What is a Hedge Fund? And how do they operate cover

What is a Hedge Fund? And How do they operate?

The term ‘hedge’ refers to risk mitigation. Earlier, Hedge Funds used to aim at reducing the risk of decline in prices of securities. Nowadays, it works for generating outsized returns. The hedge fund is not an investment instrument but refers to a collective investment structure set up. Such set up is created by some money manager or registered investment advisor and is generally organized in the form of an LLP (Limited Liability Partnership).

Moreover, the Hedge Fund is a form of an alternate investment structure. It is a private investment vehicle which pools money from high net-worth individuals. Here, fund managers apply aggressive and diverse strategies for generating large returns for investors.

Mutual Fund vs. Hedge Fund

There are a lot of people who have a misconception that Hedge Funds are similar to Mutual Funds. However, the fact is that both are quite different in many respects. For example, Hedge Funds function under less stringent regulations as compared to Mutual Funds. Investment in mutual funds is highly regulated by SEBI.

Further, Hedge Funds have a lower number of investors, but such investors are having higher net-worth. These investors are having higher risk appetite too. On the other hand, Mutual Funds are meant for a large group of people. One can start investing in a Mutual Fund with a small amount as low as Rs 500.

In addition, Hedge Funds adopt more aggressive strategies in managing their investors’ funds. Mutual Funds are not allowed to take short positions in the markets, while Hedge Funds can. So, when the stock market witnesses bearish trend, Hedge Funds can book profits by shorting, while Mutual Funds cannot. Nonetheless, Hedge funds are comparatively riskier than mutual funds as they have a higher amount of leverage.

Also read: The Beginners Guide to Select Right Mutual Funds in 7 Easy Steps.

Strategies adopted by Hedge Funds

It was stated earlier that Hedge Funds use aggressive strategies for achieving superior performance. Let us have a look at some of their most popular strategies used by hedge funds:

— Short selling: Generally, the majority of the investing population takes a long position on stocks which may make the market overpriced sometimes. Hedge Funds exhibit more interest in short selling by going against the herd.

— Equity market long short: This means taking a long position in some underpriced stocks and simultaneously taking a short position in some overpriced stocks. However here, Beta or market exposure is not completely canceled off.

— Equity market neutral strategy: It is similar to the above strategy but here, the market exposure is completely set off, i.e. Beta is zero.

— Event-driven strategies: It indicates making profits from the temporary mispricing occurring during major market events like Mergers & Acquisitions, Buybacks, Demergers, Corporate Restructurings, etc.

How do Hedge Funds operate?

The Hedge Fund industry in India started getting noticed roughly around the 2010s. Therefore, it is relatively young and yet to become popular among the people in our country. Now, let us discuss how Hedge Funds work:

1. Hedge Funds are not required to register themselves with SEBI or any other security market authority in India. In addition, they also do not have any mandatory reporting requirements.

2. You can only invest in a Hedge Fund if you are a qualified or an accredited investor. The investors are generally high net-worth individuals (HNIs) and financial services entities. The minimum ticket size of participating in a Hedge Fund is Rs. 1 crore. While investing your funds with any Hedge Fund, you get units in return like any Mutual Fund.

3. Hedge Funds allocate their investments in high risk-bearing instruments. In other words, they expose their assets to high risk in order to earn huge returns. Moreover, Hedge Funds use leverage extensively.

4. Hedge Funds allocate their funds in diverse investments like stocks, currencies, derivatives, real estates, and bonds. They can invest in a wide variety of asset classes but limit themselves to the mandates.

5. Investing in a Hedge Fund is associated with a long lock-in period. This means you cannot withdraw your investments before the expiry of its lock-in period. This makes investing in Hedge Funds comparatively less liquid than Mutual Funds.

6. Hedge Funds or the category III Alternate Investment Funds has still not received pass-through tax status. It means that the income generated by these funds is only taxable at the investment level. So, there is no tax obligation for the unitholders.

7. Hedge funds work on the concept of both management fee and expense ratio. Globally, the “Two and Twenty” system is followed. It means there is a fixed fee of 2% for the fund managers on the assets under management. Whereas, 20% refers to the income on the profits earned over and above the high watermark. In India, the fixed percentage of management fee could even go below 1% and the profit sharing ratio is usually fixed between 10 to 15%. 

Also read: Performance of Hedge Funds in India

hedge fund memes

(Image credits: www.usagold.com)

Conclusion

The majority of Indian population is still inclined towards FDs and other saving instruments. Although Mutual Funds has started gaining popularity in India lately, however, Hedge Funds are still in the nascent stage in our nation. They are yet to get significant popularity compared to mutual funds as fund houses are allowed to advertise while Hedge Funds are not.

The population of India is over 135 crores where the majority of the country’s wealth is in the possession of top 10% population. A Hedge Fund is an investment structure where the investors are mostly high net-worth individuals. Therefore, in a country like ours, it is highly unlikely that the Hedge Fund industry will become popular fast enough among common masses.

February 28, 2019 Investment Basics No comments yet
What is Sharpe Ratio? And how to calculate risk adjusted return using it cover

What is Sharpe Ratio? And how to calculate risk adjusted return using it?

The Sharpe ratio is an important metric used to determine the overall return an investor receives on his portfolio and measures the total amount of revenue earned for each unit of risk. The ratio shows the investor how their investment or fund is performing after being adjusted for risk and can help an investor understand how much their risk is worth. It is commonly used to compare the risks of two different investments against a benchmark number. The higher the Sharpe ratio, the better the risk-adjusted return on the investment.

The Sharpe ratio is often favored over a total returns ratio because it takes into account the investors risk when calculating the return. The return ratio, on the other hand, only lets the investor know the total amount of money they will earn on the investment. In certain cases, an investment that generates a high return can have high volatility and many investors find that the returns are not worth the risk. The Sharpe ratio is used to assess risky investments like equity funds where the extra return is seen as an excess risk.

Who invented the Sharpe Ratio?

The Sharpe Ratio was invented by William F. Sharpe, a Noble American Prize winner, in 1966. The Sharpe ratio is widely used today to calculate the risk-adjusted return on investments. In addition to inventing the ratio, Sharpe was also noted for his contributions in developing CAPM which assess’ the systematic risk relative to the return on a stock.

Although the ratio was named after him, Sharpe said that this was unintended. When he first developed the ratio it was called the Reward to Variability ratio but as it became increasingly popular among investors, it soon became synonymous with Sharpe’s name.

How is the Sharpe ratio calculated?

The Sharpe ratio is used to measure the risk-free return on your portfolio and helps an investor place a value on the level of risk undertaken. It can be calculated using the formula:

Sharpe Ratio = (Expected return – Risk-free return) / Standard deviation

The components of the formula: 

  • Expected Return: This could be the expected return on the investment in days, months or years. To arrive at a standard value, the total return is annualized for uniformity. When there are extreme highs and lows, the data can often be skewed.
  • Risk-free Return: The rate of return is considered to ensure the investor is receiving a good return for the risk taken. This is often a benchmark that the level of risk is compared against. For example, government securities are known to have the lowest level of risk and the Sharpe ratio assumes that a similar security purchased for the same duration should carry identical risk.
  • Standard Deviation: this value indicates by how much individual elements in a group are away from the mean and is calculated as the square root of the variance. After subtracting the expected return from the risk-free return, it is divided by the standard deviation to show how far the asset is from the mean risk. The higher the Sharpe ratio, the greater the risk-adjusted return.

Numerical Example

Let’s say that an investor has a portfolio which consists of stocks and bonds. The current expected return on his portfolio is 13% with the market volatility of 4%. The risk-free rate for the securities is valued at 6%.

Now, he is planning to add another asset in his portfolio which may reduce the expected rate of return to 11%. However, the portfolio volatility will also reduce to 2.5% after adding the asset. What should he do? Is it wise to add this asset to his portfolio? Let’s find out the answer using the Sharpe Ratio.

Initially, the Sharpe ratio for his portfolio was:

= (0.13 – 0.06)/0.4 = 17.5%

Nonetheless, after adding the new asset, the expected rate of return and the portfolio volatility will reduce. Further, let’s assume the risk-free rate of return to be constant at 6%. The updated Sharpe ratio for his portfolio will become:

= (0.11- 0.06)/0.25 = 20%

Here you can notice that although the absolute return after adding the new asset is lower. However, there is an improved performance for his portfolio on the risk-adjusted basis which is reflected in the increased Sharpe ratio. Therefore, he should add this new asset to his portfolio.

What is the Sharpe Ratio used for?

The Sharpe ratio measures the total value of an investment, taking into account all the inherent risks involved in a certain asset. Investors use the Sharpe ratio in the following ways:

— To compare two investments- The ratio can be used to compare the risk-adjusted return for two investments and allows you to quantify the excess returns over the risk-free rate. This is useful information to an investor as an investment that has a high return may not always be worth a large amount of risk. It also standardizes different types of investments that allows for easy comparison.

— It helps you decide what to invest in next- The Sharpe ratio calculation can help you pick your next investment. If your existing ratio a lower Sharpe ratio, then ideally you should choose an investment that will increase your Sharpe ratio which would lower risk and increase return. Any investment that decreases the Sharpe ratio is a sign that the investment may not be the best addition to your portfolio.

— High return does not equal a good investment- the Sharpe ratio is a good measure for the risk to return value of an investment. An investment with a return of 9% and low volatility is better than an investment return of 11% with high volatility. The Sharpe ratio takes this volatility into consideration and provides a true return on investment.

Also read:

Warning: Sharpe ratio is not always a good indicator

The Sharpe ratio is used as a comparison between two investments and sometimes there is no indication as to whether all the stocks in the portfolio are concentrated in one sector. If this is the case, an industry that is doing well will result in a high Sharpe ratio but will also be a very risky investment for the trader.

Alternatively, finding the right valued for risk-free-return and the standard deviation is often a challenge for many investors. During unstable economic conditions, historical data may not provide a true reflection of the current market environment. In today’s everchanging market, history rarely repeats itself.

Hence, when using the Sharpe ratio to assess an investment, its value should be considered in addition to other qualitative factors and ratios to help you make informed decisions.

February 27, 2019 Investment Basics No comments yet
goodwill balance sheet cover

What is Goodwill in the Balance Sheet?

Goodwill is an intangible asset that represents the non-physical items of a company has that cannot be easily valued. It is the excess value of a business after subtracting the assets from the liabilities. This value can be generated from customer loyalty, the quality of the management, the brand image or even the location of the company. Anything that adds value to a company beyond its assets and liabilities is considered goodwill.

Why is goodwill important to a company?

The importance of goodwill comes into play during a merger or acquisition. A buyer who is looking to acquire the company can pay more than the market value due to the business’ intangible assets. When acquiring another business, companies often look beyond the physical assets that the company owns and consider the brand identity, customer satisfaction and efficiency of the staff to arrive at a fair price for the company. The total amount of money that the buyer pays for these intangible assets in excess of the company’s market value is considered goodwill.

Goodwill is subjective and can be a different value for each company. When Facebook acquired Instagram, many people believed that Instagram (a free app that allows you to share images at no cost) was not worth more than $500 million. But after valuing Instagram’s total assets, liabilities and goodwill, Facebook believed that Instagram was worth over $1 billion which is what they paid for it. It is often hard to put a specific value on a company.

What creates goodwill in a business?

There are three factors that makeup goodwill in a business. They include:

1. Going-concern

This includes the existing assets in the business such as the employees and equipment that can be used in the day to day operations of the business. When these assets are functional, they create intangible value for the business known as going-concern. The going concern of a company can be used in one of two ways.

It can either be shown as an individual intangible asset for specific valuation or tax reasons or as a component of the total goodwill in the company. This second method is in accordance with the Financial Accounting Standards Board (FASB) for deriving the fair value of a company.

Going-concern can increase the value of specific assets in the business. For example, the value of a machine will be greater when it is seen as being fully functional and adding value to the business every day versus being valued as a single entity in the company. Going concern can also add value to an intangible asset such as a trademark or copyright. These assets are usually worth more when there are seen as providing continuous value to the company.

2. Excess business income

When a company earns a rate of return that is greater than the fair value of the tangible and intangible assets combined, the excess income is considered goodwill for the company. This excess income cannot be assigned to any specific tangible or intangible asset and is hence included in the goodwill of the company. For example, any income earned by an actor or singer that is in excess of their direct return from their acting or singing abilities is considered goodwill.

3. The expectation of future events

Goodwill can also be created through any future events that are not directly related to the current operations of the business. This can include a merger or acquisition, expansion of the business or new clients. When valuing a company, financial advisors will use the current operations of the business (NPV) in relation to the future events assuming that it will have a positive impact on the company.

The different types of goodwill

There are three different types of goodwill:

— Institutional goodwill

This is the company’s reputation of the company in the market and their ability to serve customers. That is the goodwill created from the collective operations of the business through its assets.

— Professional goodwill

This is the goodwill in professions such as a doctor, lawyer or athlete. It consists of two types:

  • Practitioner goodwill- this is the goodwill created by the skills, talent, and reputation of the professional.
  • Practice goodwill- this is the goodwill created by the business the professional works and includes the location of the business, its reputation in the market and the efficiency of the operations.

— Goodwill as a result of fame

Famous people can also create goodwill through various factors. For an actor, their goodwill is attributable to their skill level while athletes create goodwill through their professional accomplishments and accolades. Top business executives and politicians create goodwill through their skill level and any professional accomplishments.

Also read:

Example

Company X purchased Company Y for $115,000. Business Y has assets worth $100,000 and liabilities worth $20,000. The value of goodwill is:

Goodwill = 115,000 – (100,000 – 20,000) = $35,000

The journal entry for Company X is:

Account Debit Credit
Total assets 100,000
Goodwill 35,000
Liabilities 20,000
Cash 115,000

Goodwill is shown separately in the assets of the buying company’s balance sheet but the treatment of goodwill can vary by the accounting standard followed by the company. Under the IFRS and US GAAP standards, goodwill should not be amortized on the balance sheet every year rather the goodwill should be monitored and only reported on the balance sheet when necessary i.e. during a merger or acquisition.

Under the UK GAAP, goodwill is seen as providing continuous value to the business and should be amortized every year. The intangible assets are included in the financial statements of the buyer at their fair value (the price at which the intangible assets could have been disposed of individually).

Sometimes, the goodwill of a company can be negative (the company is sold at a price lower than its market value). In this case, goodwill is shown as an income on the buyer’s balance sheet.

Quick Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companies, feel free to check out this awesome online course- Introduction to Financial Statements & Ratio Analysis. 

Conclusion:

Goodwill refers to the reputation of a business and is vital to any company in acquiring new customers and retaining existing ones. It also attracts new investors and keeps shareholders happy. Moreover, Goodwill represents the true value of a company, that is, its total worth over and above its market value. The goodwill of a company is often valued by financial advisors for the purpose of taxation, litigation or maintaining financial statements.

February 26, 2019 Investment Basics No comments yet
mental models cover

What are Mental Models? And Why Should You Care?

“Like a pane of glass framing and subtly, distorting our vision, mental models determine what we see”- Peter Senge.

Have you ever stopped to question your perception of the world around you? Have you asked yourself: ‘Is the way you view something really how it is in the real world?’ More often than not the answer is NO because our current perception of the world serves us quite well. In fact, we barely question it at all because that’s how limited our view of the world really is.

But have you stopped to think, that in a world so large and complex, there’s more to life than what we see and recognize? For instance, there are so many ways we can look at a problem and at the same time, there’s always more than one solution to the same problem. As humans, it can be a challenge to analyze and understand the vast amounts of information present in this world which is why we need mental models.

What are Mental models?

In its most basic form, a mental model is an image or model a person has of the world around them, that is, how they perceive their surroundings. This view varies by each being and it helps shape their behavior and how they react to the different situations they are presented with. However, many people only have one mental model and try to use it to solve a variety of problems.

In 1994, during a speech to business school students, Charlie Munger summarized this with a quote ‘To the man with one hammer, every problem looks like a nail.’ Possessing just one mental model is equal to having a very narrow perception of the world, which, essentially, is not a great way to operate in the ever-changing world we live in today.

There are numerous mental models that vary by discipline and developing multiple models can help you think more rationally. Here are three mental models used in business, psychology, and economics to help you get started:

Confirmation Bias (Psychology)

Confirmation bias is the tendency of humans to favor the information that aligns with their values and beliefs and ignore everything else that doesn’t fit into our perceptions. A great example would be the Buzzfeed personality quizzes like ‘What Harry Potter character are you?’ Before you even take the quiz, your confirmation bias or the way you perceive yourself has already decided that its Hermione Granger of course!

You have already confirmed the answer to the quiz based on the traits of the character and how they match up to your own personality. This confirmation bias can be applied to our everyday lives as well. Very often we find ourselves making purchases based on confirmation bias and later finding a rational reason to justify the purchase.

A simple way to overcome confirmation bias is to analyze your reasons for buying something, be it a stock or a car- you need to look at both sides of the coin. Make a list of the pros and cons along with the reasons why you want to make the purchase and why you might want to sell it in the future.

Also read: 5 Common Behavioral Biases That Every Investor Should Know.

Moral Hazard (Economics)

A moral hazard is when one party or entity makes a decision on how much risk to take while another party suffers the consequences if things go south. Moral hazard can be dangerous as it can cause the party that does not bear any costs to practice reckless and impetuous behavior.

While in theory, moral hazard can seem unlikely, as society has come to believe that the person making the decision has to bear its associated costs as well, this concept is very much prevalent in the insurance and medical industries. For example, a person taking out a policy on fire insurance has no motivation to protect their home from the risk of fire as they know that any damage caused by fire will be the responsibility of the insurance company. Likewise, in the medical industry, doctors are more likely to prescribe expensive treatment or surgery to their patients if they are covered by medical insurance.

Another great example of moral hazard is during the 2008 financial crisis, where banks and other financial institutions were close to bankruptcy due to their recklessness and poor decision-making. In the end, it was the government that had to intervene and prevent these companies from going under using tax-payers money to bail them out. The consequences of the poor deal-making on the side of the banks was borne by the government.

Network Effect (Business)

A network effect is when the utility you receive from using a product increases as more people use the same product and service and is a common mental model used in business.

A great example is the different types of social media we use today. When Twitter was first introduced, not many people knew exactly what it was and hence not many accounts existed. At this time your motivation to create a Twitter account is not too high as there aren’t many people you can interact with on the platform. But as Twitter gained popularity and more people started using it, you were more inclined to join as the utility you receive from it is now much greater than it was before. The network effect has made Twitter a major source of news today.

The network effect is prevalent in e-commerce sites as well. With websites like Amazon, the value of the platform increases as more people purchase goods and services and leave positive reviews. This encourages more people to use the platform, thus increasing revenue for the company. The network effect is a mental model used in many businesses and is a great way for companies to gain a competitive advantage in the market they operate in.

Resources to read:

Conclusion

The mental models listed above are just three in a long list of models that exist. Mental models can vary by discipline and it can often be a challenge for humans to learn and understand all the models that exist.

However, it is important to master the primary models to gain the wisdom of the world. Charlie Munger refers to these as the ‘Big Ideas.’ Mental models can help you think ‘outside the box’ and widen your perspectives on the world. You can use them to make wise and intelligent decisions!

February 21, 2019 Investing Psychology No comments yet
How Much Should You Save  - 50:20:30 Rule cover2

How Much Should You Save  - 50/20/30 Rule!

How much should you save — This is one of the biggest questions that comes to everyone’s mind when we talk about budgeting. The importance of smart budgeting cannot be overstated as excessive spending and irregular saving habits can lead to disasters in the future.

If you want to enjoy a healthy financial life, it’s really important to have a balance between your savings and your expenses. And budgeting for individuals helps to align the spendings with savings and figuring out how much to spend on what.

If you are also struggling with personal finance, then this post may be a holy grail for you. In this post, we are going to discuss one of the easiest budgeting strategies to figure out how much should you save. And it is called the 50/20/30 Strategy.

50/20/30 Strategy

This strategy can be extremely helpful for youngsters who are just entering the world of personal finance and don’t know how to manage their spendings. Originally developed by Elizabeth Warren and Amelia Warren Tyagi, this strategy is beautifully described in their book — All Your Worth: The Ultimate Lifetime Money Plan.

50/20/30 is a really simple and straightforward budgeting strategy that can help you to define how much should you spend on your essential spendings (needs), savings and finally on your preferences (wants and choices). According to 50/20/30 strategy, you should allocate:

  • 50% of your monthly income on ‘Needs’ (like rent, food etc)
  • 20% of your monthly income on ‘Savings’ (like your retirement fund, investments etc)
  • And the remaining 30% of your monthly income on your ‘Wants’ (like traveling, dining out etc)

how much should you save 50/20/30 budgeting

(Image Credits: Business Today)

Now, let us understand all these three spending allocations in details.

50% of your income on Needs

As soon as you get your in-hand salary (i.e. your monthly income after deducting taxes), set aside around 50% of this income to pay for the things that are essential in your day-to-day life. The expenses in this category can be spendings on rent, food, transportation, utilities, health care, basic groceries, insurances etc.

Although allocating half of your monthly income in ‘needs’ may seem massive. However, when you look at the items in this list, it makes sense to allocate around 50% of your income on your needs.

Anyways, in case you are not able to manage your needs within 50% of your monthly income, you may have to optimize your lifestyle. For example, instead of living in a fancy house in a fancy locality which is too far from your workspace and adds transportation costs, you may wanna move in an affordable house with walkable distance to your office.

20% of your income on Savings

Once all your essentials are paid, next you need to allocate the 20% of your monthly income on savings. This category includes repayment of debt like a student loan, credit card debt etc along with investing the remaining for your future goals and retirement.

It’s really important that you allocate 20% of your income in this category before moving on to the next one i.e. spending on your ‘Wants’.

30% of your income on Wants/Personal choices

This is the last category in your personal budgeting. Once you are done with your essentials and savings, the final spendings should be on the things that you want. The expenses in this category include spendings on shopping, traveling, entertainment, dining out etc.

This list may also cover a few vague expenses like Netflix subscription, membership to clubs, weekend trips etc depending on your lifestyle. However, make sure that your spendings do not cross the allocated budget of 30% of your monthly income.

Example:

Let’s say that you make Rs 1.5 lakhs per month (in-hand income after paying taxes). As soon as you get your salary, you need to allocate

  • Rs 75k in meeting your day-to-day essentials like rent, food etc.
  • Rs 30k in paying your debts and savings.
  • And the remaining Rs 45k on your personal choice like dining out, traveling, memberships etc.

Using this simple budgeting strategy, you won’t run out of money to meet your daily needs, continuously contribute towards your future and retirement savings, and can also spend guilt-freely on your personal choices.

Also read: 3 Amazing Books to Read for a Successful Investing Mindset.

A few other popular saving strategies:

Apart from the 50/20/30 strategy, here are two other popular strategies that can also help you to figure out how much should you save.

  • 10% rule: This rule says that you should save at least 10% of your monthly earnings, no matter what the circumstances. This strategy is brilliantly explained in the book — The Richest Man in Babylon and works well for the people who are struggling to save money. The basic ideology behind this strategy is to ‘Pay yourself first’ and keep 10% of your savings only to yourself.
  • 100 minus your age rule: This rule tells that you should save at least the percentage of your earnings which is equal to 100 minus your age. For example, if you are 28 years old right now, then you should save (and invest) at least 100–28 = 72% of your monthly income. This rule is based on the principle that the expenses increase as you grow older (like kids, dependents etc) and hence you should save and invest more when you are young.

Also read:

Closing Thoughts:

Although 50/20/30 budgeting strategy may seem a little difficult in the beginning, however, with discipline and persistence — it is followable. Moreover, this budgeting strategy doesn’t depend on how much you earn. Even people with moderate to low salary range can follow this strategy if they are ready to optimize their lifestyle a little.

Anyways, the last thing that I would like to add is that do not take the rule too-damn seriously. I mean, do not freak out if your essential spending crosses over 50% in a month. Sometimes, you may need to review your income and expenses and make adjustments in the budgeting strategy.

For example, if you believe that your needs are less — let’s say you already own a house and hence you don’t need to pay any rent, but your personal desires are more, then you can follow the 40/20/40 strategy {40% spending on needs, 20% spending on savings and 40% spending on wants/personal choices}.

On the other hand, if your essential expenditures are high — let’s say you pay a heavy monthly rent, but your personal wants are low, then you may prefer 60/20/20 strategy {60% spending on needs, 20% spending on savings and 20% spending on wants/personal choices}. Nonetheless, whatever strategy you prefer, try to allocate at least 20% of your monthly income in savings. Remember- ‘A Penny Saved is a Penny Earned’.

February 19, 2019 Personal Finance, Save money No comments yet
Pat Dorsey's four moats cover

Pat Dorsey’s Four Moats for Picking Quality Companies

While picking a quality company for long term investment, one of the key element to check is the company’s sustainable competitive advantage or Moat.

If you are new to the concept of Moat, I would suggest you to first read this blog post. Anyways, in general, the Moat can be defined as something that keeps a company’s competitors away from eating away their profits/margins for a stretched time. And hence the companies with big moats are able to generate economic profits for a longer time period.

Although there may be dozens of factors that may be counted as a moat for a company like patents, management, technology, switching cost, entry barrier etc. However, in the book “The Little Book that builds wealth”, Pat Dorsey, ex-director of equity research at Morningstar and founder of Dorsey Asset Management, described that there are only four moats that really matters while picking stocks.

Rest all are either confused moats or not durable for a very long time period. In this post, we are going to discuss Pat Dorsey’s four moats for picking stocks.

A little Introduction to Pat Dorsey’s Moat

“FOR MOST PEOPLE, it’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that will last longer are typically able to command higher prices, because the higher up-front cost will be offset by a few more years of use. Hondas cost more than Kias, contractor-quality tools cost more than those from a corner hardware store, and so forth.

 

The same concept applies to the stock market. Durable companies — that is, companies that have strong competitive advantages — are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition. This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats. So, if you can identify which companies have economic moats, you’ll pay up for only the companies that are really worth it. 

(Source: Chapter 1 — The Little Book That Builds Wealth)

In his book, ‘The little book that builds wealth’, Pat Dorsey suggested that as a company expands, it attracts more competition. And here, the biggest element that helps the company to remain profitable and beat the competitors consistently, in the long run, is their durable economic moat.

And that’s the reason why a few companies remain highly profitable for decades even in competitive spaces. A few examples of such companies can be Apple, Microsoft, Coca-cola, P&G etc.

Pat Dorsey’s Four Moats That Matters

Here are Pat Dorsey’s four moats that you should look in a company while picking quality stocks with huge sustainable advantages:

1. Intangible Assets

Intangible assets are those assets that you can’t touch or see. A company can have intangible assets, like brands, patents, or regulatory licenses that allow it to sell products or services at a bigger margin that can’t be matched by the competitors.

For example, Coco-cola. If you look at their products, they are just carbonated sugar water and not much different from any other soda shop that you visit locally to buy cheaply priced drinks. However, when this carbonated sugar water meets the brand value of coke, they are priced way higher than what its competitors do, and still able to make way way more sales and revenue.

Similarly, in the pharmacy industry, if a company has got a patent over a specific drug, it may enjoy high sales without worrying much about the competition. And that’s why Pharmacy companies spend a lot of money on their Research and department (R&D) units.

2. Customer Switching Costs

If the customer has to cost a lot of money, time, efforts or resources to switch from one product to another, it is considered as the switching cost. If the products or services offered by a company has high switching cost (or really difficult for the customers to give up those products) then the firm enjoys a bigger pricing power and profit margin.

A great example of a customer switching cost is MS Excel. Although a lot of better tools compared to Excel are available publicly, however, to make all your employees learn any new tool, the company may have to cost a lot of time and resources.

Similarly, a few other software companies with high switching costs can be Adobe Photoshop, Auto-desk, MS Office etc. All these complicated programs cost a lot of efforts to learn and switching from one to another can be really difficult for the users. Unlearning and relearning these tools demands a lot of time, money and resources like pieces of training, courses etc.

3. The Network Effect

These are those companies whose value increases as their number of users increases.

A few examples of companies with a big network effect in recent days can be social platforms like Facebook, WhatsApp, Instagram etc. People are moving into these platforms as all their friends/peers are using them which makes them more valuable. So even if there are another better social media available, however, if your friends/family are not using them, you might be reluctant to switch there.

A few industries like e-commerce or food-delivery especially enjoy the networking effect. More customers are moving to ‘UBER Eats’ because more restaurants are associated with them. And on the other hand, more restaurants are associating with UBER Easts because more customers are moving into that platform. Overall, the users are inviting the restaurants and vice-versa and the platform benefits from the networking effect.

Another great example of industries with networking effect can be ‘Credit card’ industry. Here, customers are getting attracted to a credit card as they are accepted widely by many merchants. On the other hand, more merchants partner up with the credit cards as they have a bigger customer base. Overall, it’s all about networking effect for these companies.

4. Cost Advantages

These are those companies which are able to find better ways of producing their products or services. They enjoy cost advantages by improving processes, finding a better location, greater scalability, or access to a unique asset, which allow them to offer their products or services at a lower cost than competitors.

In general, the cost advantage is most useful in those industries where substitutes are easily available or for those products/services where the price matters the most for the customers while making their purchase decision.

A few examples of a company with cost advantage can be MacDonald (Standardized, low-cost approach and low-price menu), Walmart (low-cost advantage being scaled up to the massive effect), Vanguard (low-cost index fund that made an enormous impact on the investment world) etc.

Anyways, out of all the different sources to improve cost, Process-driven cost advantage should be carefully studied while evaluating companies. This is because processes can be easily copied. On the other hand, if the company enjoys cost advantages with greater scalability, it can do wonders for the businesses and investors.

Also read:

Closing Thoughts

In addition to the four moats that matter, in his book, Pat Dorsey also discussed a few other confused moats (things that are not exactly moats) or the eroding moats (the ones which fade away with time) like Technology, Trends, Market Position, and management.

To understand a better picture, I would highly recommend you to read the book “The little book that builds wealth”. It will help you to learn the concept of moat far better while picking quality companies. And moreover, the book is only 210 pages long. You can easily read the entire book within a week.

Finally, there’s one more point that I would like to add before ending this post. A moat on its own is not enough. There are multiple examples of companies with big moats but saturated profits. However, a combination of a moat with strong management, and growth potential is what makes a company a great investment.

February 18, 2019 Investment Basics No comments yet
3 Dumb Stock Picking Strategies That You Need to Avoid cover

3 Dumb Stock Picking Strategies That You Need to Avoid!

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger

Over the last couple of years, since I’ve started investing, I’ve come to know so many strategies followed by different investors. Whether they are- Value pickers (those who buy great businesses at a discounted price), growth picker (those who prefer stocks which are growing at a high pace compared to peers or industry) or income stock pickers (those who invests in stocks which give huge dividends), I have heard of them all.

Apart from them, another category of popular stock picking strategy are the ones who rely on algorithms, programs, expensive arrangements or robo-advisory to pick stocks. And they are also quite successful in making money from the stock market.

However, after interacting with thousands of the Trade Brains’ blog subscribers and also through my personal experience, I’ve also come to know a few dumb strategies that many people use to pick stocks which mostly turn out to be a disaster a few years later down the road. (Btw, I’ve also been a victim of a few such strategies during my rookie days. Therefore, do not feel too bad if you have been using these strategies to pick stocks.)

Now, I totally understand that picking these stupid disastrous strategies are not entirely the fault of the beginners. After all, we are neither educationally trained or psychologically programmed to pick the best strategy that suits our interests. As humans, we generally prefer taking shortcuts and this is one of the biggest reason for the individuals to pick these dumb stock picking strategies.

Nevertheless, knowing the strategies which may turn out to be a catastrophe in the future may help the newcomers to avoid them. Therefore, in this post, we are going to discuss three dumb stock investing strategies that investors need to avoid else it may turn out to be a disaster in the future.

3 Dumb Stock Picking Strategies That You Need to Avoid

1. Investing based on Free Tips/Recommendations.

You are getting consistent stock tips on your phone to buy/sell equities and you finally decided to give it a try. This is one of the most dangerous stock picking strategies. Better you should put that money on a lottery ticket if you are willing to take such a risk.

Moreover, the majority of the free tips or recommendations that you receive on your phone via SMS or WhatsApp these days– are SCAMS. Don’t believe me, then read further regarding the same here: 3 Most Common Scams in Indian Stock Market That You Should be Aware of.

Besides, let’s say you’re discussing the market with a colleague/friend/neighbor and they advised you to invest in a particular stock. Unless they are professionally trained in the market (such as research analyst or investment advisor), most of these recommendations are crap and a definite path for future regrets.

2. Picking a stock because a big investor recently invested in it.

Seriously, this is your strategy? Are you planning to match your investing strategy with that of a big successful investor?

As a matter of fact, you should understand that you can never meet the risk appetite, resources, and exit-strategies of the big investors. There are hundreds of things that may go wrong in this strategy and hence, it’s never a good idea to blindly picking a stock just because a big stock market player invested in it.

Anyways, I agree that following the stock picking strategies and portfolio of big investors can be good learning. However, do your own research before investing and avoid being anchored with big investors’ stock picks.

Also read: Is Copycat Investing Hurting Your Portfolio?

3. Picking a stock because it is continuously going higher

If there is a single lesson that you should learn from this post, then remember this- “Stock prices going upwards is not a reason to buy and prices going down is not a reason to sell.”

You should never pick a stock just because it is going higher. Stock prices movement on its own tells nothing.

Here, you need to look into the fundamentals, recent quarterly/annual results, corporate announcements, and other related news to find out the reason of price movement. Always make an informed decision after properly analyzing the company, rather just the price movement.

Bonus

4. Picking a stock because you feel it will go high

Recently, I was talking with one of my friends, Manish, and we begin discussing the equity market. After debating various investing ideas, Manish said that he is planning to buy Tata Motors share because he thinks that its price will re-bounce in upcoming months (Btw, at the time of writing this post, Tata’s share was down by over 57% in last one year).

I knew that Manish didn’t have much investing experience and hence I simply asked why he thinks that Tata Motor’s price will go up. He replied that the price is really down and he’s getting a feeling that the share price will recover and go up in the future.

Now, the share price of Tata Motors ‘may’ or ‘may not’ go up in the future. This is an entirely different discussion which I do not want to start right now. However, the answer that he gave to explain why Tata’s share price may go up is really stupid, right?

If he had talked the stuff like the sales of Tata Motors is going up, or their profit margin is increasing or Tata’s are launching a new vehicle in a segment which may be demanding among the audience, then I might have considered the reasoning. I mean, if someone gives me a factual reason why they believe that the price will go up, then I might discuss it further. However, if the reason is your ‘intuition’ or ‘gut feeling’, I can’t argue much regarding the same.

While investing in stocks, remember that you are not predicting whether it’s gonna rain today or not. Here you are analyzing companies which have fundamentals. There are a lot of pieces of information like the company’s financials, the board of directors talks/speeches, related news etc which are publically available to analyze companies. However, if instead of using these informations, you are making an investment decision based on your intuitions, you should rather be ready for an investment disaster.

Also read:

stock market meme 31

Closing Thoughts:

According to Benjamin Graham, the father of value investing, investment can be defined as “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

If you want to make decent returns from the share market, you need to stop speculating and making decisions based on these dumb strategies. If you are new to investing, take your time, learn and start building your own repeatable strategy by properly analyzing the companies which may produce consistent returns in the long term.

That’s all for this post. I hope it was helpful for you. Happy Investing!!

February 15, 2019 Investment Basics No comments yet
balanced mutual fund cover

Why You Should Invest in Balanced Mutual Fund?

The Balanced Mutual Fund is a type of Equity Mutual Fund which combines the feature of both equity and debt in a single instrument. It means that the money pooled from the unitholders are invested both in debt and equity instruments.

However, the equity element in the underlying portfolio of a Balanced Fund should consist of at least 65% of the entire assets under management. The rest portion of the portfolio can consist of debt instruments and cash in hand. In general, the exposure in equity can range from 65% to 85% and is dependent on the market condition and the fund manager’s investing philosophy.

Through a balanced mutual fund, the fund manager tries to achieve portfolio diversification within a single product. The main aim here is to increase portfolio returns by managing financial risks along with maintaining the stability of the fund.

Quick Note: You can read more about Debt Funds and Equity Funds on our website here:

Why You Should Invest in Balanced Mutual Fund?

Risk management:

A Balanced Fund comes with a mix debt-equity portfolio. As stated earlier, a substantial portion of the assets consists of equity instruments and the rest in debts. However, if the stock market returns declines, the loss on equity portfolio can be absorbed by the debts. For example, if the stock market witnessed a drop by 10%, considering your Balanced Fund is having only 65% equity exposure, your portfolio will only get reduced by 6.5%. Moreover, here the debt instruments might help you to constrain the market risks.

Asset allocation:

It takes a significant amount of corpus to create a well-diversified portfolio consisting of both equities and debts. Therefore, if you are looking to create a risk-adjusted portfolio by allocating your savings in both these assets individually, it may demand a huge amount of capital.

However, if you invest in the market through a Balanced Fund, not only your money gets spread across diverse stocks but you can also enjoy a sound equity-debt mix at a lower corpus. Taking positions in equity through Balanced Funds will not only help you grow your wealth but also reduce the fund volatility to a minimum.

balanced funds. market movements-min

(Image Credits: Sanasecurities)

Taxation:

Balanced Funds have a considerable amount of debt instruments in their underlying portfolio. But, they are taxed by the Indian Government as per equity instruments.

So, if you are redeeming your units within a year of investment, short term capital gain tax @ 15% is applicable. Otherwise, for the long-term capital gain, you are required to pay tax @ 10% if the gains exceed Rs 1 lakh. You can learn more regarding mutual fund taxation in India on our blog here. 

Switching Benefits:

Suppose you have a portfolio consisting of equity funds and debt schemes. Now, if you have to rebalance between debt and equity by mutual switching, this would cost you capital gains tax and probably exit load. However, if the fund Manager performs this activity, neither tax nor exit load is attracted on your account.

Overall, it looks relatively profitable to invest in debt and equity through a Balanced Fund than naturally creating a debt-equity mix by yourself.

Things to consider while picking a Balanced Mutual Fund

Your willingness to bear risk:

If you have a moderate risk profile, you can opt for a Balanced Fund. Balanced Fund is meant for providing equity allocation with stability support through debt securities. In case you are looking for a highly aggressive portfolio, you can consider investing in a small-cap or a mid-cap fund instead. On the other hand, if you are a high risk-averse investor, debt fund would be a more appropriate choice for you.

Performance of the fund: 

As a general rule, you should invest in a fund that has consistently beaten its peers and benchmarks over a significant period of time. Although, it may be possible that that fund performed well because it has taken comparatively more risks than its peers. However, you can’t ignore the fact that the fund’s splendid performance has occurred due to the effective asset allocation by its Fund Manager which should be considered as an advantage while investing in that fund.

The expense ratio of the fund:

The expense ratio of a Balanced Fund is the measure of the costs associated with carrying out the operation and management of the same. It is expressed as a percentage and in general, the expense ratio for an active fund can be between 1.5-2.5%. As a thumb rule, a lower expense ratio means more money in the bucket on the investors rather than the fund house. You should choose a particular scheme only after you have thoroughly compared its expense ratio with its peers.

Fund’s underlying portfolio:

As a prospective investor, you should have an overall idea of the stocks and bonds which constitute the portfolio of your fund.  The higher the quality of assets, the more is the probability of earning better returns on your investment. Therefore, always check the fund’s underlying portfolio before investing to understand a better picture.

Fund Manager’s history:

A fund which is managed by a series of Fund Managers over a considerable period of time should be less preferred compared to one which is managed for the long period by a single Fund Manager.

Further, you should also try to avoid a fund whose turnover ratio is on a higher side. Turnover ratio means the frequency of churning the underlying assets of the fund by the Fund Manager in a year. If the turnover ratio is too high, it means your cost of investing will be on a higher side too.

Here are a few other resources to read to get an in-depth knowledge of how to choose a Mutual Fund scheme:

Further, here is the list of a few best balanced mutual fund by Cleartax at the time of writing this article.best balanced mutual fund by groww

(Source: ClearTax)

Closing thoughts

You must have heard the famous dialogue “Mutual Fund investments are subject to market risks, please read all scheme related documents carefully before investing.” The said quote is not a joke but a serious disclaimer which needs to be strictly followed. Before you start off your investment journey, make sure that you have a basic understanding of the Financial Markets.

If you are a fresher in the field of equity investing, it is recommended to start your investing journey with Balanced Funds. Any person who is willing to invest in the equity market but at the same time seeking stability of his/her corpus should consider a Balanced Fund. For example, if you are a middle-aged person who is approaching retirement age, it is safer to opt for equity exposure through balanced Funds.

Investing in a Balanced Fund gives you the scope to enjoy the features of both debt and equity in one product. Moreover, here the job of fund allocation and timing of the market is in the safe hands i.e. Fund Manager of the Asset Management Company. Although, while investing in mutual funds, all you need to do is to simply stay invested and relax. However, here you also need to periodically monitor your portfolio and be active with your investments.

That’s all for this post. I hope you have understood the concept of the balanced mutual fund by now. Happy investing!

February 14, 2019 Mutual Funds No comments yet
Why buying a house can be good investment cover

Why buying a house can be good investment?

As millennials we are often given a lot of investment advice- save early, take advantage of mutual funds and employer savings accounts and get rid of high-interest credit cards. But research has shown that one of the best ways to build up that retirement nest-egg is by investing in a house. According to leading financial advisors, purchasing a home is a great investment because the property is ideally protected from inflation and it is a physical asset that theoretically does not crash or disappear as stocks do.

 Why should you invest in a home?

“Buy land, they’re not making it anymore.” – Mark Twain

Any investment you make comes with its own set of risks so it is important to do thorough research into the advantages and drawbacks before you dive into a single investment. In many countries, especially India, buying your dream home is seen as an important investment as it is the place you create your happiest memories with family and friends.

In other countries such as the US, there has been a dip in home purchasing in recent years due to the volatility of markets and an increase in the cost of living but it is worth noting that the millennial generation represents the largest percentage of first-time homebuyers.

Purchasing a home is a life goal for many and the number of people investing in real estate is slowly picking up as more people recognize its many benefits. Here a few reasons why buying a home is a great investment:

Buying a home is a safer investment

When compared to all other forms of investments such as stock and gold, buying a home is a safe and stable investment. Unlike the stock market, the housing market does not face high volatility. But although it is a safe investment, you still need to be diligent and weigh the pros and cons before you invest in a home.

You can become smarter about your expenses

When you decide to rent a home, all your rent payments go straight into the landlord’s pocket while eating into a large proportion of your income. But mortgage payments or loan payments towards your home are an investment for the future. The monthly payments you make will reduce the amount you owe on the house while your home equity increases. It is a much better solution to make payments towards a home in place of short-term rent expenses that will not provide any value in the future.

It is a great way to save your money

Buying a home these days has become an accessible goal for many young people as salaries have increased and the ability to procure a loan is much simpler. In order to ensure that you are not spending your hard-earned money on unnecessary things, a great option is to invest in a home. Not only does investing in a home lock up all your savings in one asset but it also generates a lot of revenue if you have invested in property in the right location. In India, the Central Government has a PMAY scheme which provides first-time homebuyers with a subsidy of 2.67 lakhs.

The emotional aspect of homebuying

Homeowners are more motivated to form relationships with the people in their community than those who rent. The people in the area you live in can create a dependable support system. Although this may not be a tangible benefit, buying a home brings a sense of pride and accomplishment for homebuyers. Many people view homebuying as accomplishing a milestone in their lives. Moreover, this home can be passed on from generation to generation as a family inheritance.

Buying a home can help augment your retirement income

Due to the high costs of healthcare, funding your retirement is not as simple as it once was. If you choose to buy a home earlier in your life, there is a good chance that your home will be paid off by retirement age. The equity of your home can help supplement your retirement income. It provides a safety net against the rising costs and will give you the added benefit of not having to pay rent every month.

While many people think that investing in stocks is a better way to save for retirement, it is important to remember that any return on stock comes with an added risk. There is a further risk that your stock may lose its value when you reach the retirement age, or worse, it could be wiped out completely. Investing in a home is a safer alternative for funding your retirement as the value of the investment is more stable.

It provides a safety-net

There can be many unexpected twists and turns in your life both professionally and personally. An investment in a home provides a safety net in those instances as you have something to fall back on. In a situation where you lose a source on income or there has been a surge in rent prices or an emergency that requires a lot of money, your property, which is essentially your savings locked up in a single place, can serve as a source of income.

The stability of home-ownership

Owning a home provides a sense of belonging and kinship. Moving houses frequently is often tedious and emotionally taxing, especially for children. As you become older, moving houses becomes more difficult as you begin to form a close relationship with the people in the area you live in. Owning a home is therefore important as it provides a sense of community and helps avoid the emotional discomfort of moving.

Also read: Planning to Invest in Commercial Real Estate? Read This First!

Conclusion

There a many benefits to owning a home and it is one of the best investments millennials can make. However, it is important to study the housing market in the area you decide to invest in and weigh the pros and cons before you make a decision. It is recommended to talk to real estate brokers who can give you more details on the real-estate marker along with a loan officer who can provide information from a financial perspective. Do your homework and play it safe before buying a home.

February 9, 2019 Personal Finance No comments yet
Prisoner's dilemma cover

What is the Prisoner’s Dilemma?

The Prisoner’s Dilemma is a popular two-person game of strategic thinking that is analyzed as part of game theory. It demonstrates how rational individuals are unlikely to co-operate even when it is in their best interests to do so.

The game uses the example of two prisoners being interrogated and how they respond and change their strategy over time depending on the situation.

However, before we discuss the prisoner’s dilemma, let’s first understand what is game theory.

What is Game Theory?

Game theory is the use of mathematical models to identify the reasons for conflict and cooperation between individuals. It helps us understand why an individual makes a certain decision and how their decision affects others.

The application of this theory in non-gaming scenarios is called gamification. The three main branches discussed below are closely related to game theory:

— Decision theory: This can be described as a game of an individual against nature. People’s decisions are based on their personal preferences and beliefs. The decision among risky alternatives is described by the maximization of the utility function. In turn, the utility function is dependent on various factor but mostly the level of money income.

— General equilibrium theory: This is a branch of game theory that deals with a large group of individuals such as consumers and producers. It is used in macroeconomic analysis such as the tax policy, to analyze the stock market or to fix exchange rates.

— Mechanism theory- While the game theory follows the rules of the game, the mechanism theory discusses the consequences associated with each of the rules. The questions addressed include wage agreements, spreading risk while maximizing revenue.

The Prisoner’s Dilemma

Game theory can be described as two players playing a game and listing out the choices and alternatives available to each player.

A famous example of the game theory is the Prisoner’s Dilemma where two individuals who are partners in crime are caught by the police and interrogated in two separate rooms and are given the chance to confess.

Since each prisoner has two possible options (either to confess or don’t confess i.e. remain silent), there are four outcomes to the game as represented in the matrix below:

the prisoner's dilemma 1-min Rules of the game:

  • If both players confess to the crime, they both get sent to jail but they will get a shorter sentence if one of the players is ratted out by his partner in crime.
  • If one player confesses while the other one remains silent, the one who remains silent gets a long severe prison sentence while the one who confesses goes free.
  • However, if both players don’t confess, they both get a shorter prison sentence than if they were to both confess.

 The options in the game (both risks and rewards) are represented as utility numbers.

In the table above, the positive numbers are favorable outcomes while the negative numbers are negative outcomes. However, one outcome is better than the other if the total value is greater. So -5 is better than -10.

In the table above, there are four outcomes, if both players confess, they are blamed equally for the crime (-5,-5). But if one player provides information on the other player in exchange for going free, the individual receives a utility of 3 units. But the other prisoner who does not confess and is sent to prison has a low utility of -10.

The last option is both prisoners don’t confess and sent to prison on reduced terms which results in a very low utility of -1.

Analyzing the Prisoner’s Dilemma

Once the various outcomes in the game are described, the next step is to analyze how the players are likely to respond. Economists make two assumptions when it comes to analyzing this game.

The first is that both players are aware of the total payoffs for themselves and the other player. The second assumption is that both players are looking to satisfy their personal gain from the game.

To analyze the outcome of the game, we can look at the most dominant strategies- this is the most optimal solution for one player, despite the response of the other player. Using the table above, confessing to the crime would be the dominant strategy for both players.

  • It is better for player 1 to confess if player 2 confesses as well because a utility of -5 is better than -10.
  • Player 1 should confess even if player 2 remains silent as 3 is better than -1.
  • Similarly, it would be better for player 2 to confess if player 1 confesses as -5 is more optimal than -10.
  • Player 2 should confess if player 1 remains silent as a utility of 3 is better than -1.

For player 1 and 2, confessing to the crime would be the equilibrium solution to the game.

the prisoner's dilemma 2-min

The Nash Equilibrium

The Nash Equilibrium was developed by mathematician John Nash and it shows the best response strategies in any situation. It is an outcome where one player’s strategy is the best response to the other player’s strategy and vice versa.

As per the outcomes in the table above, if player 1 confesses, it is in player 2’s best interest to confess as well as -5 is better than -10. And if player 1 doesn’t confess, player 2 should still confess as a utility of 3 is better than -1 and vice versa. The best strategies are highlighted in green in the table above.

Note: In case you enjoy visuals, here’s a simplified video on Prisoner’s dilemma:

Also read:

Why has this game become so popular among economists?

There are many reasons why the Prisoner’s Dilemma has become an important tool for economists in developing numerous economic theories.

The strategies to ‘confess’ or ‘not confess’ is used to identify if certain economic theories ‘contribute to the common good’ or ‘behave selfishly’. This is also known as the public good problem.

For example, if the government decides to construct a road, the construction of the road is beneficial to everyone. But, it would be better for the individual if the private sector and not the government built the road. When government spending does not benefit the individuals in the economy, it is known as an externality.

For two competing firms, the outcomes can be ‘set a high price’ or ‘set a low price’. For both companies, it would be beneficial to set high prices to earn higher revenue. But for each individual company, it would be more optimal if they set a low price while their competition set a higher price.

The game also shows how a rational individual should behave. As shown by the dominant strategy, it is best for both player to confess but in terms of utility confessing only results in -5 unit of versus the -1 unit they would receive if they did not confess. The conflict between the individual and the common goal is the basis of many economic theories.

The Prisoner’s Dilemma is an important tool used by economists when making decisions on economic theories and public spending. The payoff matrix can be applied to our everyday lives to find the most optimal solution in any situation.

February 8, 2019 Investing Psychology No comments yet
Planning to Invest in Commercial Real Estate cover 4

Planning to Invest in Commercial Real Estate? Read This First!

It goes without saying that investing in commercial real estate is a huge decision. Therefore, it is important that you are well informed before you make any money moves.

Investing in commercial real estate gives you the chance to dip into a new customer base and develop your business interests. It is quite different from investing in traditional real estate and requires some additional considerations. Patience is a virtue when it comes to commercial real estate as the cycle is longer and the investor needs to be well aware of trends in the market and economy.

Here are some key points to keep in mind when investing in commercial real estate:

Location Location Location

It’s all about the location when it comes to investing in commercial real estate. In every city, there are those areas that are in high demand (macro markets) and other micro-markets that are not so favorable.

When it comes to buying commercial property, there are many factors that come into play such as accessibility to roads and public transport, distance to neighboring cities and infrastructure projects currently in development in the area.

But as an investor, you need to be vigilant about emerging markets that are created as a result of the infrastructure developments. These are great areas to invest in because not only will they be in high demand but it also guarantees capital appreciation in the long term.

The property’s marketability

In addition to a great location, it is important for the property to create a steady cash-flow for the investor. The property needs to remain marketable and be able to withstand a large number of tenants and future growth. This means that you need to invest in property that is modern with trendy architecture.

Properties that encourage ‘green living’ and are eco-friendly will add to the attractiveness of the property. Other factors to consider are environment-friendly utilities, maintenance of the common spaces and good building management.

The amenities

The amenities available can add value to the property and these benefits tend to override the cost. Amenities can include many different things that can increase efficiency for the tenants on the property such as extra parking spaces or a food court if the commercial property is used for a campus or office space. These amenities can enhance the space while increasing the marketability of the property.

real estate amenties

While assessing the property, it is important for the investor to ask about who usually does the interior fit outs for the property. Traditionally, the tenant receives a bare space and installs the fit outs such as air-conditioning, lighting and sensors but some tenants may ask the building developers to install such fittings and pay an additional fit out rent.

Tenants who install their own equipment are likely to rent out the space for a longer period of time to cover their expenses.

The property’s risk

The assessment of risk bears a different meaning when it comes to commercial real estate as each property is different. While residential properties that are right next to each other face more or less the same risks, commercial property risks can fluctuate independently. Hence, it is important for investors to understand the potential risks of their investment.

These risks can include a variety of things such as zoning changes that can cause a commercial property to become residential as new suburbs develop in the area. Additionally, having similar commercial properties can create an oversupply in the market, that could drastically reduce demand. Infrastructure projects in other commercial areas can drive potential tenants away from your property.

The market dynamics

Investing is always a numbers game so it only makes sense that you keep up with them before investing in commercial property. It would be helpful to understand trends in the market along with customer’s changing wants and demands. You also need to study the historical market performance over the last three to five years to identify any anomalies or potential for reduced demand in the future.

Along with this, you should plan for the future and map out details about the tenant profile, the rent roll out, the lease contract (expiry date) along with any other information that will provide more clarity on the financials of the property. It would also help to talk to a real estate agent to discuss the details before making any big decisions.

The lease structure

Commercial leases are structured very differently from residential leases. They are either a 3+3+3 or a 5+5+5. This means they could either be a 9 year or a 15 year lease with increments in the rent every 3 or 5 years respectively.

The tenant has the freedom to vacate the property without notice, while the owner of the property cannot ask them to leave until the lease period is complete. They can, however, have a lock-in period in the contract of 3 years, during which the tenant cannot vacate the property. It is important for the investor to understand the lease structure of the property as they are often inherent risks involved. A lease with a long lock-in period is great for the investor.

Documentation

As an investor, it is important to perform due diligence and carefully analyse all title documents, permits and taxes associated with the commercial estate along with the presence of any mortgages. It is recommended to have all documents examined by a legal authority.

If you plant to rent out the space, it is important that the lessee understands their duties and obligations as per the contract. This will reduce the chance for any future errors. In addition to the legal documents of the property, the local area may have local laws that property owners need to abide by. You should have a thorough understanding of all the rules and regulations related to the property and the area it is located in.

Also read:

Closing Thoughts

Investing in commercial real estate can certainly add immense value to your portfolio but it is a decision that needs to be taken after a lot of thought and consideration. You need to conduct a thorough market analysis of the property while taking into consideration the factors listed above.

While the process of investing in commercial real estate is very time-consuming, it is unquestionably beneficial to an investor in the long-run.

February 5, 2019 Personal Finance 2 comments
interim budget 2019 20 cover

Interim Budget 2019-20: The Talk of the Town

On the 1st of February, 2019, the Interim Budget of India, for the financial year 2019-20 was announced in the Union Legislature. Our honorable Finance Minister, Mr. Piyush Goyal, who is a Chartered Accountant by qualification, gave the budget speech, which lasted for around two hours, where a plethora of points were covered.

If you were at home while the budget was announced, you might have got the privilege to watch it live on television. Anyways, I was out on the street when the budget was broadcasted live. And therefore, unfortunately, I missed it. But subsequently, I watched the same on YouTube.

A Union Budget does cover plenty of pointers out of which only a few are those which we, as an individual, can relate with ourselves. This year budget has famously talked about taxation, agriculture, health industry and many other key aspects of our country’s economy.

In this article, we are certainly not going to discuss the entire budget as a whole. Rather, we shall talk a few selective crucial points which you, as an investor, need to know in order to manage your personal finance in the upcoming fiscal year for which this budget will be applicable.

Personal Taxation and Union Budget 2019-20

Income Tax

Firstly, let me tell you that the Income Tax slabs which were for the earlier financial year will remain the same for the FY 2019-20. In other words, there is no change in the tax slab for the people. However, the tax rebate under section 87A has been made applicable for an individual having total income up to Rs. 5 lakhs, (where the previously applicable limit was Rs. 3.5 lakhs).

The tax rebate limit for the ongoing financial year is Rs. 2,500. Nonetheless, the maximum limit of this tax rebate has been raised to Rs 12,500. Therefore, as an individual taxpayer, if you have annual taxable income up to Rs 5 lakh, it won’t attract any income tax.

Note: Currently, the net income falling within Rs 2.5 lakh and Rs 5 lakh is taxed by the Indian Government at the rate of 5%.

Considering this tax rebate, even if your annual gross income goes up to an amount of Rs 6.5 lakh, you won’t require to pay any tax on the same, provided you have made investments in the instruments prescribed u/s Section 80C of the said Act.

Quick Note: Under section 80C, a deduction of Rs 1,50,000 can be claimed from your total income by investing in a few tax-deductable investment options like LIC, PPF, Mediclaim, incurred towards tuition fees etc. This can help you to reduce your total taxable income by up to 1.5 lakhs.

However, if your taxable income exceeds Rs 5 lakh (and you have not made any investment in tax saving instruments u/s 80c), then, unfortunately, you won’t get any rebate in Income Tax.

The table shared below is an example which can help you understand what our honorable Finance Minister has tried to say with respect to the new income tax rebate clause.

income tax rebate

Capital Gains Taxes of Houses

As announced in the interim budget, you will not be taxed by the Indian Government on the notional rent of the second self-occupied house property. Therefore, here the key takeaway is that exemption is made allowable up to two self-occupied house properties.

This exemption u/s Section 54 of the Income Tax Act, 1961 will now be available on your second house property but it has come with a proviso. Your capital gains should either be less than or equal to Rs. 2 crores. Anyways, this benefit can to be availed by you only once in your lifetime. (Read more here).

TDS Relief

Presently, if your interest earning on Post Office Savings and Bank Deposits used to cross Rs 10,000, TDS u/s 194A used to get attracted.

However, the proposed budget has raised the limit from Rs 10,000 to Rs 40,000. In case of senior citizens, the limit has been increased to Rs 50,000. This proposal will surely benefit the individuals who are highly dependent on the interest income from their deposits interest earned on savings deposits, fixed deposits, as well as other deposit schemes in banks and post offices.

Standard deduction and other taxes

In case you are a salaried person, previously you used to get Standard Deduction of Rs 40,000. Now, this figure has been increased to Rs 50,000 which is, of course, going to benefit you financially.

Also read: What are the capital gain taxes on share in India?

Closing thoughts

This Interim Budget will become final unless a new Government comes into power after the Lok Sabha election which is to take place in a few months. However, if indeed a new Government comes into the picture, then this Interim Budget will cease to exist. Such new Government will frame a different Union Budget which will govern the Financial Year 2019-20 in India.

Since the day this Interim Budget was announced, it has created a plethora of confusions on some specific aspects of the budget among the residents in our nation. Out of all such confusions the clause related to rebate u/s 87A has so far seemed to be the most difficult and weird for the majority of the Indians to decode. This is again needed to be said that the tax slab has not been changed at all.

Every February, the new Finance Act (i.e. Union Budget) is declared by the Central Government of India. In every occasion, the budget brings new and/or amended clauses with it which subsequently makes the Indian taxpayers feel puzzled. Therefore, it is expected that even this budget will become clear among the people in India within the next few weeks.

There are people who have shared their negative feedbacks with respect to this budget. On the other side, many people are saying that this is one of the best budgets that India has witnessed since its independence. They have also added that this budget is probably the best budget that our current Government, formed by BJP (Bharatiya Janata Party), has come up with within its current five years tenure.

February 4, 2019 News No comments yet
An essential guide to financial planning for Non-Salaried cover

An Essential Guide to Financial Planning for Non-Salaried

If you are a non-salaried person, you may understand the phenomenon of uncertain earnings. Unlike ‘salaried’ people who earn a regular income from their jobs, ‘non-salaried’ people are those whose expected annual earning is a little difficult to guess.

In general, the non-salaried people are those who earn their living by doing some business, engaging in a part-time profession or carrying out freelancing. They do not receive a monthly paycheck from their company or bosses. Moreover, this irregularity in the income of the non-salaried people is dependent on several factors like demand, workflow, competition, technical innovation, regulations, and technical know-how.

Anyways, when we talk about financial planning, for most salaried people, the health insurances and retirement funds are somewhat taken care of by their employers. However, for the non-salaried people, they need to plan all these by themselves. And that’s why financial planning for the non-salaried person is a must.

In this post, we are going to discuss how non-salaried people can plan their personal finance effectively. Let’s get started.

Financial Planning For Non-Salaried People

Last Sunday, I met my friend Aditi for a coffee. We met after a long gap of three years. She told me that she has been working on a food blog for the last two years and making decent money from it.

After talking on a few causal stuff for some time, we started discussing her finances. She told me that although she was making good money as a freelancer, however, she is struggling a little as her income as they are very irregular in nature.

If we look into her finances, in general, whatever she saves, she deposits the same in her Savings Bank Account. She has also bought a Life Insurance policy and pays her premiums quarterly. Nonetheless, she was feeling a little clueless regarding how to come up with effective financial planning that can help her meet her future financial aspirations.

As a personal finance enthusiast, I tried to help her in my own way. So, we discussed in details regarding the four pillars of the financial Planning- Emergency Fund, Insurance, Retirement Fund, and Passive Income.

Emergency Fund

Firstly, I advised Aditi to build an adequate Emergency Fund. This fund should be big enough to protect her for at least six months in case her income declines or comes to a halt in the nearer term. By Emergency Fund, what I actually meant to say was that Aditi should have sufficient money in her Bank Savings account to run her expenses for a minimum of half a year.

Therefore, Emergency Fund = 6 times Aditi’s expected monthly expenses.

Anyways, these days Bank Savings Accounts do not offer a high interest on the deposits. In fact, the saving interests are not even good enough to beat the current consumer inflation rate in our nation. Therefore, I suggested Aditi to park her savings in a liquid Mutual Fund, which will not only help her in forming a good Emergency Fund but also boost her savings appreciate at around 7 to 8 % per annum.

Insurance

Next, we discussed Insurances. Aditi already mentioned earlier that she has a life insurance policy. However, when we started discussing it in detail, I came to know that her insurance was in the nature of “Term Plan”.

According to me, although Aditi does not have an extremely high standard of living, still her Life Insurance plan should cover a minimum of 15 months’ expected annual income. So, I told her to review her policy once and in case she feels she is under-covered, she should give a thought to take another Life plan.

Another important point that I came to know was that Aditi didn’t have any Medical Insurance coverage at all. For a self-employed person, Mediclaim is an essence. I told her that it should cover a minimum of  5 months’ expected monthly income. Here, please note that many people prefer to go with Life Insurance policies in the nature of the endowment plan. For the risk-averse investors, as endowment plans provide decent insurance plus investment option.

Also read: 6 Reasons Why You Should Get Health Insurance

Retirement Fund

After discussing insurances, I asked Aditi how long she is willing to work as a freelancer. In other words, when does she plan to retire? To this question, Aditi answered that she would like to work at least 25 to 30 more years from now.

When talking about the retirement savings,  I must tell you that it does take an immeasurable amount of time to build an adequate fund. By the immeasurable amount of time, what I mean to say is that you might need to wait for around two to three decades to build a substantial Retirement Fund which could help you maintain a similar (or even better) standard of living after you finally stop earning from an active source.

If you ask me what should be the desired retirement corpus, my answer would be that you need to build a corpus which should be at least twenty-five times the expected annual expenses. Nonetheless, the big question here is how can you build such a huge corpus from around 25-30 years from now.

Don’t worry, the answer is not very complicated. Here, I will suggest you to consider investing in Equities or Equity Mutual Funds. Yes, of course, Equity investing is a little risky in the short term. However, if you opt for value investing, it can aid you in creating a huge corpus in the long run.

retirement fund-min

Passive income

As a non-salaried person, Passive Income can help you to support your basics expenses as your earnings may be filled with ups and downs.

In meaning, passive Income is that income which does not require your active time. Once your passive income mechanism is set up, you don’t need to do anything to earn that income. Moreover, Passive Income can be stable and act as your secondary source of income. A few examples of Passive Income can be your rental income, dividends, and Interests from Equities and Bonds etc.

Apart from your emergency and retirement fund, you need to build a few consistent passive income sources and to add them as other income in your financial planning.

Also read: 11 Best Passive Ways to Make Money While You Sleep.

Closing Thoughts

There is no doubt in highlighting the fact that non-salaried people are subjected to more financial risks compared to the salaried people. For all the self-employed people out there, like Aditi, effective financial planning can help you manage and mitigate the financial risk of your irregular income.

And therefore, as a non-salaried person, you should take your financial planning seriously and start working on your Emergency Fund, Passive Income, Insurance, and Retirement Fund.

That’s all for this post. Today, we tried to cover how a freelancer, business owner or an independent professional, can manage their personal finance effectively. We wish you all the best for your financial investment journey ahead. And Happy Investing!

February 3, 2019 Personal Finance No comments yet
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