Sunday, October 13, 2002

Averaging Price or Compounding Losses

My Investment Rules

After a few years of investing experience, which includes some bitter losses and some sweet successes, one tends to form some rules of the thumb for oneself. I have come across investors who have had wacky and sometimes whimsical rules that they stuck to at all times. I have mine too – two of them

Rule One – Do not lose money

Rule Two – If you manage to break Rule 1, do not be stupid enough to break it a second time

Rule one makes me work hard before putting money into a stock but many a time I do break that rule and lose money. Rule Two helps me in not losing more money by averaging the price of stock that I bought dear.

Once Bitten Twice Shy

One assumption I can safely make about any investor is that he is looking for making money rather than losing it. It therefore follows that this investor would buy a stock assuming it would rise in the future. If the stock fell it would mean that the factors underlying the assumption that the stock would rise have been proven wrong or insufficiently researched. Now if the investor still feels that the stock must rise and wants to average the price he must carefully weigh the consequences of his being wrong again. If he were losing one hundred rupees for every fall of one rupee in the stock price, he would lose two hundred or more rupees if he averaged. The prudent thing to do would be to say, "I thought this share was undervalued, so I put in some money in it – but alas it became even more undervalued. Are there factors that I have not considered or understood making the stock lose value? If the stock has halved in value in the last few months, could it not fall to one fourth or even one tenths of the value in the next few months?"

The Averaging Itch

Why is it that an investor is tempted to average? The first reason is a sense of false righteousness. "This is an excellent stock", he would argue, "why is the market being stupid enough to let it trade at such lousy valuations? It has to make a comeback, after all I have spent days poring over its annual reports."

The second reason is the inability or the unwillingness of the investor in relating to the value of the stock in relation to the prevailing prices. If a stock came down from Rs 1000 to Rs 100, the investor must decide future investment strategy depending on the anticipated future value of the stock. In arriving at this anticipated future value of the stock, he must not consider what price he paid for the initial purchase. Unfortunately, many investors don’t sell stocks with a discernible poor future because they argue, " Oh I bought this stock for a thousand bucks, how can I sell it for hundred?" or "It has fallen so much, it is unlikely to suffer any further fall. Let me buy some more so that when it goes up I’ll sell and recoup my losses"

The third reason is plain obstinacy. This type of behaviour is commonly seen amongst gamblers in casinos. Winning or losing has a deep emotional effect on this type of investors or gamblers. I saw this wonderful phenomenon in a casino in Mauritius as also among some of the ‘investors’ in the dealing room of my local broker.

One podgy man of about 40 years of age was playing the roulette and winning a considerable sum. He kept increasing his bets until he started to lose. Each loss had a fantastic effect on him – he closed his eyes and thought hard, he rotated the plastic dices from one hand to the other and considered future course of action, he gesticulated looking towards the sky pretending to complain to the almighty and told others and himself that he is going to win the next time. Further losses made him melancholy but he kept signing cheques for more plastic dices. He however kept losing, gesticulating, grunting and putting more money on the table. I had to leave but the podgy man was still playing ‘knowing’ that he will make up his losses and win finally! It is not hard to find people with the same mindset and emotional make up in front of trading terminals poring over the computer printouts of trading transactions and vowing to get it right the next time. They end up losing considerably in the stock markets. Averaging is an important weapon in the armoury of such losing warriors.

Question Thyself

If you have the ‘itch’ to average a stock ask the following questions to yourself: -

This stock has disappointed me earlier, is it possible that it might disappoint again?

Am I being emotional or am I being rational?

Is there no other stock amongst the 6000 or so listed stocks that offers more value than this stock?

Is it possible that my research is not comprehensive enough?

Am I willing to wait 5, 10 or 15 years for the stock to rise in value to my average price?

Was I wrong in the first instance to buy this stock at the price I bought it?

If the stock were to keep falling, do I have the resources to keep averaging?

If you answer the questions faithfully and with a clear head you will most probably decide to not break Rule number Two. If you do decide to break that rule, you are a man of immense resources, strong convictions and great capacity to take losses. You are in the market to pass your time rather than to seriously invest or trade. And, I envy you!
"Rich Dad Poor Dad - What the Rich teach their kids about money, that the Poor and Middle Class do not"

The title is purely an attention grabber - appealing to the millions of parents with phobias on educating their children about wealth and money.

But the book is much more - a lot of categories rolled into one. A tutorial, a self-help book, a novel with a neat storyline and a lesson on morals. It is a fast-paced, easy-reading book and a `must read' for those who have yet to gain control of their financial future. So those belonging to the top 1-2% of financially savvy people would find this book repeating what they already know!
Kiyosaki, the main protagonist, tells us what this book is really about - "Having the guts to go against the tide and get rich." This he goes about to explain in a neat and simple, step-by-step guide - using plenty of spicy platitudes and stories.
A lot of the one-line punches come from the author's early teacher - his friend's self-employed Rich Dad. This Rich Dad had the exact opposite perspective on money and money management to that of his own well-educated, high-income Poor Dad's view.
Kiyosaki's Rich Dad has a pithy way with words:

1. The extremely talented but poor people "are one skill away from great wealth" - that of selling their talent well.
2. "Money is not real."
3. Learn to be "A Jack of all trades and a master of a few."
4. "When it comes to money, high emotions tend to lower financial intelligence."
5. "Knowledge was power. And with money comes great power that requires the right knowledge to keep it and make it multiply. Without that knowledge the world pushes you around."
6. "If you hate risk and worry... start early."
7. "Winning means being unafraid to lose."
8. "Failure turns losers into winners."
9. "Cynics never win... cynics criticize and winners analyse... Criticism blinded while analysis opened eyes."

This book has an insight, which makes us reexamine our ingrained ways of thinking, about finance and our system of education. Rich Dad says, "I have more than 150 employees, they ask me for a job and a paycheck, but never to teach them about money." This brings forth the author's Rule #1 (out of 6) "The poor and the middle class work for money. The rich have money work for them... The reason for poverty or financial struggle is self-inflicted fear and ignorance, not the economy or the government or the rich."
Kiyosaki's definition of the truly Rich are those people who know, "it's not how much you make, it's how much you keep, and for how many generations you keep it."

The step-by-step tutorial begins, "If you want to be rich, you need to be financially literate" and he shows you how to gather knowledge with diagrams and easy examples. Kiyosaki calls it Financial IQ, which comes from learning about: 1. Accounting - an ability to read financial statements. 2. Investing - Involves strategies and formulas. 3. Understanding stock markets. 4. The law of the land.

There is even a chapter on "Getting Started" on getting wealthy with startling and convincing strategies. This book is one for the `must read list' to hone our existing skills, to learn new strategies in finance and to deal with everyday life with a focus and a set of rules to serve our lifetime goal `to be rich.'
Why we're getting I.T. all wrong !!!

"The matrix is all around you - when you go to church, when you pay your taxes. It is there every time you look out of your window." - The Matrix, 1999.

It's been two whole years that the dotcom bubble has burst. And we still dwell in the misconception that information technology is on a slowdown as if two whole years hadn't really been enough for us to realize. It is reflected in junta choosing different vocations for their B.E. People in 2000 AD expected the dotcoms to rise, rise and rise and never fall. Little did they realize that it was an “Irrational Exuberance”.

Fundamental physics says that bodies possessing excess energy will try to lose it and become stable. Ditto with fundamental economics- Every aberration in the system is corrected. So, from the beginning of the industrial revolution, the rule that "Any fleeting and baseless money minting industry will die soon" can be well applied here. All such bubbles have been busted. Be it the tulip bubble (when for handful of tulips…people were selling their houses) some centuries back, or be it the railway industry bubble at the turn of the century. The dotcoms however, for the people who don't know, do not represent IT industry in the entirety (though can be proclaimed to be a part of it). They were just a part of the growing phenomenon called I.T. Along with it, the common man (and others too) failed to see the rise of software services, web-services, and the sort.

Let us see some reasons for the boom, and the bust. The important thing to be noticed was that during 1997-1999 the Internet came of commercial age globally, and large companies used dotcoms as a showcase to their products (B2C) and enhance productivity (B2B). So a huge amount of people simply started investing into such net related businesses. Other companies observed that these were profitable, and hence jumped on to the bandwagon. Obviously the first few, and lucky few, generated profits. The Internet existed before this, but it came into focus only after major non-commercial applications like e-mail. After applications for the common man were launched, several people realized that it was a Pandora's Box waiting to be opened. Any company or small startup that could cook up a web application, which common people could use, profited (only on valuation terms…not in actual cash-flows). That's where the entire “valuation-rigging” making started. The companies that provided software were automatically hyped, valuation of their share prices rigged up by couple of biggies to astronomical limits and the people observed a steady exponential curve on stock prices.
Then it wasn't 'one fine day' when the bust occurred. Like the physics principle, Fed chairman Allan Greenspan realized that the overheated US economy had inflationary pressures building inside due to all these excesses in valuations. So, he adopted hiking interest rates to cool down the overheated economy and the end-product was a hard landing of the economy. The problems that led to the decline of e-commerce and online transaction sites was not due to the increased hacking into such sites, leading to misuse of credit card numbers(technology is in place to avoid such things) but in fact there was no decline at the first place. Just that the revenues are far lesser than those estimated and that is pretty reasonable since the “estimates” made initially were the part of an “Irrational Exuberance”. Also, the sites that kept on cropping up started providing hackneyed ideas. A shake out was imminent and “boys” had to be separated from the “men”. Websites were no more valued as much for the number of 'hits' on the webpage as before (and no business should be valued with such ‘ridiculous’ parameters). This led to a sudden decline in valuations of such businesses, and those who still continued with such businesses, probably made no profits, rather incurred losses though there are cases of dotcoms and allied businesses with positive cash flows.

It is a shame on the ignorance of those who identify the dotcom boom as an I.T. boom. What exactly is I.T.? Information Technology is the application of computer systems and their use in a wide range of businesses to increase productivity. In all such applications, the role of the computer is to process data or information and to solve problems or take decisions using information. I.T. brought along with it networking, newer software platforms, the Open-Source Movement, miniaturization of product lines ranging from mobile units to computers and has completely changed the life-style of people all around the world. I.T. helps to ensure that computers work to increase efficiency of the organizations. Nearly every company, from a software design firm, to the biggest manufacturer, to the smallest ‘shop around the corner’, needs I.T. to keep their business running smoothly.

So I.T. wasn't just, and isn't just about the www. For all those web- aficionados, we're riding the wave of an industry whose entire base is application of logic, mathematics and technology to improve biz-processes and the quality of life. I.T. is an omnipresent entity, one that has amalgamated into every field to pervade into it, and without which, all the industries would collapse. Don’t believe us? Remove computers and software from banking, finance, telecom, teaching, entertainment, etc. and then the effect of I.T. will be truly felt. Another study done by Time magazine emphasizes importance of IT in a more heuristic manner: Remove IBM and the whole of North America and Europe will come to a standstill. Like the age old adage goes, "The worth of water is not realized, until the well goes dry". Much of the excitement in I.T. is due to the dramatic pace of dynamism. The result of this startling dynamic nature is that ever more new applications have become economically feasible.

Some say, “Well, in this case, like every industry, I.T. has saturated.” …but some fundamental check over here…!!! What do you mean by “saturation”? There is nothing called saturation in any industry. Just a term used by some ill-informed people to give a general description of the field they don’t know. The pitcher might have overflowed, but that is not due to the shallowness of the pitcher, rather simply due to the speed with which it filled up. That just goes to show, how powerful an industry it is and the effect that it has on the world around us. Saturation is obsolete term in case of IT. At every instance, new technological advances are being made by people worldwide leading to newer avenues never seen before.

When every new industry springs up, if it is not I.T.-ised, then quicker developments will be retarded. The telecom sector has burgeoned, it is not just because we demanded telecom, but it was the need to spread and gain information, that lead us to this stage of asking for faster connections, smaller cell phones, and sleeker devices. The biotech sector, if expected to grow, will seek similar services. But actually, the more knowledgeable know that if there is anything called “saturation” then telecom industry is the one which is more saturated as compared to I.T. Large telecom companies worldwide are all loss-making. Be them from Japan (HKT/NTT DoCoMo), Be them from Europe (Nokia and the likes), all are in red. Even if we see in India, supposedly good telecom companies like Bharti Televentures is a loss making company. This doesn’t imply that telecom is saturated. Nothing in any industry is saturated. It is simply a term used by ignorant people to indicate that competition has increased. But, competition increases everywhere. No field remains without any competition.

We're not looking at an industry which is all about glamour, or making the 'fast-buck'. We're getting information across; information that billions wish to communicate to others. Who wish to say that they have become parents, or even maybe who wish to say 'the plane has been hijacked'. Information has been the lifeblood of businesses worldwide. I.T. is always there. In effect, IT has become indispensable to our lives in general and society at large. We just can't do without IT.
I.T. is here to stay. It's like the matrix. All around you and you can't feel it, unless it is gone.