Why good companies does not always make good investments

If good companies made good investments, investment decisions would be a cake walk, just pick up the best companies like google, amazon, facebook and invest your money in their stocks, and wait for your money grow. The problem is everyone knows that and this high expectation is reflected in their high share price in relation to its earnings. And if the stock is overpriced, investors can make negative returns. A good example is share price of Amazon, if you have purchased amazon.com shares 2000 you would have made huge losses, you would have to wait nearly a decade just to break even. Click here to see the historical price chart of Amazon at Yahoo Finance.

How to make a rough estimate if the share price is high:

P/E Factor

P/E is market price per share divided by annual earning per share. For example, if a company’s current share price is ₹100  per share and annual earnings per share is ₹5. Then the P/E is 100/5 which is 20. Interpretation of a range of values of P/E is available at wikipedia . A P/E value of 17 or over indicates the company’s share a trading a high price.

P/B Factor

P/E is market price per share divided by book value per share. Book value is companies asset minus liabilities. P/B may not give accurate picture for certain industries.

Shiller P/E or PE10 or CAPE       

P/E is market price per share divided by E10. E10 is the average of the inflation adjusted annual earning. An example calculation on how to calculate Shiller P/E is available at Nasdaq.com. Shiller PE is good at estimating overall market may or may be give a accurate picture of individual stocks.
None of these methods are pe

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Home Bias in investing

When I was working in a small IT Project, the manager did not want anyone to leave our team as he believed he has the best team, and it is not possible to get such team members if they leave the project. Another colleague in the team commented, “indian IT professionals are the best, and professionals from any other country cannot compete with indian IT professionals!”.  So, people around you are the best people in the world and your country is the best in the world…..…….A investor also thinks in similar lines, and this is called Home Bias in investing. This kind of thinking may have served the caveman well, giving them confidence boost, but it places investors at a higher risk when it comes to investing.

Home Bias is widespread among investors, vast majority of the people invest in their own country, some may do so with good reason, to avoid tax headaches, however many do so because of familiarity. Many investors even invest heavily with their employers by buying into their employer’s share buying schemes. They feel that they know their companies well and can trust them, but did the employees of Enron and Satyam know what is coming their way ?

Why home bias is not sound investment principle ?

The chances that your company being the best is low statistically speaking. Even if it is so, there is no reason to believe that your company will be the best in the future, Nokia is prime example. Same holds good for countries as well, Japan is a good example, Nikkei is was one of the best performing stock market till 1990, however those who have invested at its peak in 1990 suffered irreversible losses in the next 2 decades. There is no good reason to believe that your company/country will do best of all the companies and countries in the world.

How does Home bias place an investor at higher risk ?

Investing in stock market is risky, Investor should spread his bets across different assets so that returns are less volatile. Foreign stocks helps you place your bet in a number of countries, decreasing the overall risk without decreasing the returns. Setting aside a percentage of your investment in fore

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Are fund managers any better than proverbial chimpanzees throwing darts ?

Many people invest their money through mutual funds, which means your money is managed by professionals who have the right education and stock picking skills, right ? Well, that is theory, but is backed by sound evidence. A number of studies have shown that is not the case, click here to read about one such study. Studies indicate a minuscule percentage of the managers managed to beat the market or Index funds in a long run.

Does vast majority of the managers have the stock picking skills, I am not sure. Let say we have a bunch of 100 chimpanzees randomly pick stocks, by sheer statistical probability some of the chimpanzees will do better than the market in the first year, even fewer will do better in the next year and one of them will beat the market for 5 consecutive years, which by then will be hailed as investing genius!!

Vast majority of the fund managers success is down to mere statistical probability. No surprise that top performing fund for the past 5 years is highly unlikely to do so in the next 5 years. For instance, I invested in SBI Magnam Tax gain fund in 2008 looking at it performance 5 years prior to 2008, however in the next 5 years it performance was mediocre to say the least. And currently the best performing fund in my portfolio is an Index fund ‘Money Builder Index UK Index’ from Fidelity which has outperformed other active funds in my portfolio, I am now fairly convinced that most active fund managers are no better than a bunch of proverbial chimpanzees throwing darts at stock board, their success or failure is all down to chance.

Stock picking skills is a rarely in the investment world and very few possess it. It does not mean it does not exist. There are few Fund managers like Anthony Bolton who have beaten the market by a good margin for a longtime. Vast majority will underperform the market after taking into consideration the cost of managing an active fund. An investor is better of investing in Index or passive funds, as the probability of identifying the next Anthony Bolton in advance is next to zero.

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My learning journey of investing

Years ago when I was in college I have seen people lose fortunes in stock market, and the advice I got from them is that investing in shares is committing financial suicide. They have seen the devastating effect of stock market crashes and burnt their fingers. Back then I neither had the knowledge or the money to invest in stock markets.

After working many years I managed to save a few pennies, and decided that I need to base my investment decisions based on sound investments principles so that I don’t make the same mistakes and burn my fingers, so read the book  ‘The Intelligent Investor’ by Benjamin Graham, which is widely considered by many as one of the best books ever written on investment. It was an quite useful, however it did not have the practical information that a lay investor needs, so I decided to I need to a bit more reading before I am ready to take the plunge into investing………and the next book I got my hands on was ‘Smarter Investing’ by Tim Hale, it was one of the most useful book I ever read, Tim puts almost everything a lay investor need to know in simple terms……..however being a perfectionist I decided I need to read even more…………………and got my hands on to ‘The Intelligent Asset Allocator’ by William J. Bernstein which is a masterpiece on Portfolio construction. After all this reading I am confident that I am ready to take the plunge into investing into stock market and even share my knowledge.

I plan to write a series of blogs on investing in the next few weeks,  below is the first installment of the series.

Below are some of most popular ways people lose money in shares.

Buying High, Selling Low

People are very short sighted when it comes to investment decisions, they look at the past 3 to 5 years returns and expect the same returns in the next 3 to 5 years, instead of looking at past 30 to 50 years. However, market runs in cycles of bull and bear markets, investors typically buy in the bull market when share prices are raising thinking what happened last few years will happen in the future, when the bull ends and the market starts falling they panic and bank their losses by selling the shares. Though it is obvious an investor is expected to do the opposite.  Studies show that vast majority of the investors follow this approach underperform the market by a good margin.

Buying individual shares

Many people buy individual company shares without reading balance sheets and financial statements of the past few years. An investor needs to diversify by investing in at least 15 individual companies. The effort required to do the research on these many companies is too great and not worth it for a individual investor, many people don’t do it before investing.

Lack of understanding of the underlying Risks

Risk and return are intertwined, stocks deliver the best returns of all the asset classes but when the market crash, stocks can produce loses in the same magnitude. The return history of at least past 30 to 50 years of the  asset class should be looked at understand the risk.  The investor should be prepared for the potential loss that the stocks can inflict, and many times he or she is not prepared for the downside.

 

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Invest ₹1.5 lakh under 80C, 80CCC and 80CCD ? Well, not exactly!

Income Tax Act allows tax exemptions under sections 80C,80CCC and 80CCD with an overall cap of ₹ 1 Lakh. But should you really set aside ₹ 1.5 Lakh for investing under these sections ?

Well not really, considering Provident Fund(PF) is included in these investment, you need to looking to invest ₹1,00,000 minus your early PF, which can be calculated using the Salary Calculator.  For example, if your monthly basic pay is 10,000, your yearly PF contributions would be ₹ 14,400/- . Hence you should be look at investing ₹ 85,600/-(1,00,000 – 14,400) as opposed to investing  full allowance of  ₹1,00,000/-.

  • Sections 80C covers PF,VPF, PPF, NSC, ELSS, Life Insurance Premiums , Home Loan and more.
  • Sections 80CCC covers certain pension schemes and
  • Sections 80CCD covers new pension scheme(NPS)
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