The Chaos theory of Investing

Publication: The Times Of India Mumbai; Date: Mar 4, 2008; Section: Your Money; Page: 41
Is a vast and complex portfolio—with incalculable risk—worth it if you can’t predict the outcome?
JAI MEHTA is an astute fellow. This 58-year old metal scrap trader comes from a modest background, and is humble in his daily dealings with people from all walks of life. But, as I found out, he was capable of surprising pigheadedness when it came to investing decisions—those were based on what had worked for him in the past, rather than onsound principles of investing or market fundamentals. Nothing you could say would get him to budge.
He had made a killing on a few stocks recommended by his broker, and was convinced the bull run would continue forever. The sincerity of his belief is obvious from the fact that he added several thousand shares of a particular stock at ridiculous prices, thinking it had potential to rise even further.

When we were discussing his previous investing experiences, I asked him, “Have you lost money before? If so, what lessons would you say you learnt?” I got an interesting reply. Jai said, “I’ve lost a lot of money in the past, because of the tips I received.” Now, you may think that if this happened several times, it simply meant he was making the same mistake over and over. But that was not his whole reply; the interesting part is this: “Now I sell every stock based on the profits I’ve made, and I bring my cost down to zero.” I happen to think this is a good strategy, and I said as much. But it only described about half of what Jai did that was right. For the rest, he still relied on tips, sometimes buying a stock at an atrociously high price. He would continue to buy as the stock’s price rose, although at some point, he would take out the original money he invested.
However,he would still keep buying the stock, now using only the profit on the initial investment. But by this time, he was buying really high, and expecting the price to go even higher. If it crashed, he wouldn’t lose his original capital, since he had withdrawn that already. But he still risked losing a lot of his profit. The “tip” may have worked earlier, but it made less and less sense at increasingly absurd prices. My mind boggled when I saw over 100 stocks and two dozen mutual funds in his portfolio. I said, “There seem to be a lot of duds here. Many deserve to be thrown out posthaste. Why did you buy them?” I should have saved my breath—he replied, “I bought them on tips.” After scanning every stock, I concluded that almost 80% of his portfolio was tip-based. Also, he had just purchased power stocks, including Reliance Energy at Rs 2,500, on a tip that before RPower listed, Reliance Energy would deliver a return of at least 30%. I pointed out that his portfolio, heavily biased in favour of real estate and
mid- and small-cap stocks, needed more large caps and debt. But he wanted to see growth. “I can do better than 15-20% returns. And when my stocks are earning that in a matter of days, why should I waste time with debt and largecap stocks!” Now, something seemed profoundly wrong with his reasoning, but I thought it wouldn’t help if I simply said so. He would flourish his trump card of high returns, and even hours of reasoning would probably not induce him to see things from my perspective.
At the risk of losing a client, I persevered. In the process, I learned that his stockbroker brother-in-law, his portfolio manager, and his banker, were all making outlandish promises of 30-40% returns. As a result, he had come to regard that range as some sort of benchmark for returns.
Jai had around 65% of his money in equities, 30% in real estate, 2% in debt, and 2% in cash. I suggested he liquidate around 60 stocks to start with, in the next few weeks, and later get rid of another 40 stocks. Jai’s goals, like most other people’s, were simple. Firstly, he wanted to ensure a posttax retirement income of Rs 2 lakh per
month. He plans to retire in another three or four years. Secondly, he wanted to set aside Rs 2 crore for his daughter Sita’s marriage. And thirdly, he wanted to plan an overseas trip to visit his son Nirav, who lives in the United States.
An assessment of his goals, cash flow and net worth statements, insurance policies, investments, and tax returns revealed a number of things.
Assessment
Firstly, Jai’s business brought in a good income. He had no liabilities other than some short-term debt. But he was investing haphazardly.
Secondly, his equity portfolio consisted of three unitlinked insurance plans (ULIPs), 25 mutual fund schemes, 140 stocks, and two portfolio management schemes (PMS). The ULIPs, which had cost him between 30-71% in the first year, were barely breaking even, or had just turned positive. Many of his mutual fund investments were in similar schemes. There were also many redundancies in his stock and PMS holdings. His exposure to mid- and small caps was around 85%, and large caps, 15%.
Thirdly, debt exposure was limited. He had money in the Public Provident Fund through several accounts, some endowment policies that generated around 4-5% returns a year, and in fixed deposits.
Fourthly, he owned some real estate properties still under construction. He was hoping to sell in a few months. He apparently thought of real estate as something to buy, sell, and shuffle, not unlike IPOs.
We discussed how the real estate cycle works, and how it can hurt an investor. Real estate prices in India are very high today. Yet many people feel they can buy now, and sell at a whopping profit to some greater fool. Consider the situation in 1995, when the market collapsed and real estate prices dropped until they hit a bottom in 2003. That boom until 1995 was made possible by low interest rates, low prices, growing incomes and increasing urbanisation. But things are no longer the same: interest rates are high, prices are through the roof, affordability is low, and income levels have not kept pace with real estate prices.
Fifthly, the Mehtas had good medical insurance, but they also had life insurance cover, which they did not need. After this assessment, we created a comprehensive investment strategy.
Strategy
After taking into account Jai’s debt payments, we set aside 6-12 months’ worth of expenses as contingency money. We kept another Rs 15 lakh in handy cash, in case a good investment opportunity arose.
We sold 10 mutual fund schemes and put the money in floating rate funds. We advised him to sell around 60 stocks, of which he sold five. The stock we recommended he sell at Rs 14 hit the upper circuit every day until Rs 21. He did not heed our advice. But today, that stock is languishing at Rs 7. Those who want to sell can’t do so, because it has hit the lower circuit practically every day in the past few weeks. If anything good came of the whole episode, it’s that Jai’s head is no longer in the clouds of 40% returns. He regrets not having sold more of his stocks or trimming his exposure to mid- and small caps. He is generally more amenable to our logic.

We started monthly systematic investment plans (SIPs) in some mutual funds and stocks we identified, and decided to add to our existing positions on every 5-7% fall in the market. This ensured that the surplus cashflow just did not stay idle, and was deployed productively when possible.

We analysed the family’s life insurance needs, and Jai did not need any life insurance, since he had accumulated sizeable assets and had no liabilities. Then we moved on to the ULIP policies, to evaluate their prospects over the next several quarters, and take a call. We quit one immediately, and also stopped two LIC ULIPs that had high premiums, low cover, and were yielding paltry returns.

Finally, we drew up a set of rules based on cold logic, about what to do during sharp upturns or downturns in the markets. This would be a coping mechanism in times of volatility and panic. A strict rule was: never touch futures, because most people
use them for speculation, rather than hedging.

As a businessman, Jai needed to understand that equity capital was risk capital. Topping it up by leveraging and trading excessively would multiply the risk manifold. It’s hard to see and feel the risk when you get magnified returns. But it’s even harder to miss it when you sustain magnified losses! And who would want to hurt himself so badly?

MEET THE FAMILY
Jai Mehta, aged 58, rose from modest beginnings in a Mumbai chawl. Today, this metal scrap trader is a crorepati many times over. He and his wife Nita, 53, live with their 28-year-old daughter Sita, who runs a boutique. Their son Nirav, 25, is a partner in Jai’s business, and lives in the US. Jai plans to retire in 4-5 years.
Amar Pandit is Certified Financial Planner and Director, My Financial Advisor

 

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