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Investment mistakes to avoid in hard times

Dear reader, please hold this thought for a while.

In the monetary world as it has existed post 2008, the central banks of the rich world have printed a lot of money and driven down interest rates. At the start of 2020 as the covid-pandemic spread, the central banks of the developing world started doing the same.

This dynamic has essentially ensured that investors looking for higher returns have poured money into stocks, sending stock prices soaring and in the words of Ted Lamade, managing director at The Carnegie Institution for Science, this has “created a generation or two (or even three) of investors with an elevated opinion of their abilities”.

The investment expert whose story we started this piece with is an excellent example of this kind of overconfidence.

But is there a real basis for this? Let’s look at the Nifty 50 Total Returns Index and the kind of returns that it has generated over the years. A total returns index, along with capital gains, also takes dividends given by stocks into account. The Nifty 50 is an index which is a good broad representation of the overall stock market as it represents around two-thirds of the free float market capitalization of the stocks. The data for this index is available from 30 June 1999 onwards, a period of close to 23 years.

Between then and now, the average annual return on the Nifty has been around 13.6%. If we calculate the average annual return between 30 June 1999 and 18 October 2021, the day the Nifty 50 total returns index reached its peak level, the return is at 14.6% per year. And this after the stock market has gone really berserk over the last two years.

Clearly, the assumption of a return of 26% per year is totally random and has no historical basis. Further, as writer and author Morgan Housel says in a recent blog: “Past performance increases confidence more than ability.”

Also, it is worth remembering that the data availability of the Indian stock market is limited to only the past two to three decades and that’s too small a period to be making confident forecasts based on past data, as many experts tend to do.

Across the world, the returns from investing in stocks, over a longish period of time tends to be better than other investment classes. Nonetheless, there can be very long periods where the stock market does not give any returns. Take the case of the Dow Jones Industrial Average (DJIA), the most famous American stock market index. It took 25 years from 1929 to 1954 to recover from the stock market crash of October 1929. Similarly, the Nikkei 225, Japan’s premier stock market index, reached its all-time high in December 1989. More than three decades later, it’s still nowhere near that level. The point is there are no guarantees despite what stock market experts like to say when the bull market is on and even when it goes away.

It’s their job to be positive and sound confident all the time. In doing this, any nuance that should come with the investing process goes out of the window. Nuance makes experts sound weak and confused, which is something investors don’t like.

In the last few years, investment experts have popped up all over the place, thanks to cheap internet and spread of the social media. Some of their advice which seemed to work well during the bull market is a strict no-no now. In fact, it was a strict no-no even during a bull market, but investors fell for it and many of them are in a mess now because of it.

‘Don’t do fixed deposits’

One advice many investment experts have given out over the last two to three years is that investors should avoid investing in fixed deposits. The logic offered is pretty straightforward. The after tax rate of interest on fixed deposits is lower than the rate of inflation and given that, your investment is actually losing value. Why do that when stocks can give you double digit returns in a year and cryptos in a month (or even a day or two, who knows)?

A lot of the younger crowd fell for this and it worked for a while, until it didn’t. The crypto bros made snide remarks at those who invested in fixed deposits asking them to have fun staying poor.

Such behaviour stems from overconfidence. As Dan Gardner writes in Future Babble–How to Stop Worrying and Love the Unpredictable: “Overconfidence is a universal human trait closely related to an equally widespread phenomenon known as “optimism bias.” Ask smokers about the risk of getting lung cancer from smoking and they’ll say it’s high. But their risk? Not so high. Starting a new business? Most fail, but mine won’t.”

Investors have a similar overconfidence, especially those who have rarely seen a bear market. The trouble is that when you are young and have seen only one market cycle, you like to assume that things will continue to be as they are and you will not make the same mistakes as people have made in the past. As Housel puts it: “I don’t think there’s any way to understand what a bear market feels like until you’ve lived through one.”

Many millennials and zoomers haven’t lived through a bear market. Hence, it’s important for them to understand that while return on capital is important, the return of capital is even more important.

In this scenario, it always makes sense to invest a part of your savings in fixed deposits. Also, it is worth remembering that stock market crashes can be followed by a weak economic scenario as well and in this situation, it always makes sense to have some money in the bank because it allows you to make better decisions in life.

‘Buy on dips’

This is a favourite with market experts particularly on days when stock prices are falling big time. On the face of it, it is a very safe thing to say. The trouble is no one really knows where the dip will end. Also, investing is a very individual thing with the situation varying from person to person. For someone with limited savings or a lot of debt or a job which is on a shaky ground, buying on dips is a very risky strategy. The other important thing to understand here is that every person can mentally and financially take on a certain amount of risk in their lives. The trouble is most investors do not think this through.

Also, stock prices never fall in isolation. Stock markets are falling now because central banks all across the world are raising rates to rein in inflation. High inflation can derail the most robust economic growth.

Further, at the beginning of 2020, stock prices fell due to the spread of the covid pandemic dragging down global economic growth. Similarly, in 2008, stock prices crashed after it became clear that some of the biggest financial institutions in the world were in trouble. The point is that it isn’t easy to be brave when others are fearful simply because there is a reason why others are being fearful.

But experts don’t bother with such nuance. The trouble with the experts being nuanced as Gardner puts it is that “toning down the confidence of their predictions” means “foregoing the pleasure of being treated like gurus and prophets”. And that is something they cannot afford to do.

Incentives are also at play. Investment experts who represent financial institutions make money when retail and other investors go out there and buy stocks. The larger the assets under management of the institution they work for, the more the money they make.

Further, social media gurus these days have deals with stock brokerages which incentivizes them to encourage their followers to continue buying stocks. In this scenario, it is important to remember the specious association of money and intelligence that John Kenneth Galbraith talks about in his book A Short History of Financial Euphoria.

Other than the incentive of experts, there is also the incentive of TV channels and other forms of visual media at play. Jim Crammer, a popular host on CNBC in the US, once explained this succinctly when he said: “Look, we’ve got 17 hours of live TV a day to do.” The easiest and the cheapest to fill up time on TV is to get experts on and let them say what they want to say.

Storification

Stories appeal more to the human mind than complicated calculations. Many investment experts understand this and use it to the hilt to sell an investment.

Take the case of the bitcoin. The story sold was that government backed central banks have the liberty to print paper money. This liberty would ultimately lead to high inflation. Hence, you should buy bitcoin because there is an overall limit to the number of bitcoins that can be created.

Bitcoin was also compared with gold. Like the supply of gold does not go up suddenly by a huge amount, so was the case with bitcoin.

What these story-tellers avoided telling was that while there was a limit to the number of bitcoins that could be created there was no limit to the number of different cryptos that could possibly be created. In fact, if one were to put this simplistically, anyone who has the technical knowledge can do so in their backyard.

At the same time, there was absolutely no talk about how governments which had the right to create money out of thin air, would go after cryptos. As it has turned out, bitcoin was no digital gold. It has fallen by more than 55% from the peak price it achieved in early November. Of course, the price of gold has also fallen in the recent past, but the fall is nowhere as high as that of bitcoin and other cryptos. There is reason why gold has been a store of value across centuries.

Along similar lines was the story sold before the initial public offerings of many digital platforms, from Paytm and Zomato to PB Fintech and Nykaa. We were told that a great digital future awaits us— these companies would possibly be monopolies or duopolies in their area of business. Hence, we should pay a very high price for these stocks.

As it turned out, the high prices were just a reflection of too much money chasing stocks. Once that stopped happening, with the foreign institutional investors selling out, the stock prices crashed. And so did the stories.

The point: stories about company earnings not mattering can be sold for some time, but not all the time. Ultimately, every company needs a business model where its revenues are greater than its expenses and it makes a profit. As Lamade puts it: “Twenty and thirty-something investors are going to experience a world in which stocks need more than a good story to go up.” They would need solid earnings.

To conclude, diversification was and continues to remain the most basic rule at the heart of investing. Or as the old cliché goes, don’t put all eggs in one basket. The realization of how important this cliché is sets in only when things start to go wrong, as they have with stock prices and the crypto crash in the recent weeks. If you had bet all your money on stocks and cryptos, you would be in trouble right now. If you had spread it across, stocks, mutual funds, fixed deposits and gold, the value of your investment would have taken some beating, but you would still be sleeping reasonably well at night. And what is possibly more important than that?

Oh! Definitely don’t sell your house.

Vivek Kaul is the author of Bad Money.

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