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Updated: July 10, 2010 21:13 IST

Nuggets of investment wisdom

D. Murali
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Investors, especially personal investors, often ignore large parts of the big economic picture, rues Robert Cole in ‘The Unwritten Laws of Finance & Investment’ (www.vivagroupindia.com).

He notes that many investors prefer to focus attention on specific issues that seem likely to affect individual shares, or on narrow comparisons such as the difference between the interest rates payable on deposits at rival banks. “It is as if investors assume they can do nothing to take account of the big picture and are somehow obliged to assume – or hope that the general environment will be benign.”

PV of the living goose

For instance, it is tempting to assume that investments have innate capital value, while in fact the value of most things is related, directly or indirectly, to the income produced, the author observes.

The goose that lays the golden eggs has minimal value as a carcass; it has much greater value as a producer of precious metal, he analogises. “If you can calculate how many eggs will come, their size and the prevailing price of gold when they are laid, you will get a pretty good idea of the present value of the living goose.”

Likewise, dividends are crucial. A quote cited in the book is of Nils Taube, exhorting investors not to underestimate the value of a company with a strong record of paying an increasing dividend, because long-term evidence suggests that dividends have accounted for an astonishing two-thirds of investors’ total returns.

Wonders of compound interest

Dividends seem small, at first sight, insignificantly small, so how can a few rupees matter much? Yet thanks in part to the wonders of compound interest, and the fact that successful companies increase dividends at an accelerating pace, dividends create lots of value, explains Cole. The best companies, in his view, are the ones that can increase dividend payments, because the result is a rise in the capital value of the company.

An apt insight of Charlie Munger, mentioned in the context of compound interest, is that there are huge mathematical advantages to doing nothing. Though the interest paid on interest is less obvious, it magnifies the value of investments, Cole instructs. “Like a snowball rolling down a hill, value can be added at exponential rates. After a surprisingly short period the accrued interest can grow larger than the original lump of capital.”

Imprudent indebtedness

On the converse, the interest accumulation can work against you, in the case of debt. It is easy for honest borrowers to become enslaved in a repayment process which, thanks to the burdens of interest, chains people to an exhausting treadmill, the author cautions. “Even relatively modest rates of interest rack up the overall costs if you borrow over any significant length of time… At 12 per cent a year, the cost of repaying a twenty-five-year loan is more than trebled.”

The ‘ugly’ face of debt is evident in imprudent indebtedness, which lies at the heart of many investment failures; fraud, silliness and bad luck are the other common causes of failures, he finds. “If you make investment losses on borrowed money, the effect is crippling.”

Damage potential of inflation

Another economics concept that the book discusses is ‘inflation,’ once described by Ronald Reagan to be ‘as violent as mugger, as frightening as an armed robber, and as deadly as a hit man.’

More dangerously, like a wolf dressed as a sheep, inflation can appear to be a good thing, in the short term, as Cole alerts: Wage-earners see inflation to be good because employers are obliged to increase salaries; industrialists may put up prices and increase revenues, reaping what they see as a positive from inflation; and inflation appeals to borrowers, including mortgage payers and governments, because it reduces the size of debts in real terms.

Despite seeming thus innocuous, inflation lowers the underlying value of money and makes it more difficult to plan ahead, guides Cole. “Wage earners might get paid more, but they also have to pay more for the things they need and want. Industrialists also have to pay more to produce goods. Since lenders lose where borrowers gain, inflation makes it more difficult to take out loans…”

Dramatic hyperinflation as in Zimbabwe hits the headlines, but small amounts of inflation do lots of damage as well, one learns. If you retire on a fixed income and the cost of living rises even quite slowly, the things that you can put in your shopping basket will become progressively less appetising, forewarns Cole. “They may become progressively less nutritious, too.”

Investment history repeats itself

Towards the end of the book is a section titled ‘axioms of experience,’ opening with a quote of John Templeton, thus: “The four most expensive words in the English language are, ‘This time it’s different.’” Investment history repeats itself, reminds Cole. Protect yourself through proper planning, he urges.

“Investment insight comes with information and intelligence. Those armed with facts and astute interpretative skills are best placed to protect and improve the value of their savings.” From the pages of ‘Pride and Prejudice,’ Cole extracts the description of Mrs Bennet by Jane Austen – as a woman of ‘mean understanding, little information, and uncertain temper’ – and says that the three attributes are connected and, with finance and investment, often lead to disaster.

One other way to reduce the cost of making mistakes is to play games. Run dummy portfolios using web tools offered by online stock-broking firms, the author suggests. He assures that important principles of risk-taking and investment can be learned through board games such as backgammon and chess, or playing card games such as poker and, especially, contract bridge.

Apply rules appropriately

It is not unusual to expect hard-and-fast laws and infallible rules to work in the world of finance and investment. Alas, this is a realm with very few absolute truths, as in life, says Cole. “Even sensible rules are not always applicable or appropriate, and have downsides. Hence the value of the Chinese proverb which says that deep wisdom comes with deep doubts.”

Choose horses for courses, he counsels; that is, different sorts of investment wisdom should be applied in different market circumstances, and for different purposes. “What suits the parent saving to help pay for a child’s education, for instance, will not suit the teenager saving for a new computer game or the newlyweds who want to buy their first house.”

The book mentions a quote of Dick Amey, as follows: ‘Three groups spend other people’s money: children, thieves, and politicians. All three need supervision.’ To the list, you may add ‘investment advisers,’ too, because ‘it is far easier to experiment with money that is not your own and fail to spot extravagance, profligacy, wastage and fuzzy logic.’

Accept full responsibility for the investment decisions that affect your savings, the author recommends. At the very least, it is good to ensure that those looking after your cash have what is sometimes called ‘skin in the game,’ he adds.

Investor, the gardener

The sign-off page of the book compares an investment portfolio to a garden, in terms of constant maintenance that is required, routine jobs to be done and emergency tasks that will not wait, all in a changing environment. “Where gardeners look to the seasons, investors look to the economic and market cycles. Like garden plants, investments have periods when they catch the attention – when they are flourishing – but they also need time to be left undisturbed, for preparation, rest and regeneration. Some investments last a long time; others have a shorter life expectancy.”

Left to their own devices entirely, investments go to seed alarmingly quickly, tells Cole. He guarantees, however, that with time and effort, skill and some luck, there are rich rewards to be harvested.

Imperative read for the knowledge-thirsty investor.

**

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