Tricks of the mind

You will never hear an insurance salesman say "when you die…" or even "if you die…". It is always "if something unfortunate happens…". We don't want to hear bad news, not even contemplate about possible bad events in the future. Most of us tend to put off buying insurance or writing wills for this reason; we do not want to contemplate our own deaths. A lot of things in life can be attributed to running away from the fear of the inevitable; some things in financial planning included.  There is also a cultural bias here. In most cultures it is considered inauspicious to talk about bad things. And death, everyone agrees, is a bad thing.

 

In the middle of our straitened, stressful circumstances, we all dream that one day the clouds will open, and a huge light full of blessings will descend on us from heaven. There are enough instances in mythology of heroes being showered with flowers by the Gods – the fact that they did something extremely heroic to deserve it is often forgotten.  Every alternate fairy tale is about the poor Cinderella meeting her Prince; only the settings differ. All religions promise deliverance in the hereafter. Religions also impose stiff conditions to the deliverance, but we do not want to think of those difficulties all the time. We always want to believe in the ultimate deliverance; life will somehow ensure that we reach there.

 

Financial products exploit this to the hilt. The Pension Plan has a promise attached to it that in your retired life, you will keep getting a monthly income; the Child Plan advertisements show some children playing on the beach, and your child playing with a stethoscope around her neck, playing on our sentiments, and somehow managing to convey that investing in that plan will ensure that your child will become a doctor. Never mind that the child may have other ideas; or that the amount you get will depend on the amount you put in. More important, never mind how and where the investments are made, what are the charges, commissions, and leakages; and is that the best use of your money? We will subscribe to the plan, contribute a few thousand rupees a year, and happily live in the illusion that we have taken care of our child's future. Ditto for daughter's marriage. Marriage plans are very popular too.

 

The Child Plan, Marriage Plan, or any such "life goal" plan from any insurance company invests in some equity and some debt through a mutual fund inbuilt into it. After deducting a lot of commissions. Why can't we save on the commissions and invest directly in equity or debt ourselves through mutual funds? It has the same effect, while saving a huge lot on commissions. We perhaps do not want to do that since the end use is not labeled – how are we sure that we are taking care of our daughter's marriage, or child's education, unless someone labeled it as such? Also, we do not want too much transparency – the opaque structure of these products suits us since we want to live in the assurance, never mind its full or complete validity, that we are doing our duty – please let me not know how I am doing every once in a while. Why swallow the bitter pill of reality every time – the comforting opiate of faith and hope is no doubt better?

 

We repeat our puja every day, and go to the temple every Tuesday. That gives us a lot of comfort since we are taking care of our after-life through some rituals which promise deliverance. Religions have rituals which hold the promise of unleashing great potent forces; so does financial planning!

 

When you ask share traders about their trades, you will always hear success stories more than stories of losses made. Partly it is deliberate, the desire to impress others through stories of success. Partly it is due to the fact that the mind tends to forget the bad experiences over time, or discounts their importance, and builds up the good ones. In terms of evolution this may be a desirable thing since optimistic and positive minds tend to live longer and happier, but in terms of decision making such forgetfulness may not be the ideal thing. This may induce us to get into risky trades without considering the downsides. Several times, when we are sold on some investment, we want to avoid going into the downsides; our mind rejects all the negatives and soaks in the positive news. Not a different state of mind from someone in love and possibly not married – the mind sees only positive things about the beloved. Marriages and staying together are known to shatter such illusions. But as in the case of investments, it may be too late – you have already bought into it.

 

There is the other extreme too, that is very common.  There are people, in fact many of them, who are so afraid of taking risks, that they will invest only in Fixed Deposits. With nationalized banks. "No shares for me, thank you, they are too risky". "Real estate? I have heard enough stories of people losing their land to encroachment". They are very happy to earn 7% pre-tax on their FD's while inflation runs at 9.  But they sleep better.

 

Morals to these stories? When it comes to investments there are several morals you can pick. Whether you derive morals from them or not, it is good to be aware of these tendencies. One of the things a good investor needs to avoid is self delusion. And as seasoned investors will vouch, that is the most difficult thing to do.

We work in default mode

Have you ever missed the money that is deducted from your pay-slip every month as PF contribution? It is very likely you don't even know what the contributions along with interest have amounted to, over the years. If, on the other hand, you had been investing the same amount in a bank account at the same rate of interest, would the corpus have amounted to so much? Very unlikely, if you come to think about it, for you would have dipped into the money along the way; it would have come out in small chunks and you would never have realized it.

 

There are people who sometimes buy some shares and forget about them entirely for some years, or even decades. One fine day they wake up to discover that the shares are worth a significant sum of money.  If they had been keeping track of it regularly the temptation to sell the shares somewhere along the way would have been too high.

 

The power of compounding is incredible. It multiplies your money to unimaginable proportions if left untouched over a long period of time.

 

The same effect can be observed in real estate. Since the amount of investment is very high to start with, you put in all you have, and borrow a substantial sum. You take a large loan from the bank and get into an EMI commitment, all that you can afford. As you get additional income along the way, your focus is to prepay the loan to bring the loan down to more manageable levels. You adjust your lifestyle in order to be able to pay more towards loan repayments. All the while, when you are focusing on the repayment, the land or apartment is left to grow in value undisturbed. And one fine day you find that you are free of the loan and your real estate is worth a substantial sum of money.

 

In all the above cases, there is not too much thinking or decision making to be done along the way. You make the decision at the time of buying, and then operate in a default mode. You would of course do well to monitor the portfolio once in a while for any signs of fundamental changes in assumptions; but you leave the portfolio pretty much alone. 

 

The key to wealth creation lies in not being too active!  All of us like to operate in the default mode; the trick is to identify those default actions that are beneficial to us in the long term and then get into the habit. Too much thinking and analysis could be detrimental in this situation; in fact too much thinking and analysis is injurious in most situations!

 

We can use this insight into a fundamental trait of human psychology to our advantage. It is good to have certain long term goals for investments and then keep working toward s them in a programmed manner. It is not really a good thing to switch from one investment to another too often. It is good to go in for borrowings, especially for buying your house, and for investments, since it forces us to work towards the repayment.

 

Whatever your income is, decide on how much you want to spend, and put the balance into a separate account. This account should be earmarked for investments, and linked to a demat account as well. Whatever investments you do are from this account, and whatever returns you get, including dividends, go into this account and not into your spending account. Once a month, you invest the balance money lying in this account into some investment, whether in direct equity, equity funds, fixed deposits, debt funds, real estate, or gold/silver. Any sale or redemption proceeds go back into this account. This way you have "paid yourself first" by diverting money into your investment account from your spending account.

 

As to the investment account, you don't take anything out; just keep putting in. Any money that is used from there goes into investments; any money coming in from investments comes into the investment account.

 

You should also be aware of how the same tendency to operate in a default mode is misused by marketers in structuring financial products. All insurance products that have a savings element attached to them compel you to pay the premium periodically, which is good; they also compel you to not look at how your investments are performing too often, which is also good; hence, when you finally get some money back in the end, it seems like a big sum to you.

 

However, what we ignore is the fact that a huge percentage of premiums paid on such insurance products goes towards administration charges, agents' commissions, and all other kinds of charges. Since we are operating in a default mode, we do not think about this, but we should. What if the same money that we paid as premium goes into our own investment account and we invest in a mix of equity and debt mutual funds? The insurance company too does the same thing – runs a mutual fund at the back end and puts our money into a mix of equity and debt.  When we do it on our own, we will save on all the commissions and the miscellaneous charges. And if we leave it alone long enough, and not check our corpus too often, one fine day we will be surprised at the amount of money we have left.

 

Think about it. And think of other ways in which you can get into some "good habit" default modes of operation. And think about how many other ways marketers dupe you by taking advantage of the fact that we all operate in default mode.

We trust in everyone, but ourselves

When we go to the doctor we trust that he will give us the best advice possible which is in our best interests. The same applies for a financial advisor – or what passes for financial advisors in our country, which is insurance agents, ppf agents, relationship managers and middlemen of all kinds. In case of the medical profession, at least we pay some fees to the doctor, so there is some incentive for him to stay honest if he is of the principled kind. In case of financial advisors, we do not pay anything; we know that the agent gets paid his commissions from the company which sells us the product; and still we expect that the advice will be in our best interests!   We have an infinite capacity to delude ourselves, so as to not take responsibility for our own actions!

 

Almost every diagnostic clinic offers a standard percentage cut to the doctors who recommend their tests. The doctors have targets from the hospitals they are part of for "bed occupancy" and " revenue per bed per day".  Medical representatives keep pushing doctors to prescribe their more expensive brands in preference to cheaper generic alternatives. Doctors are sponsored on foreign junkets which are titled as seminars. Equipment such as sugar monitors are sold at a subsidized rate since the strips which are consumables required daily can be sold at fifty times the production cost.

 

Consumers are not well educated on generic or other-brand alternatives for the same drug. Even those who ask for a generic alternative get cheated because there is an industry out there which makes very cheap generics with very expensive printed MRP's which makes it a double whammy – the consumer pays more than what he would pay for a reputed brand for buying a cheap generic! Medicines are also bundled into all kinds of useless combinations in order to position them better and increase the price - in several cases the combinations are actually harmful.

 

If you are unfortunate enough to land up in a hospital for an ailment yet to be diagnosed, you can be sure there will be several tests, and several cross referrals to other specialties and further tests prescribed by those doctors. When you are being admitted to the hospital you will likely be told that only the more expensive rooms are available. This will happen especially if the hospital knows that you are going to claim insurance – they ask you that question even before asking you your name.  All operation and consultancy charges are in direct proportion to the amount you pay for the bed.  I don't know how this system is allowed to persist; apparently it has something to do with cross-subsidizing the people who are less well off, but surely there are better ways to do that?  

 

When it comes to insured patients the system ensures that the bill is inflated.  The patient does not mind; he thinks he is getting better treatment at someone else's cost. Third Party Administrators (TPA's) in case they are involved take a pretty big cut as well. All this is finally paid for by all consumers in the form of higher insurance premiums and also higher costs even for those who do not have insurance. The US healthcare system shows us to what ridiculous levels all this can reach. We in India have started moving down the same path – for the last few years, the rate of inflation in medical costs is more than twice the normal inflation rate.

 

When anything becomes an industry with large investments,  with an entire ecosystem emerging  to back it up, you can be sure demand will be engineered or induced in such a way that the industry survives and grows. Do you hear the Biocon ads on diabetes control  on FM? Is that the industry responding to the large incidence of diabetes or is it industry creating a hype around the disease to create an unnecessary need to do expensive tests and increase daily monitoring?  When there are several huge hospitals in the city with investments of a few lakh rupees per  bed, don't you think there is an incentive for the hospitals to create a need around using their services? To what extent is the hospital there because the patients need it, and to what extent are the patients lining up because the hospital came up in the first place, is a moot point. The answer in all such cases is fuzzy.

 

Just like medicine, financial services is also an industry. Just as with the medical industry, we need to be aware of the pitfalls of dealing with the financial services industry – not all companies or advisors out there are out to cheat you, but there are many who will; and there are many who will take advantage of your ignorance to push an unsuitable product on you, which while it may not be cheating, would be bordering on the unethical.

 

The insurance agents have their targets. They are induced to push ULIPs which are pure scams, even in the so-called "capped commissions" new avatar, or the old fashioned Endowment plans which are non-transparent with huge commission structures, and never Term Insurance which is all you need the life insurance company for.  

 

Mutual Fund distributors push new untested funds by asking you to shift your money and keep churning – this is because the commission on new funds is higher. The fund industry will keep coming out with newer variants of funds most of which do not make sense and have very vague mandates. They keep shoving the same toothpaste into newer packaging. New mint flavored flexi-cap infrastructure diversified fund! I am waiting for that to come – that day is not far away.

 

Recently a scam came to light – it was discovered that some very large corporate clients of money market funds were effectively earning two days' interest by deploying one day's funds – this used to happen by taking advantage of the cut-off times for different funds that were kept different to aid in this. Who pays for the extra day's interest? The other unit-holders of the fund, of course. Since SEBI has put in place some rules to safeguard against this in future, the fund industry fears a drop in corpus.

 

Gold and silver may be a good investment, but not in the form in which they are usually sold.  There are huge margins on gold and silver which are charged in various forms – making charge, melting charge, labor charge, margin charge – which makes jewelry or silver items a bad investment. Even the margins on gold biscuits or silver bars can be quite high if you do not know where to buy them.   Since more and more people are starting to get a little savvy about gold values, the industry has started pushing diamonds now – diamonds may be forever but their investment potential is poor. To the best of my knowledge all rocks last forever. The diamond industry led by De Beers has done a fairly good job of capitalizing on the already existing mystique around diamonds, and adding to it, to their commercial benefit.

 

The relationship manager at the bank has his targets – and they are product specific. You can be sure that whatever product he is pushing is based on the commissions the bank is getting, and not because he has your best interests at heart. He also has the unfair advantage of having access to your bank account information, and knows how to strike you at your most vulnerable moments, when you have money to spare.

 

None of this should surprise you – when it is an industry out there, all these practices are bound to exist. What should surprise you however – it does me – is how we as consumers are not really bothered to educate ourselves at least to the extent required to see through these marketing tactics and decide on what is really good for us. I suspect a large part of the reason is our reluctance to take things into our own hands; in case we educate ourselves we have to face up to the fact that we are ourselves responsible for our health (or illness), both in the case of physical health as well as personal finances. It is far easier to just trust someone blindly and blame the vagaries of fate and the vicissitudes of life for our state of perpetual impecuniousness. 

The Citibank Fraud

Rupees four hundred crores siphoned off into his relatives' account by a relationship manager. People are very surprised that this has happened, but come to think of it, If not Citi, it would be some other bank; if not this type of fraud, it would be something else.

The very fact that you are custodian for someone else's money, and the fact that you are bang in the center of flows running into crores of rupees, is a situation that is ripe for such frauds.

It starts with the very top. The government encourages banks to lend money to depositors in the name of farmer loans, or priority sector lending, where the cost of operations and probability of recovery, and the returns in terms of interest, are much lower.  The fact that many of these loans are subsidized introduces a kind of power in the hands of the branch manager that can only lead to favors being doled out for a fee. Once the fee is given for the favor that is doled out,  is it also implicitly understood that repayments can follow their own logic ?  Once in a while, to make a political point, the government announces loan waivers.  The borrowers are aware of this and they take full advantage of it. It is usually the rich farmers who gain from such schemes; for such favors, I am sure other favors are percolated back up, in return, to politicians who make this happen.

The manager who sanctions the loan at the bank is dealing with someone else's money and discharges a fiduciary responsibility for the depositors. The branch manager sitting in  a  remote town with the power of patronage at his disposal, who is not earning very much by way of salary, has an incentive to tweak the system a little bit. He can if he wishes rationalize it to himself ,  since person A to whom he grants the loan who is in a position to help him in other ways, may be an equally sound borrower as person B, so what is the harm? There are also all kinds of intimidation tactics used on branch managers at remote village branches to dole out loans, or else.   The recent case that came to light last month of a few public sector bankers making money on loan sanctions surprised no one. Thankfully, in that instance, even the expected outrage from the media was a bit muted; perhaps they realized that it would be naïve to protest too much.

Apart from their interest income, every bank is into increasing fee - based income nowadays. This leads them to sell all kinds of products to their customers, sometimes whether they need them or not. In my own case, when I was CFO of a company that had both revenues and expenses only in rupees, I had this guy from a multinational bank trying to sell me a product that involved rupee - dollar interest rate swaps, and dollar-yen rate differentials. The way it was being sold, I could easily have fallen for it, except that I knew my board would think I had gone nuts. Again, with reference to behavior patterns, this may have no direct bearing on corruption, but it does do a lot to the way business and revenues are viewed inside the bank. There is also the proprietary trading desk of every bank. The bond trader who buys and sells billions worth of bonds every day, stands to make huge profits (or losses). The bonuses of people in the trading desk, and of course of those who are in the merchant banking division, are quite substantial. This I am sure puts an overall pressure on the system and on others to become aggressive and earn more, which are all risk - inducing behaviors.

It is not as if banks are in a position to recover their  moneys   easily, if the borrowers decide to turn sticky. The legal procedures to be followed are very complex and time consuming. Sending bouncers to recover the money is not permitted. Attaching property takes time; and when the time comes, there may be nothing to attach. Borrowers use the legal system to their advantage to delay things. Frequently banks are forced to offer fresh loans under a different guise to enable repayment of installments due, in order to reduce the amount of defaults shown in the books. Yes Bank recently asked its Microfinance borrowers to repay 400 crores owed by them to  Yes   Bank prematurely; I do not know what the status is right now but I am sure the repayments have not flowed in – how can they ,  given that the moneys have already been lent out and the institutions themselves are in some amount of trouble?

Then you have the institutional fund managers which include banks, insurance companies and the like. They buy debt securities from the market in various forms and guises. When the subprime crisis hit, several banks the world over almost went under; some of them were bought over by others, and almost all were severely dented. This was due to such securities on their books.

Barings which was an old and venerable institution went down because of a rogue trader in derivatives. The internal controls of the bank were not strong enough to stop bad money chasing good. 

As a depositor, there is a lot of comfort that the government has insurance in place to cover for banks going bust. However, there are limits for such covers, and if several banks decided to go bust at once, there will never be enough money in the system to cover it. As an investor  though , there is no comfort available.

In the Citibank case, it was a case of forgery, coupled with naivete on the part of some, and collusion in case of others. Reminds one of the Bernie Madoff scandal, again quite recent, where Mr. Madoff of New York hoodwinked several sophisticated institutional investors over several years, with fictitious investment statements generated on his office computer. He was just running a Ponzi scheme. You thought such investors would know better.

Banks of course have elaborate mechanisms and internal controls to mitigate these risks. All companies do. But such controls are frequently bypassed. And when it comes to companies dealing only in money, it is far easier for lapses to go unnoticed for far longer, and the effects could be far more devastating. All this constitutes a case for a significantly higher risk quotient when it comes to institutions where money is the product being bought and sold.

If you want to invest in a bank as a shareholder it is something worth keeping in mind.

A crazy market called Private Placements

Do you remember the times when IPO's were the rage in India? The broker would whisper to you a few months before the proposed issue, that the shares are available directly from the promoter's holdings, the so-called management quota, which offers assured allotment. The IPO is a lottery, you may or may not get the shares, if you get them you may get too few, this is an opportunity not to be missed, such things don't come around too often, everyone is making money look at the previous issue from the same promoters, the fact that he is under investigation by the CBI is proof that he's made so much money that the politicians are jealous of him'… You rush to subscribe since you don't want to miss out.

 

People who missed the Google IPO at $85 are feeling pretty miserable today since they don't want to miss the next big thing – Google's shares are quoting above $600. If you missed out the recent Coal India IPO you will be feeling a little left out. Never mind the several other IPO's that tanked. Human memory is short on failures and long on successes. On hindsight, we always see ourselves picking out the winners.

 

Venture Capital and Private Equity firms invest in companies before they go public. They keep looking for companies that are run by committed promoters, have a good idea that has great potential, have already shown that the product has takers, have exhausted their initial funds, are not yet ready for an IPO, and are desperate for additional funding to see them through till the IPO. The VC takes a substantial stake and gives the company a new lease of life. Whether the company will succeed or not is still uncertain, but if it does the VC makes multiple times his investment. The VC gets in at a reasonable valuation, and cashes out at the IPO. For every five investments he makes, he expects two to tank totally, two to at least return his principal, and one to do so well that it makes up for the rest.

 

People who invest in VC and PE firms are very clear about the risks they are taking. They are definitely expected to be in the HNI category.  Then there are the Angel Investors who enter at an even earlier stage than VC's. Their money at stake is lower but their risks are much higher. All these investors do a lot of Due Diligence, including sending a team of marketing, accounting, finance, and legal experts to rip apart the company's books and rip open the promoters' brains, before taking the call to invest. The company's financials, mind you, are not available in the public domain since it is not listed.

 

And then there is the IPO and the post IPO secondary market. This is where the early guys cash out, and the public boards the bus. Considering that it is now a public company where a lot of uninformed guys like you and me invest, widows put in their pension money, etc. the degree of disclosure is mandated at a far higher level by law. There is a whole ecosystem of analysts and reporters who mine the company's accounts for information and write informed pieces for the larger audience.

 

The system, with all its kinks and flaws, seems fair. At least on the surface. Till Facebook happened; and Zynga, Groupon, and Linkedin.  Facebook and Linkedin are "social" companies that need no introduction; Groupon is a "social" site that gets people together to buy things by driving better bargains; Zynga is the gaming company that is behind the "social" games like Farmville, Mafia Wars, and the like. Facebook has 500 million subscribers today – if it were a country it would be the third largest after India and China – and it is growing. Groupon just refused a $ 6 billion buyout offer from Google (that's Rupees 25000 crores). Zynga's games are spreading faster than any virus, and show signs of staying in the human system far longer. All very successful, and all following the latest theme of "social networking". Reminds us of the 90's  when dotcom was the rage.

 

And all of them are yet to come out with their IPO's. They are run by their promoters – usually kids just out of college which is not to take away from their genius – who still exercise total control, have a few employees, a lot of server farms, and zillions of column centimeters in the media. Their total investments in the venture thus far would be in the region of a few (ok maybe a few hundred) million dollars – definitely nowhere near even a billion.

 

They are sitting on a gold mine. How do they cash out? They can go in for an IPO and sell part of their stake and still retain control and net a few billion each.  But this involves greater disclosure, more scrutiny, and more accountability to the public. They will get there eventually, but every promoter is reluctant for obvious reasons.

 

They could invite VC's or PE's who will descend with their lawyers and accountants and dig into the innards before they put in their money; and they are savvy investors who can afford the experts' fees.  They can't sell to too many of them of course; SEC rules stipulate that any company that has above 500 investors will have to comply with higher disclosure norms irrespective of whether it is listed or not. And a lot of employees in these companies already have stocks; some of them have even sold their stakes to others.

 

Or they could do something in-between that enables them to have the cake and eat it too. Facebook has got in touch with smart merchant bankers. They are creating an investment fund, or Special Purpose Vehicle (SPV), call it what you will, for investors to put in their money so that it can be invested in Facebook. There are hundreds of investors at the backend but the tally for SEC purposes is just one, since the "vehicle" is shown as the investor. Facebook has just raised $ 2 billion through this route. The problem is, this is based on zero public disclosure, no one knows what they are getting into, the  investors into those vehicles are funds which handle other people's money (people like you and me), they are investing on a faith and a promise, and a lot of hype. The implied valuation of Facebook based on the current placements is $ 50 billion dollars, which is a lot of money if you come to think of it. Considering the fact that Facebook just issued $ 120 million to a PE investor Elevation Partners six months back at an implied valuation of $ 14 billion things look definitely scary.

 

There is a lot of criticism. The SEC is investigating, but current laws seem insufficient to deal with this. People are asking questions as to how this can happen. But the merchant bankers are unfazed. They are saying things like this gives an opportunity to people to get in early, it broadens the market, it deepens the market, it is akin to late stage private equity investment, it is good for the economy, it is good for the entrepreneur, and so on. But merchant bankers are known to be masters of spin, quite unscrupulous, and very thick skinned.

 

Linkedin, Groupon, and Zynga – it's a similar story out there.

 

Where will this go and end? Let us watch developments. At the pace at which events unfold nowadays, the denouement cannot be far away.

 

 Anyone betting on a repeat crash like what happened during the dotcom or the subprime?