Illusion of Control in Investing

We are all overconfident. We have this natural assumption that if we are doing something ourselves, we'll do it better than anyone else. Psychologists call this 'Control Bias' and it applies to all sorts of areas of human behaviour. I came across it in an article by an American security expert named Bruce Schneier. He is a cryptographer and computer security specialist who has evolved into a thinker and writer about all kinds of risks and security. I find it interesting that some of his ideas about risk and human reactions to it have great relevance to investing. A couple of years ago, I wrote about how people tend to overrate the risks they face from rare, but dramatic events and underestimate the risks that they face from everyday events.

According to this article, we tend to underestimate risks in situations where we are in control and tend to overestimate risks in situations when we are not in control. The most common example is the fear of flying versus the perception of risk while driving. There's clear evidence that flying in a commercial airliner is by far the safest mode of transport that there is. In contrast, Indian roads are quite unsafe. Yet, many sensible people have a deep fear of flying, but are quite unconcerned about taking huge risks while they are driving.

Worse, people take slippages in safety levels on the road unthinkingly. They chat on their phones while driving (it's not unusual to see two-wheeler riders type SMS messages while driving); they drive after having had a couple of drinks; they drive when they know their brakes or tyres are not good; they overtake while turning, so on and so forth — the list is endless. And yet, they are scared of flying. All these could be examples of ‘Control Bias’. When we are doing something ourselves, we have an illusion of control, which feeds a biased view of safety. We underestimate risk because we are in possession of all the facts and we feel that we can control the situation when in reality we can't. When flying, we really don't know what's happening so we do not have the illusion of control.

I find that this illusion of control is exactly what makes investors underestimate risk while investing. Many investors don't actually know enough to be dabbling in stocks. Yet they do so because they have a large amount of information which makes them believe that they know enough to be in control. Someone sells investors a story about a stock and that story appears to have enough information to give an adequate illusion of control. If the story is dished out by a brokers' employee and is dressed up as research, then it appears to be all the more believable.

This is also the reason why many knowledgeable investors advise even newbies against investing in mutual funds. The experienced investors have enough information of stocks, but feel inadequately informed about what is going on if their money is in a mutual fund. The mutual fund investment manager is like a pilot and you don't know what he's doing, so naturally, you assume the worst.

Unfortunately, investing also has its equivalent of driving drunk or without good brakes and tyres. Almost no individual stock investor follows any systematic risk-control procedures on their portfolio. They don't diversify properly. They allow their portfolio to have odd concentrations in one or two stocks or sectors and they don't track what is happening to the stocks they own. The fact that they are doing things themselves gives them the illusion that they know what's happening and if the situation gets tricky they'll manage to get out of it.

An article by Dhirendra Kumar (CEO, Value Research)

SIP, Simple, Simplest

For people who sell things, and for many who buy them, 'features' are generally thought to be a good thing. Whether it's cars or mobile phones or vacations or houses, the more the features the better a product is supposed to be. However, when it comes to financial products meant for savers and investors, this passion for features is a problem, since features tend to obscure the inherent attributes of a product. Worse, when feature is afflicted with financial concepts like mutual fund SIPs (Systematic Investment Plans), whose very reason for existence is to provide simplicity, then the problem becomes very serious.

It's very easy to get involved in over-complex analysis and lose sight of what is actually important. Consider an email I got a few weeks ago from an investor. This person wrote that he had read in an article somewhere that that if one increased one's monthly SIP amount by 10 per cent every year, then the final value would increase by 45 per cent. The investor wanted to know whether this was true and if it was, then should this ten per cent increase be a simple increase or a compounded one. I didn't quite know how to respond.

At one level, it's good to see that a saver is taking his investments seriously and is minutely examining what he is doing, and what effect it is producing.

However, at another level there's a problem because there's a touch of ritualism in what is going on here. Someone is applying the maths slavishly, without understanding what is going on. Firstly, settling the answer to this question is a fairly straightforward arithmetic exercise, although the idea dubious even without running any numbers. Secondly, even though it's maths is not quite there, what the original article seems to be trying to convince readers of is that basically, if you invest more then you will end up with with more money. One can hardly argue with that, even if it is not some magical number produced by an investment ritual.

However, the bigger problem is the idea that there is some magic to the very simple concept of investing in a volatile asset by averaging your cost. All that the idea of an SIP is, that you should keep investing a fixed sum regularly in an equity fund, regardless of market conditions. Over a long-term, you end up buying more units when the markets are down and fewer when the markets are up. Thus your average purchase price is much likelier to be than what it would have been otherwise. Therefore, when the time comes to redeem your investments, they are very likely to be worth more than what they would have been. That's all there is. There are no guarantees, and there are certainly no fixed formulae of expected returns. Hypothetically, if the stock markets were to go into a general long-term stagnation or decline, then it won't work out. But in the real world, since you are investing in something that has a high volatility but a general trend upwards, you'll come out well.

However, the value of an SIP is not in the maths, but the psychology. It's the simplest way of investing regularly and getting good returns from equity without having to worry about when to invest and when not to invest and often missing out on the best opportunities.

Of course, mutual fund markers have exploited the attraction that complex, feature-laden investment options have for investors. There are a number of SIP plans to which market-timing has been added as a feature. There are AMCs and advisors who'll raise or lower your SIP amount based on index levels or PEs or such tricks. This is ironic because avoiding market timing is the whole point of doing an SIP.

If there's one investment technique where keeping it simple and avoiding every complexity is of the highest value, it's SIPs. In other words, keep calm and keep investing.

An article published in valueresearchonline.com 

Why unclear tax treatment is making investors wary of NPS ?

Will NPS (National Pension System) investors be hit with a tax surprise when they retire? The unfortunate answer is that no one knows with certainty, and no one in the government has bothered to clarify. Unless the tax treatment of NPS at withdrawal is known with certainty, it simply will not take off.

Three weeks ago, the Union Budget 2015 gave a big push to the NPS by creating a Rs 50,000 tax break that can be utilised only by investing in the NPS. In his speech, the finance minister also promised that the government would bring legislation that would enable NPS to be an alternative to the EPFO. In the days since, I have written a few times about the NPS and received a lot of feedback.

In general, I find that there are two things that define people's response and opinion about the NPS. One is taxation, and the other is intense hostility towards the scheme from many established financial advisors. The taxation bit is entirely the government's fault.

Unlike the EPF and the PPF, NPS withdrawals are taxable income. When an NPS member retires, 40% of the accumulated money in the account has to be used to buy an annuity which will pro vide a pension. The money is not taxed at the time of the annuity purchase, but the resulting pension is taxed like any other pension. 

The problem that people have with the NPS is that the remaining 60% is taxable, in contrast to EPF and PPF. Savers consider this to be unfair and most financial advisors cite this as an overarching reason for disqualifying NPS as a vehicle for discretionary retirement savings. However, there is an additional problem with this, over and above the taxability. 

Common sense would dictate that the accumulation in NPS should be treated as capital gains. Moreover, the acquisition value of the NPS units should be indexed according to the cost in flation index that flation index that the government releases every year for the purpose.From the point of view of the nature of the investments and the asset types, NPS is identical to a debt-oriented hybrid mutual fund, and savers should expect a similar tax treatment. 

This is a crucial point. As I had written in this column last week, with cost-adjustment, the equitycentric options of NPS would cumulatively earn so much more than EPF that on a comparative basis, the annuity would be free and even after that, and even after paying capital gains tax, savers would still have more left over than the EPF. But without the cost-adjustment, NPS would truly be at a dis advantage. So is cost-adjustment available for NPS? 

As with so many other things in India's taxation system, no one really knows for certain. I asked a number of chartered accountants (CAs) and tax lawyers and got an almost equal number of divergent opinions. Some thought that indexation would be available and some thought not. There was even a view that the entire withdrawal would be treated as income for that year! That sounds absurd but then, absurdity is hardly a deterrence for India's revenue collectors.

One very logical opinion was that of the PFRDA's first chairman Dhirendra Swarup, who midwifed the whole NPS project during its most critical phase. He thinks that while it made sense for indexation to be available, it would actually get tested only when someone would actually file an income tax return with such an assumption, and then the assessing officer would reject it and then there would be a round of appeals and cases and arguments and so on. 

Since the first generation of NPS members are still a long way from retirement, we are probably still some years from a clarification. This is an absurd situation and if the government is serious about encouraging NPS, it must clarify the grey areas in NPS taxation without delay. 

Otherwise, with such a huge uncertainty hanging over their heads, it makes little sense for savers to choose the NPS. As things stand, financial advisors are hostile to the scheme because they can't make money out of it. Having an unclear tax treatment just gives them a stick to beat the NPS with.

An article published in economic times by Dhirendra Kumar (CEO, Value Research)

Equities are a great compounding machine; India has great growth prospects: Prashant Jain

Mr. Prashant Jain, Executive Director & Chief Investment Officer, HDFC Mutual Fund has collectively over 20 years of experience in fund management and research in mutual fund industry. He is unarguably one of the best fund managers in the country. While most fund houses struggled to sell their equity products in recent years, HDFC Mutual Fund has steadily managed to increase its equity asset base over the past two years. The latest figures show that HDFC Mutual Fund has retained its top position with an average AUM of 1,41,000 crore. A Master in Business Administration from IIM, Bangalore and B.Tech (Mechanical Engg.) IIT, Kanpur, prior to joining HDFC AMC, he has worked with Zurich AMC and SBI Mutual Fund.

Around two years ago you had penned a thought-provoking piece titled 'It's tomorrow that matters.' Has that tomorrow come? What is your outlook for the coming tomorrows?  

I think the "tomorrow" that was referred to in the article dated May 24, 2012 has come.

The table below summarizes the key parameters then and now.

	Then FY12	Now FY14	Remarks
CAD (% of GDP)	4.2	1.9	CAD has improved sharply since then
FD (% of GDP)	5.7	4.1	FD has come down & should come down further over time
WPI (Average)	8.8	5.5	WPI fell to 5 year low in August
CAD: Current Account Deficit, FD: Fiscal Deficit, WPI: Wholesale Price Inflation
	2012A	2014E	Remarks
Euro area GDP (% growth)	(0.6)	1.0	From crisis, Europe has since moved to stability
	Then May 12	Now Sep 14	Remarks
Gold Price in USD (t/z)	1,561	1,208	Gold prices are down ~22% in USD terms
Gold Price in`(MCX-10g)	29,183	26,772	Despite higher customs duty & INR Depreciation, gold prices are down ~8% in India
SENSEX Index Level	16,219	26,630	SENSEX is up ~64%
Roll P/E - 1Yr forward	13.0	15.6

Source: Bloomberg, CLSA, Citi and BAML research, Data updated till 30th September, 2014, E - Estimated

From the above, it is clear that fundamentals have improved both globally and locally between 2012 at the time of the European crisis and now. Panic and pessimism of 2012 has since been replaced by rising confidence and optimism for the future. The key message of the note - that the best investments are made in tough times - though greeted by skepticism then, has been largely vindicated. (The Sensex is up 64% since the note dated May 24, 2012).

Looking at the future, I think another, equally promising, "tomorrow" beckons.

The worst on the economic front in India is clearly behind us - GDP growth is improving, current account deficit (CAD) has narrowed sharply, fiscal deficit (FD) is slowly but surely moderating, inflation is steadily coming down with visible moderation in key constituents i.e. food and fuel. Lower interest rates are thus a natural corollary over time.

A strong, growth oriented and business friendly government bodes well for economic growth and for businesses.

Given the likely recovery in the capex cycle, over the next few years India's growth rates should exceed China's in my opinion. By the turn of the decade, India should thus emerge as not only one of the largest but the fastest growing economy as well.

Current P/E multiples of equity markets are reasonable - neither expensive, nor cheap. However, corporate earnings should be better than estimates as corporate margins are significantly below the long term averages and should improve as capacity utilization and business conditions improve. There is thus room for multiples to expand as growth improves and as interest rates move lower besides strong earnings growth.

With markets at new highs, a new government in place and P/Es at moderate levels, has your outlook for the Indian equity markets changed?

A popular observation about the markets is that the markets have run up nearly 40% in last one year! A more pertinent observation is that the markets are up only around 30% from the pre Lehman levels over the last 6 years! Markets have thus sharply underperformed nominal GDP growth over the last six years, in spite of the sharp move in recent months.

As mentioned earlier, P/Es are still reasonable; there is room for P/Es to move higher over time as growth picks up, as corporate margins normalize from depressed levels and as interest rates move lower. Most importantly, the growth prospects for the Indian economy are now very encouraging.  Imagine what growth India can deliver in a good environment when it has grown at nearly 5% in a year as challenging as the last year!

Should investors dabble directly in stocks or stick to quality mutual funds? 

If an investor has good understanding, he or she may go in for direct equities. In my experience, however, the vast majority of direct investors have not done well - the most popular stocks in 1992 were in cement; in 1999 it was the turn of IT/ TMT / ICE stocks; in 2007 it was the turn on the infrastructure related stocks, and in last few years it is the FMCG stocks that have become most popular. While it is too early to judge the outcome of popularity of FMCG stocks, the popular direct investments in earlier cycles have not been successful for the majority.

On the contrary, a majority of mutual fund schemes have outperformed indices over the medium to long periods of time and have thus added significant value.

The table below makes an interesting reading. As on 30th August, 2014, between 80-90% of equity funds' assets have outperformed their respective benchmarks.

	3 Years	5 Years	10 Years
% of AUM Outperforming Benchmark	82%	93%	93%
% of Schemes Outperforming Benchmark	67%	75%	64%

Source: NAV India, Data as on 30th August, 2014, Internal Calculations

Are big schemes are better than smaller ones?

It is also interesting to observe from the above table that the percentage of AUM outperforming their benchmarks is significantly higher than percentage of schemes outperforming their benchmarks. This implies that larger schemes have done better compared to smaller schemes.

There have been many who have repeatedly suggested that large mutual fund schemes are constrained by size and underperform their smaller counterparts. The data above clearly shows that on the contrary, bigger schemes have done better.

The reasons for this are fairly simple. As I have often said in the past  all mutual fund schemes are tiny in India. Infact,  HDFC Equity Fund, the largest equity scheme,with ~`16,000 crs AUM is only 0.17% of market capitalization. True, it is large compared to other schemes, but it is small relative to market. Size is thus not a constraint. Besides, larger schemes are more likely to be managed by more experienced managers. And finally, larger schemes have lower expenses!

Brief us about the performance of some of your funds and your AUM.

HDFC Mutual Fund is the largest mutual fund in India - overall, and more importantly in equities. While this represents the support and faith of millions in brand "HDFC" and in our capabilities, what is most satisfying is that our funds have been able to add considerable value and have done significantly better than both the benchmarks and competing funds over the medium to long term.

Given below is the track record of five of our largest Equity / Balanced Funds vs. the benchmarks over the medium to long term.

HDFC Fund vs Benchmarks

		Return CAGR (%)
	Start Date	AUM inRs. crs. Aug 2014	1 year	3 years	5 years	Since Inception	Rs.  10,000 Invested at Inception has become Rs.
HDFC Equity Fund - (G)	Jan 95	15,813	73.2	21.7	15.9	21.2	443,050
CNX 500			46.1	17.3	9.3	9.8	64,157
Excess Returns			27.1	4.5	6.6	11.3
HDFC Top 200 fund (G)	Oct 96	12,905	60.0	19.9	13.5	22.7	323,285
BSE 200			42.5	17.0	9.2	13.0	89,770
Excess Returns			17.5	2.9	4.3	9.7
HDFC Mid-Cap Opp.	Jan 07	6,862	91.4	28.2	23.5	17.3	31,880
CNX Midcap			63.2	17.2	11.2	9.7	19,595
Excess Returns			28.3	11.0	12.3
HDFC Prudence	Feb 94	6,846	68.2	20.1	16.8	20.3	453,584
CRISIL Balanced			27.4	13.9	9.1	NA	NA
Excess Returns			40.8	6.2	7.7
HDFC Tax Saver Fund	Mar 96	4,670	70.2	21.1	15.1	27.8	933,774
CNX 500			46.1	17.3	9.3	12.7	91,636
Excess Returns			24.1	3.8	5.8	15.1

(Returns as on 30th September, 2014), Source: NAV India, Internal Calculations

Past performance may or may not be sustained in the future

What is noteworthy is that each of these funds has generated sizable excess returns over their respective benchmarks across different time periods. The effect of 5-14% CAGR excess returns over long periods is dramatic:

HDFC TAX Saver:	Rs. 10,000 invested at inception is ~Rs. 934,000 in less than 19 years at CAGR# of ~28%, 93 times
HDFC Prudence:	Rs. 10,000 invested at inception is ~Rs. 4,54,000 in little over 20years at CAGR# of ~20%, 45 times
HDFC Equity Fund:	Rs. 10,000 invested at inception is ~Rs. 4,43,000 in less than 20 years at CAGR# of ~21%, 44 times
BSE SENSEX:	Rs. 10,000 during the same time is only ~Rs. 67,000 in little over 20years at CAGR# of ~10%,6.7 times

Source: Bloomberg, Internal calculations, Reference made to SENSEX is only for easy understanding of market movement.

# Past performance may or may not be sustained in the future

This represents possibly the best value addition across mutual fund schemes over long periods and across several market cycles in India. This is a result of a long term, disciplined approach to investing and a very talented, experienced and dedicated team at HDFC Mutual Fund. It will be our endeavor to further build on this solid foundation.

The fact that these schemes are some of the largest schemes in the industry, once again suggests that size is not a constraining factor for performance.

You often advocate low P/E investing. What would your advice be to retail investors?

My advice to investors is very simple and has stayed the same for a long time. Equities are a great compounding machine (Sensex itself is up 270 times since 1979) and India had and has great growth prospects. To benefit from this, an investor should assess and allocate one's risk capital (that portion of capital which can be kept aside for few years and on which volatility can be tolerated) to equities.

Asset Allocation is the key to successful investing and surprisingly it is also the most neglected, as most of the attention is focused on timing, security selection, moving across funds etc. 

Studies have suggested that in investing, up to 90% of returns and wealth over long periods are driven by asset allocation only and not by security selection or timing.

After asset allocation, all that an investor needs is patience and discipline: Patience to remain invested for long periods in equities / equity mutual funds to allow compounding to work and the discipline of not panicking and on the contrary increasing allocation to equities when the returns over the past few years have been disappointing or in simple words when the P/Es are low (practice low P/E investing).

The data below pertaining to two of our long running funds highlights the low holding periods of mutual funds in general by the majority.

	AUM holding for more than
Scheme	3years	5years	10 years
HDFC Prudence Fund:	52%	23%	3%
HDFC Equity Fund	34%	15%	2%

Source: HDFC Mutual Fund, Data as on 31^st August, 2014

The data on above suggests: 

Only ~2-3% of assets in equity funds are held for more than 10 years

Only ~15-25% of assets in equity funds are held for more than 5 years

Only ~30-50% of assets in equity funds are held for more than 3 years

Short holding periods of mutual funds dilute the potential of equities: As was highlighted in the answer to the previous question, compounding over long periods multiplies wealth manifold. Investors with short holding periods clearly do not benefit from this. That is why it is often said that "Time spent in markets is more important than timing the markets".

You had mentioned in your 2012 note, how Gold prices were high in real terms similar to 1980 levels or so. Could you explain the same and your view on Gold now? 

The nature of gold is such that it tends to preserve the purchasing power in real terms (this implies that gold returns are nearly equal to inflation) over very long periods. If holding gold for longer periods could increase purchasing power, then India should have been much richer by now.

There is one more characteristic of gold - it tends to do very well in times of heightened uncertainty, crisis like situations, when interest rates are very low etc. Though gold tends to give outsized returns (and delivers significant real returns) around such times, these are typically followed by long periods of underperformance till the real returns wither away.

The following chart gives the real price (adjusted for inflation) price of gold in USD terms.

It can be observed that Gold prices went up sharply in real terms around 1980 and again post 2008.

The time around 1980 was characterized by a rapid rise in oil prices (from ~USD 14/bbl in 1978 to ~USD 36/bbl in 1981 (Source: BP)), high inflation, Soviet intervention in Afghanistan as well as the impact of the Iranian revolution. Post 2008, the Lehman crisis led to a sharp decline in interest rates and excessive money supply (QE). Gold did very well on both these occasions.

The fact that gold had created uncharacteristically high real wealth between 2008 and 2012, and the expectation that the environment would eventually improve, had prompted me to suggest a negative outlook for gold in 2012 in the note referred to earlier. 

As the global economy returns to normalcy, as interest rates expectations / interest rates change, charm of gold should continue to recede. As the above chart suggests, gold prices are still high in real terms despite the correction. Moreover, Indian gold prices are supported by high customs duty which should normalize over time making gold even less attractive.

How would you compare FDs vs. Gold vs. Equities

The following table gives the returns on CAGR basis and the risk as measured by Standard Deviation over 1, 3 and 5 years holding periods of Sensex, 1 year SBI Fixed Deposit (FD) and Gold in INR terms for the last 30 years:

in last 30years	SENSEX	FD @ SBI	GOLD
CAGR (%)	16%	9%	10%
Rs. 10,000 has become	9,12,496	1,22,434	1,84,990
Standard Deviation 1 yr period	58	2	14
Standard Deviation 3 yr period	22	2	8
Standard Deviation 5 yr period	15	2	7

Source: Bloomberg, 1 year FD rate has been taken for computation of FD returns; Data pertains from Mar 84 to Mar 14

A careful reading of the above highlights the shortcomings of gold as an investment compared to both FDs and Equities.

FDs vs Gold
While long term returns on gold are comparable to long term returns on FDs, volatility of gold returns is much higher. Gold is thus inferior to FDs for short to medium term or low risk investments in my opinion.

Equities vs Gold
While long term returns on equities are much higher than returns on gold (appreciation in Sensex was 5x of gold*), volatility of equity returns is higher to a lesser extent (3x over 3 year holding periods and 2x over 5 year holding periods). Equities are therefore a superior asset class compared to gold for long term investments and for those with tolerance to volatility in my opinion.

The number of Equity / Balanced mutual fund schemes is  more than 400  and continues to rise. How does an investor choose the right scheme?

John C Bogle, founder of the Vanguard group has suggested in his book "Common Sense on Mutual Funds" that three to five mutual fund schemes that have done well across market cycles are all that an investor needs for one's equity portfolio.

Unfortunately, as the table in response to an earlier question suggests, a majority of investors in mutual fund schemes have low holding periods and tend to jump from one fund to another chasing short term performance. This approach is likely to be both counterproductive and expensive. The table below ranks the calendar year performance of the ten largest Equity / Balanced Funds for last 10 years (each color/alphabet represents a scheme).

It can be clearly observed that there are no funds that have been consistently on the top. To take an analogy from the game of cricket, the best batsman is not the one who scored the highest in the last game but is the one who has the best batting average in say, last 10 or 20 matches. Just as one match cannot be used to judge a good batsman, similarly one year's performance is too short a time to judge equity funds. Instead, there is merit in assessing equity funds' over 3-5 year periods (infact ideally over a market cycle that is typically 6-8 years).

Funds that have a good track record across market cycles are likely to be investors best bets and 3-5 such funds is all that an investor needs in my opinion from the 400 or so schemes.

Past performance may or may not be sustained in the future.



Souce: An interview published in IIFL IQ | Vol 1, Issue 4