How to invest in volatile and falling markets?

Sum analyzes investment strategies across asset classes for investing in volatile and falling markets. 

Part 1 - Cash Holdings

Disclaimer: Views in this blog are personal and do not recommend an investment strategy. Please exercise due diligence before taking any investment decision.

We love gains and we fret losses. In fact we hate to look at losses or recognize them. We stop opening envelopes or emails containing our monthly portfolio statements and we flip the pages of newspapers printing the NAV of our SIPs and MFs, especially when our portfolio is underwater. Analysts call it the ‘unopened envelope’ syndrome; a situation which is typical with the investor psychology of loss aversion.

Markets world over are in a tailspin so I expect a lot of unopened emails and envelopes with portfolio statements in them. Ironically the ‘unopened syndrome’ happens at a time when the portfolio has lost some weight and it becomes even more important to analyze it and make some tactical adjustments. I present a general overview of investing principles with respect to different asset classes in a falling and highly volatile market.

Cash (including cash instruments)

Cash in this context includes your savings and checking accounts along with instruments which can be readily converted to cash without a loss in value. Ideally an investor should hold cash equivalent to his 6-12 months income for unforeseen expenses and contingencies. Holding cash is a personal decision depending upon the particular circumstances and near term foreseen expenses. Cash as a reserve is also dependent on the status of insurance cover of the investor. An investor holding adequate life, health, disability insurance along with insurance cover for assets like house, vehicle etc would require less cash reserve relative to an investor who is under insured both with respect to his life and physical assets. (Insurance requirements are discussed as a separate bullet point).

In a recessionary and volatile environment cash suddenly becomes a valuable asset. Falling markets provides good pockets of opportunities across asset classes which can only be exploited if the investor is holding excess cash. But it is equally unwise to hold cash in anticipation of falling markets; the caveat being that if you are expecting positive cash flow (besides your regular income) you should not rush to invest it. Rather you should take some time to identify undervalued assets and invest in them. 

Bottom line: Holding cash in falling and volatile markets is not a sin. Exploit value by investing in undervalued assets. 

How expectations lead to Recession....

Some analysts have come up with an innovative way to judge an upcoming downturn in the economy. They have developed a benchmark that measures the mention of the word ‘recession’ in newspapers and journals. They assume that as the mention of the word ‘recession’ increases in print and electronic media, the chances of a recession in the near term also increases. Besides the heuristic they have developed to predict an upcoming recession, I feel they have also built in a behavioral phenomenon of market expectations. It’s the expectations about economic conditions that contribute to building a consensus among market participants in predicting business cycles. The benchmark index measuring the ‘r’ word is up again and chances of a recession have increased in the near term, at least based on the predictions on this model. In the following few paragraphs I would try and explain what is recession, how it is caused and what are the means to correct it.

Recession is a stage of business cycle when the economy of a particular country as measured by the growth in its GDP falls for two consecutive quarters. Economic activity in an economy is a function of expectations which various market participants like producers, consumers and investors form for near, medium and long term economic conditions. For example if the market participants feel that government is likely to increase interest rates in the future, they have formed expectations of a rate increase. Such expectations and resultant consensus of future economic conditions guides the participants to act based on such expectations. The expectations formed by market participants are thus a very important element of the movements in the business cycle.

Let’s assume a decision by the government (like a rate hike) makes the market participants expect that the economic activity will slow down in the future. The producers are the first to act on these expectations and they start reducing their inventory in expectation of weak economic activity and thus less demand. The slowing of the inventory cycle reduces demand for raw material and other purchases required for the production process. Thus slowdown in purchasing by the businesses is the first visible sign of an economic slowdown. This is the reason purchasing managers index is monitored very closely and its results have implications on the markets. The purchasing managers index measures the expectations of a sample of purchasing managers by asking them about their purchasing decisions in the future.

The slowdown in inventory cycle and reduced demand by businesses is accompanied by reduced labor requirements as the reduced production requires less labor. Some labor is laid off while there is no fresh demand for new labor. Unemployment increases and thus there is a reduced demand from people who have lost their employment or from those who are not willing to work but not finding the work. As the demand lowers further, businesses make another downward adjustment in their production and inventory cycle. Thus production and inventory cycle gets into a vicious cycle with low demand and unemployment. Each acts to push the other down. In such an economic environment the GDP and the rate of growth in GDP starts falling. A continuous fall of GDP growth in two quarters is classified as a recession.

At this stage when recession has set in, low demand and unemployment is pushing down production and a spiral effect is taking place, economic policy action by the government and central is sought to provide impetus to the economy by removing this imbalance of demand and supply. Since recession is caused by lower demand, the best way to prevent it or correct it is to increase demand.

Government intervenes through its monetary and fiscal policy to stimulate demand and thus kick start the economy. The government gives signals to stakeholders of efforts being made for a recovery so that expectations can be formed in the market of a market recovery. Government through its central banks implements the monetary policy in stimulating the demand.

Central bank through its monetary policy cuts the rate at which it lends money to the banks. It also cuts the reserve ratio required by banks to keep minimum funds with itself in liquid forms. Thus more money is available with banks to lend and since the banks can borrow from the central bank at lower rates, they are ready to lend at cheaper rates. Cheap money attracts businesses and consumers, who start want to exploit this opportunity in building assets and increase consumption for future. Thus the availability of cheap money raises stakeholder’s expectations of increase in demand and an economic recovery.

Since the banking system is lending at low rates, they also reduce the interest they give on deposits. This is done to maintain its net interest margin or the net profit it earns while accepting and lending funds. The incentive to save goes down, as the interest rates of deposits falls, but the incentive to borrow is more as the interest rates are also low.

The government also uses its fiscal policy to stimulate demand. It increases the government spending during recessionary times to stimulate demand. Such spending often leads to a hole in the government’s balance sheet and is categorized as a fiscal deficit (excess of expenditure over revenues in the current year). This deficit is plugged by either by the reserves with the government or with foreign investment in the countries assets. Still another way to plug this deficit is by devaluing the currency. Thus a loose fiscal policy compliments monetary policy in stimulating demand.

Thus the businesses take advantage of cheap money and start taking loans at very low rate of interest for investing and expanding its businesses. The consumers too start spending by taking loans to take advantage of low interest rates. The incentive to save is less due to low interest rates on deposits so that money too comes into the system in terms of spending in real estate or investing in assets like equities etc. The demand increases and the economy starts a recovery. As demand increases businesses start to expand production and build inventories. They start increasing wages and hiring more people to increase production. The people gets employment and more wages which increases their purchasing power and thus demand increases even further. At this stage since demand is very robust; prices of goods start increasing. This is because now more demand is competing for the same level of goods and services. Inflation also increases because demand outpaces supply as demand increases more swiftly than the supply. It takes some time for businesses to increase supply, but because of factors listed above demand has already increased.

Increasing inflation makes the value of money less. As the same goods are now pricier so the same quantity of money now buys less. So now the focus of economic policy shifts to containment of inflation as it pinches the consumers. They are able to buy less quantity of goods with the same money or the same quantity of goods with more money as compared to the past. This reduces their demand for products. Increasing inflation also hits producers as their input cost increases. Their profitability depends on their ability pass on the inflation in their input cost to their consumers while maintaining the same level of sales. Increase output cost reduces demand for the products. As demand lowers, expectations of a slowdown and recession start taking shape again and thus the business cycle is back to where it began from.

The central bank has the toughest role in balancing the economy during different market cycles through its monetary policy. The focus of central bank’s policy has been to contain inflation and keep it within ‘reasonable limits’. It chooses interest rate management as its primary tool of monetary policy to make control inflation. The central bank policy statements particularly related to interest rates and thus seen by market participants with such curiosity and interest as these policy statements help the market form expectations of future and we have seen that it’s the expectations that move the markets.

It is pertinent to mention here that it was a sustained fiscal deficit (excess spending) in the case of Greece which has brought it to the brink of a sovereign default. The government has spent more than its revenue on a sustained basis and thus exhausted all its reserves. It has also accumulated huge foreign debt in plugging this hole. The investments made by foreign investors in Greek’s sovereign assets are unsecured and risk a default because of a big fiscal deficit. It is not able to get out of the situation by devaluing its currency as it a member of a economic union (EU) with a unified currency the value of which is determined by the union and not the independent states. The members of EU are getting together to bring a coordinated action as they are attempting to ward off market expectations of a Greek default. They are assuring the market to avoid expectations about sovereign default and a full blown recession which would bring all the major world economies to a slow down or recession. Thus expectations hold the key.

Censorship or No Censorship ?

“In some countries, television and radio programs are carefully censored for offensive language and behaviour. In other countries, there is little or no censorship.”

My views on this....

Censorship of television and radio programs is a contentious issue which directly confronts the basic human right of freedom to expression and places a restriction on the content quality that is suitable for public viewing. The restriction or censorship of offensive language and behaviour is a generally accepted and practiced phenomenon in different parts of the world though the relative level and quality of censorship may differ. Local, cultural and social factors coupled with language and dialects define he level and limits of censorship  I support censorship of television and radio programs only if they are censored for offensive language and behaviour and such censorship do not infringe upon unbiased access to information and news flow.

One aspect of censorship is that the programs are carefully censored for offensive language and behaviour which is understandably done to prevent a degeneration of society and degradation of cultural values. It is done to prevent hurting any religious or socio-cultural sentiments or exposing vulnerable minds to such offensive content. Each society and culture is different. So in case of censorship ‘one size fit all’ approach cannot be applied. A program which is considered offensive and unsuitable for viewing in a very conservative and closed society may be absolutely suitable and acceptable to be a part of the culture in a open and broad minded society. The limits of censorship thus needs to be applied based on local socio cultural factors and by building a public consensus on what is unsuitable for general viewing.

Another aspect of censorship is the abuse of censorship by people and organizations for thie rvested interests. It is being done under the veil of censorship of television and programs, but the intent is to satisfy certain politically motivated vested interests. Certain societies fail to give regard to public consensus in implementing such censorship controls. Any censorship or control whose intent is to satisfy vested interests and not preventing degradation of society by unsuitable and offensive content is an infringement of basic human rights and should not be practiced. Certain communist countries have very strict regulations and censorship laws to censor television and program to air any views which are against the ruling regime. Such rules and censorship have placed a limit of the freedom of expression of its citizens which is unethical and unlawful.

The degree to which censorship should be allowed is certainly a relative concept. It should be decided based on factors such as local culture, traditions and norms. Social set up and local language and dialects needs to be factored in to build a public consensus of what are the limits which the society is willing to place on itself and thus restrict programs which it feels are unsuitable and offensive. For example certain programs which are suitable for public viewing are regarded offensive and unsuitable in the Islamic countries and are thus censored. The limits and degree of censorship should thus be self imposed based on above discussed factors rather than imposed on the society in isolation by the regulators.

The definition of success

Author: Success can be defined simply as the ability to choose how to spend one’s life.

Critical Evaluation

 

The author’s view of success as the ability to choose how to spend one’s life is very generalist and not indicative of comprehensiveness of success as a philosophy and as a phenomenon. Success for some is relative while for others it is absolute. A person who views success as being better than the benchmark by a certain degree views it as a relative concept whereas people who view success as the achievement of a certain degree view it as an absolute concept. Both the views however take a view which is much larger and wider in scope than the author’s statement of success as the ability to choose how to spend one’s life.

Firstly success can not only be categorized in terms of one’s choice of his or her own life. Success for some is beyond the realms of choice that was not bestowed but rather forced upon them. These are the people who redefined success and created means beyond the choices their ability bestows them. A self obsessed dictator has all the ability and might to choose how to spend his life. But is he successful? He may consider himself to be successful, but the real success will not come from his own choice but from the choice he is able to bestow on others to enjoy the same ability to choose their respective lives. In my view a person who provides other with the same ability to choose their own lives is successful in the true sense.

Though the ability to choose one’s own life is the ultimate wish every individual, but I feel individuals with this ability may still be unsuccessful if they create an environment where others are not able to possess the same ability of choice.

 

I acknowledge that the definition of success put forward by the author is one aspect of defining success. But I feel there are a lot of other dimensions and extensions to success which can be defined not only with one’s own ability to choose but with influencing other people choices and abilities. It was not Mahatma Gandhi’s own commitment to non violence that can be termed as the basis for his success. But it was his ability to influence others to commit and follow the same principles that define his success.

 

Shared decision making or central authority ?

Which is more productive method of performing a group task: allowing all group members to share in the decision making, duties and responsibilities or appointing one member to make decisions, delegate duties and take responsibility?

Centralization or decentralization of decision making is one of the key features of organizational framework and it determines the hierarchy and number of levels at each hierarchy. The importance of centralization or decentralization of decisions can also be judged from the fact that the level of centralization determines the level of authority, responsibility and accountability in an organization. In my opinion sharing decision making or central authority in a group task involving decision making depends on the status and magnitude of urgency and importance of decision coupled with confidentiality and oversight that needs to be maintained.

 

Firstly, in my opinion group activities that involve taking quick decisions and actions are more suited for a structure with a central authority as the group may take some time to arrive at a consensus while taking a decision. More over certain important decisions involves taking an overview of the entire situation and a broader picture which may not be possible at a shared decision making platform. The central authority can take all the divergent views under consideration and then take a final decision based on the broader over view. In some situations confidentiality and secrecy needs to be maintained in of the decision. Such situations warrant a central authority more than the shared decision making. An example of this is the investment banking function of a banking company which is in possession of secret information which may have a bearing on the stock price of the company if the same information is used by the research team of the same bank. The bank may separate the two divisions in such a scenario and create a temporary firewall between the two departments with the responsibility of oversight with a central authority. This will prevent leakage or misuse of information.

In some cases when a broad based consensus is required in decision making, shared decision making may be more effective than central authority. Shared decision making also instils a sense of responsibility and belongingness in the team members. The participative form of decision making may be slow but it is much more comprehensive and take divergent views into consideration. Democratic form of government is the best example out of an organization of shared decision making. Its effectiveness is also highlighted by board of director’s format of decision making in companies.

Shared decision making certainly looks to be more ethical and practical way of decision making based on its participative and democratic nature. However in certain cases as highlighted above, particularly when speed of decisions and confidentiality are key criterion of decision making, central authority method of decision making is more effective. However both the methods can co exist in a system depending upon the nature and importance of subject under consideration. Both methods of decision making can in fact complement each other rather than being substitutes.

In the end I would like to conclude by saying that rather than preferring one way of decision making over the other I would like to base the preference on the merits of each method as may be applicable to the particular subjects and situations under consideration. Shared decision making can be preferred for certain key decisions requiring extra due diligence whereas routine matters and subjects can be processed through a central authority method of decision making.

Personal faults of great achievers

Are the personal failings of great achievers generally unimportant compared to the individual achievements?

Not always does a cloud have a silver lining. Great achievers and successful people often have personal failings which hold varied degrees of importance in their professional and public lives despite their individual achievements and successes. Some people reach the epic of professional and individual achievements but their personal failings hold them back and present an alternate view to their success and achievements. The people who idolize their success and achievement often are the ones who are most shaken by the personal failings of these great achievers.

A reason for the personal failings of successful and great achievers can be attributed to them being over obsessive with their individual and personal goals. They often live two lives, one which has given them success and achievement and the other which is very personal and not in public domain. Often they may succumb to personal failings in their personal lives. A big example of this is the drug abuse by many great achievers in the music and film industry. Another example is the domestic violence by many great achievers. I feel it is their personal self esteem which they want to satisfy when they succumb to personal failings.

Personal failings of great achievers are important for another reason. This makes us believe that we all are humans and prone to mistakes and failings. Success and achievement in an area does not guarantee similar success and achievement in other field. These achievers may feel they are above the scope of any failings and mistakes which makes them overconfident and thus even more prone to mistakes and failings. A recent case of sexual assault by a head of a world financial institution with a hotel waitress highlights the point that even though successful and great achievers may have had their way in their professional and individual lives they cannot be given the same leeway when they fall or succumb to mistakes and errors.

Though some people may opine that great achievers add a lot of value because of excellence in their area of expertise and thus their personal fallings can be ignored, I feel they are humans and their success in one field should not form the basis for ignoring their fallings in other fields.

In the end, it can be concluded that although great achievers like Gandhi and Washington did have some personal falling and errors they were certainty accepted their these fallings with grace and accepted them. Great achievers would be even greater if they acknowledge and self correct their personal failings and mistakes.

Energy Sources and Worldwide Competition

Energy sources and worldwide competition

Energy is the base of modern economic and human development. Not only does it provide the required input for different industries and services but also provide a better and efficient lifestyle for the humans. The competition for sources of energy is thus understandable. The competition for energy in fact has intensified and diversified over different sources of energy. In my view the completion for energy is not just restricted to sources which are in limited supply but an increased competition is between different stakeholders for developing newer and more efficient energy sources. The competition is thus healthy and provides an efficient market for energy.

One reason why I feel, competition in energy market is healthy and provides an efficient market is because completion in this market helps in price discovery. Energy constitutes a major component of cost of livelihood and is a major cost in production. Its pricing is thus very important. Competition prevents markets to move too far away from efficient prices and thus influence demand by setting the right prices. For example when crude oil demand rose more than its supply, the prices rose sharply. In the short term, consumers were unable to change their consumption patterns but in the medium and long term consumers did react to high oil prices and demand started to taper off.

 

Another reason why I feel competition in energy markets is good and should be encouraged is because competition prevents any individual energy player to influence prices and supply by gaining a market dominant position. Since prices for similar goods are similar in a highly competitive market, worldwide competition for energy sources prevents abuse of market dominant position by individual players. Competition for energy sources has also lead to the development of derivatives market and trading of energy sources on the bourses like other commodities. Companies and individuals can hedge their energy requirements and speculate on energy prices in active energy markets.

Since energy is one major ingredient in economic development of a country it is very natural for different countries to compete for securing their energy requirements of the future. For example the emerging economies of Asia, China and India are competing fiercely in Africa to secure energy assets and thus securing their future energy requirements. It has also been seen that competition for energy sources has diverted efforts of some market players towards innovation and discovery of different sources of energy which can be effectively tapped like tidal energy and solar energy. It is a work in progress and a positive side effect of competition for energy sources.

However the stiff competition for energy sources is encouraging the price rise as demand for the sources is increasing more than the supply. Also some energy sources which are non environment friendly the competition has resulted in excess exploitation of the resource and thus more damage to the environment. Some mechanisms like carbon credits and tax on polluting industry is the regulatory framework developed to check excess competition and usage for energy sources which are polluting the environment and encouraging clean and green energy sources.

In the end I would conclude by saying that competition for energy sources has lead to more efficient usage and pricing of energy products. It has also increased the energy supply by usage of more efficient and innovative technology, and development of alternate sources of energy. Such completion should be encouraged while at the same time setting up regulations in place to prevent wastage of energy sources.