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Commentary

Illusion of Safety

At the Mall I frequent to, a guard uses a hand held device to screen me – front and back. Neither he knows nor I as to what he expects. Beeping is considered normal since Belts / Pens and variety of things cause the same sound. But a illusion is created that once you are inside, you are safe.

Seat Belts and Helmets are compulsory in most cities across India and the world. But do they really make a difference or are they providing a incentive for people to risk more?

In his book, Risk, John Adams tries to showcase as how humans are comfortable with a certain level of risk and if there are new safety mechanisms introduced to reduce that risk, we take higher risk that shall match our earlier risk profile we were comfortable with.

The Risk Thermostat

A model originally devised by Gerald Wilde in 1976, and modified by Adams (1985, 1988). The model postulates that

  • everyone has a propensity to take risks
  • this propensity varies from one individual to another
  • this propensity is influenced by the potential rewards of risk-taking
  • perceptions of risk are influenced by experience of accident losses—one’s own and others’
  • individual risk-taking decisions represent a balancing act in which perceptions of risk are weighed against propensity to take risk
  • accident losses are, by definition, a consequence of taking risks; the more risks an individual takes, the greater, on average, will be both the rewards and losses he or she incurs.

The above chart showcases how we take risks and balance the same based on Rewards & Risk. Unfortunately what it doesn’t show is that Accidents which help one understand “Perceived Danger” isn’t just a stroll in the Park. When they happen, depending on the intensity can set back financial plans of years.

A part of our earnings are saved and where we save is based on multiple factors including future returns. While real estate has always been a place for investing big (dumping all savings plus taking a load of loans), it was only in the years from 2004/05 to 2012/03 that things went crazy.

Doubling of prices became a norm and investments that became 10x in under 10 years a reality. Yet, here we are with prices going nowhere (not yet South other than a few panic driven sales) and lot of projects stuck without being completed.

Mean Reversion is a concept that many don’t understand but holds itself true almost everywhere you go. Gold had a fabulous few years and while we continue to buy, the price is going anywhere but up. Its been 5 years and we are still 15% away from the price we saw in 2012.

Gold tripled in price between 2007 – 2012 but for anyone investing in 2012 expecting similar returns, he surely would be sorely disappointed.

With Gold and Real Estate not delivering returns, the only other logical choice of investments have been the stock market. Where gold left off, Equities have picked up from there.

Last five years have been very good for market and I am not speaking about India alone. Almost every other country is on a unprecedented bull run. Mutual funds have seen good times, but this time around, the rush is crazy for even fund managers to wonder if it makes sense to keep investing or better to close funds for fresh investments.

Since Modi came to power, Retail investors have plunged in big time investing their savings in Equity and Debt Mutual Funds (70% in Equity Funds, 24% in Debt, 4% in Balanced funds, 1.5% in ETF’s and 0.5% in Fund of Funds).

This in-turn has driven up valuations big time though thanks to timely changes by the Index Management committee’s, we still aren’t at 2008 highs not to mention 2000 peaks.

There is optimism in the air and why not – equities have been delivering returns even though underlying companies aren’t really able to deliver on Analyst expectations. And the best part is that despite all the hype, we aren’t even close to bubble territory kind of move.

Mergers and Acquisitions start hitting peaks as Optimism grows irrationally and yet we are still at a stage where one hears about more companies cutting down dead wood than buying new forests. Bubbles need easy money for Promoters to do stupid things.

These days, with Public Sector Banks reeling under Non Performing Assets, they are lucky if they aren’t being squeezed out. Those caught with loans more than what they can afford are trying to unload assets as quickly as they can.

Reliance Energy wanting to sell its Crown Jewel, JP Associates selling off its Cement Plants or they wishing to sell their prime jewel, the Yamunna Expressway, Tata’s literally giving away part of their Telecom business for Free – these aren’t the things you hear if there is a lot of unbridled optimism in the Air.

When a asset class becomes too expensive, the immediate thought is that the only way it could go is for a Crash to happen and in a way, the stock market has been a excellent candidate. Every-time we got over-valued, we have crashed and the next time won’t be any different.

Yet, not all mean reversion happens by way of price crash. Time correction is another way for markets to decompress valuations till they reach the mean (or rather mean meets the price).

When Gold reached its peak in 2012, a investor who got in at the lower end in 2003 was looking at a impressive CAGR return of 24.5%. Today, the same investor if he held to the asset has a CAGR of 9.80% – a okay kind of returns.

Assume gold stays around same place or makes a all time high 5 years from now. A investor who bought and held for the 15 years (remember, buying was at bottom) would be seeing a CAGR of 7.60%. These days, Banks give out as much and that return without a iota of Risk.

Markets have had a wonderful run in the past few years – the future though is uncertain (as it is all the time). Valuations are expensive yet we aren’t close to bubble territory. Foreign Institutional selling is being easily absorbed. We saw that in late 2007 as well, but Mutual fund investments were never so strong at that point of time.

Time based corrections remove the panic but depress the returns. If you are planning your life based on the past returns, maybe its time for you to take a quick rain check. Its never too late to keep some powder dry for no matter how good you think you are, you don’t want to be in a place like Tata Tele found itself.

The illusion of safety in Mutual Funds can make one take risks higher than what he ideally should. Keep track of your Allocation and stay away from exposure that you cannot digest in the next fall – whenever it comes.

 

 

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