Mental Accounting in Stock market

Hello friends, in today’s article, we see mental accounting in the stock market from chapter 7 of the book stocks to riches by Parag Parikh. In this, we understand, how we lose lots of money, by mental accounting error. This bias helps you to understand behavioral finance and get the idea of saving money and investing also.

so let’s start

Previous Chapter 6

Mental Accounting:- Stock to riches Chapter 7

Mental Accounting in the stock market

In this, the author (Parag Parikh) gives us some instances ( examples ) to show how mental accounting works,

so starts

Example 1

Dilip has just taken an MBA in finance. He was intelligent and had a sixth sense when it came to picking stocks. He worked for a brokerage firm and was respected for his ability to read the markets.

After a couple of years, he married Sonia. At that point in time, he had around Rs. 2 lakhs in his bank account. the year was 1991 when the process of liberalization had begun and the stock market was just taking off.

Being adventurous, Dilip decided to use his savings to trade in stocks. It was a wise decision considering his track record as a stock picker and his past success with the brokering firm’s clients. In the first year, his capital increased to Rs. 8 lakhs.

In 1993, his capital rose to Rs. 14 lakhs. two years later, confident in his success, he quit his job to become a full-time trader.

Sonia did not agree with this decision but he told her this would give him more time to develop his skills by attending various seminars and keeping up with his reading which was so very important.

he continued to do well and in 1994, his capital increased to Rs. 30 lakhs. the couple went on a trip to London. Sonia was very happy as they had moved to their own one-bedroom apartment.

In 1995, his capital soared to over Rs. 60 lakhs and so did his confidence. Being conservative, Sonia preferred to play safe. She insisted that Dilip should put aside some money in different safe assets, which they could fall back on in times of need. She was against Dilip investing all their capital in the stock markets.

Dilip did not heed her advice. He thought the higher the investment the greater the profit. Their different approach to money created a rift between them.

Arguments followed and the relationship was strained. Dilip’s winning streak ended and he began to lose. But he thought that since he had a comfortable balance there was no need to worry.

he betted heavily in a market that was going down and by 1997 he had lost everything. His flat was mortgaged to a financer, and Sonia filed for Divorce.

She accused him of being a compulsive gambler who lacked the financial prudence to take care of his wife. She said he could not handle money and had lost Rs. 60 lakhs in just two years in spite of her warning to save for their future.

Dilip was shocked. he had only lost Rs. 2 lakhs and that also over a period of six years.

so while reading this example, we don’t know about mental accounting, so for this author to give the explanation, just wait for more two examples, then we get the three examples and their explanation.

Example 2

Sunil and John were good friends. they worked for the same company and were financially sound. they enjoyed the good life and decided that every Saturday they would dine at a five-star restaurant. Each would pay the bill every alternate week. The first Saturday they dined at the Taj and Sunil paid the bill of Rs. 3000 with his credit card. the next Saturday they dined at the Hilton and this time john paid the bill of Rs. 2800 in cash as he did not have a credit card. the following Saturday the bill was Rs. 4200 and Sunil paid with his credit card. Next when john was due to pay, once again he paid the bill of Rs. 3900 in cash. After a couple of more such Saturday bashes, John told Sunil that they should quit going to five-star restaurants as it was very expensive. Sunil disagreed. He felt they needed this recreation and that they could afford it. He insisted they carry on and John gave in much against his wishes. The next time Sunil had to pay the bill he forgot his credit card and paid cash. the following day he told john that he agreed with him about staying away from five-start hotels.

These examples also do not give direct thought to mental accounting,

let’s see example three

Example 3

Bomsi was a spectator at a cricket match. He had with him a bag in which he had carried his provisions for the day. During the game, he was seen talking loudly and frequently on his mobile phones of which he had three. Suddenly, in the midst of an interesting over, he was heard arguing with an ice cream vendor. the dispute was over price. Bomsi showed the vendor this bag and told him, ” I have bought everything from home, even water. The only thing I can’t bring is the ice cream because it melts. But I will not allow you to cheat me.”

Now Bomsi was a cricket aficionado. he cheered both teams enthusiastically. After the lunch break, a player completed a century and Bomsi was ecstatic. he called the ice cream vendor, grabbed his bag, and generously distributed ice creams all around.

Within the next three hours, he did this twice more. After the game ended he settled his bill with the vendor and even gave him a hefty tip. this man who had fought over the price of ice cream in the morning had distributed ice creams by the dozens to people he did not even know. When asked about what he had done, he replied, ” I love cricket and I love to gamble on the game. When I win I like to celebrate. all my bets paid off. It’s the bookies who are now paying for the ice creams, so let the people enjoy.”

after this example, the author gives the idea of mental accounting

the author says, ” Mental accounting is an idea developed and championed by Richard thaler It underlines one of the most common and costly mistakes people make when dealing with money. it’s the tendency to place different values on the same sum of money depending on how it has been acquired and the effort required to acquire it.

Traditional economic theory assumes that money is fungible, meaning that one type of monetary unit can replace another. this means that Rs. 100 in lottery winnings, Rs. 100 in salary and an Rs. 100 tax refunds should have the same meaning as they have the same purchasing power. but studies indicate this is not so with individuals. People mentally separate their money in different accounts, giving each account a different significance.”

The three examples mentioned earlier

demonstrate how mental accounting affects people’s behavior, the author explains

the author says, ” Going back to example one Dilip started with Rs. 2 lakh and now has nothing. to him, his loss is only Rs. 2 lakh because his gains in the stock markets were merely his winning from his original capital and so not his own money. He treated the two accounts separately Sonia, however, does not suffer from this bias.

In example 2, every time john paid the bill with hard cash he felt the pain of seeing money go out of his pocket. Sunil did not experience this pain when he used his credit card. But When he paid in cash he understand the pain of parting with the money. and his attitude changed. In our minds, we distinguish between cash accounting and credit card accounting. Actually, both are the same, but we view them differently because of our mental extravagant when we use a credit card.

In example 3, Bomsi was stingy with his own money. But when he won, he become very extravagant. to him, his winnings were not his own money but that of the bookies. Hence the celebration mentally, he accounted separately for his own money and for his winnings. Let’s see what you would do in the following two situations.”

After this, the author gives the two situations to understand the mental accounting regarding money.\

Situation A:- You have paid Rs. 500 for a movie ticket. When you reach the theatre. you find that you have lost the ticket! Would you buy a new ticket? or would you prefer to go back?

Thinks about this, and keep your answer in mind.

Situation B:- You go to the theatre to watch a movie. when you reach the ticket window you find that you have lost Rs. 500 out of the Rs. 2000 you were carrying. would you still buy the ticket?

now think about this also and give the answer to yourself.

and check is right or wrong from the author’s explanation.

the author says, ” Most people would say no to the first situation and yes to the second.

However, both entail a loss of Rs. 500 and the cost of Rs.1000 to watch the movie. So why take different decisions? Because most people segregate the loss of the ticket and the loss of cash into independent categories or accounts and therefore react contrarily to the two situations.

Mental accounting is directly correlated to our emotional state. to understand it better, let’s consider different types of mental accounts and the human behavior associated with them.”

So for better understanding, the author gives us real-life experience and how mental accounting is work.

Earned Income V/s gift Income:-Mental Accounting in Stock market

in this, the author says, When we receive our salary cheque we are careful how we spend it. For we that money is sacrosanct, the fruit of our hard work.

But if we got a gift of the same amount of money you would treat it very differently we may spend it lavishly.

Mentally, to us, this is free money, but our salary money is not what we earned it, hence mentally we put it into a different account.

So this type of mental accounting has so many times happened to me. I know you also face this type of mental situation.

let’s now talk about other experiences.

Quantity of the money in Question:-Mental Accounting in Stock market

In this, the author says, ” we create mental accounts according to the quantity of the money and treat them differently. A tax refund is a tax-deferred payment by the tax authorities.

But when we get a tax refund of say Rs. 1000 we are likely to spend that without giving it due thought. However, a tax refund of Rs. 2000 will set us thinking, whether to deposit it in a bank or buy mutual funds and stocks, we do this because Small amounts go into important decision accounts.”

so this type of mental thinking really happens in our life, so now we know that then from now we know this, then think before spend and remember this mental accounting.

let’s take another example in real life

Large Purchases V/s Small Purchases:-

In this, the author says, ” When you want to buy a fridge you make a lot of inquiries before making the purchase you check out models and prices and even brands when you have found the one you like you to do some hard bargaining and maybe get a discount of Rs. 500 on a fridge costing Rs. 20,000. That makes you happy, but do you do the same when shopping for groceries do you realize that if you put in a little effort and are able to save Rs. 10 a day, at the end of the year, it would add up to a savings of Rs. 35000? Compare this with the saving of Rs. 500 on an expense that may not recur for the next 10 years or so.

Many people are cost-conscious when making large financial decisions, but they relax their discipline when it comes to small purchases. but that’s where the difference matters.”

These things also happen with us.

let’s see about credit card and cash example

Cash V/s Credit Cards:-

In this, the author says, ” Today credit cards are a status symbol. Everyone wants one, and every book is aggressively marketing it. It is a big profit earner for the bank and a hole in the pocket for the user who is not aware of the harm it can cause remember the example of Sunil and John

Sunil realized the value of money only when he paid the bill in cash. Because we have different mental accounts, we treat cash and credit card transactions differently. People tend to shop more. If they use credit cards as against paying cash. Actually, both represent your own money. It’s just that credit cards make us extravagant since we don’t see the money change hands. Moreover, we pay interest on the credit offered it is for this reason that credit card companies do a flourishing business.”

lastly, the author gives the Sacred money examples

Sacred Montey:-

in this, the author says, ” Ramesh was a successful investor and had done reasonably well for himself. One day he inherited Rs. 10 lakhs from his uncle. The uncle had worked hard and saved his money all his life. He did not take any risks and looked after this money with care.

Ramesh treated this money as sacred as he had received it from someone. who had toiled all his life to earn it? He would not consider putting it into the stock market where he had done reasonably well. Instead, he put it into bank deposits. The money was marked ” Sacred ” in his mental account. Had his uncle been extravagant may be Remesh would have played the stock market with the money”

After this, the author gives the impact of mental Accounting on Investors.

Impact of mental accounting on Investors:-

In this, the author gives, four examples of the impact of mental accounting

the author says, ” Mental accounting affects not only our personal finances but is more pronounced in the world of Investments.

  • Why do investors hold on to losing investments? They may offer various reasons to justify their action but the fact remains that mentally they are unwilling to accept that they are making a loss. Mentally we tend to believe that we book a loss only when we sell. Intellectually we recognize the loss but we hope that it will vanish. this is a common mental accounting error.
  • Why do investors earn less interest and pay more? Ravi is highly educated, has a successful career in margin trading, and is a savvy investor, in spite of the high interests paid by him, his returns from the business seem quite handsome. Being conservative he prided himself on having comfortable bank deposits to take care of any unforeseen eventualities. He knew that the bank deposits offered a lower rate of return but he felt that was a price he would pay for the margin of safety, that banks offered. It is ironic that he pays high interest in his margin trading while his own money earns a much lower interest in bank deposits. How much better he would be if he utilized his own money for his own stock trade and avoided paying such high rates of interest. this is not a stray case; most people make such mistakes. The problem is that they have two mental accounts. – ” Safe Money” and ” Risk Money ” – For the same money ( it’s also called mental accounting)
  • Most people believe that a bonus share is a freebie given by the company to its shareholders. they even buy moe shares on such news but they are dead wrong. Companies give bonus shares to capitalize reserves and balance their finances. But investors don’t see it that way they consider it to be a windfall. This leads them, to become extravagant. Most investors suffer from this mental accounting error that’s why the stock markets rise on such announcements.
  • Day traders trade in and out of a stuck time and again, with very narrow spreads. they think that they are generating income profitably. but consider the transaction costs and the brokerage they pay on such volumes. What they are in actually is the business of enriching their brokers. and the tax authorities. It’s like buying groceries not heeding the cost.”

Then the author gives the plan of action and advice

let’s see advice first

the author says, ” Before discussing the plan of action it is important to understand that there are no set rules. the best advice is to refrain from using credit cards and to treat all monies equally.

We all have our individual faults and we have to decide what we need to do for ourselves. mental accounting also has its positive and negative aspects and it is up to each individual to know what is best for him for instance, If you are a big spender and unable to curtail your urges, mental accounting could be the most effective way to plan your fixed mortgage payments kids education fund and retirement savings.

In order to eliminate the harmful effects of mental accounting while preserving  its benefits you need to audit your own mental accounting system.”

Then the author gives the plan of action for mental accounting, to avoid our loss

you can read this plan, in the book, buy the book, from the following link ( image)

so this is all about the mental accounting from chapter 7 of the book ” Stock to riches”

Decision Paralysis:-Stock to riches Chapter 6

Hello friends, in today’s article we see the decision paralysis bias from the book stocks to riches chapter 6. In this, the author i.e. Parag Parikh gives wonderful examples that help us to understand this concept. so if you have some decision paralysis bias, then you have to read this article, and understand it, to avoid the decision paralysis bias.

Previous Chapter 5

Decision Paralysis and The endowment effect:-

Decision Paralysis

for starting the author give wonderful examples, and then we try to understand the decision paralysis in detail, let’s start with examples,

Roopesh ( a businessman) has come to meet with Satish ( a portfolio manager).

Roopesh:- I am a businessman I have inherited from my father a portfolio of various stocks. He was an investor and he died five years ago. I’ve always wanted professional help on handling my portfolio as I know nothing about stocks and My own business keeps me busy.

Satish:- it would be a pleasure to construct a good portfolio for you. I have been in this profession for the last 20 years and have many high net worth individuals and corporates as my clients. could I have a list of your stocks?

Roopesh:- Here it is, Can we discuss it right now? I have already wasted five years doing nothing.

Satish:- At a glance, I can see that it is a very lopsided portfolio and drastic changes are required to balance the industry weightage. A number of stocks will have to be sold as they are not viable. Had you done something about the portfolio immediately after your father died you would not have been saddled with so many junk stocks? since we need to act quickly I will put my comments on this sheet. (Decision Paralysis)

Roopesh:- Oh, thank you so much for understanding the urgency of the situation and working on it the right way. I will get everything in order and meet with you the day after tomorrow.

Satish:- That’s may not be possible as I am extremely busy, how about next week?

Roopesh:- Satish, you know the urgency so please spare some time for me. I will adjust my schedule.

Satish:- Is 4. P.M. okay with you?

Roopesh:- It’s perfect. Thanks for squeezing me in I just need to get over this. I am so indebted to you for your time.

they meet at the scheduled time.

Roopesh:- I did some homework and I have a few queries.

Satish:- Please go ahead, I will clarify all your doubts.

The meeting goes on for an hour. Initially, Roopesh’s questions are the same but Satish is patient and clarifies all his doubts. the meeting ends with Roopesh scheduling another appointment after a couple of days.

Roopesh:- Thank you once again for your time You know how urgent this is for me so before I finalize I brought my wife along so that she too is clear about everything. Meet my wife Meena

Satish:- Nice meeting you. Now, what can I do for you? I hope your husband has explained everything to you. If you have any questions don’t hesitate to ask.

Meena:- I am just a housewife. I do not understand investments. My husband insisted that I come as he wanted to finalize some business with you. He told me that you are an expert in your field and he trusts you very much. I am happy that he has ultimately taken a decision after five years. (Decision Paralysis)

Roopesh:- Yes, I am glad I have met the right portfolio manager. now to complete the formalities and take action, shall we meet tomorrow? Please give me an appointment as this matter is my first priority.

Satish:- Okay. since we will require time to finalize, let’s make it 6 P.M. tomorrow.

Roopesh:- thank you very much. I will be there. I will bring my wife too in case you need her signature. goodbye.

The next morning, Roopesh calls Satish’s secretary and asks her to reschedule the meeting two weeks later, Roopesh walks in with a gentleman.

Roopesh:- Satish, meet my friend Atul. He is a leading chartered accountant. before finalizing. I thought he should meet with you and you can clarify his doubts. I hope you don’t mind.

Satish:- Yes, Atul please go ahead with your questions,

Atul:- I have heard a lot about you. I have nothing to ask a professional like you. I know Roopesh Is in safe hands. Roopesh, I know of Satish’s reputation and you can be assured that you have got the best professional working for you.

Roopesh:- thank you. Now Atul has given me the green signal I do not have any hesitation. I will call tomorrow and fix a time so that I can bring my wife and we can complete the formalities.

the next day Roopesh calls Satish’s secretary and asks for an appointment after three weeks as he has another urgent business appointment the secretary refuses to reschedule the appointment.

I know while reading these examples, we can’t get any logical sense, so read the following explanation to understand the logic of the above examples. (Decision Paralysis)

After these examples, the author explains about above examples.

the author says, ” Why did the secretary do that, especially after Satish had spent so many hours with a prospective client and the signing was a near certainty? What do you make of Roopesh’s behavior? Why was he post poring his decision? Suffers from decision paralysis. He can not make decisions and is resilient to change Satish had lost trust in him. He guessed that nothing would make him act. To buy time Roopesh went on a business trip, then bought his wife along, and after that his friend Atul. His wife and his friend were not even informed about the talk. He had had with Satish and neither was competent enough to ask Satish any worthwhile questions though Roopesh harped on the urgency of the matter and insisted that it was a top priority he just could not decide what to do. Perhaps he has been behaving this way earlier as well. He fears change, so he prefers maintaining the status quo.”

He understands that he needs to take action but he can not.

then the author explains decision paralysis or Status quo bias.

the author says, ” this phenomenon hampers us in many areas of life, from choosing an investment option to buying a house. Once you are familiar with the complicated forces at play you will understand why choice and change can be so intimidating.

A significant sequence of decision paralysis in financial decisions is that by deferring purchase you may miss the opportunities or run the risk of prices-rising. Imagine there is a very good house for sale. You like it because it suits all your requirements and the prices seem right. But you can not decide and opportunity to see a few more houses. With multiple choices a decision is difficult. As time passes another bidder enters the fray and you lose the opportunity. Because of decision paralysis, you lost the house.”

then the author explains, what factor needs to be making decisions.

Taking Decisions:-

In this author explain the different factors that need to take decisions

the author says, ” We have to understand that deciding not to make a decision is also a decision. when we make a decision we give ourselves a chance to have from the present comfort zone. Once we do that we have a 50-50 chance of going right or wrong. If we choose not to take a decision we miss this chance of going right.

Maintaining a status quo in times of continuous change is definitely unwise. Another way of looking at decision paralysis is that it is a natural human tendency to resist change.

So one is the reason that is why we can’t make the decisions.

  • Fear of going wrong
  • the possibility of losing
  • to avoid looking foolish
  • Unwillingness to take risks

then the author explain the above point

the author says,” All these reasons stem from our psychological and cognitive defects. the most acute of these is loss aversion and egocentric human nature. Along with that heuristics like regret avoidance and belief perseverance also play a significant role in our mental makeup”

then the author gives the illustration story to understand better way.

the author says, ” suppose, you inherit from your rich uncle Rs. 50 lakh and you want to invest it. You buy stocks, bonds, fixed deposits, etc. according to your preference and needs. It is simple you have the money and you allocate across assets. But if you were to inherit a portfolio of stocks amounting to Rs. 50 lakh, what would you do? you need to make multiple choices. You could sell the stocks in the portfolio and buy different stocks or some bonds etc. Or you could leave the portfolio as it is. Most people would choose to leave the portfolio as it is. they would choose to maintain the status quo. when there are multiple options. One is more likely to delay on action or take no action at all the greater the choice. The harder the decision.”

Then the author explains what is investing and decision paralysis relation.

Investing And Decision Paralysis:-

In this, the author gives examples to understand this relation between investing and decision paralysis in a better way.

let’s see examples

the author says, ” Decision paralysis plays an important role in Financial markets especially when you are dealing in the stock markets. the volatility of the stock markets also adds to distorted human behavior. Most people would do nothing or as well as we call it, maintain the status quo. Here are some examples of decision paralysis at work.

  • During the IT boom stocks reached new heights this went on for over a year. Those who invested in tech stocks become wealthly. a number of us, find managers and clients, thought that the markets were irrational and that the tech stocks were priced high. However, everybody wanted to ride the wave, confident that they would sell when the market softened. A fund manager of a leading mutual fund who also shared my opinion on the market. Valuations said he would sell when the tide turned. His fund had a weightage of 80 percent in the technology sector. When the market dropped it did not go down in one go. It was gradual before the steep fall come. Actually, the fund manager should have sold when the market began to weaken. He had been looking forward to such a situation, yet when the time come for him to do it he did not sell. He suffered decision paralysis and so did millions of other investors who made huge profits in the tech sector. I had consistently advised him to sell. He did not and suffered a loss when he liquidated.
  • We all remember the story of the unit trust of India ( UTI) the guardian to millions of Indian investors, corporate pensions widows working class, etc. Established in 1964 it was the only Indian mutual fund where Indians invested their savings. Operating in a socialistic environment the fund was open-ended but not net asset value ( NAV) based. It consistently distributed dividends and the governments supposedly guaranteed repayment. One could enter and exit at the price made available by UTI itself. Liberalization in 1991 and the entry of private and public sector mutual funds. Soon Challenged UTI’s supremacy. Despite operating in a competitive environment it continued to follow its earlier policies. In 1995 the stock markets boomed. that was the time to make it open-ended and let investors enter and get at the current NAV. times were changing and UTI’s position was threatened. The writing was on the wall but no action was taken. The Deepak Parikh committee was appointed to advise restructuring of UTI but nothing was done. Until one day the inevitable happened. this not only shattered the investors of UTI but also shook. the stock markets and it took over a couple of years for the markets to recover.
  • Another example of decision paralysis is when investors buy top-performing funds and do not reshuffle. their portfolios. they are happy since their funds are doing well. but when there is a choice of funds it is important to choose the right one, which may not necessarily be the one that has performed well. On the contrary, the chances of it sustaining its performance are much lower. By definition, a mutual fund captures the mutuality of the market so in the bull phase you should reshuffle. don’t let decision paralysis hamper your investment decisions.
  • Greed and Fear are a part of the market flow excess characterize the bull phase where every stock is sellable. During such a phase all types of companies enter the capital market to capitalize on the bull run. Money becomes easily available. Investors get trapped by such stocks when the bull run ends they swear they will get out of such stocks as soon as they can. For years they prefer to maintain the status quo as they get greedy, hoping to make more money on such junk stocks.

then on these examples, the author gives a short note.

the author says, ” I have come across various examples of investors who are unable to decide and prefer to maintain the status quo. why do people behave this way? Is the prospect of change so frightening? yes, it is and the concept of the endowment effect explains it all.

then the author explains the endowment effect

Endowment Effect:-

to understand this effect, the author gives the two situations, and their explanation.

The author says, ” What would you do in the following situations?

1 ) You have been gifted a souvenir jug worth Rs. 100 ( in the marketplace). Someone offered to buy it from you. What is the very least you would expect to be paid for the jug?

A) Rs. 100      

B) Rs. 80

C) Rs. 70

D) Rs. 50

second situation

2) Your neighbor has received a souvenir jug worth Rs. 100 ( in the marketplace) as a gift. he offers you the jug for sale. What are the most you are willing to pay for the jug?

A) Rs. 100

B) Rs. 80

C) Rs. 70

D) Rs. 50

It is obvious when someone offers to buy the jug from you, you would like to be paid Rs. 100. but when the same jug is offered to you, you would like to pay only Rs. 50 why is there such a big difference in the price offered and the price tendered when the person is the same and the jug is the name?

Because we perceive that whatever belongs to us is more valuable than that belongs to others. When something comes into our possession its value increases. In a way, this explains why people prefer the status quo to change by foregoing change in favor of the familiar they express happiness with the current situation. True, a decision to do or not to do something would be influenced by a host of other factors such as doubt, fear, or confusion.

Nonetheless, keeping things as they are is a vote of confidence for the current circumstances, irrespective of whether they are good or bad. a preference for holding on to what you have is a lot stronger than most people think.

because people place an inordinately high value on what they have, a decision to change becomes difficult. Of course, people do manage to overcome this tendency, for if they didn’t they would not sell their homes as trade their used cars, or divorce their spouses. but to the extent that the endowment effect makes it difficult, to properly value what is and isn’t yours, you may fail to pursue options that are in your best interest. In fact, the endowment effect is just another manifestation of loss aversion. people, place too much emphasis on instant gratification and too little value on Opportunity Costs.”

then the author talks about the impact of the endowment effect.

Impact of Endowment Effect:-

To understand this effect impact author gives us real-life examples, in that examples how the endowment effect is used. let’s see step by step

the author says, ” The endowment effect is very relevant to invest. Stock market participants, Analysts, Fund Managers, and companies all become victims of the endowment at one time or other. here are a few examples of the endowment effect as it plays out in real life.

Overvaluing One’s Holdings:-

Ganesh:- “ What is the price of Tata Steel?”

Broker:- ” It is Rs. 298/299 ”

Ganesh:- ” Give me a call when it reaches Rs. 300, I need to sell.”

the price reaches Rs. 301.

Broker:- ” The price is Rs. 301/302. Should I sell? It is one rupee above your limit of Rs. 300.”

Ganesh:- ” No. The market seems to be going up I will wait for a price of Rs. 305, give me a call then.”

the prices go up to Rs. 306 and the broker calls.

Broker:- “ The price is Rs. 306. What should I do.”

Ganesh:-“Wait till it touches Rs. 315. then don’t even ask me, just sell. I am sure it will go up. This is a great company and such a low price is ridiculous.”

the price falls to Rs. 301.

Broker:- “ The markets are down and the stock is back to Rs. 301.”

Ganesh:- ” The market may be down but the stock can not go down. I know we will get the price Tomorrow. when the markets are up. don’t worry we will sell tomorrow at Rs. 315. I just can’t believe that the market is selling a good stock so cheap.

After these examples author explain why Ganesh does that

the author says, ” Every time the stock went up Ganesh would increase his limit. Was he playing games? No. he is a serious investor. He strongly believes that Tata Steel is a great company. He is proud of his holding and he firmly believes that the market is undervaluing his stock.”

Other Examples

The Trial and Money-back Guarantee scheme:-

Raju:- ” Mom, see what I’ve got, the latest stereo system. It will fit perfectly in our drawing-room. Wait till I play it. you will love the sound.”

Mom:-” Raju, where did you get the money for such an expensive stereo.”

Raju:- ” it’s on a 15- day trial basis. the shop round. the corner allows you to use the goods before you buy. Since college is closed for two weeks. I thought I’d listen to some music at home.”

Mom:- ” Are you sure they will take it back without any fuss?”

Raju:- “ Of course mom, don’t worry. here is the card. It says that they will take it back no questions asked, it returned within the 15-day trial period.”

Mom:- ” that’s great, handle it carefully. They may not take it back if it is misused.”

Raju:- “ Don’t worry I will be careful.”

After 14 days,

Mom:- ” Raju, don’t forget the trial period ends tomorrow. we have to return it, though we will miss it.”

Raju:- ” Mom, can we keep it and make the payment A good system makes a difference. Moreover, it fits in with our decor like it was specially made for us.”

Mom:- ” Yes, you are right. let’s keep the stereo we will make the payment.”

so you get the idea of the endowment effect. (Decision Paralysis)

then the author gives us an explanation.

the author says,” Notice how taking a product on trial got Raju and his mother to buy it. the shop owner understands the endowment effect very well. he knows that once the stereo becomes a part of their endowment it will be very difficult for them to part with it. they did not find out whether the stereo is competitively priced, whether there are better models in the market, or whether some company has introduced a better model.

Because it had become a part of their endowment it become very precious to them.

Businesses understand the endowment effect too well that’s why they are willing to give their product on trial with a money-back guarantee on purchases. they know that once customers own the product, even if it is for a few days, its perceived value increases, and they may not want to return it.”

So for avoidance the investing mistakes by cause of decision paralysis and endowment effect.

the author gives us the perfect plan of action to avoid this.

so, if you want to read that plan, you can read that plan in this book, by ordering this book from the following image link

to Solve the following problems

  • You have a hard time choosing investment options.
  • you react adversely when your decisions turn out poorly.
  • you buy products on trial but never return them.
  • You delay making investment and spending decisions.
  • you hold on to stocks you own.
  • You go on a company visit and buy stocks
  • you do not have a retirement plan in place.

So, this is all about decision paralysis and the endowment effect.

I highly recommend buying these books, from the above link,

if you buy these books, you will avoid losing millions of money on useless things.

so then buy these books, and improve your investor behavior mindset.

Loss Aversion from Stock to riches Chapter 5

Hello friends, in today’s article we see chapter 5 from book stocks to riches by Parag Parikh. This chapter is all about two concepts i.e. Loss Aversion and Sunk Cost fallacy. lose aversion bias is the most famous bias that people use in their life and take wrong decisions. so let’s understand this concept and use it in our Investor journey.

Previous Chapter 4

Loss Aversion & Sunk Cost Fallacy:-

loss aversion

In this chapter, we learn about the most famous concept of psychology. before starting author give Warren Buffett ( great investor) and Benjamin Graham ( father of value investing) quotes.

” I will tell you how to become rich. close the doors. Be fearful when others are greedy, Be greedy when others are fearful.”    – Warren Buffett lecturing to a group of students at Columbia University.

” Most of the time, common stocks are subject to irrational and excessive price fluctuations in both directions as a consequence of the ingrained tendency of most people to speculate or gamble to give way to hope fear, and greed.”                        – Benjamin Graham ( father of value investing)

the author explains how this emotion actually works in the stocks market i.e. fear and greed

the author says, ” We have all heard that investors greed when the stock markets are in a bull chase and their fear when the markets are falling. It is important; therefore to understand how these emotions of greed and fear impact our thinking and make us act in ways that are contrary to our financial markets? How do we make decisions when faced with risk?  How do fear of losing and greed for gains impact our decision-making?

then the author explains, loss aversion and sunk cost fallacy

the author says, ” As far as our feeling toward our losses is concerned, we suffer from two behavioral Anomalies: Loss Aversion: that is our fear of losing, Sunk cost fallacy:- that is our inability to forget money already spent.

As far as our feelings towards gains are concerned, we suffer from status Quo bias that is our Inability to make decisions, and the Endowment Effect that is the tendency to fall in love with what we own and this resists change.”

after this, the author gives examples of loss aversion. you should read in the book, for that buy this book, from the following link

To understand more about the loss aversion concept, the author gives us two scenarios, this is a wonderful scenario, I bet if you will read it the first time, then you definitely give the wrong answer. (Stocks to Riches Chapter 5 on Loss Aversion )

the author says, ” let’s take a look at the following two scenarios.

Scenario 1:- you are given Rs. 1000 and two options

A) Guaranteed win of Rs. 500

B) Flip of a coin. If it’s heads you get Rs. 1000 and if it is tails you get nothing.

Which option will you choose? Now let’s go to Scenario 2

Scenario 2:- You are given Rs. 2000 and two options

A) Guaranteed to lose of Rs. 500

B) flip of a coin. If it’s tails you lose Rs. 1000 and if it is heads you lose nothing.

Which option do you choose?”

After this, the author gives the right opinion before that read this scenario again and keeping in mind your option.

then the author says,” Research Suggest it’s more than likely you chose option A in Scenario 1 because there was a guaranteed win of Rs. 500.

you acted conservatively and took the opportunity to lack in sure profits But in scenario 2, you would most likely choose option B because you did not want to be confronted with a guaranteed loss of Rs. 500.

Hence you were willing to take more risks if it meant avoiding losses. It is this bias that makes gamblers so popular with the casinos. (Stocks to Riches Chapter 5 on Loss Aversion )

Why is it that when confronted with a sure profit we become conservative and when confronted with a loss we tend to take more risks? it’s because the pain of a loss is three times more than the pleasure of an equal amount of gain.

Over time pain becomes terrifying and pleasure becomes boring. consider this, you get an electric shock while using your T.V. that will scare you and you will avoid going near the TV till the fault is set right.

Now contrast this with the pleasure you get when you buy a car for the first time. After a while, you get bored with it and you long for a better and bigger car. It never stops your desires keep upgrading because pleasure over time becomes boring.

We tend to see losses and profits in isolation and that is the reason we are more prone to suffer from loss aversion. Hence, we should not view different stocks or different classes of assets individually but as part of the portfolio as a whole.:

then the author gives examples of equity

the author says, ” suppose, there is a decline of 10 percent in equities and a rise of 8 percent in bonds, we should look at the overall effect which is only 2 percent. or take the case of a portfolio with 10 stocks, each valued at rupees one lakh. If two stocks depreciate by 50 percent, the overall effect on the portfolio is only 10 percent but if we were to look at the stocks in isolation we should see it as two stocks losing 50 percent in value that’s a big shock, and we could make decisions that we repent later.”

then the author gives the answer of before given scenario

the author says,” In the scenarios mentioned earlier if we looked a the final financial position after exercising the options, the automatic choice would be option A in both cases as it would leave us with Rs. 1500.”

then the author gives the impact of loss aversion

Impact of Loss Aversion:-

  1. Investors tend to prefer fixed income investments to stocks
  2. Investors tend to take their profits very early
  3. Investors take more risks when threatened with a loss
  4. Investors tend to hold on to losers and sell winners
  5. Tax Aversion.

1) Investors tend to prefer Fixed income investments to stocks:-

In this, the author says, ” witness the period of after the bursting of the dotcom bubble till the beginning of 2003, everyone was so afraid of losing that they preferred to stay invested in fixed income securities they shunned equities although that was the best time to invest because of attraction valuations and good dividends yields. the pain of investors losing fortunes in technology stocks was so vivid and true and true that investors were not willing to risk anything in the stocks markets. the emotion of fear was so strong it created loss aversion. Actually, the right time to invest is when others are scared.” (Stocks to Riches Chapter 5 on Loss Aversion )

2) Investors tend to take their profits very early:-

In this, the author says, ” To be successful in the stock markets it is important to ride the winners and discard the losers. However, loss aversion makes us ultra-conservative so we book profits very early. we all suffer from loss aversion and that is the reason we find that winners get a small number of profits and losers pile up huge losses. winning streaks tend to be short-lived.”

3) Investors take more risks when threatened with a loss:-

In this, the author says, ” They tend to lose their balance. when confronted with a loss and become more daring and venturesome. this is not due to courage but because of madness caused by the pain of a loss.

One of our clients bought 10 low-valued stocks all quoting below par. when I questioned his wisdom in putting his hard-earned money in such stocks he replied that if just a couple of them turned out to be multi-baggers he would make good money he believed so strongly in his strategy that he held on to over a hundred such junk stocks in the hope that one day he would make it big. since he was losing he kept taking bigger risks and increased his exposure.”

4) Investor Tend to hold on to losers and Sell winners:-

In this, the author says, ” A portfolio of stocks with a few winners at the top followed by a long list of losers is not uncommon. as discussed earlier, it is because we go for sure gains and take more risks when threatened with a loss. so if you have one such portfolio you need to know that your decision-making is being controlled by loss aversion. Instead of riding the winners, you are riding the losers.” (Stocks to Riches Chapter 5 on Loss Aversion )

5) Tax Aversion:-

in this, the author says, ” People are always wary of paying taxes. this is also one sort of loss aversion tax is an outflow and it is considered to be a loss but in reality, we pay tax on our income we need a change of mindset. always count your income net of taxes this will enable you to avoid tax aversion arising out of loss aversion.”

then author explains about the Investors, after giving the impact of loss aversion

the author says, ” the idea that investors are not risk-averse but loss averse is one of the main tenets of behavioral finance. while the distinction might seem trivial; studies have shown that investors will increase their risk, defined in terms of uncertainty, to avoid the smallest probability of losses. it is not so much that people hate uncertainty, but rather that they hate losing.?”

Friends, this concept looks easy, and you think that that’s only, I know already, but from my experience when we include our hard-earned money, then we go in this loss aversion concept, and most of the time we lose.

So I recommend you to be cool and don’t say, it easy, this is not easy, it’s simple, and simple things is not easy

so let’s come to our topic

then author explains our Sunk Cost fallacy concept

Sunk Cost fallacy:-

To understand this concept, the author gives some examples, that we use in daily life, and how sunk cost fallacy occurs in our daily life.

examples 1)

Investor:- I have invested in Sterilite Optic, it is a great stock. I have read about the telecom boom and I am sure this is right.

Broker:- the telecom crazy has ended, there is overcapacity and the story is over the stock is going down as the industry fundamentals have changed.

Investor:- so what, I will buy more and bring down my cost of purchase. I know it was a great stock please buy 2000 Sterilite Optic.

Examples 2)

Housewife:- I thought investing was fun so I enrolled in these classes. I think I have made a mistake as I feel I am not cut out for this. but I will complete the course as I have already paid the fees and they don’t have a refund policy. (Stocks to Riches Chapter 5 on Loss Aversion )

Example 3)

Student:- I am not interested in commerce. I took it because I wanted to be with my friends. I know I have made a big mistake. But since I have already completed three years I would rather complete the rest and take the degree.

Example 4)

Businessman:- In the last two years, I have spent so much money on car repairs, I would have been better off buying a new one.

Examples 5)

Teenager:- Oh, what a boring book, I should not have wasted my money on it. With great difficulty I read the first 30 pages, I still have 400 more pages but I hope to complete that by the end of this week.

Example 6)

Day Trader:- it’s really tough to make money in such volatile markets. I should not have got this terminal at home. It’s a fixed expense every month, I have to trade every day so that I can at least recover my fixed costs.

After these awesome examples the author gives the two scenarios, just like the loss aversion concept scenario, and after that author gives the above examples, which is right and what should we have to do right for them.

the author says, ” why do people do what they do not like? Is it not simpler to choose not to do it? Now, what would you do in the following two scenarios?

Scenario A:- You have complimentary tickets for a Filmfare awards night. On the evening of the program, there is a severe rainstorm, and traffic is disrupted due to floods. You have to travel from Colaba to Andheri.

Would you go? Yes or No

Scenario B:- You have bought a ticket for a Filmfare awards night for Rs. 1500 on the evening of the program there is a severe rainstorm and traffic is disrupted due to floods. You have to travel from Colaba to Andheri.

Would you go?  Yes or No

Choose your answer wisely,

then the author explains, what is the sunk cost fallacy concept and behind this scenario how these works.

and also explain the psychology behind this scenario

the authors say, ” Most people would go for the show if they had paid for the tickets and would avoid it if they had received the same as complimentary. actually, this distinction makes no sense as the money for the ticket is already spent. you will not get it back whether you go to the event or not. What we must really look at is the additional risk we are taking by braving the Strom and the additional costs we may incur if the car is damaged or we fall sick. the danger posed by the rainstorm is the same, whether the tickets are free or paid for.” (Stocks to Riches Chapter 5 on Loss Aversion )

This particular type of loss aversion to which we all are prone is what Richard thaler described as the Sunk Cost Fallacy.

You increase your commitment to justify your past actions because your ego is tied to be commitment.

then the author explains Sunk Cost Fallacy, for the previous six Examples

the author says, ” Let’s go back to the statements given earlier

  • the investor make a decision and does not want to admit that his decision has gone wrong. so to justify it he buys more stock and takes solace in that he is bringing down his cost of purchase.
  • The Housewife goes through the ordeal because she is already enrolled. She does not consider the extra time, energy, and money, by way of transportation, she will spend to fulfill the original wrong choice.
  • the student takes his graduation because he has already completed three years, would he really learn much when he is not interested in the subject?
  • The businessman should have recognized that there is something like the economic life of a car rather, he chose to continue spending on repair as every time a new expense come up he thought of the previous repair cost and thus went on and on.
  • A teenager has already spent on the book, so he will finish it however boring and time-consuming it is.
  • the day trader operates a business he knows will fail, but since he has already incurred fixed expenses he will keep going.

then the author says, ” each of them had a choice, to do or not to do. However, they considered doing what they don’t like because they wanted to justify their previous actions, also, they did not want to appear wasteful and incompetent in their financial decisions.

But Sunk cost Fallacy can also help us in a positive way. for example, a person joins a gym vowing to work out regularly. Instead of paying daily charges if he were to take a yearly membership, the sunk cost fallacy would help him to be regular, as he has already expended the year’s fees. This serves as a motivation to keep going.”

then the author explains, what impact of sunk cost fallacy

Impact of Sunk Cost Fallacy:-

1) Averaging Cost of Purchase

2) Spending on Repairs

3) Government Spending on Unviable project

let’s understand one by one

1) Averaging Cost of Purchase:-

In this, the author says, ” generally, when investors go wrong in their purchase of stock they buy more at every fall. they believe that this will bring down the cost of their purchase. there is nothing wrong with that, provided they are confident that the stock has great value. But if they buy only to justify past actions, then they are prone to sunk cost fallacy.”

2) Spending on Repair:-

In this, the author says, ” Two years ago you pointed your old car. last year you replaced the tires and changed the suspension. this year the mechanic informs you that the engine needs an overhaul. every year you justify your spending on repairs because of earlier expenditures when actually you need to discard the car as it has reached the end of economic life. Maybe it is wiser to buy a new car. spending on repairs is a common sunk cost fallacy with most of us.”

3) Government Spending On Unviable Project:-

In this, the author says, ” Bureaucratic procedures have delayed a project and it has now become unviable but a lot of steel and cement have already reached the site and the plants are ready. The initial fees of the engineer have been paid. Since so much money has already been spent the project is completed even though it is unviable. this is how sunk cost fallacy works with the government”

then the author gives examples of how the sunk cost fallacy occurs in day-to-day life.

the author says, ” the influence of sunk cost fallacy is evident in our day to day lives. How many times have we not sat through a boring movie just because we had bought the tickets? Here are some examples of the impact of sunk cost fallacy

At a buffet (the system used in an event to provide foods) there are a variety of dishes as the restaurant has to satisfy the palates of different types of people. Instead of exercising our choice, we tend to overreact only because we have paid for it. that is sunk cost fallacy working on us. the next time you go to a buffet, remember your health is more important than indulgence.”

It is not enough to understand the two behavioral anomalies of loss aversion and sunk cost fallacy. We have to recognize our own anomalies so we can improve ourselves and become better investors. (Stocks to Riches Chapter 5 on Loss Aversion )

So this is all about Loss aversion and Sunk Cost Fallacy concept.

In this chapter, the author gives the suggestion to become a better investor, I think you should read this in the book for you can buy the book from the following link

lastly, the author gives some questions to understand you are the victim of loss aversion and sunk cost fallacy

answer the questions

  • Do you prefer fixed income securities overstocks
  • Are you tempted to move out of the markets when the prices fall?
  • Does your portfolio consist of a few winners followed by a long list of losers?
  • Do you sell your winners fast and hold on to losers
  • do you make important spending decisions based on your past spending?

then the author gives the right answer

the author says, ” if your answer is yes, then you are a victim of loss aversion and sunk cost fallacy.

then the author gives suggests avoiding being a victim or loss aversion and sunk cost fallacy.

buy this book, from the above image link, and improve your portfolio performance.

Stocks to Riches Chapter 4:- Introduction to Behavioural Finance

In today’s blog, we see the introduction to behavioral finance from chapter 4 of the book stocks to riches by Parag Parikh. This is a wonderful chapter you should understand how our feeling is work in the stock market and how can we have to get precautions.

so let’s start

Previous chapter

Introduction to Behavioural Finance:-Stocks to Riches Chapter 4

Stocks to Riches Chapter 4

In this chapter 4, the author explains behavioral finance with wonderful examples

let’s start with examples of peoples behavior

  • “With such positive news from the company why is the stock going down”
  • “I am a qualified chartered accountant. I went through the finances of the company and I feel that at the current price, the stocks are too expensive. I would not buy it nor recommend the same to anybody. But I am surprised that in the last two weeks the stocks are up 15 percent.”
  • “My friend works with this company. they told me that it was doing exceedingly well and that they have an export order worth crore in hand so I bought the stock. It’s six months and I have been waiting but the stock is going down.”
  • ” the company has announced a 1:1 bonus, it’s good news so I bought the stock but the stock went down instead of going up like I thought it would.”
  • ” I read the mornings newspaper and was impressed by the finance minister’s speech and his intention to give sops to the economy. the markets greeted the news positively and went up so I bought stocks the next day the markets were down for no reason and I lost on my investment.”
  • ” I heard the expert’s comments on T.V. on the current budget presented by the finance minister. they were not very happy with it. I sold my stocks only to find that within a week the markets were up 10 percent. I don’t know why I sold my stocks which I had been holding for the last four years.”
  • ” I can not understand the markets. I would rather stay away.”

after his behavioral statement, then the author tells, how this statement happens

the author says, ” Aren’t all these statements familiar you have heard them on perhaps made then yourself. In an ever-changing and uncertain world, we are trying to find some predictions where none exists. The easiest thing to do is to avoid such irrational markets. But then you would be missing out on one of the most favorable modes of investment. (Stocks to Riches Chapter 4)

My sincere advice would be to catch the bull by the horns. confront the problem rather than run away from it. Try to understand why it is happening to you.”

then the author gives their own experience, in dot com bubble time.

the author says, ” during the IT bubble. Too found myself bewildered and confused. The valuations of the dot-com businesses and IT stocks seemed highly inflated. Pundits in the market and the media were pontificating on the new economy and giving convoluted justifications for what was approved to be sheer insanity. I wondered, was the entire world mad and I the only left the same, or was I insane and the world perfectly rational?

I had a client who had invested around 70 lakhs in different IT stocks in 1998 on his friend’s recommendations in 1999, his portfolio value was around Rs. 5 crores when he asked for my advice I told him, to sell as I thought that the PE multiples were very high and the valuations seemed for too stretched.

He did not do so and six months later when we met he informed me that the portfolio value was around Rs. 6 crores. Once again he asked me what he should do I was a bit embarrassed by the question, as I knew that he was, not asking for advice. but telling me indirectly that I was not in sync with the markets. I still insisted that he sell but he did not sometimes later the portfolio value went up to Rs. 8 crores.”

then the author explains why they 3 times give the wrong advice and his friend portfolio value is growing continuously.

the author says, ” this was the frustration I had to go through, of being in the investment business and not able to advise clients correctly. there were times I had sleepless nights fearing that the world was going too fast for me to understand. I doubted my abilities, my competencies, and my knowledge. (Stocks to Riches Chapter 4)

The inability to understand the madness added to the frustration. In fact, I lost quite a few clients as they thought that I was too conservative and not in tune with the new economy.”

then the author tries to find out the answer, for the above going wrong, why this happens

the author says, ” find an answer to this question I did some serious soul searching. my quest led to a fledging little know field called behavioral finance. ”

then the author explains, how emotions change and he is right with his decision, the only people, driven by their emotions. to understand this, the author gives good examples of true stories

the author says, ” this is a true story of a friend who ran a coaching class with one of his colleagues they started off well and within a couple of months they were full to capacity after six months, few students complained to my friend about his colleague’s rude behavior.

The allegation was that he was very short-tempered and arrogant. they wanted him removed or else they would discontinue the classes. My friend was worried. this colleague was his partner and he could not be removed. Moreover, he was a brilliant professional and an able tutor.

After a couple of weeks, the colleague fell ill and was absent for some time. the students were very happy. they thought that they had been successful in removing him.

one day my friend learned that the colleague had a brain tumor and needed an operation. this news shocked my friends, as now his partner would be out of action for quite some time. He informed the students of this calamity. the students were stunned and this shock changed their attitude. Hatred and resentment gave way to empathy and love. they visited him at the hospital and took him flowers. they repented their stand and prayed for his early recovery so that he could come back to teach.”

then the author told, what is the purpose behind this story.

the author says, ” purpose of this story is to understand that is humans we are emotional beings and our behavior and decisions are guided by our emotions. Frequently emotions prompt us to make decisions that may not be in our rational financial interest. Indeed decisions that enrich us emotionally may impoverish us financially.” (Stocks to Riches Chapter 4)

Behavioral finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs.

then the author explains, Classical economic theory vs behavioral economic theory.

Classical Economic theory V/S Behavioural Economic theory:-

the author says, ” Classical theory talks about the efficiency of the markets and people making rational decisions to maximize their profits. It assumes that the markets are efficient and no one can take advantage of its movements. It also assumes that humans are rational beings and will act to maximize their goals.

However behavioral economists believe that the markets are inefficient and human beings are not rational beings.”

then the author, give the examples

the author says, ” Consider the examples if you and I were walking down a busy street in Colaba and you said you saw Rs. 5 coins on the road. I would say it is impossible. so many people walk this read and the markets being efficient someone would have definitely picked it up.

But in reality, we do come across such instances. this shows that the markets are not as efficient as they seem to be further, if we assume that people make rational decisions to maximize profits then how do we explain people giving to charities or throwing a party to celebrate a birthday or an anniversary?

Definitely, this is not about maximizing profits by rational people.

here’s another example of how irrational we can be. the acronym Tips:- stand for To Insure prompt service

If TIPS ensures good service we should be tipping before the service starts. Yet, we give tips at the end of the meal. We even give tips when the service is substandard. (Stocks to Riches Chapter 4)

Tipping is more a custom, we do it mechanically unaware that we are behaving irrationally. yet, in economic theory we are rational beings always intent on maximizing our economic status. this is a common mistake we make without realizing its pure economic implications.”

after this, the author explains behavioral finance and why we react like this.

the author says, ” Behavioural finance researchers seek to bridge the gap between classical economics and psychology to explain how and why people and markets do what they do. Behavioral finance raises a couple of important issues for investors. the first is whether or not it is possible to systematically exploit irrational market behavior when it occurs.

The second issue is how to avoid making sub-optimal decisions as an investor. the goal is to close the gap between how we actually make decisions and how we should make decisions.

  • Hold on to stocks, that is crashing
  • Sell stocks that are rising
  • Ridiculously overdue and Underdue stocks
  • jump in late and buy stocks that have peaked in a rally just before the price declines.
  • Take desperate risks and gamble wildly when our stocks fall.
  • Avoid taking the reasonable risk of buying promising stocks, unless there is an absolutely ‘ assured ‘ profit.
  • Never find the right price to buy and sell stocks.
  • Prefer fixed income overstocks.
  • Buy when we have to sell and sell because others are selling.

then the author explains, how psychology plays a wonderful role.

the author says, ” Psychology can play a strategic role in the financial markets, a fact that is being increasingly recognized.

Students and proponents of behavioral finance create investment strategies that capitalize on irrational investor behavior. They seek to identify market conditions in which investors are likely to overreact or under react to new information,

These mistakes cause underpriced or overpriced securities. The goal of behavioral finance strategies is to invest in or disinvest from these securities before most investors recognize their error, and to benefit from the subsequent jump or fall in prices once they do.”

then lastly author gives the three sources of Alpha for superior performance.

i think you should read this in the book, for buying the book, visit the following link

 

so this is all about the Introduction of behavior finance, from chapter 4 of the book Stocks to riches.

Ways of Investing

Hello, friends in today’s article we see chapter 3 from the book, Stocks to riches. In this chapter, we learn three ways of investing. let’s see them one by one.

Previous Chapter

Three Ways of Investing:-

there are three ways by which an investor can invest to achieve superior results.

1) Intellectually Difficult

2) Physically difficult

3) Emotionally difficult

let’s see first is an Intellectually difficult path

The Intellectually Difficult Path:-

the author says, “An investor like Warren Buffett, Charlie Munger, John Templeton, and a few others have taken the intellectually difficult path of beating the markets. this path is pursued by those who have a profound understanding of investing can see future trends clearly, and can comprehend business and the environment. they know that Patience is a virtue and therefore take a long-term position.

We admire them but usually in retrospect initially, we may see them as being misguided but that is only because of our inability to grasp their point of view.”

then the author explains the method that helps this big investor to become big.

this method’s name is cashflow.

Those are big investors, they see how businesses work, their economic policies and market forces that affect the business environment, and how businesses show the cash flow. So this is the most difficult path, and it required a keen mind to study the different concepts of investing.

the author says, ” A good grasp of the various fields of management is required to understand the organizations and their ability to capitalize on various business opportunities. Good knowledge of the field of liberal analysis is basic to the development of various investment concepts.” (Ways of Investing)

then the author explains the name of the game in investing to get a superior return.

the author says, ” Here the name of the game is Patience. Such investors are always on the lookout for good opportunities and bargain prices. As long-term investors, they are willing to wait for them. they are not perturbed by events news rumors and gossip that create short-term volatilities.

They have a strong belief in their abilities since their goal is investing long-term for cashflows. As against capital gains, they are in no hurry to invest. They strongly believe that opportunities are always there but that when the biggest of them come, one must have the money to invest.

They are therefore very careful about allocating resources. They never buy on impulse. They can be out of the market for months, even years. they have the patience to wait till the right moment. Brokers usually do not like such investors as they do not churn their portfolios regularly.”

Then the author explains Intellectually investor qualities.

the author says,” Intellectually investors are also emotionally strong. that is the reason they are able to exercise such restraint.

we all want to be such investors but we cannot as we believe that we are not allowed intellectually blessed as they are. This is a wrong notion. the reason they are intellectually capable is that they work hard and make effort to reach that stage.

They constantly explore opportunities by talking with management, examining different viewpoints on business, trying to understand economic policies and their effect on business environments, etc.

their intellectual capability is derived from their hard work and their strong belief in the long-term approach to investments. Moreover, they use common sense in their judgments and are not swayed by rumors.” (Ways of Investing)

so these types of intellectual qualities you should practice to get a superior return.

then author talk about the second difficult  path is The physically difficult path,

The Physically Difficult Path:-

then the author explains, how we have to do work physically to get the proper investment opportunities, for that author gives the following explanation.

the author says, ” Most people are deeply involved in the physically difficult way of beating the market. they come early to the office and stay late. they do not know what their children are doing as they don’t have time for them.”

the author explains the whole things that regularly fund manager does each and every day of life. And this type of doing is the same as the other fund manager is doing.

then the author explains, why these people do this, and also gives their own experience on the physically difficult path.

the author says, ” In my experience, in the stock market dealing with fund managers has been really amusing. they sincerely believe that keeping themselves busy this way makes them look important and increases their ability to pick up the winners. Once I was at the office of a fund manager and we were chatting informally The telephone rang but he did not answer it. after a couple of rings, the call went to the answering machine. This is how most of them behave. show the world they are busy.”

then author explains how the day trader has also a physically difficult pathway.

the author says, ” the day traders also take the physically difficult path of investing. they spend the entire day collecting information and making decisions based on that information. (Ways of Investing)

so, with all the fund managers and the day trader trading the same path, how can any one of them achieve better results.?”

then author explains how good opportunities come, and what we have to do physically difficult path.

the author says, ” Good opportunities come once in a while and you spot them only when you are cool and have the time to think. The physically difficult path is based on the assumption that there are a lot of opportunities out there and you have to keep digging hard to be successful at investing. the current volatility in the market is the result of too many people trying to invest by this method.”

Life is simple. we make it complicated.

then the author explains the third difficult path and its most important and difficult path, if you master this way of investing then you are 90 percent ready to get a superior return.

The emotionally difficult Path:-

the author says, ” Most of us may find the intellectually and the physically difficult paths too daunting. In that case, we could opt for what is called the emotionally difficult path. Actually, this path is very straightforward. Simply work out, a long-term investment policy that is right for you and be committed to it.”

then the author explains how people think and act on the television news and rumors happening in newspapers, you can read, by ordering this book, link in below image.

after this author gives one example

the author says, ” If one were to compound money at a modest rate of seven percent the money would double at the end of 10 years and it would be 16 times at the end of 40 years.

Patience also helps you to control transaction costs. the more you churn your portfolio the more you pay the broker in terms of brokerage and of course the government in terms of taxes on your capital gains.

then you also have costs like depository charges, transactions tax, and service tax. all these costs would be avoided if one has Patience.

The emotionally difficult path requires an understanding of how our emotions guide our decision making especially when we deal with money. Our emotions directly affect our decisions on investments and expenditures.

We have to learn to think with our emotions rather than have our emotions do the thinking. understanding our own anomalies as also that of others will help us become better investors.” (Ways of Investing)

In the next fourth chapter, we will learn how to use our emotions to our benefit.

lastly, the author explains why is investing so difficult.

Why is investing so difficult:-

the author says, ” the most difficult part of investing is understanding the behavior of the stock markets. Market fluctuations are based on the varied opinions expressed by its participants, which in turn are subject to change commensurate with the changing sentiments of people.

it’s the crowd behavior that dominates the decision making and it is responsible for the sudden changes in the sentiments. take for instance.

The black Monday in May 2004. the markets lost around 700 points when the elections brought Congress to power.

What precipitated this huge fall? had anything gone drastically wrong with the performance of the companies whose stock prices crashed?

Definitely not. but the sentiments changed the BJP being voted out of power was a big change and normally we do not like changes.

Hence there was gloom all around and people dumped stocks as though there was no future. The herd mentality was at work and the markets crashed as each one wanted to get out faster than his neighbor.

If you were emotionally strong and you had bought when the others were panicking, you would have ended up making a huge fortune. (Ways of Investing)

But this seems easy only in hindsight. At that point in time going against the crowd is the most difficult but the most sensible thing to do. Understanding behavioral science is the key to success in this financial market. Its application not only helps you control your emotions but also helps you to understand others’ emotions and benefits from their mistakes.”

On emotion, Warren Buffett has a quote

“ If you can’t control your emotion, then you can’t control your Money”

so emotion is the main part of investing.

so this is all about the ways of investing from the book, ” Stocks to riches ” by Parag Parikh

Investment strategy:- Stocks to Riches Chapter 2

Hello friends, in today’s blog, we see Investment strategy from the book Stocks to riches chapter 2, this book was written by value investor Parag Parikh. so in this chapter 2, we see investment strategy and the difference between investment and speculation. so let’s see one by one strategy.

Previous Chapter 1

Investment Strategy: Investment and Speculation

Investment strategy:- Stocks to Riches Chapter 2

In this chapter, the author explains investment strategy and the difference between investment and speculation.

the author says, ” Investment strategy is the first issue that investors should consider. Investing is an act of faith, a willingness to postpone present consumption to save for the future, thus investing for the long term is central to the achievement of optimum returns for the investor.

there are two sources of returns in the stock markets:-

  1. Fundamentals are represented by earnings and dividends.
  2. Speculation is represented by the market’s valuation of these fundamentals.

then the author ( Parag Parikh) explains in detail above two sources of return.

the author says,” the first is reliable and sustainable over the long run; the second is dangerous and risky. these lessons of history are central to the understanding of investing. these two sources of return could be further classified into cash flow and capital gains.”

After this, the author explains what is Cash flow and how we have to consider ourselves.

Cash Flow concept:-Investment strategy:- Stocks to Riches Chapter 2

the author says, ” When one believes in the fundamentals of investing, one is looking at the dividend payout of the company. these arise from the company’s earning potential, and are possible, only when the company has a positive cash flow. this cash flow is a product of the fundamentals or inherent strength, of the company, the sustainability of the business, and the robustness of the business model.

along with that, there are other variables such as the quality of the management, competitive market position, core competencies, etc. Investing in such companies enables the investor to earn a regular income over many years.”

then, the author explains investment value.

the author says, ” the investment value of a stock is the present worth of all the dividends to be paid upon it. this is best explained by John Burr Williams, ” A stock is worth only what you get out of it. A stock derives its value from its dividends, A cow for her milk, a hen for her eggs, bees for their honey, and stocks for their dividends.”

then the author explain capital appreciation,

the author says, ” the capital appreciation that takes place is seen primarily from the angle of bonus and right shares, which in turn increase the shareholding leading to higher dividends. As a result, the shareholding cash flow is augmented.

The rise in stock price is secondary as there is no intention of selling for capital gain. It is only satisfying to know that one can cash in on such a huge appreciation in times of need.

When investors follow this cash flow model of fundamental Investing. it is always based on the premise that over a long period, the stock markets will go up irrespective of the turbulence.

For them, the bull and bear markets are part of the investment process. on the contrary, they wait for a bear market, as they are able to get bargains there is also a strong belief that equity investments are the best hedge against inflation.” (Investment strategy:- Stocks to Riches Chapter 2)

You all know, nowadays, there is huge inflation, so if you want to beat inflation, then equity investment is best.

then the author talks about the Capital Gain concepts, and what is the benefit of that, and how can we use them for our purpose or goal in life?

Capital Gains Concept:-

The author says, ” When a stock goes up in value and one sells it at a profit, that gain is known as a capital gain. When people buy stocks in the belief that the prices will go up and they will be able to make a profit, it is known as speculation.

the price of a stock listed on the stock markets reflects the value of the fundamental. Speculators bet on the market value of the fundamentals. Now there are traders and speculators who buy and sell stocks according to their perception of the correct price of the stock based on the fundamentals. Say a company like Colgate is quoted at a price of Rs. 145.

A trader may feel that according to the fundamentals of the company Rs. 145 is a low price and that the stock could go up so he would buy that stock at Rs. 145. when it goes up he makes a profit, which is his capital gain, if it goes down he makes a loss.

Stock price movements take place for a variety of reasons and the investor is vulnerable to a host of uncertainties yet he is willing to take the risk. Here people are not looking at the fundamentals of a company.

they are looking at the stock price going up because of probable factors, Such as the fortunes of the company changing, expectations of higher profits a technological breakthrough, etc. they buy and sell stocks on information or an opinion or a rumor. the idea is to benefit from a price movement.

the inherent gambling instinct in a human being is responsible for the huge turnover in this kind of speculation.

speculation perse is gambling. In the stock markets, the other name for speculation is trading. it gives some credibility to the process and also has a different tax treatment ( the basic difference between speculation and trading is that in the former no delivery of the stocks is taken and in trading, the delivery is effected.

The capital gains model is based on the premise that stock markets always witness bull and bear phases; one follows the other. For speculators and traders, the trick is to take advantage of the ups and downs of the market,

Volatile stock price movements excite them, they follow the short-term approach. They strongly believe that since markets always fluctuate, a long-term strategy is useless. In fact, during the tech boom, I interacted with some experts and fund managers who held the firm view that the old ways of investing were out as the rules of the game had changed. (Investment strategy:- Stocks to Riches Chapter 2)

To buttress their claim they cited the example of how warren Buffett missed the tech boom. today I know for sure that all of them are nursing their wounds, this is what short-term success does.”

then the author explains why warren Buffett missed the tech boom, and why they are so successful.

the author says, ” Warren Buffett’s success till date is due to the fact that he would refrain from buying business he did not understand. He would buy stocks that were quoting a discount to their intrinsic value, and he would buy businesses from which he could visualize sustainable earnings over the long term. As the tech stocks did not fit in with these conditions he stayed away from them.”

Then the author gives the case study of Infosys companies.

I think you should read this case study, by buying this book from the following link

then the author says ” let’s sum up, let’s take the example of a cattle farm and a dairy farm. In a cattle form, the asset is the cattle, cattle are bred and reared to yield good value when they are sold to the slaughterhouse. this is what is speculation and trading. You buy on the asset, wait till the price, Increase, then sell it off in the market for a profit. this is how capital gains investing works.

on the other hand in a dairy farm, the asset is also cattle, here too the cattle are bred and reared but they are not sold to the slaughterhouse. the cattle have long-term use, they are used to obtain a regular supply of milk.

In both cases, the asset is the same but it is used differently one for meat and the other for milk. similarly, in the investment world, some people used stocks for capital gains by trading while others use them. Stocks for cash flow by investing long term.”

then the author explains the law of the Farm

The Law of the Farm:-

Then the author explains how to make money in the stock market, by applying the simple law of the farm.

the author says, ” Stock market investing is all about managing the rewards associated with the risks undertaken. without risk, there is no return. Invest you must but before that, you must bear in mind the law of the farm. You reap what you sow but the crop is also subjected to the changing seasons. the seeds have to endure summer, rain, winter, and spring before it turns into full-blown tree. Stock market investments also work that way. there are no shortcuts if we invest in the right stocks with the right business model and fundamentals, over the long run we are assured of optimum returns. However, to do this requires patience and we have to go through the ups and downs but it is important to stay the course. (Investment strategy:- Stocks to Riches Chapter 2)

Getting carried away y the greed of quick returns ultimately destroys wealth as it does not conform to the law of nature. Many of us forget that nature and society are one.”

then the author gives the best strategy of investment.

The Best Investment Strategy:-

the author says, ” There is nothing wrong with speculation as such on the contrary it is beneficial in two ways, Firstly without speculation untested new companies like Infosys, Satyam, and in earlier times companies like Reliance, would never have been able to raise the necessary capital for expansion.

the tempting chance of a huge gain is the grease that lubricates the machinery of innovation.

Secondly, the risk is exchanged every time the stock is sold and bought, but it is never eliminated. when the buyer buys a stock. He takes the primary risk that the stock will go down.

However, speculating can go wrong if people.

  • Do not understand the difference between investing and speculating.
  • Speculate without the right knowledge and skill.
  • Speculate beyond their capacity to take a loss ( that is called margin trading.)
  • The Greatest problem today is that most investors are acquiring speculative habits believing that they are investing.
  • The Attraction of quick money and the advent of the futures market have lured them to margin trading. for a number of people, this has become a full-time occupation due to the advent of the internet and online trading. This could be bad news especially when they are dealing with their life savings. “

then the author explains the risk Reward ratios.

Risk-Reward Balance:-

the author says, ” the important thing to remember is that investing is all about risk and Reward and vice versa.

the investor needs, to select the right balance when choosing investment vehicles and the strategy.

During the IT sector boom, the stock prices of IT companies were going up by leaps and bounds and people were buying such stocks at any price thinking that the price would go up. There was no rationality as to the value and the price. People were thus only buying risk, there was no effort to balance the risk-reward ratio. (Investment strategy:- Stocks to Riches Chapter 2)

We all know the fate of various IT Investors when the markets crashed. In March 2003, when the Iraq war was on, the markets were vert down and some of the stocks were available at ridiculously low valuations. the dividend yield was also very high. the price to earnings (P/E) ratios was attractive. This was the time to invest in Good Stocks as one would be only buying reward and the risk would be minimal. The risk-reward ratio would be in the investors favor.”

so this is all about how much you take risks with companies fundamentals, not speculative manner, that gives the high rewards.

then the author explains long-term investment.

the author says, ” Here are certain facts which prove the point that long-term investment is very rewarding and that patience is a virtue in equity markets. Three companies ( and there are several others), that have given excellent long-term returns to investors who bought stocks over a decade ago and held on to them, are Hindustan lever, hero honda, and Infosys.

The Hindustan lever has given a compounded annual growth rate ( CAGR) of 21 percent in returns for the last 13 years, whereas hero honda, has given 41 percent CAGR to shareholders on their investments during the same period. Infosys has delivered an astounding 79 percent annual return to shareholders since its listing 11 years ago. All these figures include dividends. as we can see this is higher than the returns available in any other investment avenue like bonds or bank deposits. (Investment strategy:- Stocks to Riches Chapter 2)

However, this does not mean that these stocks have only gone one way that is upwards.

They have had pretty serious declines at various points in time but despite that, the long-term result from owning them has been impressive.

The Hindustan lever has been falling for the last two years, Infosys had a very sharp decline after the bursting of the bubble in technology stocks and Hero honda also fell significantly in early 2003 when its quarterly sales slowed down.

Short-Term investment can also be rewarding for the speculator who is able to take risks and time the markets. Take the case of a speculator who had bought Infosys, at Rs. 2000 when the market started moving up and sold it when it went to is 13,800 within a year and a half. He made tremendous gains and he laughed at the investor who hold on to the stock since the beginning and got a return of 79 percent CAGR.

a Speculator could have short sold Hindustan lever at Rs. 210 in November 2003 and recovered it at 4,120 in august 2004 making a return that even a long-term investor in Hindustan lever would envy.

Speculators do make a killing, as some would have definitely done during the various periods of the boom and the bust cycles. the only rider is, can they do it consistently over time! A lot of speculators could have made more money than the long-term investor on the above stocks.

So it is different to say which strategy is good and which is bad. It depends upon the individual’s mental attitude, discipline, risk-taking ability, and patience.

from the above paragraph, some points conclusively prove

  1. Long-term investing can be very rewarding if you buy the right company at the right price.
  2. a stock can decline significantly in the short run and yet give a decent long-term return.
  3. Short-term investing ( speculating) can also be very rewarding if you are able to time the markets and take advantage of short-term volatility.

 

As we can be seen from the above table even though the net profit of Infosys has grown it 43 percent CAGR, 2000-2004 the market capitalization has fallen by 14 percent CAGR in the same period.

This is the impact on investors when a good business is bought at irrational prices. the P/E ratio has continuously declined. (Investment strategy:- Stocks to Riches Chapter 2)

So if one had bought the stock at a higher price in 2000 he would be losing money in spite of the company showing improved performance, this is the risk one takes when one is speculating.

Most of the IT experts and fund managers ignored Benjamin graham’s words of warning. ” Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

In today’s changing times there is so much uncertainty that looking at the long-term approach seems unviable. Hence the stock markets have become the bedrock of brute speculation.

this is the reason for so much volatility. It is also turning long-term investors into short-term punters. this is how the investment world works today. If you want to be a successful investor there are three ways of investing Chapter 3 looks at the best way to invest.

so this is all about chapter 2 from the book Stocks to riches by Parag Parikh

If you want to earn a lot of money in the stock market, you must read this book. This is only of my favorite book, so when I was looking I am away from my value investing strategy, then I read this book, and again set my mindset as a value investor.

this book explains wonderful investment strategies, be read continuously.

Stocks to Riches Chapter 1 Summary

In this article, we see chapter 1 summary of the book Stocks to Riches by Parag Parikh. This is one of the books regarding the psychology of investing. Guy’s if you are haven’t read this book, then I highly recommend to you, order this book from the following link and read it. this is my all-time favorite book, and this book has only  110 pages. If you want to succeed in investing.

What is investing:-Stocks to Riches Chapter 1

Stocks to Riches Chapter 1

let’s start, chapter 1 investing, before that let’s talk about the author

Author’s profile:- Parag Parikh is the Founder Chairman of Parag Parikh Financial advisory services limited (PPFAS), Mumbai. Mr. Parikh Has over 25 years of experience in investing, broking, and advisory business. he regularly shares his insights through guest contributions in many of India’s leading financial publications such as the Economic Times, Business Standard, and DNA, through appearances on CNBC, NDTV Profit, Aaj Tak, and Star News, as well as by undertaking lectures at various investor and educational forums.

Mr. Parikh has a Masters in Commence from Mumbai University and is a Certified Financial Planner ( CFP) from the Financial Planning Standards Board Of India. He is an alumni of the Harvard Business School having successfully completed the prestigious Owner President Management Program. He has also attended the program on Investment Decisions and Behavioral Finance at the John F. Kennedy School of Government at Harvard. (Stocks to Riches Chapter 1)

A keen Believer in nurturing one’s physical, mental, emotional, and spiritual side, Mr. Parikh engages in Physical activities such as golf, reads extensively, and practices Vipassana regularly.

so this is the profile of the author

let’s start, chapter 1 investing.

The author ( Parag Parikh ) says, ” Investing is a challenging game and we were all into it at some time or the other the clearer we are about it, the more successful we will be at mastering it.”

Son:- Dad, give me some money, I want to invest in the stock market. All my college friends go to this broker who provides terminals where one can invest.

Dad:- Invest?

Son:- Yes, My friends make a lot of the money they buy stocks on the broker’s advice and when the prices rise, they sell and make a clean profit. (Stocks to Riches Chapter 1)

Dad:- Well, this is the age for you to study, get good grades so that you can get a good job that will secure your future, I don’t want you to get into speculating in stocks.

Daughter:- Dad, you have to give me some extra money this month, as I need to buy some gold jewellery. I will be getting married in a couple of years and I need to start building my jewellery collection now.

Mother:- Baby, look at yourself in the mirror. you are putting on so much weight if you want to look good wearing gold jewelry you require a good body. Why don’t you go to the gym for a regular workout instead of wasting your time watching Tv? it’s high time you start watching your figure if you want to get a good husband and settle down in life.

Daughter:- Oh mom, my boyfriend is a big investor he buys and sells commodities. he knows how to make money. We have decided to get married. you need not worry about my future.

Son:- Oh, So he is a commodity investor? Great! Dad, I talk to you it’s a great business. I want to be a stock investor. you don’t understand what a big thing investing is you can make a lot of money through it, See dad, you slag the whole day at your factor, become an investor and we will become rich.

Mother:- Children, your dad works, so hard at his factory, which is why we have a comfortable life. it’s wrong to run down your father, he choose to set up this factory, so what if he did not get into investing.

Son and Daughter:- But we can make big money through investing. Why should dad work so hard at the factory when this is a better option?

Mom:- I don’t want to get into this debate but I am happy to have inherited from my father some stocks and a real estate property. I get my regular dividends from my stocks and the rent from the property. why should I bother about investing?

Dad:- Well, I think I will go to sleep. I am really confused about this. Investing is a difficult subject good night.”

Then the author explains the above conversation. (Stocks to Riches Chapter 1)

the author says, ” In the above conversion no one understands ‘ Investing ‘. The son and the daughter talk about it but do not know what it exactly is.

Father has invested in the factory and asked his son to invest in his education, but he does not know about investing means either. the mother asks her daughter to invest in her body by exercising regularly. the daughter does not real investing Not commodity trading. the mother is a real investor in stocks and real estate. yet she does not know about it.”

After this, the author explains, what is investing?

the author says, ” Investing is a very exhaustive subject. It means different things to different people. At some point in time well all are investing in something. It may be relationships, It may be a marriage or a career.

Life is all about doing something to reap benefits in the future. so all of us are in the investment game. However, it means different things to different people.”

then the author gives examples of Investment.

People Invest in.

  • Large families so that when they grow old, their children can take care of them.
  • Land and crops, in order to fend for themselves and their families.
  • Small families, to provide a good standard of education ad living for their child.
  • their health, by exercising regularly and eating a balanced diet.
  • Charitable works, to serve the poor and the needy, and
  • An external asset like real estate, shares in listed companies, gold silver, etc, so that they can fall back upon them in tough times. (Stocks to Riches Chapter 1)

after this, the author says,” thus we have a lot of people doing different things in the name of investing. this makes the subject of investing very complex.”

then the author explains the different types of investment products.

Investment Products:-

the author says, ” these come in the form of stocks, bonds, mutual funds, real estate, precious metals, insurance, commodities, etc.”

then author explains how these products fulfill their purpose.

the author says,” the reason people choose one form or another is distinct as each is designed to satisfy a particular need.

  • Stocks offer dividends and capital appreciation.
  • Bonds are much safer than stocks and offer a safe return on the money invested.
  • Mutual funds may be seen as less risky than stocks.
  • Investment in real estate could be for capital appreciation, to earn rent, or for self-accommodation.
  • Insurance is used as security.
  • Precious metals like gold and silver appreciate over time and are therefore a good hedge against unforeseen political uncertainties.

thus, each investment product has different distinct characteristics and each is designed to satisfy a peculiar need. Each is designed to do something different. (Stocks to Riches Chapter 1)

After this long list of investment products. the author gives the investment procedure.

Investment procedure:-

the author says, ” there are three-technique methods or formulae for dealing the various investment products.

  • If one were to buy an investment product and hold it, then the procedure adopted is called going long.
  • If one were to sell an investment product and then buy it, the procedure adopted is called Going Short.
  • If one buys and then sells, the procedure adopted is called trading.

There have been various innovations in investment procedures by the introduction of the future and options market.l we have thus different procedures to speculate and hedge in the form of call options, put options, and futures. all these different types of procedures make the interactions of the financial market.”

After this procedure, the author explains Investor Classification.

Investor Classification:-

the author says, ”

  • A stock trader is one who uses the product stock and the procedure trading.
  • A long-term investor, on the other hand, used the product stock and the procedure of buying and holding long.
  • A short-sellers uses the same product stock and the procedure of selling and then buying back.
  • Similarly, a real estate speculator whose product is real estate adopts the procedure of speculation.
  • A collector of rare coins buys and holds long the product of rare coins. (Stocks to Riches Chapter 1)
  • A commodities futures trader adopts the procedure of the futures market to trade in commodities.
  • A stock options trader adopts the procedure of the futures market to trade in commodities.
  • A stock options trader adopts the procedure of hedging in the product of stocks.
  • A day trader uses the product stocks and the procedure of speculation.
  • A square is one who wants to hold over a long term by putting his money in the bank.

so thus, there are different types of people doing different things with the same investment products. Under the banner of Investing are people who are really gamblers, speculators, traders, hedgers, savers, dreamers, and losers.

after this, the author gives the wonderful investing plan and the difference between trading and investment.

If you want to read it, then buy this book from the following link.

Security Analysis: Chapter 15

Hello friends, in today’s article, we see a summary of chapter 15 of the Security Analysis book by Benjamin Graham and David Dodd. Chapter 15 is about the Technique of Selecting Preferred Stocks for Investment. so let’s see

Previous Chapter 14

The technique of Selecting Preferred Stocks for Investment:-Security Analysis: Chapter 15

In this chapter, the author explains, if we decide to buy the preferred stocks while seeing their disadvantages, so author gives some techniques to select preferred stocks.

The Author Says, ” For preferred stocks, we required to stringent the minimum requirement as compared to bond. So what is the minimum requirement for interest coverage ratio, this given in the following table (image)

Security Analysis Chapter 15

Now you can see, in three industry Segments

So for preferred stocks required more high multiple like in public utility is 1.75 of Fixed charges and for preferred stocks earning is 2 times of Fixed charges and Preferred stocks dividend.

Now Come for minimum stock Value requirement, in this also as compare bond and preferred stocks.

In this, you can see for preferred stocks required more. (Security Analysis: Chapter 15)

In public utilities, required 50% more than bond means 1/2 and for preferred stocks, 66.67% means 2/3 ( Bond + Preferred stocks equal)

So in this chapter 15, we discuss both tables and how to calculate this value.

 

How to calculate Rations?

The first thing is to use the method name is ” Total Deductions method“, for interest coverage ratio to compare with minimum coverage ratio.

So in this method, we have to divide earning by Bond interest + Preferred dividend.

In Bond, we only divide by bond interest but in this, we use both ( bond interest + Preferred dividend)

so some of you say, why not we use the prior deduction method,

Because, we know that, by using the prior deduction method

the result looks like Preferred stocks are more secure than Bond. so that’s why the author uses the total deduction method.

Let’s come in Stock Value Ratios

Security Analysis Chapter 15

For Bond, we use in the numerator, stocks equity( common stocks) and divided by funded debt( bonded debt).

For the preferred Stocks case, in the Numerator, We take only common stocks and in the denominator, we take bonded debt + Preferred stocks.

If Suppose You want the stock value ratio, for this preferred stocks are two type

1st Seniority preferred stocks

2nd Seniority preferred stocks

so for this type of preferred stock using the following method

  • If we want to calculate for 1st seniority preferred stocks Value ratio. so In 1st seniority of preferred stocks in the Nenomenator of equation presents 2nd seniority preferred stocks + common stocks and in the denominator, we can use Bonded debt + 1st preferred stocks. (Security Analysis: Chapter 15)

In Bond, we have to take face value, and 1st preferred stocks we have to take market value.

1st preferred stocks face value we can’t take, because, preferred stocks’ actual par value is different than the stated value.

for this, the author gives example to understand the above statement

e.g, The preferred stocks and this stated par value is $1 but those are preferred stocks holders, they have to get $100 for liquidating preferred stocks.

so the actual par value of that stock is $100, not $1. so for this, we have to use Market Value.

We can see tables(for referring above note page image) in that we say, for Preferred stocks the minimum requirement is more as compared to bonds.

So for seeing this formula, we know that, let’s take

The interest coverage ratio, in the numerator same ( EBIT- earning before interest tax) but in the bond case, we divided by fixed charges, and in the case of the preferred stock, we divided by fixed charges + preferred stocks dividend.

so those are preferred stock coverage is found less, because, we required maximum, as the author gives us

Let’s see in Public utility examples, for the preferred stocks the interest coverage ratio is 2 times. (as given in table by author)

Means, Interest coverage ratio = EBIT / Bond interest + preferred dividend.

            Interest Coverage ratio = 2

so, for Bond ( Interest coverage ratio = EBIT / Interest charges )

Now we surprise

so its value is more than 2 times because the denominator is small

If for preferred stocks is 2, so then bond interest coverage ratio is more than 2. obviously by math

So then the author says, ” Yes, the interest coverage ratio for the bond is more than 2, but people thinks, for preferred stocks coverage ratio is have to be lenient or less stringent, (Security Analysis: Chapter 15)

Because, preferred stocks coverage ratios denominator is more, so the value may be small,”

then Author says, This type of thinking is wrong.

Because, in any company have a bond and preferred stocks, and in this company preferred stocks is when safe, then this company bond is safer, with a good margin of safety.

If the bond is less safe then how are preferred stocks safe? ( common sense)

If the coverage ratio is minimum then this is only limited to bond coverage ratio, not for preferred stocks.

that’s why the author takes 2 times the interest coverage ratio for preferred stocks and for bonds only 1.75.

then the author talks about cumulative Issues and Non Cumulative issues

 

Non-cumulative stocks Issues/ cumulative Stock issues:-

Cumulative Stock issues:- Cumulative preferred stocks are those, in them, the dividend is suspended by the director, so this dividend is accumulated and this dividend is paid later.

But in Non-Cumulative Stock Issues:- In this, if the dividend is suspended, then they are not be recovered or accumulated. So those are new continued dividends, that are only given by the company.

That dividend is missed by the director, that dividend is gone forever.

Then the author says, ” Buying cumulative stocks is better than the Non-cumulative stocks.

Because, in non-cumulative stock problem is, those are common stockholder, they taking advantage, because, the director can suspend, your dividend. in those years also when companies earning is good, and this money is used by the director to improve the company. By this activity, the direct benefit to the common stockholder.

And Your dividend is missed by the company is not given in the next dividend time.

so there is not any benefit for non-cumulative stocks means full loss

On this Non-cumulative Preferred stocks lose, taking benefit by a company means on your expense, taking other profits. (Security Analysis: Chapter 15)

So those are company directors they play in trick, is that

Firstly they suspend your dividend and when they give a dividend to common stocks holder before some time that they give the dividend to the non-cumulative stockholder.

When a company wants to suspend its dividend, so for this they stop the first dividend of the common stockholder and some time after they stop the dividend of preferred stockholders also.

after this difference, the author talks about, ” those 21 preferred stocks, that do good in depression also.

Out of 440 listed stocks on NYSE in 1932, that on 21 stocks is doing good and perform well in depression with any loss.

So those are 440 listed stocks on NYSE in them only 40 (9%) are Non-cumulative preferred stocks.

By knowing this, you may be surprised, those are 21 stocks, that do good in depression, so in them,

the author gives 3 observations, they are as follows.

  1. The number of Non-cumulative issues was higher than cumulative issues, in those 21.
  2. No. of preferred stocks proceeded by bonds were higher than without bonds in those 21. ( as we discussed, in those company, that have only preferred stocks, that’s is good for the preferred stockholder.)
  3. The industry best represented is the snuff business, with three companies.”

(snuff business is a type of business of Tobacco)

So, the author says, ” Buy seeing the only result, we can’t say, non-cumulative stocks is superior.

or we can’t have to say, preferred stocks with the bond is better than, only preferred stocks companies.

or we can’t say, Snuff business is the safe business”

Logically the author says, ” This reverse is best means, the cumulative issue is better and preferred stocks without bond is better. (Security Analysis: Chapter 15)

But this result occurs, it only proves that if this thing does not matter most and maybe desirable but you become successful or not on this things, this observation not affect.

Then the author says, In conclusion

What matters most to success.

  1. Outstanding record of the company for a long period in past
  2. The strong inherent stability of the company
  3. Absence of concrete reason to expect substantial change for worse in the future.

so this is all about chapter 15 of the security Analysis book by Benjamin Graham and David Dodd.

Security Analysis:- Chapter 14

Hello friends, in this article, we see the chapter 14 summary of the book Security Analysis. Chapter 14 is all about the What is Preferred stocks, and their origin story, and also their advantage and disadvantage.

Previous Chapter 13

Preferred Stocks Analysis:-Security Analysis:- Chapter 14

Security Analysis Chapter 14

So, from this chapter, we discuss the only preferred stocks, and their Analysis based on the Advantages and Disadvantages of the Investor to buy that preferred stocks. let’s start

The author told, In The Intelligent Book also is that Preferred stocks are not Attractive Investment, it is Unattractive Investment.

The author says, ” Preferred stocks represent an Unattractive form of investment.”

so let’s find out why

Because 1st reason is that the Preferred stocks Principle and their income return is limited. whatever they told first is that amount only paid by the company.

and Second Reason the author told, is that Those are Preferred stocks holder, they don’t have any Claim on company. or in the author’s words is that ” Interest payment gets at any cost.”

and also Author says, ” Preferred stocks are the Limitations of Bond and Stocks Mixers, and Preferred stocks are more vulnerable than bond at the worst Condition of company.” (Security Analysis Chapter 14)

Because preferred stocks have a claim after Bond Holder.

 

What is the difference Between Bond and Preferred Stocks? (Security Analysis Chapter 14)

Ans:

The difference is that those are bond interest is compulsory to pay by the company, if the company is not paying, this type of company called a Defaulter.

Those are preferred stocks Dividend payment depends on the Board of directors of the Company, they pay or not pay.

If a company’s earnings are good and also make more than the preferred stock’s dividend, so usually preferred stock payment is done, but in this claiming point of preferred stocks looks unusefulness ( no benefited ).

If Companies Perform Bad and they generate very low earning, so bondholders have a claim on the Asset of the company, but they don’t have Practical value of that asset just like, we discussed in the bond Analysis series in all previous chapters. (Security Analysis Chapter 14)

Because, If the business fails, then properties value also fail, means decreases

so Investor think and they make the general rule, ” Bond instruments form is not have the special advantage as compare to preferred stocks. If the company is good then preferred stocks and bonds are also good. If the company is bad, then the bond is also bad.”

Read this again and think above two lines.

But the author says, ” this type of investor thinking is not good. Preferred stocks are weaker than Bonds.”

Because, bondholders get the money but those are directors of the company, they stop preferred stocks dividends.

why this happen

Because, if the company is capable, but they don’t pay preferred stocks dividend, and they give a reason like, that the Company has the good time in future, for that purpose they suspend the dividends of the preferred stocks. and say if the company grows, then you get the benefit also. for example, like, the company wants to expand.

that’s why they try to collect cash and save cash or in future any emergencies come, for that emergencies, they save the cash to deal with that problem. (Security Analysis Chapter 14)

so this happens with preferred stocks dividends.

so those are preferred stocks holder have the following types of conflict problem

Conflict of Interest come to Preferred stocks Holder:- Security Analysis Chapter 14

1 ) first is that what happens in the company I don’t care, I just want the continuous income.

2) Second is, If Company suspends the dividend, in the future, the company will perform well and become a great company.

and If the company uses the proper money of the holder of the preferred stock, then they get a good return on that money in the future.

so these two types of conflict of interest come to preferred stocks holder, and also a conflict of interest come between preferred stocks holder and commons stocks holder

Because, if companies director stops payment of preferred stocks dividend, then this money helps to build a company or grow the company.

so Because of this activity, common stocks holder get more benefits than the holder of the preferred stock

how this when, let’s see

When a company grows, then earing grows and share price is also growing so that’s benefit goes to the Common Stocks holder.

Preferred Stocks holders, not get the benefit of the company growth, because they get regular, whatever the dividend payment. This payment depends on what decides when we buy that preferred stocks.

So being great company, they don’t get benefit or advantage of that great company, as much as we see one side.

On the Other Side, The common Stocks Holder gets a benefit on earning and the preferred stockholder gets a benefit on companies expenses.

And also Board of Director of companies have also the conflict of Interest

Many times, they favor Common stocks holder, more than preferred stockholders, because they give the vote for the selection of companies’ board of directors. (Security Analysis Chapter 14)

Or In many times, the board of directors is not favored for common stocks holders, instead of that, they favor Management people.

Because, they get the salary, from the management. so many times, they don’t see the best interest of the common stockholder or preferred stocks holder, instead of that, they only see their own best interest.

Then the author says, ” this is the weakness of preferred stocks holder as compared to the bondholder.”

there is only one solution is that Preferred stocks holder has to be voting rights on the enterprise when the dividend is suspended by the director, then preferred stocks holder have to be immediately voting control to put money in the right place.

But practically is not happening. If in any company happen like this then preferred stockholder not take good advantage of that voting right.

So this thing of control also becomes useless.

Then after this author says, ” Yield or risk is not Commensurable.”

High Yield is not offset High risk

If you buy preferred stocks, and you have fear is that you will lose your principal amount and for this offer company give you a high dividend yield. so for this, they don’t offset.

What thing is offset is the thing is you have to get a good chance of principle profits, without losing it.

let’s see some qualifications of preferred stocks

Qualification of Preferred Stocks:

Here is one question come is that what criteria to buy preferred stocks

The author says, ” there are Three criteria for buying preferred stocks.”

1) Preferred stocks, have to fulfill the Minimum requirement of bonds

2) Exceed these minimum requirements by a margin to offset discretionary Feature of Dividend payment ( means those bonds minimum requirements, they have to exceed well with good margin)

Because we have those risks ( which risk) is the board of directors of the company can suspend our dividend payment, because, they have the power for this.

then author show, the 21 companies list, in those company have preferred stocks that were listed on New York Stock Exchange in 1932.

Between 21 companies only 5 companies perform well in depression also.

then, the author says, ” Sound Preferred stocks are not impossible things, but it is exceptional phenomena.”

exceptional because sound preferred stocks are the mistakes of the company. (Security Analysis Chapter 14)

Why mistake,

The mistake is, because, the company can issue bonds but they issue preferred stocks.

If they issued the bond, they get the Tax benefit, but on preferred stocks, they don’t get that benefit.

If preferred stocks perform well, then the company don’t get benefit from them, because the preferred stockholder is only benefited.

and on dividend company have to pay tax.

The author says, ” Issuing preferred stocks only benefits the company, because, they can stop any time dividend of preferred stocks.”

If the company is not suspending the dividend of preferred stocks, then the benefit is going to the holder of the preferred stock, because, company issues bonds but they issue preferred stocks and they don’t get tax benefits also.

Now some Investor says, Like that, We don’t agree with this, because the company is giving limited income to the preferred stocks and the company can invest properly money, that comes from by issuing preferred stocks and can get the better return on their investment ( that money come from by issuing preferred stocks). Whatever company pay to preferred stockholder on that basis company earn double profit. so this benefit gets the company.

But, the author tries to say is that ” the main purpose of preferred stocks is that company can suspend dividend at any time.”

So in this case, then the author is right.

Because in this case the only company is benefited

If the dividend suspends the loss goes to the preferred stockholder and if the dividend payments, then the company gets lost. (Security Analysis Chapter 14)

So if this type of Problem happen in preferred stocks, then why this is very much popular ( in 1940 before)

then the author says, ” just before the first world war, the majority preferred stocks is the industrial issues and they have speculative natures.”

Because they get discounted price than the par value. so profit possibility is moe and after that continue for 15 years got prosperity in the USA in 1920 on this basis preferred stocks give the awesome return.

On this basis, preferred stocks perform better than bonds, but actually, that is not.

Then the author talks about the study of the University of Michigan.

The University recently study ( 1940) and then, the author observes and prove that

Preferred stocks are without bond is better than preferred stocks with bond.

This means, If a company issue bond and preferred stocks and you buy preferred stocks of this company so this is not a wonderful idea, instead of that you can buy the preferred stocks of those company that don’t issue bonds.

When adverse development happens means depression/ recession comes, then company earnings decrease, so in that, if the company has issued the bond, then this bond gets benefited, than preferred stocks. so buy only those companies’ preferred stocks, they are not issued the bonds.

The other thing, the author observe from the Michigan university’s study is that preferred stocks stability depends on common stocks stability.

If common stocks decline then preferred stocks also decline.

then Author says,” is like, if Head’s come win common stocks, and if tail comes, preferred stocks lose.”

Why do common stocks holder win?

Because Heads means the good performance of the company and common stocks holder get unlimited capital gain.

And tail means, Company perform badly then preferred stocks also decline in values, as same as common stocks holder.

If Investor Analysis is good and they think in the future company give a multi-bagger return, then why do you buy preferred stocks instead that buying common stocks and participating in profit.

If the Investor is doubtful then buy the preferred stocks, why this doing is good

because they have to take risk of principle by buying Common stocks.

so they get lost, so they don’t have to do, at that point they get the good opportunity to principle profit.

so this is all about Chapter 14 of the Security Analysis book by Benjamin Graham and David Dodd.