Impact of Diversification

Pictures always say it much better than words.

Here is a graph of returns over time of 3 different asset classes:



Here is a graph of the returns including that of the average - represented by the black line - of the 3 asset classes



Source: The Coffeehouse Investor

As the author, Bill Schultheis, points out, the above chart

clearly shows that volatility is reduced (by diversification) without sacrificing long-term returns. In the short run, the top performing asset class will outperform the black line. That is to be expected. In the long run the black line (your diversified portfolio) keeps up with all the individual asset classes.

Want to argue that the above is just a theoretical graph with no numbers? Well, here is a graph based on actual data for a 38-year period in the US markets:

Source: Merriman

Interestingly, the next chart show what happens when you combine local stocks with international stocks - you get almost the same level of returns - but with less risk.


Source: Merriman

I rest my case!

"Faster economic growth = lower the stock returns!"

At a time when more international funds are being launched to lure Indian investors, an article in the Wall Street Journal - quoting a study by Elroy Dimson of London Business School - serves as a good reminder on the real purpose of international investing - diversification. Not returns chasing.

Based on decades of data from 53 countries, Prof. Dimson has found that the economies with the highest growth produce the lowest stock returns -- by an immense margin. Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

...if you think about this puzzle for a few moments, it's no longer very puzzling. In stock markets, as elsewhere in life, value depends on both quality and price. When you buy into emerging markets, you get better economic growth - but, at least for now, you don't get in at a better price. "It's not that China is growing and everybody else thinks it's shrinking," Prof. Dimson says. "You're paying a price that reflects the growth that everybody can see."

...High growth draws out new companies that absorb capital, bid up the cost of labor and drive down the prices of goods and services. That is good news for local workers and global consumers, but it is ultimately bad news for investors. Last year, at least six of the world's 10 largest initial public offerings of stock were in emerging markets. Through June 30, Asia, Latin America, the Mideast and Africa have accounted for 69% of the dollar value of all IPOs world-wide. Growth in those economies will now be spread more thinly across dozens of more companies owned by multitudes of new investors.

Beware of the ULIP pitches - now, from MF distributors!

Now that SEBI has banned entry loads on mutual funds, beware of mutual fund distributors turning into ULIP marketing machines - lured by their ridiculously high commissions.

Quantum AMC's Ajit Dayal who has been promoting direct investments - ie, sans distributors - for a long time has an article on SEBI's move to ban entry loads.

The distributors are not yet out of business - or their Living in Plunderland mentality. They may stop selling mutual funds, and start selling you a lot more of Unit Linked Insurance Products (ULIPs). Do you want to guess why? Yes, that is correct; the distributors make a lot more money selling you that junk than they did selling you the elephant droppings which were disguised as musk oil - an aphrodisiac.

The distributors and wealth managers will play the regulatory arbitrage: go where the regulator is less vigilant.

AIG did that.
Lehman Brothers and Bear Stearns did that.
Most who worked for AIG, Bear Stearns or Lehman did pretty well in life.
Their customers and investors - well, who cares about them anyways?

So, don't be surprised if your distributor and private client wealth manager calls you and explains to you why mutual funds are terrible places to invest and why ULIPs is the best thing since aaloo tikki.

I've read several articles which clearly explain why ULIPs are a bad idea for consumers - compared to a combination of cheap term insurance and investments via mutual funds (or directly) in a mix of stocks and fixed return assets. Here is Deepak Shenoy's well researched post which shows how ULIPs are nothing but a rip off.

If you ask me, I would never invest in a ULIP, ever. I don't want to ban these products - I'm all for freedom here - but I ask you this, if a bank said they would give you 2% return on your Fixed Deposits, will you invest? Especially when you can get 3.5% in a savings account? The 2% offer isn't illegal, it just plays on how stupid you are at a given time. ULIPs prey on the same thing, under the guise of an otherwise less-than-toxic word: Insurance.

Fixing TV Coverage of Stock Markets

Here are extracts from Barry Ritholtz's advice to US financial television channels. I'm sure some of these recommendations apply very well to our business TV channels as well.

2. Bring us People We Don’t Have Access to. What various FinTV channels do really well is when they bring us long, thoughtful interviews with the likes of Warren Buffett, WIlliam Ackman, David Einhorn, and others. People we wouldn’t ordinarily have access to.

4. Risk: All traders must appreciate the potential downside of trades. So too, must FinTV. Explain stop losses. Understand Risk/Reward. Recognize there are periods when Buy & Hold is a jumbo loser.

6. Separate the Signal from the Noise. Understand that most of the day-to-day action is simply noise. Look at a long term chart, you can barely see 9187 or 9/11. If those major events get lost in the long term trend, what does the intraday jags, kinks and reversals mean? Very little. Recognize that not every data release, slice of news, or rumor is at all significant. Stop treating them as if they were.

7. Fact Check: An awful lot of things on air get stated with authority and confidence. Much of them are little more than junk or pop myths. Why is it that the more dubious a proposition is, the greater the confidence the speaker seems to muster? Consider fact checking as much of the statements that are made on air as possible, and making frequent corrections.

8. Accountability is important: I am astounded at some of the money losing hacks that are various shows again and again. These are the “articulate incompetants” to use Bennett Goodspeed’s phrase. Why not keep track of the records of guests — and let the viewers know how their past few calls have been. Are they Perma-bulls or bears? Are their stock picks awful? Are they reliable money makers? If not, let us know. (Of course, the better question is, if not, why even have them on?)

13. Most stock picks are losers. That’s normal, but the audience does not realize this. A big part of the challenge is informing the viewer that finding the biog winners is a low probability, high outcome event. As in a baseball, a 350 hitter is a star. Explain this to your audience.

14. Stop the Bull/Bear Debate: This is a vast over-simplification of the market, and often does not serve the audience well. There are nuances and variables that get lost when you reduce everything to black and white.

Hat tip: Paul Kedrosky

Know thy REAL enemy: INFLATION (not Volatility)

Amit Trivedi has an interesting article on the topic at moneycontrol:

If a financial plan is carefully drafted, one must adhere to that unless proven that it is a completely wrong plan or that the initial assumptions were wrong. However, often people tend to change their financial plan in light of adverse short term price movements, without giving a thought as to what inflation can do to their future finances. At the same time, people have also changed the allocation to the riskier assets looking at the recent short term superior performance.

Any investor would be better off understanding the two prime risks of investments – volatility and inflation. Volatility of prices is the short term risk – inflation is long term risk. An investment plan must be made keeping these two risks in mind.

Inflation does not affect one much in the short term as the prices of essential commodities do not rise too much in short period, normally. Because of this, we tend to take inflation very lightly and ignore it while planning for our long term goals. Volatility on the other hand is an immediate risk as the prices of various securities fluctuate in the short run. This is the difference between the two risks – the former being almost invisible in the short run whereas the latter being magnified by the discussions around it. We tend to, then, overweight volatility and underweight inflation.

The Market as a Weighing Machine

"In the short run the market is a voting machine. In the long run it's a weighing machine." - Benjamin Graham.

There couldn't be a better line to describe the current post-election euphoria in India (accompanied, of course, by a global rally). Hopefully, corporate earnings do catch up with the voting machine!!

"Investing shouldn’t keep you busy"

From an interesting article by Yogesh Chabria in MoneyControl:

I’m sure most of you might be wondering if it is really possible to get rich by doing nothing. Some of you might even be thinking that I have surely lost it. That is what one of my close friends, who was taking my advice, thought. She had received a sizeable amount of money after selling some ancestral property around a year ago, and wanted me to help her out with it. It was the first time she was investing in the stock markets, and like most other people, thought that she would spend hours a day, carrying a laptop, trading in stocks and watching business channels. She wanted to be busy with the stock markets.

Fortunately for her, I didn’t allow her to do any of that. I asked her to pursue a hobby, go on a holiday, meet her family, start a business, perform community service or do anything else to keep herself occupied. The stock markets aren’t a great place to be “busy.” I strongly believe that investments aren’t meant to keep you busy; they are meant to make you rich.

Based on my advice, she invested her money in a few companies that had strong fundamentals and a visible growth. I told her to stop looking at the prices everyday and tracking daily upward and downward movements. Just staring at stock prices would not magically make them rise.By doing nothing, she didn’t get scared of temporary falls in stock prices. She didn’t get nervous and sell her stock when it fell by 10%. When the stock rose by 30%, she didn’t feel greedy and sell it either. She didn’t even know about such minor falls or rises.