The 100 minus age rule for equity allocation is a simple formula that suggests how much of your portfolio should be invested in stocks based on your age. According to this rule, you should subtract your age from 100 and invest that percentage of your portfolio in stocks. For example, if you are 30 years old, you should invest 70% (100-30) of your portfolio in stocks and the remaining 30% in bonds or other less risky assets. The idea behind this rule is that as you get older, you should reduce your exposure to riskier assets and increase your allocation to safer ones.

First things First - Understanding the term ‘Portfolio’

We often get confused with the term ‘Portfolio’ consisting of only  liquid assets like Fixed Deposits, Mutual funds, stocks, etc. However, portfolio means our entire networth which also include Real Estate and Gold, etc. Hence, whenever we use the ‘100 minus age’ formula for arriving at optimum Equity allocation, we should also consider other asset classes like Real Estate and Gold for arriving at the equity percentage allocation.

Why does the formula suggest higher Equity allocation at younger age and gradual reduction as we age?

The logic behind this formula is that younger investors have a longer time horizon and can afford to take more risk with their investments, while older investors have a shorter time horizon and need to preserve their capital and income. By gradually reducing the equity allocation as you age, you can lower the volatility and risk of your portfolio. 

The formula assumes that Equity is a higher risk asset class as compared to Real Estate, Debt or Gold due to Volatility. Accordingly, to avoid uncertainties at the time of retirement when we don't have any other source of income, allocation towards Equity is being reduced.

What are the drawbacks of using the 100 minus Age formula for Equity Allocation?

Misconception called Equity is Risky Asset

As I explained in my post How is Risk misunderstood, Volatility is not Risk. Volatility gets eliminated or mitigated if our investment horizon is more than 10 years. Why 10 years? It is because generally an economic boom and recession cycle lasts between 5 to 10 years. Accordingly a bull and bear market cycle is assumed to last between 5 to 10 years. 

Present retirement age is between 58 to 60 years. Present life expectancy in India is 70 years and has been increasing year on year. Accordingly, investment horizon after retirement will most likely be more than 10 years. Hence, Equity will no longer be a Risky investment as compared to Gold or Real Estate for this time horizon. 

Not taking Equity allocation is a bigger risk

As per this article on livemint, a list of how various asset classes have delivered in terms of returns in the last 10 years (2011-2020) are as under:

As can be observed, over the long term (i.e. 10 plus years), equity has beaten all other asset classes in terms of returns. Even in earlier periods also, Equity has beaten all other asset classes. Accordingly, by not investing in equity as we age, we are compromising on returns. 

Counterview

We often get a counterview quoting Nikkei 225’s poor performance over the past 30 years. 

Nikkei 225 is a stock market index based out of Japan. It  has not given any returns in the past 30 years. 

My response to this counterview is that India is not Japan. Japan has an aged population. India has a young population. Japanese economy became a developed economy by the 1990s. India is still a developing economy.  Further, India’s nominal GDP per capita was $1,940 in 2020. This was lower than many other developing and developed countries such as China ($10,484), Brazil ($6,450), South Africa ($4,980), Russia ($9,877), UK ($39,229), USA ($63,416), Germany ($45,466) and Japan ($35,291). Indian economy is still developing and there is still a long runway for growth for many years to come. 

Accordingly, equity performance of the Indian stock market is likely to outperform all other asset classes for multiple years to come. 

Small % difference in returns can lead to big difference in terminal corpus

While % difference in performance between Equity and FDs look small at a difference of only 4.5%. If we consider equity to continue generating long term returns of 13.2% vs FDs (debt) of 8.7%, then over a 20 years time horizon, corpus in equity will multiply 12X times and corpus in FDs multiply 5X times which turns out to be a very significant difference.  Hence avoiding equity allocation is a bigger risk.

What is the best strategy to withdraw a fixed amount of cash from our stock portfolio every month without losing too much value due to market fluctuations?

In Real Estate or Fixed Deposits (Debt), we can easily withdraw money on a monthly basis in the form of rental income or Interest. However, we often face the dilemma of whether we can withdraw from equity due to market fluctuations. Withdrawing money from portfolio is critical after retirement to meet our expenses as we will not have any other sources of income. 

The 4% withdrawal rule comes to our rescue. As per the 4% withdrawal rule, if we withdraw a maximum of 4% of our equity portfolio every year to meet our expenses after retirement, then the corpus will not get depleted even during bear market phase.It implies, we need to have a corpus of atleast 25 times our annual expenses at the time of our retirement to meet the 4% rule. Any amount less than that, then we need to avoid equity all together after retirement. 

A more conservative rule is the 2% withdrawal rule i.e. we need to have atleast 50 times our annual expenses as a retirement corpus..

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Brief history of evolution of machines

In 1997, IBM's supercomputer Deep Blue defeated the world chess champion Garry Kasparov in a six-game match. Deep Blue was a specialized machine that used hand-coded rules and brute-force search to evaluate millions of possible chess positions per second. The defeat of Kasparov was a landmark event, as it showed that machines could surpass human intelligence in complex domains such as chess. However, Deep Blue was not a general-purpose AI system, and it relied heavily on hand-coded rules and brute-force search. In the following decades with increase in computing power and amount of available digital data, AI research progressed rapidly, with advances in machine learning, natural language processing, computer vision, robotics, and other fields. AI systems became more capable of learning from data and discovering new strategies without human intervention.

In 2017, a new milestone was achieved when AlphaZero, a program developed by Google's DeepMind, taught itself to play chess (as well as Go and shogi) at a superhuman level by playing against itself millions of times. AlphaZero did not use any human knowledge or rules, but instead relied on a deep neural network and a reinforcement learning algorithm to learn from its own experience. AlphaZero demonstrated a novel and creative style of play that amazed chess experts and revealed new possibilities for the game. It also showed that AI could achieve general intelligence across multiple domains by using self-learning methods. The evolution of AI from Deep Blue to AlphaZero reflects the increasing autonomy and generality of AI systems, as well as the potential for AI to surpass human intelligence in more domains in the future.

ChatGPT which was made public in November 2022 is a conversational AI model developed by OpenAI that can generate natural and engaging text responses to any prompt. It is trained using reinforcement learning from human feedback and fine-tuned from a large and advanced language model. ChatGPT can answer questions, converse on various topics, and generate creative content. ChatGPT has amused the world with its impressive and surprising performance in natural language processing.

AI vs Humans in stock market investing

While AI is fast evolving and is surpassing human intelligence in various domains, in this post I can think of four drawbacks in AI when it comes to stock market investing:

Drawback 1 - Garbage in Garbage out

AI systems do not work on their own completely. Prompts are sets of instructions or guidelines that are used to guide AI systems in making decisions or performing tasks. They are designed to help the AI system understand what is expected of it, and how it should go about completing the task at hand. By crafting effective prompts, you can ensure that you get efficient outcomes from AI that meet your needs and expectations. Prompts are provided by Humans. Accordingly, AI can give effective output only if the prompt is effective. So, if the input given is garbage, then output will also be garbage.The efficiency of the AI model depends on the underlying Human working on it. 

The weakest link is the underlying human giving prompts. Accordingly, AI has to finally rely on human giving prompts for arriving at stock market investing strategies. Hence efficiency of the investing strategy depends on the human providing inputs.  

Drawback 2 - Whole is not greater than sum of parts

Conventional wisdom says that the whole is greater than the sum of its individual parts. For example it's difficult to break a bunch of sticks when tied together whereas the sticks can be broken easily individually. 

But in stock market investing, if the majority of the investors follow a similar strategy, then they will become the market and start representing the market. Returns earned will automatically become average returns. Instead to beat the market, we need to think unconventionally or take unpopular strategy. 

Even if an AI comes up with a strategy and becomes popular, then if the majority of the investors start investing in the strategy, then returns will automatically become average as they start representing the market. Market is a self correcting mechanism.

There is no single strategy which works for the majority of the investors. If it works, then it automatically becomes an average return earning strategy.

Whole is not greater than the sum of individual parts in the stock market. Instead, the whole is the average of individual parts. 

To beat the market, we need to remain small and not be big enough to represent the market. We need to follow the unconventional or least possible strategy.

Drawback 3 - AI is a black box

A strategy developed by AI is like a black box. Due to various reasons like complexity and uncertainty of the market, black swan events or sudden shocks, inaccurate data, etc, even if a strategy is developed by AI, we may not have confidence that the strategy will work.  Wealth creation through the stock market is not overnight and instead done over a period of 20 to 30 years of working life of a person. Generating returns in those 20 to 30 years is critical. Lacking confidence in an investment strategy will be a big deterrent. 

For example, Nikkei 225 (Japanese index) gave per year returns of 12.5% from 1961 to 1991. But from 1991 till 2023, it gave negative returns. An AI model trained on data provided between 1961 to 1991 could not have predicted the next 30 years outcome. 

COVID-19 is another example which disrupted the financials of various companies. An AI model trained on data between 2009 till 2019 could not have predicted the COVID-19 impact. 

Drawback 4 - AI works on feedback

AI works on feedback mechanisms. For example, Google search results work on feedback provided by users in the form of clicks i.e. whether we are clicking a link on the 10th page or the first page, etc. Similarly, Amazons recommendations for products works on feedback in the form of purchases made by user, searches done by user, etc. 

In stock market investing, what can be the feedback? 

• Backtesting models -  Back testing means testing a strategy on past data. Back testing may not work like we have seen in the case of Nekkei 225 or COVID-19. Testing on past data may not work in the stock market; there is no correlation with how the future pans out.

• Future performance of the strategy- Future performance of the AI strategy can be a feedback for AI. But how long does AI need to observe the future performance for? Should it be few months or should it be multiple years? Volatility dominates shorter tenor performances. Optimum tenor will be 10 years to mitigate volatility. After 10 years of feedback, if the strategy developed by AI did not generate market beating returns, then do we need to wait for another 10 years to improve the strategy?

We cannot rule out AI completely

While I highlighted some of the drawbacks of AI with regard to stock market investing. Investors can make more informed and efficient decisions using AI. AI can help in expediting their research and provide timely alerts/updates upon which investors can make a decisions. 

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If you try to find reasons for this fall by going through financial news, typical reasons you will find are startup funding winter, FIIs withdrawing money, tech layoffs, Adani impact, Banking crisis in USA, etc. 

In this post I'll try to explain this fall through volatility. Markets, unlike Gravity, move both up and down. These up and down movements are called Volatility. These up and down movements are temporary. Volatility gets magnified when we see the markets with a short time horizon like say a few months. Let's look at NIFTY chart for the past 10 years instead of 3 months as above.

The 10% fall in the past 3 months appears like a small blip in the 10 years chart of NIFTY. Overall NIFTY has multiplied nearly 3 times in this 10 years which is a CAGR of ~12%. The NIFTY chart appears like an upward trending line except for a few blips in between. 

The more the time horizon, the lesser the volatility as the up and down movements appear like small blips in a 10 year chart  instead of large movements in a 3 month chart. 

Is the volatility high at present?

We have an Index called INDIAVIX which measures short term volatility for a time horizon of 30 days. INDIAVIX is a short form for India Volatility Index. It is a volatility index based on the NIFTY Index Option prices. It measures the market's expectation of volatility over the next 30 days. Higher the INDIAVIX values, higher the expected volatility and vice-versa.

INDIAVIX is presently at 14.8 levels which is nearly the average levels since 2011. Hence, present volatility is at all time average levels.

If you look at the INDIAVIX chart, you might have observed a steep spike in 2020. Volatility during COVID-19 crisis was high during the steep fall in March 2020. You can observe the same by looking at below charts of NIFTY and INDIAVIX.

During the volatility spike in 2020, NIFTY fell steeply by nearly 40% in March 2020. NIFTY again started increasing subsequently.

As explained above, INDIAVIX measures volatility only for a short time horizon of 30 days due to which there is a spike in March 2020 as the NIFTY fell by nearly 40% in a span of 30 days.  However, Volatility reduces with increase in time horizon as these up and down movements appear like small blips. We unfortunately do not have an index to measure volatility for longer time horizons. 

Tools at our disposal to beat volatility

Following are 2 tools at our disposal to beat volatility

• Time Horizon: As explained above, higher the time horizon, lower the volatility

• Systematic Investment Plan (SIP): SIP ensures that we invest during both up and down movements thereby mitigating volatility.

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Signature Bank with balance sheet size of USD 100 Billion was the next to fall on Sunday, March 12th, ranking as the third-largest bank failure in U.S. history. Signature had a cryptocurrency business. While Signature didn’t have loans backed by cryptocurrencies or hold cryptocurrencies on its balance sheet, it had a payment platform for processing crypto transactions. But deposits associated with the crypto platform had been dropping, with the fall in crypto prices in the last one year. While this was not a big concern, collapse of SVB led to Bank run on Signature also which led to its collapse.

What Makes Banks Fail?

A Bank’s business model typically involves taking money in the form of deposits and giving the same in the form of loans to the public. Business model of a Bank is by default fragile as a Bank has an obligation to payback majority of liabilities as and when demanded. These liabilities are in the form of deposits from the public. More obligations means more fragility in the business model.

Both SVB and Signature Banks collapsed due to Bank run i.e. majority of depositors of these Banks have demanded for their money. 

While a business model of a Bank is fragile, Banks at the same time are critical for an economy as they mobilize capital from depositors and lend the same to Borrowers which is in turn is  deployed for setting up new businesses, capex, etc which in turn contribute for employment generation, economic development, etc. The other alternative to saving money in a Bank is keeping money in a safe locker which was the norm many decades ago. Money in a safe locker does not contribute to the economy. 

To build trust in the Banking system, Governments & Central Banks across the world introduce various measures. For example FDIC insures deposits upto USD 2,50,000 in USA i.e. depositors receive back money upto USD 2,50,000 even if a Bank collapses. Similarly, in India,  Deposit Insurance and Credit Guarantee Corporation (DICGC), which is a fully owned subsidiary of the Reserve Bank of India, insures deposits upto Rs 5 lakhs per depositor. 

Apart from Bank run, there are other risks which a Bank faces. Some of these are:

Credit risk:

As explained above, a Bank takes money from depositors and lend the same to various Borrowers. What if Borrowers do not pay back the money? Then a Bank will not be able to pay back depositors. To mitigate this, a Bank needs to maintain % of liabilities in the form of Equity Capital. Equity Capital is shareholders money and is a lability which a Bank is not obligated to pay back unlike depositors money. The minimum capital to be maintained depends on the riskiness of the lending i.e. if a Bank lends to risky borrowers, then the capital requirements increase. Further, RBI mandates Banks to invest part of depositors money in safe instruments like SLR and CRR.

Market Risk:

A Bank takes money from depositors at a lower interest rate say 4% and lends to borrowers at a higher interest rate of say 6%. The difference of 2% is the profit earned by a Bank. The collapse of SVB started due to loss incurred in its long term bonds due to an abrupt increase in interest rate by the Federal Reserve. To mitigate this risk, RBI introduced MCLR linked lending and Repo linked lending which better manages this risk as compared to earlier benchmark rates of Base rate or PLR based lending. 

Operational Risk:

Loss incurred by PNB due to Nirav Modi fraud is primarily an operational risk. Details can be found in this economic times article How Nirav Modi cheated PNB of Rs 14,000 crore through fraudulent LoUs. Other forms of operational risk are accidentally sending Rs 10 Crs instead of Rs 1 Cr requested by the customer due to manual entry error. Each Bank continuously works towards identifying and mitigating such risks. Central Banks regularly audit Banks to identify such risks.

ALM Risk:

A depositor generally opens a deposit for 1 to 2 years. Whereas a Borrower takes a loan for 5 to 7 years. Further, a depositor might deposit only Rs 1 to 2 lakhs whereas a borrower might take a loan of few Crores, This mismatch is ALM risk. Banks have dedicated teams to monitor and mitigate this risk. 

Investors Point of View

Even if we are aware of these various risks, the difficulty an investor faces is that these risks cannot be easily identified/measured by analyzing financial statements of a Bank. SVB and Signature Banks had Buy ratings by the majority of equity analysts prior to both Bank’s collapsing. 

While many Banks have been wealth creators for their shareholders and many Banks will continue to be wealth creators, an investor should be aware that there are always unmeasurable risks involved.

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Q1 Is inflation friend of equity and enemy of debt?

Inflation can have both positive and negative effects on equity and debt. Inflation is the general increase in prices and fall in the purchasing value of money. As prices rise, the value of money falls, which can lead to a decrease in the value of fixed-income investments such as bonds. This can make inflation an "enemy" of debt, as investors may see a decrease in the value of their investments.

On the other hand, inflation can also have a positive effect on equity investments. As prices rise, the value of a company's assets and earnings may also increase, which can lead to an increase in the value of its stock. In this way, inflation can be a "friend" of equity, as it can lead to an increase in the value of stock investments.

It's important to note that the effects of inflation on equity and debt can vary depending on the specific circumstances and the overall state of the economy.

Q2 Can you give me examples of inflation being friend of equity investments?

As I mentioned earlier, inflation can have a positive effect on equity investments in certain circumstances. For example, if a company's assets and earnings increase due to rising prices, the value of its stock may also increase. This can lead to higher returns for investors who hold the company's stock.

Additionally, if inflation is expected to increase in the future, investors may be more inclined to invest in stocks rather than in fixed-income investments such as bonds. This is because stocks are generally considered to be more capable of providing protection against inflation than bonds.

Q3 Wont discount rate increase with inflation thereby reducing value of equity investments?

It is true that an increase in the discount rate, which is the interest rate used to determine the present value of future cash flows, can reduce the value of equity investments. However, it's important to note that the relationship between inflation and the discount rate is not always straightforward.

In general, the discount rate is determined by a variety of factors, including the expected rate of return on investments and the level of risk associated with those investments. Inflation is one of many factors that can affect the discount rate. However, other factors such as the overall state of the economy and the expected future performance of the company may also play a role.

Therefore, it's not always the case that an increase in inflation will lead to an increase in the discount rate and a decrease in the value of equity investments.

Q4 Wont federal government increase interest rates with increase in inflation thereby increase in value of debt investments?

It is true that the federal government can increase interest rates in response to rising inflation. When inflation increases, the value of money decreases, which can lead to a decrease in the purchasing power of consumers. To combat this, the government may increase interest rates to make it more attractive for people to save their money instead of spending it. This can help to slow the rate of inflation and protect the purchasing power of consumers.

However, it's important to note that the relationship between interest rates and inflation is not always straightforward. The Federal Reserve, which is the central bank of the United States, sets the interest rates and uses a variety of tools and policies to manage the economy. Inflation is just one of many factors that the Federal Reserve considers when determining the appropriate level of interest rates.

Therefore, it's not always the case that an increase in inflation will automatically lead to an increase in interest rates and a corresponding increase in the value of debt investments.

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Newton's first law i.e. Law of Inertia states that 

“An object at rest remains at rest, or if in motion, remains in motion at a constant velocity unless acted on by a net external force”

In this post, I will try to explain how the stock market follows the Law of Inertia.

Below is the comparison of 2 companies. Let’s call them Company A and Company B

Both the companies are in the same industry/sector. Management of both companies have shown consistent performance in the many years including the last 5 years which is evident from Sales growth of approx 50% (which includes 2 years of COVID impact).

From the above parameters we can safely assume that Company B can be easily valued atleast 3 times that of Company A.

In the above example, Company A is actually Eicher Motors and Company B is Bajaj Auto Limited. Unlike our expectation of Company B being valued atleast 3 times that of Company A, both the company are valued nearly the same.

Both the companies are primarily into 2 wheelers. Both Rajiv Bajaj, MD of Bajaj Auto and Sidhartha Lal, MD of Eicher Motors have shown exceptional management skills in the past many years. Then why is the market giving both the companies similar valuations when the size of Bajaj Auto is 3 times Eicher Motors?

This anomaly can be explained by going back further 5 years i.e. from 2011 to 2017.

The profits of Eicher Motors grew at a scorching pace during the period 2011 to 2017 as compared to that of Bajaj Auto. However, growth of Bajaj Auto and Eicher Motors remained at similar pace during 2017 to 2022.

Due to this the share price of Bajaj Auto grew gradually during the last 10 years 

Whereas share price of Eicher Motors skyrocketed from 2014 to 2017 and then remained flat from 2017 to 2022.

Market still expects Eicher Motors to repeat its high growth performance achieved during 2011 to 2017 as compared to Bajaj Auto even after 5 years. This is the law of inertia into play.

However, the exceptional performance of Eicher Motors achieved during 2011 to 2017 is primarily due to the growth/creation of the premium bike segment wherein Eicher had an edge as it is an existing entrant and capitalised the segment growth. Now Eicher has no longer the edge as it is in a similar mature market as Bajaj Auto. The same is evident from performance during 2017 to 2022.

So while Bajaj Auto should have been valued 3 times Eicher Motors, both companies are instead being given similar valuations.

Conclusion

Market shows inertia in correcting valuations of a company, be it undervaluation or overvaluation. If we can enter an undervalued company and accumulate through SIPs during this inertia period, then we can achieve a high overall CAGR when the market corrects the valuations. Market took time to realise the growth of Eicher Motors due to which price started rising from 2014 when growth started a few years earlier i.e. from 2008. So period of 2008 to 2014 is inertia period.

During the correction period also the market tends to show inertia due to which valuations reach the overvaluation zone from the undervaluation zone. This is what happened with Eicher Motors from 2014 to 2017.

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Meaning of this proverb is that everyone will have good luck or success at some point in their lives. As you can observe, I have highlighted the words “at some point”. It implies that the timeline is uncertain. While it is sure that there will be good luck, when will this good luck or success embrace is the question. Similar phrase in the stock market is “Timing the market is difficult”. I am a staunch believer of this. I really dont know when the next bull market comes or when the share price of the company I invest in increases. 

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Only way to overcome this uncertainty in timeline is to buy time. We can buy time in 4 different ways. 

1.) Personal Level:

We should only invest in the stock market the money that we don't need at least for next 10 years. Timeline of 10 years is because generally one  economic recession and boom cycle comes every 5 to 10 years. Hence there are high chances of good luck or  success embracing us in the stock market within a span of 10 years. By committing to invest at least for a time horizon of 10 years, we can overcome the time uncertainty to an extent. 

2.) Company:

Invest in companies which have high chances of survival. 

We can use the Waterline principle instituted by Wilbert L Bill Gore to identify companies which have high chances of survival. 

Gore compared the level of allowable risk to the waterline on a boat.

Risks above the waterline wouldn’t sink the boat. If a decision goes bad and produces a hole in the side of the boat above the waterline, you can fix the hole, learn from the experience, and carry on.

Risks that fell below the waterline, in contrast, can blow a hole that can sink the boat.

While the above principle is for risk tolerance in decision making, If we can re-imagine a company as a Boat. Then if say 90% of a boat is below the waterline, then it is very easy for a hole to hit below the waterline. Such companies are risky and have a very low chance of survival. On the other hand, if only 10% of a boat is below the waterline, then it is very difficult for a hole to hit below the waterline. Such companies have high chances of survival. 

For example, Wonderla Holidays could easily overcome COVID-19 impact and generate lifetime high profits in Q1-2023 as it is like a boat which is only 10% below waterline. On the other hand, PVR is under process of being merged with Inox which might not have materialized if COVID-19 had not happened.

Companies with high levels of leverage and weak moat are like boats which are 90% below the waterline. We need to try to avoid investing in such companies and instead invest in companies which are like boats with less than 10% below the waterline. Such companies have negligible debt and strong moat.

3.) Management:

Finding companies which are floating 90% above the waterline is job half done. We also need a captain who ensures that the company remains 90% above waterline in the future as well. That is why I like promoters or management who hate to take debt and who are also keen to take multiple small bets instead of one large bet. In other words, management of the companies should have similar risk tolerance.

4.) SIP:

Doing an SIP in companies ensures that our entry valuation is not at high levels. It gets averaged down through SIP as we enter the company at different time horizons.

Remember, every dog has its day. If all the above 4 points are meticulously followed, then there will come a day when the company we invested in gives us good returns.

Rule number 2: All eggs in one basket

We are taught not to invest all our savings in one investment vehicle and are often advised to diversify. This is because, if all eggs are put in one basket and if the basket falls, then all our eggs break in one go. To mitigate this risk, we often diversify. 

What if we are forced to put all eggs in one basket? Then to mitigate the risk, we may cover the basket with bubble wrap. Put the contents in a carton box filled with grass. Write fragile on the box. Basically we try to take various precautions to ensure that the basket does not fall and eggs do not break even if the basket falls.

While diversification is a good tool to mitigate concentration risk, we should not become complacent while diversifying. 

Even though we are diversifying, we should think as if we are putting all eggs in one basket while choosing each and every investment idea. To put it in another words, for every investment idea we choose to invest in, we need to ask ourselves, are we ready to bet our networth on the same?

Rule number 3: Not see the forest for the trees

Not see the forest for the trees means being unable to get a general undertanding of a situation because you are too worried about the details.

We need to filter out news we consume so that we can see forest for the trees. I keep asking myself the question “Will this news article be relevant even after 10 years?” to help me filter out all the noise prevailing in the media. This helps in focussing on the big picture and not getting worried about the minute details.

As a thought experiment, try to pick a 10 year old newspaper and read the same. You will realise how irrelevant the majority of the articles are. 

Rule number 4: Fear of missing out - FOMO

We often face the mental pressure of missing out on an investment idea where others have invested and made good money out of the same. This phenomenon is called FOMO - Fear of missing out. 

To avoid this situation, we need to understand the difference between error of omission and error commission. 

Error of omission is where we missed out an investment idea and it pans out to have given very good returns. 

Error of commission is where we invested in an idea and it turned out to be a dud. 

Error of commission is more dangerous than error of omission. Its forgivable to commit an error of omission but not at all ok to commit an error of commission. 

As Warren Buffet once said “Return of the money is more important than return on money”.

If we focus on the return of our money, then return on money will automatically follow. Hence, we can focus on avoiding the error of commission by making peace with the error of omission and overcoming the fear of missing out.

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Higher the Risk, higher the return

Risk in the above term is defined as volatility of returns. Volatility is further defined as the degree of variation. For example, a Fixed Deposit in a Bank is considered low volatility because returns i.e. interest earned on Fixed deposit (FD) has low degree of variation. In the last 25 years, the lowest 1 year FD rate is in the year 2004 which is 4.6% vs highest rate which is in the year 1996 which is 12%. The degree of change of rate of interest in the past is very low due to which we assume that FDs have low volatility i.e. low risk. If we had invested Rs 1,00,000/-  in 1 year FD, then at the end of the year, we might have ended up in the range of Rs 1,04,600/- to Rs 1,12,000/-. Hence, the maximum return we could have earned is Rs 12,000/- and lowest return is Rs 4,600/-.

Whereas, the volatility of returns in the stock market is very high. In the last 25 years, the lowest annual return in NIFTY is in 2008 which is -ve 50% vs highest annual return is in 2009 which is +ve 75%. The degree of variation of returns is very high due to which we consider the stock market as high volatility i.e. high risk. If we had invested Rs 1,00,000/-  in NIFTY, then at the end of the year, we might have ended up in the range of 50,000/- to Rs 1,75,000/-. Hence, the maximum return we could have earned is Rs 75,000/- and maximum loss is Rs 50,000/-.

FD is a low risk investment in which we could earn a maximum return of Rs 12,000/- in a year. stock market is a high risk investment in which we could have earned a maximum return of Rs 75,000/- in a year.

This explains the phrase “Higher the risk, higher the return”

How is “Risk” misunderstood

There is actually another definition of “Risk” which is more relevant while taking an investing decision. This second definition of Risk is “Probability of loss”. 

What is the probability of loss in an FD? At first glance, the probability of loss in an FD might appear to be Zero. But, actually, we might lose money in an FD in the following scenarios:

1. The Bank in which we open FD goes bankrupt. - Yes Bank saga: Rs 8415 Crs at stake, will AT1 bon holders ever get their money back? AT1 bond holders of Yes Bank, which was sold as Super FD, have not got their money back. 

2. While the gross return on an FD is interest earned. The net or real return on a FD is interest minus inflation. - How FDs give a negative rate of return. Hence, we can actually earn a negative real return on FDs thereby incurring loss.

3. Interest rate on FD is negative - Negative interest rates explained. In 2014, the European Central Bank (ECB) was the first central bank to adopt a negative interest rate policy, to address the eurozone crisis. The Bank of Japan (BoJ) has been fighting deflation for two decades. It was the first central bank to move to a zero interest policy in 1999, and its key rate has been negative since 2016. Neither the BoJ nor the ECB have been able to move rates back into positive territory.

What is the probability of loss in the stock market? If we go by annual returns of NIFTY, then NIFTY has given negative annual returns in 5 out of the last 25 years. If we instead look at 10 year returns of NIFTY, then it had always given positive returns. Hence, Risk is Zero in the stock market if viewed from a longer term perspective of say more than 10 years. NIFTY has multiplied 17 times in the past 25 years (from 1107 points in 1996 to 17354 points as of Dec 31, 2021) which translates to 12% CAGR.

Whereas the 1 year interest rates on FD fluctuated between 4% to 12% per year. If we adjust the same for inflation, then real returns are much lower. As we have seen, Risk on FD is not Zero.

Hence, by redefining the term Risk, the phrase gets modified as “Lower the Risk, Higher the return”

Lower the Risk, Higher the return

Instead of focusing on volatility, we should instead focus on reducing probability of loss. How do we reduce the probability of loss? There are multiple tools/ways to reduce Risk i.e. the probability of loss in the stock market. Few such tools/ways are explained below:

Time Horizon

As discussed earlier in this post, the probability of loss in the stock market reduces with an increase in time horizon. The longer the tenure of investment in the stock market, the lower the probability of loss.

Diversification

Instead of buying shares of a single company, we can diversify our portfolio, by investing in multiple companies. Negative returns in few companies can be compensated by positive returns in other companies in the portfolio.

We can also think of diversification in terms of time. SIP is a tool for diversifying over time. Market is sometimes undervalued (i.e. bear market) and sometimes overvalued (i.e. bull market). With SIP, we are effectively entering the market at average valuations thereby reducing the probability of loss.

Investing in companies with Zero or near zero debt

Oftentimes, the share price of a company deteriorates if the company goes bankrupt. If a company does not owe any external money (i.e. company with zero or near zero debt), then the chances of a company going bankrupt is also very low.

Investing in companies with Strong Moat or in other words sustainable competitive advantage

If the chances of revenues and profits deteriorating in a company is low, then the chances of share price decreasing also reduces. Companies with strong moat/ sustainable competitive advantages can withstand various external factors to retain their revenue and profit margins.

For example, key raw material for Asian Paints is derived from Crude oil. The company can easily pass on the increase in crude prices to customers by increasing the prices of their products without having any impact on their profit margins or revenues.

Try to avoid investing in companies with shady Management

Oftentimes, returns in a company are compromised, if Management of the company finds ways to not share the earnings of the company with minority shareholders. There are multiple examples where investors lost money by investing in companies with shady management. For example Hinduja Global Solutions hits 20% lower circuit as lower-than-expected dividend disappoints investors

Try to avoid investing in companies which are overvalued 

While it is difficult to arrive at the accurate valuation of a company, it is instead relatively easier to identify whether a company is overvalued or undervalued with higher probability. We need to try to invest in companies which are undervalued and try to avoid investing in companies which are overvalued.

For example, the share price of Reliance Industries Limited remained constant at around Rs 500 per share from 2009 till 2017.

But during this period revenues increased by 50% and Profit before tax increased by 40%. Apart from growth in revenue and profits from its core business, the company  also invested nearly Rs 1.5 lakh Crores in Jio till 2016 which was yet to contribute to revenues and profits of the company by 2017. Jio started earning significant revenue and profits for the company post 2017. 

Despite increase in revenue and profits from 2009 to 2017 and also potential future earnings from investments in Jio, the share price remained constant at Rs 500 per share from 2009 till 2017. The share price subsequently multiplied to nearly 5 times by 2022 from 2017 levels. Trying to invest in companies which are undervalued and avoiding companies which are overvalued reduces probability of loss.

Conclusion

Going to war without shield, sword or training is a high risk situation. Likely returns are low from the same. Whereas, going to war with proper weapons, armory, training and strategy is a low risk and high return situation. Time Horizon, Diversification, SIP, zero debt companies, good management, etc are like sword and shield before entering a war called the stock market.

Trying to understand the definition of risk is the first step in the investment journey.

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