Why the Recency Bias is your enemy

Why the Recency Bias is your enemy

Consider these scenarios.


A passenger on the observation deck of a cruise ship spots precisely equal numbers of green boats and blue boats over the duration of her trip. However, the green boats pass by more frequently toward the end of the cruise while the passing of blue boats were concentrated toward the beginning. Following the cruise, there is a high probability that the recency bias could influence the passenger to recall that more green than blue boats sailed by.


You’re driving in a new city. You pass an equal number of red and blue cars, but most of the blue cars are spotted at the end of your journey. Studies suggest you’re more likely to think there are more blue cars than red cars on the road.


Recency bias describes our tendency to extrapolate our recent experience into the future. Investors do the same. And when it comes to investing, this can have disastrous consequences. Because it skews our view of reality and the future. What happened yesterday, might not necessarily happen again today, let alone tomorrow.


During a bull market, people inadvertently tend to forget about bear markets. As far as human recent memory is concerned, the market should keep going up since it has been going up recently. Investors therefore keep buying stocks, feeling good about their prospects. When a bear market descends, falling stock prices can lead to panic selling, because hey, the market “will keep falling and never recover”.


Consider an investment mistake that can be partly attributed to recency bias. In 2009, one bought shares of the paint, coatings, and chemicals manufacturer PPG Industries. This was a highly cash-generative company that had consistently raised its dividend for decades and was in good financial health. But the market was near its nadir and the company was clearly going through a rough patch. Looking at it from a contrarian and value-oriented strategy, one acted on this once-in-a-lifetime buying opportunity. From the date of purchase (February 20, 2009) to the end of October 2017, the stock returned 27.6% annualized, as against 17% of the SPDR S&P 500 ETF.


Before you go wow, the investor notes that he missed out on the rally. One month after buying, he sold his shares. Why? At the time, it seemed like the world was ending, that the market—and maybe even the global economy—had more pain in store.


Recency bias got the best of him. His opportunity cost was greater still, as his recency bias led me to leave the proceeds of that sale in cash for years afterward.


How can we try to control recency bias? Acknowledge it. Half the battle is won if you recognise that it exists. And any investor can fall prey to it. Any – irrespective of age, gender, nationality or race. It is human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes. Whatever has happened most recently will largely determine what you think is most likely to happen next – even if, in reality, there’s no logical reason to assume that the recent past will have any impact on the future. 


Get a grasp on the long-term trend in the market. Gut-wrenching falls notwithstanding, it has been positive. Markets grow as economies grow as corporate earnings grow. This trend has persisted through countless crises. Despite all upheavals, markets are still driven by the same fundamentals. Work with what is in your control. Control your asset allocation. Stay diversified. Invest in the right instruments taking into account the investment tenure.


Set realistic expectations. Comprehend the risk you can take. Try to minimize taxes. Have a sound buying thesis. Don’t get swayed by the latest performance numbers, however good. Always stay grounded in fundamentals, whether buying a stock or a fund. Be aware of the role it has in your portfolio.


The recency bias happens when we assume recent performance equals future performance. Despite the disclaimers, our minds naturally want to project from the past. Sometimes that’s real (momentum), and sometimes it is just a trick of the mind. We’re not good at telling the two apart. Remember that cyclicality comes with the terrain. Pay attention to the cyclical nature of asset class returns, securities or asset groups. No investment or fund performs spectacularly year after year. You will be vulnerable to a downdraft, but if you have invested based on a solid thesis, and it still holds, the downturn will in most cases be just temporary.


Remember reversion to mean, the basic law of “financial physics”. What goes up must go down, and what goes up the most usually goes down the most. Find appropriate professional assistance. The services of a financial adviser are extremely essential to help you stay grounded. 


There are no market geniuses, just those in control of their emotions The curse of Overconfidence in investing Investment involves risk of loss.




Happy Investing
Source:Morningstar.in

Public Provident Fund Trick: You can add Rs 11 lakh to PPF with just Rs 2500 in 5 years

Public Provident Fund Trick: You can add Rs 11 lakh to PPF with just Rs 2500 in 5 years

 

PPF Investment : Public Provident Fund (PPF) is one of the few investment options that has stood the test of time over several decades. The sovereign guarantee that it enjoys on both the principal invested and interest earned is the clincher while the interest income also remains tax free. On top of it, there is income tax benefit under section 80C on the amount invested in PPF. Therefore, PPF enjoys E-E-E- status as it comes with tax exemption at investment stage, growth remains tax exempt and even maturity remains tax-free. One other important feature of PPF remains largely ignored-Compounding of interest that happens annually in PPF. PPF being a long term scheme of 15 years, the impact of compounding is the best in PPF.

The minimum and maximum annual investment in PPF is Rs 500 and Rs 1.5 lakh and PPF contributions need to be made each year for 15 years to keep the PPF account active. By investing a minimum of Rs 500 during one financial year, one can keep the PPF account active. The interest is on the outstanding balance in the PPF account. Let us see the effect of compounding, if contribution in the last 5 years of PPF is kept only at Rs 500.

 

Impact of compounding on PPF An example: The interest rate of PPF is assumed to be 8 per cent per annum throughout the 15-year period.

On investing Rs 1.5 lakh each year, the maturity value comes to about Rs 43,50,547-where Rs 22.5 lakh is the principal invested and nearly Rs 21,00,547 lakh is the interest earned, that makes 48.28 per cent as the interest amount!

Now, let us suppose one invest Rs 1.5 lakh each year only for the initial 10 years and then invest only Rs 500 for the last 5 years to keep the PPF account active. The maturity value comes to about Rs 34.5 lakh, of which 56 per cent is the interest!

’The amount of interest earned in the last five years is nearly Rs 11 lakh on a total additional contribution of Rs 2,500. This is possible because of the effect of compounding as interest declared earns interest on each year’s balance amount.

The above is just an example to show how compounding works in PPF. Ideally, one should maximise the contributions and if investible surplus is not available at the beginning of the financial year, try to make PPF deposits before 5th of each month. The PPF rules allows one to extend the PPF account indefinitely in a block of 5 years, with or without making fresh contributions. The longer you run your PPF account, more will be the impact of compounding to reap its benefits during your retirement.

 

Happy Investing

Source:Yahoofinance.com

Is gold really golden?

Is gold really golden?

Savers need to be clear about what gold is, and what it is not

One would have thought 5,000 or so years would be enough to decide an argument but it turns out that gold's utility as an investment is still not a settled matter. There's the traditional view of gold, that it's simple and useful investment, a protection against bad times, and all households should invest in it. Those who believe this think that gold is an easily liquifiable form of wealth that can also be relied upon to gain value. Another, more modern view is that gold is a commodity to be traded just like other commodities, which is not of much use to the individual saver.

 

The third view, to which I subscribe, is that gold can legitimately be seen as an investment, and while it does have some unique features, it's just not a very good investment. Any investment must be evaluated primarily according to returns, with liquidity, stability and other such factors being additional concerns. On these grounds, gold doesn't score very well.


Not only do the returns tend to be worse than other investments, there are some fundamental reasons why this will always be the case. That's because gold belongs to a class of investments that do not actually produce anything or create any value. Any rise in its worth is based on the belief that when the time comes to sell, someone else will pay more for it. Unlike equity or bonds or deposits, the money that you invest in gold does not contribute to economic growth. An equivalent amount of money deployed in a business or any other productive economic activity will generate actual wealth and will grow larger in a very fundamental way, while a given quantity of gold will just remain the same.


So, am I saying that no one should ever invest in gold? I believe the answer is clear. For those who are reading this column and therefore must be having access to a modern financial system with all its investment options, gold makes no sense. Gold makes sense only for those who have no access to or no trust in the financial system. Gold is best viewed as an alternate currency. During the demonetisation period, there were stories of housewives who turned out to have secretly saved large amounts of cash. That's the kind of person who could have done better with gold instead of cash.
Of course, in India, physical gold has served yet another purpose which is a variation on this, that of keeping wealth away from taxation.


If you still must buy gold, then there are many forms of 'paper gold' available. There are gold-backed mutual funds available which closely track the value of gold.


However, if you don't mind locking money away for at least five years, then there are Government of India's gold bonds. Their value increases in step with gold, plus there's an extra interest of 2.5 per cent per year. Unlike gold mutual funds, the gains from the gold bonds are tax-free. The limit is a generous 4 kg per person.


Gold's place in history and culture makes it difficult for people to accept that gold is not a good investment. We instinctively think of gold as wealth, as a kind of a currency that survives all kinds of historical troubles. This is undoubtedly true. Gold has value because everyone thinks it has value. For many people, that's enough. However, don't think of it as an investment without understanding the reality.

Happy Investing

Source: Valueresearchonline.com

The inflation monster is destroying your wealth every year!

The inflation monster is destroying your wealth every year!

What compound interest gives, inflation takes away. Take a closer look at the problem

 

Believe it or not, Rs 10,000 in 1982 was worth just Rs 552 in 2018, all thanks to inflation. While you may earn compound interest on your savings, whatever compound interest gives, inflation takes away. To put it another way - inflation is effectively the reverse of compound interest; it's like decompound interest.

 

Since a year's inflation occurs on top of the previous year's inflation, this means that the effect is just like that of compound interest. Consider a situation where you invest Rs 1 lakh in a deposit which earns you 8 per cent a year. At the same time, prices are also generally rising at the rate of 8 per cent a year. In such a situation, your compounding returns will just about keep pace with inflation. The actual amount will increase, but what you can do with it will not.


So, for example, during a ten year period your Rs 1 lakh will become Rs 2.16 lakh. However, at the same time on an average the things you could have bought for Rs 1 lakh will also cost Rs 2.16 lakh. In effect, you have not become any richer. The purchasing power of your Rs 1 lakh remains what it used to be ten years ago. And the increase in how much money you have is little more than an illusion, as it is completely negated by a corresponding rise in prices.


But inflation may not be so kind as to stay at the level of the interest you are earning. What if it's more? And what if this goes on for a very long time? Now supposing your returns are 8 per cent but inflation stays at 10 per cent and twenty years go by, let's find out what happens.


So while your investment of Rs 1 lakh will grow to Rs 4.66 lakh, things that used to cost Rs 1 lakh will now cost Rs 6.73 lakh. Now, the purchasing power of your Rs 1 lakh is just Rs 69,000. Your investment has actually made you poorer! This is not a theoretical example - it actually happens to millions in India. In our country, over the past thirty to forty years, the inflation rate has been either the same or a little bit higher than the interest rates of many of the deposits that are available. Unfortunately, too many people think that the two problems are unrelated.









All these people earnestly saving away their money suffer from the inability to account for inflation. People think in nominal terms and the future impact of inflation is awfully hard to internalise. The real solution to this is that we should become a low-inflation economy, but since that's clearly not on the agenda, savers should always adjust for inflation mentally.


If Rs 1 crore sounds like the kind of money you'll want twenty years from now, then you will actually need to have about Rs 4 crore. If you work backwards from there, you will need to save about Rs 68,000 a month if the returns are 8 per cent. That's a depressingly large amount, but there it is, there's no escape from the arithmetic (you may make similar calculations quickly and roughly using the 'rule of 72').


What this example actually tells you is that over a long period of time, you need a form of investment that is inflation-adjusted. While a lot of investors think that equity is risky, it requires a little bit of thinking to see that inflation is riskier. And to match inflation, and to get real returns on top of that, you have to latch on to something that goes up with inflation. This is not difficult because the value of goods, services and assets in the economy is inherently inflation-linked. And so risky or not, equity and equity-linked investments are the only game in town to protect yourself from inflation.

Happy Investing

Source: Valueresearchonline.com