Fortune Watch

One of my friends writes some interesting stuff that is being written nowadays about investing, is fond of using the word fool. But he doesn’t do it the normal way – the way, say, a school teacher does. For example, I remember him once saying that banks were the default suppliers of foolishness in the markets. This idea of foolishness in this special sense makes it easier to understand why markets behave the way they do. What exactly is this foolishness? I think it’s best defined as what is not.

We’ve all heard of the Efficient Market Hypothesis, which says that financial markets are ‘efficient’, meaning that the prices of stocks (or other securities) reflect all known information and therefore incorporate the collective beliefs of all investors about the future. For the hypothesis to be correct, people must have equal access to all information and have rational expectations.

I think the kind of foolishness we are talking about is everything that is the opposite of all those factors that make the market efficient. It’s a bit like heat and cold in physics. You could say that the flow of knowledge and rational expectations keep the markets efficient or you could say that it’s the flow of foolishness that keeps the markets inefficient. Isn’t that a problem? No, it isn’t, most certainly not. Inefficiency is what keeps the stock market interesting and profitable. If the markets were as efficient as the hypothesis says, then those who can identify and mark out foolishness would make less money.

Therefore, a steady and limitless supply of foolishness is the greatest of assets. Foolishness is the life blood of the stock market. Without foolishness, we would be nowhere. Instead of worrying about how well companies are doing and how much the economy is growing, smart stock investors should instead worry about whether an adequate supply of foolishness will be maintained. I’m happy to inform readers that if present trends continue, they have nothing to fear.

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In years of answering people’s questions about investing, I’ve come to classify two major sources of problems: One, investing without thinking enough, and two, thinking too much about investments. We all know at least a few hypochondriacs who continuously suspect themselves to be suffering from dangerous illnesses and require frequent visits to specialists and get exotic medical tests done to allay their fears.

Similarly, there are a vast number of investment hypochondriacs who suspect their asset portfolios to be suffering from some dangerous disease. Generally, they believe that this disease can only be diagnosed by having a specialist examine the portfolio and test it by applying exotic formulae that will perform some magical analysis. Somewhat like its medical version, investment hypochondria, too, is encouraged by these specialists who claim to detect and cure exotic diseases suffered by investment portfolios.

One of the most popular type of diseases in this field is a faulty asset allocation. Many people are worried sick about whether their investment portfolios have the correct amount of money allocated to debt and equity. Periodically, I get asked about what the formula for calculating asset allocation is and sometimes I’m actually asked this not by a patient but by a budding specialist.

The problem, of course, is that there is no formula, nor can there ever be. Asset allocation is just a fancy term for investing according to your needs. Try to get anyone like this to plan your investments and they’ll start by putting up a charade whose purpose is to convince you that finding out correct asset allocation is a complex process that requires proprietary formulae being churned up in complex looking spreadsheets invented by teams of MBAs.

By this process, deciding on an asset allocation starts by figuring out how risk-averse you are and how much risk you are willing to take to get the returns you want. This sounds so logical and systematic but is actually completely useless. Professional investors who are investing other people’s money may be able to find out their location on a risk-vs-return continuum, but at the back of their mind, everyone else wants zero risk. And guess what, zero risk is effectively possible if you do asset allocation the right way.

The key to really figuring out asset allocation is simply to make a rough time table of the future, one where you try and lay down when you will need how much money. Now, what you need to understand is that over some time horizon, most asset types turn zero risk, or as least as close to it as humanly possible. What you need to do is to match your investment time horizon (and not some theoretical risk level) to the asset type. Assets like bank Fixed Deposits and cash mutual funds are always zero risk, short-term income funds are zero risk after six months, and a good stock portfolio like a well-chosen set of diversified equity funds are close to zero risk after maybe seven years.

I‘ll admit this is a slightly simplified view but what I’m trying to do here is to demonstrate the principal on which individuals should base their asset allocation. There is no formula for asset allocation. The right way to do this is to figure out what you plan to do with your money in the future.

In simple economics, there is little distinction between savings and investments. One saves by reducing present consumption, while he invests in the hope of increasing future consumption.Therefore, a fisherman who spares a fish for the next catch reduces his present consumption in the hope of increasing it in the future.

Most of the people probably have savings accounts with ATMs to access their hard-earned cash and be able to store away any extra cash in a place a little safer than a mattress. A few of you may even have some stocks or bonds.

Let me explain why while a savings account in the bank may seem like a safer place than the mattress to store your money, in the long-term it is a losing proposition! If you open a savings account at the bank, they will pay you interest on your savings. So you think that your savings are guaranteed to grow and that makes you feel extremely good! But wait until you see what inflation will do to your investment in the long-term!

The bank may pay you 5 percent interest a year on your money, if inflation is at 4 percent though; your investment is only growing at a mere 1 percent annually.

Saving and investing are often used interchangeably, but they are quite different! Saving is storing money safely, such as in a bank or money market account, for short-term needs such as upcoming expenses or emergencies.

Typically, you earn a low, fixed rate of return and can withdraw your money easily.
Investing is taking a risk with a portion of your savings such as by buying stocks or bonds, in hopes of realizing higher long-term returns.

Unlike bank savings, stocks and bonds over the long term have returned enough to outpace inflation, but they also decline in value from time to time.The rate of returns and risk for savings are often lower than for other forms of investment.

Return is the income from an investment. Risk is the uncertainty that you will receive an expected return and preservation of capital. Savings are also usually more liquid. That is, you may quickly and easily convert your investment to cash.

The decision about which investment to choose is influenced by factors such as yield, risk, and liquidity. Investments may produce current income while you own the investment through the payment of interest, dividends or rent payments.

When you sell an investment for more than its purchase price, the profit is known as a capital gain, also called growth or capital appreciation.

Too much money in the Stock Market.

When there is too much money in the stock market, it can be a warning sign that things are about to change.

New money coming into the market could means investors who have been holding cash investments (CDs, bonds, and so on) are jumping into equities.

Individually, this may be a good decision, depending on where investors place their money.
Better Stock Return Unfortunately, what often happens is inexperienced investors watch a bull market run and want to get in on the better returns the stock market offers.

They may not choose their investments wisely and push the prices of hot stocks even higher. Because they are inexperienced, they buy stocks they hear about on television or from friends.

Rather than do their own research, money pours into the market and pushes up certain stocks beyond reasonable expectations.

If you have been a stock investor for at least 10 years, this scenario may sound like the tech bubble of the late 1990s.Stock Market Bubble. Huge amounts of cash poured into the market creating a demand for something to buy. During that period, it was any stock that had to do with the Internet.

Like any market where there are more buyers than sellers, prices shot up until professional investors began pulling their money out of the market and values crashed.

This doesn’t mean you should stay out of a market where there is lots of enthusiasm. However, be careful about what stocks you buy and even more careful about what you pay for them.

Don’t rely on the market to keep its enthusiasm forever.