Parag Parikh - Stocks to Riches (2005, Tata McGraw-Hill Education) - libgen.li

Stocks to Riches: Insights on Investor Behaviour by Parag Parikh

Preface

Paradigms govern financial decisions more than market forces.
Need basic knowledge of how money grows and universal principles of austerity and hard work.
Investing puts money to work, governed by the law of the farm (delayed gratification).
Equities are the preferred asset class due to tax efficiency.
Stock market volatility reflects investor behavior, which changes as part of a herd.
Understanding behavioral finance is key to investment strategy.
Patience, eschewing greed, and conquering fear are fundamental.
Behavioral finance helps understand reflexive responses to the Capital Market.
Author's background: investor, stockbroker, financial planner, and money manager with education in behavioral finance.
Knowledge gained from scholars like Amos Tversky, Daniel Kahneman, Richard Thaler, and Warren Buffet.
The book brings knowledge of great thinkers into an Indian context.
Experiences shared with investors, fund managers, corporates, and the media.
Belief in the start of a major bull market in Indian history (January 2005).
Learning to recognize psychological and cognitive errors in investment decisions is crucial.
Stockbroker profession offers an ideal vantage point to observe behavioral patterns.
Different types of investors have varying agendas, perspectives, goals, and thought processes.
Chapter 1 explains what investing really is.
Chapter 2 distinguishes between investment and speculation.
Chapter 3 helps understand different ways of investing.
Chapters 4 to 8 cover the psychology of investing.
Chapter 4 introduces behavioral finance and emotional decision-making.
Chapter 5 explains reactions to fear and anomalies like Loss Aversion and Sunk Cost Fallacy.
Chapter 6 explores greed and behavioral anomalies like Decision Paralysis and the Endowment Effect.
Chapter 7 discusses the tendency to treat the same amount of money differently based on its source, effort to acquire, and timing (Mental Accounting).
Chapter 8 explains mental heuristics and decision biases.
Chapter 9 challenges the myth that open-ended mutual funds are the best investment for retail investors.
Money management has become a business due to open-ended mutual funds; individual portfolio managers could better serve investors.
Chapter 10 covers real-life stock markets, their participants, and their behavior.
Stock market bubbles are formed by behavioral anomalies.
Booms are followed by busts due to fear and greed.
Chapter 11 explains why to invest and why equity investment is the best option.
Equities are tax-efficient and will form a major portion of every Indian’s portfolio.
International investment companies will be attracted to India.
Dhirubhai Ambani sowed the seeds of the equity cult in 1977.
2005 marks the beginning of the Indian equity tidal wave.

Acknowledgements

Acknowledgements to clients, friends, business associates, fund managers, brokers, investors, etc., for insights into their behavior.
Gratitude to the publishing team at Tata McGraw-Hill.
Special gratitude to Mr. Chandra Sekhar for his belief.
Recognition to Dr. Shantanu Nagarkatti for initiating Behavioral Finance.
Thanks to Praful Satam for help in diagrams and charts.
Special remembrance to the author's late father, Shirish Parikh, and late aunty, Anjali P. Shah.
Grateful to the team at Parag Parikh Financial Advisory Services Ltd., including Rajiv Thakker, M. Alarkan, Hiten Sampat, Manoj Shroff, Hiroo Thadani, Nirjhar Handa, Jayant Pai, Kunal Kalra, and Shishir Karnik.
Appreciation to Tarunika (mother), Geeta (wife), Neil and Sahil (sons), and Sitanshi (daughter-in-law) for support.

Investing

Investing is a challenging game.
Conversation highlights different understandings of investing within a family.
Investing means different things to different people.
Investing is about doing something to reap benefits in the future.
People invest in families, education, land, health, charity, and external assets.

Investment Products:

Stocks: Dividends and capital appreciation.
Bonds: Safer returns.
Mutual funds: Less risky than stocks.
Real estate: Capital appreciation, rent, or self-accommodation.
Insurance: Security.
Precious metals: Hedge against political uncertainties.
Each product satisfies a particular need.

Investment Procedures:

Going long: Buy and hold.
Going short: Sell and then buy.
Trading: Buy and sell.
Innovations: Futures and Options markets.

Investor Classification:

Classified by products and procedures.
Examples: Stock trader, long-term investor, short seller, etc.
Under the banner of investing are gamblers, speculators, traders, hedgers, savers, dreamers, and losers.

Investing as a Plan:

It is a personal plan to achieve goals and move from one comfort level to another.
Need to invest earnings wisely to prepare for old age.
Example of a working couple planning for children's education, marriage, bigger house, or illness.

Investment Vehicles:

Analogous to different types of cars for different needs.
Different investment goals require different vehicles.

Trends and Diversification:

Awareness of changing trends is necessary to benefit from them.
Diversification into different asset classes is important.
Need to move on to new asset classes when purpose served.
Law of nature: Whatever goes up must come down.
Move money from appreciated asset classes to bearish ones.
Requires sufficient financial knowledge or professional advice.

Each Plan is Different:

Investment plans differ based on age, gender, family size, aspirations, and goals.
Example: Young man favors stocks and real estate, retired person favors bonds.

Trading is not Investing:

Many focus on products (stocks) and procedures (trading) without a plan.
Trading is a technique, not investing.
Day traders example.
Investment advertisements may arouse gambling instincts.
Be careful of instant gratification ideas.

Plan of Action:

Make an investment plan.
Decide on investment vehicles and procedures.
Understand if trading or investing.
Investment planning is a continuous process requiring discipline and patience.

Investment Strategy: Investment and Speculation

Investing involves postponing consumption for future savings.
Two sources of returns in stock markets:
- Fundamentals (earnings and dividends).
- Speculation (market valuation of fundamentals).
Classified into Cash Flow and Capital Gains.

Cash Flow

Belief in fundamentals means looking at dividend payouts from company earnings.
Variables: Management quality, competitive position, core competencies.
Investing in these companies enables regular income over years.
$A stock is worth only what you get out of it.$
Increase in shareholding leads to higher dividends.
Rise in stock price is secondary.
Investors wait for bear markets to get bargains.
Equity investments hedge against inflation.

Capital Gains

Profit from selling a stock at a higher value is capital gain.
Buying stocks in belief that prices will rise is speculation.
Stock price reflects value of fundamentals.
Speculators bet on the market value of fundamentals.
Traders and speculators buy/sell stocks according to their price perception.
Stock price movements happen for various reasons, investor vulnerable to uncertainties.
Inherent gambling instinct drives speculation.
Speculation has a differential tax treatment.
Capital gains model based on bull and bear phases.
The trick is to take advantage of market ups and downs.
Short-term approach is favored.
Tech boom example: Experts claimed old ways of investing were out.
Warren Buffet's success: Refraining from businesses he didn't understand, buying stocks at a discount, sustainable earnings.

Case Study on Infosys: September 2000

Study on market valuation of Infosys Technologies Limited.
Stock price shot up from Rs. 2,000 (Jan 1999) to Rs. 12,000 (March 2000), then down to Rs. 7,000 (Sept 2000).
Irrational market valuing fundamentals.
Infosys at Rs. 12,800 commanded a market cap of Rs. 85,000 crore.
Revenue compounding example at 85 percent annually for 10 years would lead to USD 9.2 trillion value, equaling the USA GDP.
Irrationality: Infosys cannot continue to grow at 85 percent, and it cannot quote at 100 times revenue.
Many lost fortunes speculating on the stock price.
Those who bought for cash flow and held onto the stock are wealthy.

The Law of the Farm

Stock market investing is about managing risks and rewards.
Without risk, there is no return.
Reap what you sow, but the crop is subjected to changing seasons.
Invest in right stocks with the right business model and fundamentals for optimum returns.
Requires patience to go through ups and downs.
Greed for quick returns destroys wealth.

A Good Strategy

Speculation benefits by providing capital for expansion and innovation.
The chance of a huge gain lubricates the machinery of innovation.
Risk is exchanged every time the stock is sold and bought.
Speculating can go wrong if:
- People do not understand the difference between investing and speculating.
- Speculate without the right knowledge and skill.
- Speculate beyond their capacity to take a loss.
The problem today is that most investors are acquiring speculative habits believing that they are investing.
The attraction of quick money and the advent of the futures market have lured them to margin trading.
For a number of people, this has become a full-time occupation due to the advent of the Internet and online trading.

Risk-Reward Balance

Investing is all about risk and reward: higher risk, greater reward, and vice versa.
Investor needs the right balance when choosing an investment vehicle and strategy.
During IT sector boom, people bought stocks at any price without rationality.
Buying only risk with no effort to balance the risk-reward ratio.
In March 2003, markets were down due to Iraq war, available stocks at low valuations with high dividend yield and attractive P/E ratios.
This was the time to invest in good stocks as one would be buying only reward with minimal risk.

Nothing is Right or Wrong

Long-term investment yields excellent returns to investors like Hindustan Lever, Hero Honda, and Infosys.
Hindustan Lever gave a compounded annual growth rate (CAGR) of 21 percent in returns for the last 13 years.
Hero Honda gave 41 percent CAGR to shareholders on their investments during the same period.
Infosys delivered an astounding 79 percent annual return to shareholders since its listing 11 years ago (includes dividends).
These returns are higher than any other investment avenue like bonds or bank deposits.
These stocks declined but the long-term results were impressive.
Short-term investments can be rewarding for the speculator: for example, speculator who bought Infosys at Rs. 2,000 and sold it at Rs. 13,800 earned massive gains.
Speculator made a killing by short selling Hindustan Lever at Rs 210 and recovering it at Rs 120.
Hard to say which strategy is good or bad, relies on individual attitude, discipline, risk-taking ability, and patience.
Long-term investing rewarding if you buy the right company at the right price.
A stock can decline significantly in the short run and yet give a decent long-term return.
TABLE: Infosys profit growth vs market capitalization and PE ratio
Net profit of Infosys grew at 43 percent CAGR, 2000–2004, but market capitalization fell by 14 percent in the same period.
PE ratio continuously declined.
If one had bought the stock at a higher price in 2000, they would be losing money.
Most of the IT experts and fund managers ignored Benjamin Graham’s words of warning: “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.”
Looking at the long-term approach seems unviable due to uncertainty, hence the stock markets have become the bedrock of brute speculation.

Three Ways Of Investing

The Intellectually Difficult Path

Investors take the intellectually difficult path of beating the markets.
Requires profound understanding of investing and clear vision.
Patience is a virtue in long-term positions.
Admiration comes in retrospect, due to inability to grasp their viewpoints.
Method about cash flow approach.
Requires keen mind to study business and economic policies.
Good management grasp and knowledge of liberal arts needed.
Such investors are always on the lookout for opportunities at bargain prices.
Not perturbed by gossip that creates short-term volatilities.
Goal is investing long-term for cash flows, not capital gains.
Never buy on impulse and can be out of the market for years.
Brokers dislike the lack of churn.
Emotionally strong and exercise restraint.
Hard work and belief leads to intellectual capability.

The Physically Difficult Path

People are deeply involved in the physically difficult way of beating markets.
Come early, stay late, choosing work over family.
Overloaded with information: visit companies, plants, and talk with management.
Information overload, constantly making/receiving calls, and monitoring stock price movements.
Market Gossip excites and base decisions one rumor.
Political developments, monsoon forecasts, GDP growth figures play important role.
Market timing on the news.
Expend tremendous physical energy and effort to beat the market.
They don’t realize that others are doing the same.
Sincere belief that keeping busy makes someone look important and increases to pick up winners.
Opportunities come when cool with time to think.
Based on assumption there are a lot of opportunities to dig hard to be successful at investing.

The Emotionally Difficult Path

Work out a long-term investment policy that is right for you and be committed to it.
Do not buy when friends or broker tell you about a great investment opportunity or when newspapers report big investment opportunities.
When broker offer credit facility against shares, stay calm and unconcerned.
When analyst on TV tell the market is going to crash do not sell.
Emotional discipline is the most difficult.
Believe in yourself and the investment policy to which you are committed.
The emotionnaly difficult long-term approach to investments wealth.
Stress on cash flow, compounding focuses investor's attention goal.

Why is Investing so Difficult

The most difficult part of investing, is understanding the behaviour of the stock markets.
Market fluctuations are based on the varied opinions expressed by its participants, which in turn are subject to change commensurate with the changing sentiments of people.
Crowd behaviour that dominates the decision-making is responsible for the sudden changes in the sentiments. Understanding behavioural science is the key to success in the financial markets.
- Its application not only helps you control your emotions but also helps you to understand other’s emotions and benefit from their mistakes.

Introduction to Behavioural Finance

Statements reflect bewilderment and confusion in the ever changing world of stock market investing.
Instead of wondering why this is happening to you, try to understand why it happens to most people.
An example story from the IT bubble and feeling bewilderd and confused.
The quest for answer led to fledging, little known field called Behaviour Finance.

If Investments do Well, why do Investors Fare Poorly?

Paradox: Studies show equities have done well with returns of 15.80 percent, yet investors say equity investments are risky.
Reality: Human beings make decisions with their hearts, not just their minds.
Emotions guide decisions that may not be in our rational financial interest.
Decisions enrich us emotionally, impoverish us financially.

Emotions Change Paradigms

The story of colleague-tutors and their students.
Emotions prompt decisions that may not be in our rational financial interest.
Behavioral finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs.

Classical Economic Theory v/s Behavioural Economic Theory

Classical Economic Theory: Markets are efficient, people make rational decisions, maximize profits.
Behavior economists: Markets are inefficient, human beings are not rational.
TIPS example.
Behavioural finance researchers seek to bridge the gap between classical economics and psychology to explain how and why people and markets do what they do.
Behavioural finance raises issues:
- Is it possible to systematically exploit irrational market behavior?
- How to avoid making sub-optimal decisions as an investor?
Goal is to close the gap between how we actually make decisions and how we should make decisions.
Psychology can play a strategic role in the financial markets.
Proponents of behavioral finance create investment strategies that capitalize on irrational investor behavior.

The Three Sources of Alpha for Superior Performance

In the past the traditional managers were able to get information on companies faster than their peers by virtue of their superior relationships with the insiders in the companies, the politicians, bureaucrats, etc. The ability to get first hand information was the competitive edge.
With the progress of computer technology, large amounts of information could be processed quickly. The assimilation of information became easy due to faster communication channels and the advent of the Internet.
We now have real time information–the quantum and speed add to the confusion. The human mind is faced with continuous decision-making and this overload leads to emotional decisions out of fear and greed. The Nobel Prize for Economics was conferred on Daniel Kahneman, who outlined the Prospect Theory, one of the key pillars of behavioural finance.
Understanding human behaviour and identifying mispriced securities due to such behavior is new competitive edge.

Loss Aversion and Sunk Cost Fallacy

Warren Buffet: "Be fearful when others are greedy. Be greedy when others are fearful."
Benjamin Graham: "Most of the time, common stocks are subject to irrational and excessive price fluctuations as a consequence of hope, fear, and greed."
Understanding our strong emotions of fear and greed is important as it impacts our thinking and make us act in ways that are contrary our financial interest.
Prospect Theory: expounded by Daniel Kahneman and Amos Tversky is one of the pillars upon which the whole of behavioural economics rests.
Toward our losses:
- We suffer from two behavioural anomalies Loss Aversion, that is our fear of losing and Sunk Cost Fallacy, that is our inability to forget money already spent.
Toward our gains:
- Status Quo Bias, that is our inability to make decisions, and the Endowment Effect, that is the tendency to fall in love with what we own and thus resist change.
Loss Aversion
Scenario 1: Given Rs. 1000, choose:
A. Guaranteed win of Rs. 500.
B. Flip a coin for Rs. 1000 or nothing.
- Scenario 2: Given Rs. 2000, choose:
  A. Guaranteed loss of Rs. 500.
  B. Flip a coin to lose Rs. 1000 or nothing.
  Research suggests people chose conservatively locked in sure profits, but were willing to take risks in order to avoid losses.
- Pain of loss is three times more than pleasure of equal gain.
  Over time, pain becomes terrifying, pleasure becomes boring and desires keep upgrading.
- Tend to see losses and profits in isolation and that is the reason we are more prone to suffer from loss aversion.
  Should not viewed different stocks or different classes of assets individually but as part of the portfolio as a whole.

Impact of Loss Aversion

Investors tend to prefer fixed income investments to stocks.
Investors tend to take their profits very early.
Investors take more risks when threatened with a loss.
- Investors tend to hold on to losers and sell winners.

Sunk Cost Fallacy

Braving rain and a flood to watch a Filmfare Awards after paying Rs.1,500 vs. having complimentary tickets.
Sunk Cost Fallacy described by Richard Thaler.
Increase your commitment to justify your past actions because your ego is tied to the commitment.

Impact of Sunk Cost Fallacy

Investor justifies past actions by using this, that he is bringing down the cost of purchase.
Housewife endures class, because she is already enrolled.
Student takes graduation and may not be learning.

Getting Out From Under

Answer the following questions:
- Do you prefer fixed income securities over stocks?
- Are you tempted to move out of the markets when prices fall?
- Does your portfolio consist of a few winners followed by a long list of losers?
- Do you sell your winners fast and hold on to losers?
- Do you make important spending decisions based on your past spending?
If the answer to all the questions is yes, then you are a victim of Loss Aversion and Sunk Cost Fallacy.
- The following suggestions will enable you to make wiser investment decisions in the future to master loss aversion.
Diversify within asset classes and across assets and taking an overall view to avoid loss aversion traps
Avoid looking at gains and losses in isolation, invest within certain percentage range of an industry etc

Check Your Appetite for Loss

Start with the assumption that you are probably more sensitive to losing money than you actually think.
Do you sell the winners and hold the the losers? The alternative is to sell half of each.

Decision Paralysis and the Endowment effect

Having trouble making decisions or resilient to change and fear decision making is a cause of Decision Paralysis.
Missing opportunities by losing out on prices rising.

Taking Decisions

Deciding or not to make a decision is also a decision so act 50/50.
Staying the same is unwise.
Fear of change includes risks such as:
- Possibility of losing.
- Avoid looking foolish or unwillingness to take risks due to emotions make up.
End result is loss reversion and egocentric human nature.

Investing and Decision Paralysis

During booms stocks reach new heights that do not last.
- Fund Manager of of leading Tech stocks should has sold out when markets weakened instead of holding the stocks in order to avoid total loss.
  The Deepak Parekh committee was appointed to advise restructuring of UTI but nothing was done.

Endowment Effect

Having something makes us feel that it is more precious than what we were willing to part with. Loss reversion makes this even harder. Being in denial of circumstances.
For example, having been offered a souvenir and then having been offered less, it is perceived as a loss to give away the product.
Ganesh limits price to sell Tata Steel for one rupee less after waiting so long to sell.

Overvaluing One’s Holdings

Raju buying Stereo set that fits perfect then returning before the trial period.
Purchasing becomes more precious and they should have done been a comparison to competing brands.
Analyst visiting the factory to see for sure, before they invest, or the company may be trying to endorse their stock. Going to analysis meets is a good way to confirm the product/ stock is doing well and have information supported that they would have gotten before.

A fund manager’s Story

Having invested into a teck company that later reported, it has difficult times approaching during a visit to the company
It makes you in tune with the company to take any possible corrective action.

Confirmation traps

The endowment effect leads people to go in for instant gratification and to ignore future opportunity costs. Some people refuse to invest in public provident funds even though they benefit from the employer having to put in an equal amount. They want to enjoy the pleasure of getting the whole salary without deduction.

Decision or not to deciding is also a decision

Postponements and delays may seem to be the path of least resistance.
Put yourself on autopilot with a little going towards investment in stocks during a trial and error stage. If you have fixed expenditures like a house mortgage instruct your bankers to make the necessary payments every month.

5 easy action steps to take or not take

Earmark your plan
Look back at your plan
Change your mind and approach to your plan if needed
Do not follow people plans make you own
Learn to sceptice good
If you worry about the choices and decisions that lie ahead is that worst situation that can happen in your life

Mental Accounting

Tendency to place different values to the same sum of money depending on acquired the effort required to acquire it.
Mental Accounting affects people’s behavior starting with losses.
Different behavior with cash verses credit card. Let’s see what you would do in the following two situations.
- lost ticket versus lost money.

Situation.
### Episode 1

Dilip started 2 with Rs 2 lacks losses. He to him his loss is only Rs 2 lacks because his gains in the stock markets were merely his winnings from his original capital and so not his own money treated the two accounts separately.
* Sonia however does not suffer from these buy.

Episode 2

Because everyone and the friend with credit card the full time part with the money attitude change since we have different mental accounts and we treat cash in Credit Card transition differently people use Credit Card because they don't believe the money change therefore business are good this is the different in our mind with cash transactions.
What kind of money do we use with others to see it in our own state mental is the money for the other.

Episode 3

Bomsi who was seen cheap with his friend because he didn't have anything to waste and had used all that one had. But wanted to save for the special moments later.

Impact of Mental Accounting on Investors

Why do investors hold on to losing investments?
Mentally they are unwilling to accept that they are making a loss to and hoping it will vanish.
Why do investors earn less interest and pay more:
There two metal accounts safe and Risk with the same money. Most people believe that a bonus issue given by the company to its is a shareholders they will make more by this by buying as if it a gift.

Plan of Action

o devise a plan of action you have to assess your prone for the metal is this going to use those thousands a lottery to spend and for those the second part no since 10 and they you were saving account you place then use those for your expensive shirt how it will be if your answer of first question is year and no 1 sec and then make it an easy to make spend with savings then use more and that you you will be able to control.
Having a wind fall should not cause to do different and to what it does what it can lead to.
Be careful what you want and always what and plan that you can follow up. By thinking what the results are you can sharpen your Internal Audit system

Mental Heuristics

### Question 1: Three birds are sitting on a tree. Two decided to fly away. How many birds are there on the tree?
### Question 2: Observe the following picture
Which line appears longer?

Availability Heuristic

One bias associated with availability is ease of recall. We are more likely to make judgments based on recent or easy to remember events rather than similar, harder to recall instances. It would be the story of the India shining the power of information and those that made the calls positive.
The Power Of Numbers For the numbers side. we we we assessment about an event is from The Occurence and The Reactions.
A newly open and good store people rush because of the performance will will continue and grow in the future or for all of the things that there are there.
We cannot always tell about the people around us with overconfidence or not to be aware of the signals sent to look at in and give in in stock price. And those signal does signal.

Mutual Fund 3 Good for people

Question 1Three birds are sitting on a tree, and two decide to fly away, and now what's your move do, and the second one. What's the line, and why these questions. To not always follow signals but to analyze the situation and then make a judgement. In short, just because everybody know there something doesn't means that the same is also valid for you.

People need to make better choices with a better thinking and look to not always follow the signals others are following.

The Stock Market Bubble

Stock markets are fascinating because they are unpredictable. Furious activity is followed by long periods of lull.
Many a fortune is made and lost. The greed and fear of
participants make the stock markets volatile. The one who can understand this, and in turn exploit it, is easily the master.
Stock markets are known for their intermittent bubbles. To understand who and what causes them, we need
to ascertain how the system works and what drives the participants. ### Stock are meant to work on the system. ### a human body is a type system with the system all around and system withing.
There are various connection that must work and communicate with the whole for that everything must come together the action and that feedback this leads to loop and balance, so a new part in there may be difficult with delay and that also has effect with the past which lead to changes in the present!
At people's beliefs is that sustains the system to work and this lead to good the progress.

The Psychology of Stock Market Participants

Government Likes Boom and has economic balance

Has an boom market.
Sends signals and foreign invest
sends a message
sur government and it makes the country well. well

Brokers are good and they clientel. increases business opportunities.

Making the Bubble

to provide illusion you made to believe that the price or in and then boost the value this makes people master and you know how to get over the people it can be easy by telling to their week point

. For this purpose you need to know the system to do it right.

For making an circle or something that it is going to be in the system for as much has the is there a new to enter again and if you've created something is going to the business or everything is for sale.

So, having said that the to follow every time or be the same there and at least. So

also has a is there a good time and has a the or
yes and not to let the is there a new so long has the is always with one another.
So what or everything is one a new system
With how it runs and this must get what the system from the to make a everything is that system.
And at last everything is that system the the with all the business, to people and there must

what's a better is that every is what must so

Why Must One Invest

Understanding the facts and financial literacy to make decisions.