Situational profiling an investor by stage of life

Situational profiling an investor by stage of life

In life stage classifications, investment policy and particularly risk tolerance are determined by one’s progress on the journey from childhood to youth and adulthood, maturity, retirement and death. A person’s ability to accept risk should begin at a high level and gradually decline through his lifetime, while willingness to assume risk should be driven largely by cash flow considerations. An individual’s investment policy can be viewed as passing through four general phases:

o   Foundation

o   Accumulation

o   Maintenance

o   Distribution

Foundation

The individual is establishing the base from which wealth will be created (marketable skill, establishment of business, acquisition of educational degree). During this phase, the individual is usually young, with a long time horizon, which normally would be associated with an above average tolerance for risk. Risk tolerance should certainly be above average in the foundation stage if the individual has inherited wealth. Lacking such wealth, the foundation phase may be the period when an individual’s investable assets are at their lowest and financial uncertainty is at its highest.

Accumulation Phase

Earnings accelerate as returns accrue from the marketable skills and abilities during the foundation period and gradually reach their peak. In the early years of the accumulation phase, income rises and investable assets begin to accumulate. Income generally continues to rise as the individual reaches peak productivity. If individual personal spending habits do not change, the gap between income and expenses may widen throughout the accumulation phase, allowing for an increase in savings. This phase is characterized by increased risk tolerance, driven by their increasing wealth and a still long term horizon.

Maintenance Phase

The individual has moved into the later years of life and usually has retired from daily employment or the pressures of owning a business. This phase focuses on maintaining the desired lifestyle and financial security. Preserving accumulated wealth begins to increase in importance, while the growth of wealth may begin to decline in importance. Risk tolerance will begin to decline, not only is the individual’s time horizon shortening but his confidence in the ability to replace capital or recover from losses is often diminished. In this stage investors typically reduce exposure to higher volatility asset classes and increase exposure to lower volatility investments.

Distribution phase

Accumulated wealth is transferred to other persons or entities. This phase begins when the individual is still reaping the benefits of the maintenance phase and retirement. Tax constraints becomes important as investors seek to maximize the after tax value of assets transferred to others. Although asset distribution may take place in the later stages of life, planning for such transfers can begin much earlier.

Although the progression from accumulation to distribution may be linear, it is not necessarily so. Individuals in the accumulation phase may become dissatisfied with a career choice and return to the foundation phase. Situational assessments allow investment advisors to quickly categorize potential clients and explore investment issues likely to be of greatest importance to them. Dynamic relationship exists among the above considerations. The value of situational paradigms therefore lies more in their general insights into human behavior and less in their ability to fully interpret individual circumstances. Investment advisors should emphasize the process of gathering and assessing relevant situational information rather than the specific category in which an individual investor may fall.

Investment Decision Making in Systematic Investment Plans

Sum evaluated how heuristics affect investment decision making in Systematic Investment Plans. 

Investors face two challenges: making good decisions and sticking to them. Most individuals do not make decisions in the rational, well informed and unbiased manner assumed by standard economic theory. There 

are bounds to human rationality, self control and self interest which can be explained as under:

Bounded rationality (Human problem solving abilities) Limits on time and intelligence means individuals cannot be expected to solve problems optimally. Experimental evidence suggests most people use rule of thumb (or heuristics) to cope with the limits of their abilities and these heuristics can in certain contexts lead to systematic errors in decision making.

Bounded Self Control: When the right thing to do is apparent, people may fail to do it for reasons of self control (most of us have eaten, drank or spent too much)

Bounded Selfish: Failure to pursue own self interest to the extent normally assumed of homo economics

Status Quo Bias in Decision Making: The option to do nothing or endorse a previous choice

Portfolio Diversification and Investor Perceptions of Risk

There is evidence that investors in SIPs often display attitudes to risk and portfolio construction that are at odds with accepted investment principles. I try and explain some of them as follows:

Myopic Loss Aversion: Seeking to avoid short term losses despite the long term horizon usually in planning for retirement. There is also evidence that the balance of funds on offer unduly influences individual’s choice of asset allocation in SIPs

1/n heuristic: Investors take the range of offer as implicit guidance from the investment vehicles as to the appropriate asset allocation strategy – a so called endorsement effect

Company stock ownership/ Investing in industry in which the investor in employed: One of the most worrying aspects is the high level of investment in own company stock / same industry amongst employees in SIPs. The strategy is dubious as the stock is correlated with the employee’s labor income and future employment prospects. It appears employees do not view their employers’ stock or the industry in which they are employed as risky. The example of Enron highlights this heuristic in investing. Majority of Enron employees invested their pension plans in Enron own stock. Thus when the company went bust, employees lost their jobs and their savings at the same time. Another theory that supports the above belief is that investors like to invest in familiar industries/ companies. There is also a home country bias linked to this theory.

The obvious solution to dealing with significant behavioral barriers to the effective use of SIP for retirement provision is to offer some form of education to participant; which brings to light two kings of investors:

Planners: Who take active interest in providing for their own retirement

Avoiders: Who are either intimidated by financial matters or are simply uninterested

Less attention can be given to those planners who will seek information anyways; in order to have impact on avoiders’ information should be straightforward

Stakeholders in the investment industry should encourage investor education not only in later but also in spirit. It is this lack of education which caused investors to build unrealistic expectations from equities while not weighing the inherent risk in them. The result is a flight of capital from equity markets of domestic individual investor. Wounds take long to heal especially those caused by bears and bulls. It’s about time the investment industry presents a similar flight of capital from SIPs caused by losses to investors who have made wrong pickings without adequately considering the risk/ return interplay.

Euro Crisis: Where is the lender of last resort?

Sum constrasts the Euro Zone problems with countries who pursue an independent monetary policy and suggest a possible solution to the present Euro Sovereign Crisis. 

The Europe problem has been getting complex by the day. It started with Greece and inevitably everyone knew it is destined to spread to PIIGS (Portugal, Italy, Ireland, Greece and Spain) sooner than later. So here we are witnessing history in the making yet again. Europe, a union of nations formed to exploit synergies by forming a common understanding and policy framework on different subjects is falling like a pack of cards.

Complex and difficult situations demand serious path breaking efforts on the part of stakeholders to overcome the difficulty. The regulators and lawmakers in European Union are working their guts out to provide a temporary relief to the nations who found themselves underwater due to excessive spending and faulty policies. Once the bloodshed is controlled by temporary measures, efforts would then made to address the structural issues.

I have gone back and forth to the drawing board many a times trying to deconstruct the Europe Sovereign Crisis and start all over again in finding the missing link by studying the structural framework of Euro.

My recent efforts are aimed at contrasting the PIIGS with some other sovereign nations having independent currencies and monetary policies (i.e. having independent Central Banks). So I started with a comparison of Spain (Euro zone) with Britain (Independent currency and central bank). Both Spain and Spain have similar debts, deficits and inflation (in percentage terms). Spain, as a part of European Union has embraced the Euro and thus has given up its independent monetary policy in favour of a common European Central Bank. Britain, on the other hand Britain has an independent currency and has a central bank that pursues an independent monetary policy.

Let’s suppose that both Spain and Britain face a Sovereign Debt Crisis. The crisis is caused by excessive spending resulting in high fiscal deficit which is financed by foreign and domestic debt investments. As the debt repayment becomes due both the countries are overstretched with their finances and unless their debt is refinanced the creditors face a possible Sovereign Default. In the absence of any other source of refinance, the countries would only be able to refinance at steeply increased rates. Thus borrowing at high yields will increase the risk of a sovereign default by these countries in the future even higher.

If Britain is unable to roll over its debt at acceptable yield levels it will force its central bank to buy the bonds and in the process devalue its currency. Thus a liquidity crisis is averted by a devaluation of currency. In the case of Spain, refinance at acceptable rates is not possible because it does not have an independent central bank which can be forced to refinance the debt. Thus a liquidity crisis is highly likely in case of Spain if yield on refinancing of debt spikes higher.

One possible solution to this problem could be a consistent effort by the European Central Bank wherein it can give a guarantee to stand by its member countries in times of distress particularly when they face a liquidity crisis (or refinancing problems). For example if Spain needs to refinance its debt and it is unable to do so at reasonable rates, ECB should step in as a lender of last resort and buy the bonds. The value of Euro should thus be made up of weighted average of the respective members states economic parameters. Monte Carlo Simulations and Black Scholes Options Pricing Model can be reconfigured to accommodate financial parameters of member’s states. These parameters can be weighted in accordance with weights (which can be calculated using another set of economic parameters) to derive the targeted value of Euro. ECB should then balance inflation targeting with managing exchange rate expectations thorugh its monetary and fiscal policy.

At any stage the value of Euro should reflect the financial and economic strengths and weaknesses of its members. If PIIGS are refinanced by ECB, the relative devaluation of Euro in accordance with the weight PIIGS in Euro should be undertaken, so as to bring its value to a realistic level. It would not doubt be detrimental to the disciplined and hard working members who have instilled fiscal prudence and best practices in their respective states. A weaker currency would hurt the imports. A weaker currency however would be welcome across the board, especially by the exporters.

The downside to this solution is that bond purchases by central bank expand the money supply, potentially leading to inflation. A hyperinflationary economy may develop as a result of monetising budget deficits. Thus the reluctance of ECB to lend to governments is understandable. Germany is in particular still in the awe of hyperinflation in had to experience during 1920-24 due to monetizing its budget deficit. It’s opposition to such a plan is thus understandable, but as they say tough situations and circumstances demand tough solutions. So Germany pave way for a representative Euro, pay way for maintain order in the union your fondly formed.

Civil and criminal laws: Is obeying them our primary responsibility?

"The primary responsibility of citizens is to obey their nation’s civil and criminal laws"

The author’s statement that the primary responsibility of citizens is to obey their nation’s civil and criminal laws forms the fulcrum of modern society’s premise of fundamental rights and duties for its citizens. The modern society and representative form of governance confers upon its citizens certain fundamental rights and list the duties its citizens must perform as a part of a society.  The obedience of nation’s laws and regulations is one such duty the society expects from its citizens. But in my view the author’s statement is biased and invalid if seen in isolation and without giving due consideration to changing socio economic environment. 

Recently the world has seen uprising in West Asian countries particularly those which were under the rule of oligarchs and dictators. The uprising in these countries was primarily against the regime and autocratic laws and regulations which made the oligarchs and dictators strong while undermining the basic human rights of the common man. People revolted against a change in leadership in these countries and demanded for a representative form of government. The author’s statement of obedience of nation’s civil and criminal laws does not hold in the scenario when the common man is affected and he revolts for a change, sometimes even by undermining the nation’s. civil and criminal laws. 

Another situation where the above statement does not hold is when the present civil and criminal laws are unjust and formed by people who do not hold the mandate to do so. An example of this is the freedom movement of India led by Mahatama Gandhi. Under the leadership of Gandhi, India fought for its freedom from British Rule by practicing non obedience and non violence. 

In a democratic set up where laws and regulations are formed by a representative form of government and duties conferred upon the citizens; the primary responsibility of citizens no doubt is to obey the nation’s civil and criminal laws. Without such obedience, a rule of law will not prevail and a system of justice and fair society will be unthinkable.

In the end I would like to reiterate I do not agree with the author’s statement if seen in isolation. If we make provisions for civil disobedience and non cooperation by citizens if their common interests at large are affected by such laws and regulation, the statement can be accepted as a generalist opinion. The statement also holds for mature societies with a fair system of justice and legislature. 

What's more important in an enterprise; the process or the result?

“In any enterprise, the process of making or doing something is ultimately more important than the final product.”

An enterprise has a perpetual existence. It involves an ongoing process that involves many processes and procedures to produce or manufacture products or services for marketing, selling or consumption purposes. The final product goes through a rigorous process of transformation with varied degrees of time and effort.  A process of value addition takes place at each step to produce the final product right from the inception of idea to transformation of raw material and semi finished goods into a final product. Thus the author’s statement that the process of making or doing something in an enterprise is ultimately more important than the final product holds good in my opinion.

The primary reason why I believe process is more important than the final product is because the opportunity to gain a cost advantage or design leadership can be exploited during the various processed and procedures involved in the production process. Innovation if any can be introduced and core competencies developed during the process of making or doing something. The result of such efforts and competencies will reflect in the final result which the final product we are talking about. An example of this process preference can be found in the development of the cheapest car in the world – the Tata Nano; manufactured by Tata Motors. The company gave more importance to the process of designing and production of the car and obtained patents for the processes and production procedures used to manufacture the car. The end product, the world’s cheapest was not only possible through a product centric approach alone. A system led approach made the dream of producing the cheapest car in the world possible.

Another reason why I give more weight to the process than final product is because a systematic approach and streamlined procedures is required for the successful production, marketing and sales of a product. In the systems approach to management the focus of attention is on the processes of doing or making something. Two companies making identical products can be differentiated by the process and procedures each company is following. A well thought out and professionally structured process reflects in the DNA of the final product. One of the biggest examples of a systems led approach is the Apple. The company has introduced blockbuster consumer electronic goods which had caught the fancy of people. Although the company focused on making a cutting edge final product, it obtained its objective by prioritizing the processed and procedures for the same.

However it needs to be acknowledged that the final product is the ultimate destination an enterprises is aiming to reach. All efforts and resources of the company are thus directed towards achieving the objective of a superior final product. But the efforts and resources thus used are channelized through systems and procedures which if used otherwise will prove counterproductive in giving an edge to the company.

Thus I agree with the author’s statement that in any enterprise, the process of making or doing something is ultimately more important than the final product. This is especially true if we take a system led approach to management. An interplay of final product and strong systems and procedures in a coordinated fashion will ensure overall success of an enterprise.

Greece Crisis: Any opportunity for Hedge Funds?

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My take on how Hedge funds can benefit by investing in distressed assets amid the ongoing Greece Crisis

The crocodile’s eyes are not shedding tears this time. Rather they are lit up with the prospect of a Greek Sovereign default. Most Hedge funds (stakeholder love calling them crocodiles) are under invested in European banks and financial institutions so they are likely to take a relatively light hit as compared to post Lehman crisis. They are also well placed with respect to cash positions primarily because of low investment opportunities in the developed world particularly in the US.

So even the slightest prospect of a Greek Default and a resultant exit from Euro is making the Hedge Fund managers sit up and take notice. An exit from Euro will stretch the Greece economy beyond its means and a bank run will render many businesses bankrupt; particularly the one’s with exposure to other parts of Europe. A business which has Euro debt to pay to financial institutions and banks outside Greece would risk default. The Greece will have a weaker currency post the default and the Euro will strengthen.

A weak currency will make Greece attractive, particularly to Euro zone. Holidaying in Greece will be cheaper for Europeans as Euro will buy more Greece currency. Similarly investing or buying a business in Greece with real assets (say a luxury beach resort) will make economic sense. Hedge funds look for opportunities to buy cheap and sell high by adding value. They may buy businesses in Greece, bargain with creditors for a haircut and keep the business solvent. They may then add value and sell it for a huge profit a couple of years down the line. Buying such claims would be like investing in distressed assets so the risk /return payoff would not be linear. Rather the risk/ return would resemble that of a call option. 

Investors and fund managers who are ready to take the extra pain of searching value in the abyss by careful and well structured valuation would find this crisis a blessing in disguise.

My take: Look for a 40-50 room beach hotel in Thessaloniki or Mykonos with debt on its balance sheet. You may be able to pick it up lower than its real asset value. 

Coming Soon to a market near you – Lehman II

 An alternate view on Greece currency crisis and how Greece should think differently.

 

Greece should be saying “Screw Eurozone, It’s all over” akin to what Lady Gaga tweeted after her concert in Delhi (Screw Hollywood, its all Bollywood). Greece is at the threshold of a major economic disaster. Not that a sovereign default will happen for the first time in the world, but it’s the complexity of a single currency union and the resultant lack of consensus that is making the markets and investors nervous. Greece is caught between a rock and a hard place. It needs help from Eurozone partners to evade sovereign default and keep its credit lines open. At the same time the conditions set forth by Eurozone are pushing its economy further downhill in terms of competitiveness and long term growth and stability.

Greece at the moment looks like any other common person who has incurred more debt than he or she can repay considering his or her current income and assets. A default is thus very likely. Greece is looking towards its partners to bail it out of this situation by lending money; much like any other common man would do in such a situation. However, the problem is that its partners are enforcing stiff conditions on Greece, in terms of controlled spending, cut in jobs and continuous monitoring on measurable basis of austerity measures to help it out of this mess. Once Greece accepts the austerity measures and cut spending and jobs, its growth will further fall and its ability to repay the debt will diminish. A bailout from partners would no doubt avoid a global economic catastrophe and give Greece relief in the short and medium term. But it would be stressed again when the loans from its partners become due. 

An alternate, which Greece should be considering at this stage is a full blown sovereign default. It sound outrageous and unethically in the first place, but if I am Greece this sound like a long term solution to my problems of low growth, unemployment and balance of payment situation. Lets consider what will happen if Greece goes into a full blown sovereign default. If Greece defaults, outside the preview of what is being proposed by Eurozone, it would be forced to exit Euro and there may be a bank run on its banks and financial institutions. Its currency will devalue and local businesses will face bankruptcy. It will also import high inflation as currently Greece is a net importer.

But on the other side because of a devalued currency its competitiveness will increase and it will slowly start to be an attractive market for cheap manufacturing in the Eurozone. Its long term prospects, if seen from a 10-15 years perspective, may be healthier than if it sticks to the austerity conditions as a precondition to staying inside the Eurozone. It can also consider setting up preferential zones for emerging market companies to set up businesses and provide easy and cheap access to labor and infrastructure. Since the emerging market currency would buy more of Greece devalued currency, it would indeed be attractive to set up business in Greece. 

Greece needs to evaluate the pros of cons of being in the Euro currency versus an exit from Euro and having its own currency. At this stage the long term prospects needs to be balanced with the immediate and medium term prospects and consequences. A short sighted vision at this stage might lead to a permanent defect which would be difficult to correct later.

No doubt a sovereign default would wreck havoc on a global scale. But then some other countries (particularly Thailand and Argentina) have been in similar circumstances and they have only come out stronger thanks to their independent currency and fiscal/ monetary policy. Greece should take a cue from India too. In 1991 India was at the verge of a sovereign default. But devaluation of its currency coupled with structural reforms turned the table and today India is one of the more stable and better managed countries embarking on a high growth trajectory.

As Lady Gaga says, Screw Hollywood, it’s all Bollywood; Greece too should be saying Screw Eurozone, it’s all over.