Indo Pak match

Gladiators out on the field,

Each country's chosen champions;

A Roman Circus, where the assembly

lines the stands, cheering, and bays for blood.

Caesar is there up in the stands,

Displaying love for sports, and country.

Millions more are lining the aisles,

with scarcely disguised lust for victory.

Pent-up passions coming to the fore,

Jingoists waving flags, and uproar.

It's not about the game on the field,

It's far beyond that, and much more.

All wars require an arena,

for some, it is the cricket field.

They need champions, and an enemy:

To fight is an inbuilt human need.

Tera Kya Hoga Kalia?

An exercise in probability theory

You are of course familiar with the Kithne Aadhmi The scene in Sholay.  For those of you who are not, this is how it goes.

Kalia and two others (they are not named in the film - let’s call them Amar and Akbar) are sent by Gabbar on a special assignment to liquidate Jay and Veeru. The three brigands are thrashed by our heroes and return empty handed.  Gabbar is not amused.  He lines them up in front of him and starts loading his revolver.

It’s the famous Hindi film revolver with six chambers.  Gabbar loads three bullets in three adjacent chambers.  He rotates the chambers effectively randomizing them. He turns and faces Amar, Akbar and Kalia who are standing in that order respectively.

The plan is simple.  He will point the gun at Amar’s head and pull the trigger.  He will then proceed to Akbar and do the same.  Kalia is the last in line, and he will do the same to Kalia.  He will not randomize the chambers between shots. You are now at the point where he is about to start this famous Bollywood version of Russian roulette.  You are part of Gabbar’s gang and you are also the bookie.  You would like to offer odds to the rest of the gang.  Before that, however, you need to calculate the odds.  So you take out your pad and proceed to calculate probabilities for the following possibilities.  You had better be right, since your money is on the line.

1. Before the shooting starts: What is the probability of Kalia dying?
2. After the first shot: if Amar is dead, what is the probability of Kalia dying?
3. After the second shot: If Akbar is dead, what is the probability of Kalia dying? (you don’t know Amar’s fate)
4. After the second shot: If Amar and Akbar are both dead, what is the probability of Kalia dying?

You also know that Gabbar is an avid gambler and likes to play cat and mouse with his victims.  He has already told you his alternate game plan. After the first shot, Gabbar might give an option to Akbar to choose whether he wants Gabbar to randomize the chambers or not. In such a case:

5)      In case Amar is dead, what would Akbar choose?
6)      In case Amar is alive, what would Akbar choose?

Akbar happens to have an M.Sc. in statistics and hence is likely to be very logical in his choice.  He also wants to live if he can help it.

Now that you have calculated all the above, imagine another scenario, where Gabbar is going to randomize after every shot.  In such a scenario:

7)      Before the shooting starts: What is the probability of Kalia dying?
8)      After the first shot: if Amar is dead, what is the probability of Kalia dying?
9)      After the second shot: If Akbar is dead, what is the probability of Kalia dying? (you don’t know Amar’s fate)
10)     After the second shot: If Amar and Akbar are both dead, what is the probability of Kalia dying?

You can post your solutions in the “comments” section against this article.

(don’t try googling – you won’t find the answers since I just made all this up)

The Globalization of Unpredictability

“The crisis in Japan is going to cause huge losses to insurance firms.” That much is obvious, but the point to be noted is that it seems to have caught both the insurance companies and the power utilities running the plants off guard. One thought the business of insurance firms as well as people running nuclear plants is to be prepared for unpredictable risks.  As one of the officials of the firm running the nuclear plants was quoted saying “we were prepared for disasters such as Tsunamis, but we were unprepared for an earthquake and Tsunami of this magnitude causing this extent of damage”. The whole world is concerned with the extent of damage wrought in Japan. The tentacles of the financial system extend across the world, and any incident anywhere impacts the rest of the world in myriad ways.

Rise and fall in stock market indices are normal. What is not normal is the extent of crash that sometimes happens – a case to point being the worldwide fall in the aftermath of the Global Financial Crisis. The reason was not just sub-prime, but a host of other global economic factors, which again somehow seemed to be linked to sub-prime; no one really knows or can unravel the full extent of these linkages.

We are shocked and dismayed at such meltdowns. When the entire system suffers a shock like this, our faith in our infallibility is shaken. We believe we have built systems and processes to take care of any shocks and that the even tenor of our lives will not be shaken. Both at an individual level, as well as a systemic level, we convince ourselves, we have the ability to withstand shocks of any kind.  How valid is this belief and in reality is this kind of insulation achievable?

Historically, humankind has always been exposed to unpredictable events.  One king used to invade another and there used to be plunder and pillage as a natural consequence. Natural calamities would destroy or carry away lifetimes of effort and destroy entire towns or villages. Lack of communication systems would keep people cut off. A flood or a drought would destroy means of livelihood with monotonous, but unpredictable, regularity. There were no insurance mechanisms in place. People had to rely on their own ingenuity, and their personal and social networks to get back on their feet and continue with their lives. This has always been true and it has been accepted as part of the human condition. 

What has also been true is that we always recognized the unpredictability of human affairs, and accepted a lot of things as the workings of fate. Every culture has a strong thread of resilience running through its philosophy and way of life to enable its people to cope with unpredictability. Human ingenuity has evolved over time to absorb these shocks and emerge stronger for it. To that extent things are the same. What is different, however, is our increasing belief that we have built, or shall be able to build, systems of increasing sophistication to mitigate these risks. I am now referring specifically to financial mitigation – we feel that our stock markets, banks, insurance companies, global tie-ups, and other constructs will somehow eliminate these risks.

We have built complicated statistical models with all kinds of distributions and sigma limits to contain the world within bounds of predictability. We build such models based on past experiences after ignoring outliers as not fitting the model; make a range of assumptions on the future which, being a range, will be restricted to one; model the future into one of our known theoretical constructs; make our decisions based on that, and then rest easy on the assurance that we have managed to control the world as known to us!

It is not any different from what we have historically done; humans have always insulated themselves into a cocoon of comforting predictability, whether it be in terms of geography, community, religion, culture, business networks, or martial alliances – all to make life more predictable. Invariably, some outside influences have broken into these cocoons, shattering all illusions, and exposed the vulnerability of human life and human endeavor.  Our statistical models are nothing but an extension of this search for predictability and security.

What is different now is the interlinkages across the world which makes more and more people depend on the same models and the same constructs, and the forces that compel entire systems to make decisions based on the same set of assumptions. When money is pulled out of the Indian stock market, a lot of money is pulled out because all FII’s think alike; they think alike since they follow the same accepted wisdom; they follow the same accepted wisdom since everyone is interlinked and believes in the same infallible reality on a far greater scale. Insurance companies compete with each other to offer lower premiums – for doing this I am sure they have to ignore some of the “outliers” in terms of risk; other insurance companies have to follow suit since if they do not, they will be out of business. All hedge fund managers think alike. So do all fund managers, actuaries in insurance companies, central banks worldwide, presidents and prime ministers,… the list goes on. Even if they don’t think alike they are forced to act alike. The interlinkability of the modern world ensures that.

When problems are at a retail level, the impact is restricted. More and more problems today reverberate globally in terms of impact. Paradoxically, as we strive to control our  own destiny more and more through these global systemic constructs, we get more and more impacted through remote events happening elsewhere and are less and less in control of our own destiny!

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.