Aggressive investors like the readers of this article must be having more than 50 per cent of their net worth in equities, especially if they are below 40.

With each investment be sure to invest no more than you can afford to lose, so you can sleep at night. And use dollar cost averaging – taking a fixed proportion of your personal savings each month to add to your investment holdings, so that volatility becomes an advantage over a long time horizon. Only then will diversification begin to make statistical sense.