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!

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.

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.

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.

random walk theory cover

Warning: Random Walk Theory may change the way you look at stocks

The Random Walk theory is a statistical model of the stock market that shows that stock prices with the same distribution can be independent of each other. In other words, the prices of these securities are not influenced by past events in the market.

The random walk theory was developed by Burton G Malkiel, a professor at Princeton University and was discussed in his book A Random Walk Down Wall Street. The theory applies to trading securities and states that movements in the price of a stock are random and that any research conducted to predict future price movements is a waste of time.

What is the random walk theory?

The random walk theory does not involve the technical analysis of a stock which uses historical data to predict future prices. Nor is it a fundamental analysis to study the financial health of a company. It is, however, a hypothetical theory that states that the prices of the stock move at random. The random walk theory asserts that stock returns can’t be reliably predicted, and stock movements are just like the ‘steps of a drunk man’, which no one can foretell.

This theory is based on the assumptions that the prices of securities in the market moves at random and the price of one security is completely independent of the prices of the all the other securities.

It’s as random as flipping a coin

A random walk down the wall streetThe concept of random walk theory goes all the way back to a book published in 1834 by Jules Regnault who tried to create a ‘stock exchange science’. This was further developed by Maurice Kendall in a 1953 paper that suggested that share prices moved at random. The hypothesis was popularised by Malkiel in his best selling book A Random Walk Down Wall Street.

To prove his theory Prof. Malkiel conducted a test. He gave his students a hypothetical stock worth $50. At the end of the day, he would flip a coin which would determine the closing price for the stock. Heads meant the closing price would be a half point up while Tails meant the price would be half-price down. This meant there was a 50-50 chance of the price going up or down. Prof. Malkiel and his students tried to determine the market trends from the prices.

Using the results gathered from the test, the professor went to see a chartist. A chartist is a person who predicts future movements in stocks based on past trends and believes that history repeats itself.

Looking at the results, the chartist told the professor to buy the stock immediately. However, the coin flips were random and the stock did not have any historical trend. Prof. Malkiel used this example to argue that movements in the stock market were as random as flipping a coin!

What are the implications of random walk theory?

Many people only invest in a stock because they believe that is worth more than they are paying. However, the random walk theory suggests that is not possible to predict the movement in the stock prices. This means that investors cannot outperform the market in the long-run without taking on an inordinate amount of risk. The only solution is for an investor to invest in a market portfolio (such as an index) which is a representation of the total stock market. Any changes in the stock prices in the market will be reflected in the portfolio.

In addition to this, if the short-term movements of stock are random, investors can no longer buy stocks based on the time-value of money theory. Therefore, a buy and hold strategy will be ineffective as stocks can be bought and sold at any point of time.

Criticisms of the theory

One of the criticisms to the random walk theory is that it ignores the trends in the market and various momentum factors that have an impact on the prices. Many critics say that the price is affected by many trends and very often these trends are very hard to identify and it may take a large amount of historical data and fundamental analysis to figure it out. But just because these trends are hard to recognize, it doesn’t mean that they don’t exist.

Another criticism states that the stock market is vast and there are a countless number of elements that can have a large impact on stock prices. There a large number of investors in the market and each trader has a different way of trading. Hence, it is likely that trends emerge over a period of time which would allow an investor to earn a return in the market by buying the stock at low prices and selling at high prices.

Also read:

A Non-random walk

As a refute to the random walk theory, there are a number of technical analysts who contend that the price of a stock can be predicted on past trends and historical data. They believe that traders who can analyze these trends and make predictions have the ability to outperform the market with their superior knowledge.

Then there is the luck factor. The random walk theory states that only way a trader can outperform the market is purely by chance. This is an inaccurate statement, however, because there are some traders such as Paul Tudor Jones who managed to continuously outperform the market. It is more likely that technical analysis of the stock market is in play here and not just dumb luck.

However, it is important to remember that technical analysis can only help predict the probable changes in stock prices and not the actual price.

Conclusion

Choosing to trade based on the random walk theory is based on the preferences of each trader. If you believe that stock prices are random, it would be best to invest in a suitable ETF or mutual fund and hope for a bull market. But if you truly believe that trends and predictable and that stocks can be traded based on historical data then you should use your technical and fundamental analysis skills to actively trade in the stock market.

algorithm trading cover 3

What is Algorithmic Trading (Algo Trading)? And how it works?

Technological developments help define the future and we tend to rely on them more and more everyday. Investors are no exception to this rule as they use of technology to take advantage of optimal market conditions and earn high returns.

One such technology is algo trading or algorithmic trading which is a type of stock trading that uses statistical models and equations to run trades on a program designed by the user. Algo trading has become more popular in the last few years as it has been made more accessible to investors. It currently comprises of 35-40 per cent of turnover in Indian Stock Exchanges.

What is algorithmic trading?

An Algorithm is a code that is designed to carry out a certain process. Algorithmic trading uses computer programs to initiate trades at high speeds based on preset conditions such as the stock prices or the current market conditions.

The algorithms can include a level of manual intervention or can be fully electronic also known as zero-touch algos. The trades are initiated based on pre-set quantitative factors, arbitrage opportunities and the client’s preference. In India, the most commonly used algo is the Application Program Interface (API) that lets investors choose their strategy and enter in their requirements. The trades are then executed by the brokers.

For instance, algorithmic trading can be used by a trader who might want to implement trades when the stock price reaches a certain point or falls below a certain level. Based on the current market conditions, the algorithm can recommend how many shares to buy or sell. Once the trader enters the program requirements, they can sit back and relax as the trades automatically take place based on the preset conditions.

What are the benefits of algorithmic trading?

Algorithmic trading automates the trading function which is incredibly advantageous to traders. This makes sure that the trades are carried out at the right time during optimal market conditions which increases the chances of high returns. The traders does not face the risk of missing out on important opportunities in the market.

Another key advantage of algorithmic trading is that it removes human emotion from the trading equation as the trades are defined by preset conditions. This is advantageous because human emotions can cause investors to make irrational decisions based on fear and greed.

Algorithmic trading also allows you to backtest. This essentially means that the algorithms can be tested on past data to see if they have worked in the past or not. This is helpful because it lets the user identify any flaws in the trading system before they run the algorithm on live data.

In addition to this, algo trading reduces the time spent analyzing markets and lowers the associated transaction costs. The numerous benefits have made it a popular tool among investors in many stock exchanges today. 

Strategies used in algorithmic trading

Although the computer initiates the trades, the user still has the ability to input the strategy they wish to use. They can decide the volume, the price and at what time the trade should happen. Therefore the algo strategies used by the investors can have a large impact on their earnings. Here are the most common strategies used in algorithmic trading:

Trend based strategies:

One of the most commonly used algo strategies used is trend-based strategies. The involves following the current trends in the market and executing trades based on that. The trader uses technical indicators such as the moving average and the price level of the stock to assess the market and the system generated recommendations to buy or sell required to fulfill the conditions entered by the trader. This is one of the easiest strategies to implement as the figures are based on historical and current trends with no requirement for complex predictions.

Arbitrage strategy:

An arbitrage opportunity exists in the market when there is a difference in the price of securities on two stock exchanges which can result in a risk-free profit. In algo trading, the arbitrage strategy algorithm is used by the computer program to identify the differences in prices and make use of the opportunity in an efficient way.

The speed and accuracy of algo trading comes into play here because the price difference in the stock may not be high but the high volume of trade can lead to a considerable amount of profit. This arbitrage strategy is most commonly used in forex trading.

arbitrage trading

(Image credits: Corporatefinanceinstitute)

Trading Range or Mean Reversion strategy:

Also known as the counter-trend or reversal, this strategy is based on the principle that although prices go up or down, it is only temporary and they eventually come back to their average price. In this strategy, the program identifies the upper and lower limit of the stock and carries out trades when the price goes above or below this range. The algorithm calculates the mean price of the stock based on historical data and when the price goes out of bounds the trade is executed with the expectation that the stock will come back to its average price.

However, this strategy may not always work as the price may not come back to its average price as quick as expected and the moving average can catch up to the price leading to a lower risk to reward ratio.

Also read: How to read stock charts for beginners?

Conclusion

Algorithmic trading was introduced in India in around 2009 and has been growing in popularity due to its low cost and the availability of skilled resources, especially with traders who trade on proprietary books. SEBI (Securities and Exchange Board of India) has also played a positive role in the adoption of algorithmic trading in India which will help further its acceptance and incorporate the trading on a larger scale in stock markets.

Although algorithmic trading is automated, the user still has the authority to choose which strategy to follow depending on various factors. It is especially beneficial for small-time investors who want to increase liquidity in the market making it easy to enter and exit the market while decreasing price inefficiencies in trading stocks.

How to read stock charts for beginners cover

How to read stock charts for beginners?

For anyone looking to actively trade in the stock market, it is essential to know how to read stock charts. A stock chart is a chart that shows the price of a stock plotted on a time-frame that can range from minutes to many years. It serves as an important tool for picking the right stocks and easy to find on websites such as Yahoo Finance or Google Finance.

The ticker symbol of a company can help you find its stock chart. The ticker is a series of letters found in a company’s name (Apple= AAPL). Stock charts can help you identify stock price movements and make decisions on whether to enter, buy, sell or exit the trade.

When you first look at the chart

Stock charts come in various forms, they can be candle charts, bar charts or line charts.

In addition to the view of a stock chart, you also get to pick the time frame. The most commonly used ones are intraday, weekly, monthly, year-to-date (YTD), 5 years, 10 years or even a complete history of the stock.

how to read chart 1-min

(Stocktrader.com)

Once you have picked the chart view and time-frame, it is now time to understand the various features of a chart. For demonstration purposes, we can look at a candlestick chart.

On a candlestick chart, the red candles show downward price movement, while the white (or green) candles show an upward price movement. The chart has numerous technical indicators such as the moving average index (MA), the relative strength index (RSI) and the moving average convergence divergence index (MACD). These technical indicators are used to analyze future price movements.

Support and Resistance lines

how to read chart support and resistance

(Image credits: BabyPips)

The next step is to look for the support and resistance lines. As the name suggests, the resistance line indicates a point which resists the price from rising further. It shows the maximum supply for a stock where the level is always above the current market price. There is a great probability that the stock would rise up to the resistance level, absorb the supply and then decline. For traders, the resistance line is an indicator to sell.

Alternatively, the support line indicates a point that stops a price from falling lower. It shows the maximum demand for a stock in the market. There is a high chance that a stock price will reach the support line, absorb all the demand and then bounce back. The support line is a signal to buy stock.

Below the stock chart is a window that shows the trading volume of the stock. The volume shows how much of the stock has been traded over a period of time. The green bars show the greater buying volume days and the red bar shows the greater selling volume days.

how to read chart

(Image credits: Investors Underground)

Why is the volume important?

The volume of a stock is an important indicator of whether or not to invest in a stock. This is because the trading volume is influenced by the buying and selling of stocks done by big traders, large investment banks, mutual funds or exchange-traded funds (ETFs). It can be the high-value trading done by these large firms that causes the price of a stock to go up or down.

An individual investor can use the volume as an indicator of buying or selling stock, forecasting future price trends and identifying the support and resistance level. When there is a bullish market- that is investors are optimistic and expect the prices to rise- there is high volume trading on up days and low volume trading on low days. However, during a bear market- when investors are less optimistic- there is high volume trading on down days and low volume trading on up days.

how to read chart

(Investopedia)

Other technical indicators

In order to better understand the price movements and trends in a stock chart, investors use a variety of technical indicators. One such indicator is the 200-day moving average which is a stock’s average closing price in the last 200 days. A high 200-day average signifies a bullish market while a low 200-day average shows a bearish market. In reality, however, when the 200-day average is extremely high it is a sign that the market may soon go down and that investors are far too optimistic and when the 200-day average is low it signifies the reverse. The shorter the moving average, the greater the change in the market.

The 200-day average indicates whether a stock is healthy or not and is often compared to the 50-day moving average. When a stock in the 50 day moving average crosses the 200-day moving average, it achieves the ‘golden cross’ status. That is the stock may go up to a much higher price. On the flip-side, if a stock in 50-day moving average goes below the 200-day moving average, it is known as the ‘death cross’. This means there is a good chance the price of the stock will go down in the future. Technical indicators are used in conjunction with momentum indicators to analyze the direction and strength of a stock’s price movement.

Understand the overall trend of the stock

When looking at a stock chart it is important to understand the upward and downward trend of a stock but you also need to analyze the background of the stock as well. This involves understanding how a particular stock usually trends- does it have low price movements or is it constantly volatile?

Another factor to consider is the possibility of the trends reversing. Momentum indicators such as Relative Strength Index (RSI) or MACD can help identify if a stock has reached its peak giving investors the opportunity to exit the market. Understanding these trends can help you make better decisions about what stocks to purchase.

Also read: Fundamental vs Technical Analysis of Stocks

Conclusion

Knowing how to read stock charts is important for any trader. It provides perspective on the price movements of stocks and will help you make better decisions to improve profitability. Hopefully, this guide gives you a better understanding of how to read stock charts before you start trading. Always remember, by failing to prepare, you are preparing to fail.

How Does The Government Control Inflation cover

How Does The Government Control Inflation?

We cannot minimize the explosive effects of inflation. High inflation has the ability to topple governments, ruin nations and reduce economic growth. It discourages savings and reduces the overall productivity in the country. In its creepiest form, inflation can reduce the purchasing power of people, this means the pensions and savings of people can now buy less than it did before.

In response to this, governments have many powerful tools they can use to control the rate of inflation in the economy. These policies have been discussed in detail in this article.

What is inflation?

Inflation can be described as a continuous increase in the general level of prices. In some cases, inflation can be used to encourage spending in the economy. However, this is not always the case as inflation can often get out of hand and the purchasing power of people drastically decreases. The government will then have to intervene to create balance in the economy.

Inflation can be measured using the Consumer Price Index (CPI). The bureau of labour statistics chooses close to 500,000 products from more than a 100 categories which are included into a ‘basket’. The prices of the goods are used to calculate the price index.

Effects of inflation

Inflation, depending on its severity, has the ability to disrupt economies. There is an uneven distribution of income that can affect many sectors in the economy. They are discussed as follows:  

— Effect on various economic groups- If there is low inflation in the economy, job seekers can benefit from this as increased demand will lead to a rise in employment. However, an unhealthy level of inflation can be disastrous for the economy as people pull their money out of financial institutions and their purchasing power reduces.

— Government spending- During inflation, the government, like individuals, have to pay more for wages and supplies. In order to raise more revenue the government can increase taxes but people will may have the ability to pay for them and some groups will be affected more than others.

— Savings and Investment- If inflation is on the rise, it is not a great time for savers as the decrease in the value of money reduces the value of savings. Many people move their investments to stocks and property during inflation. It is a favorable time for borrowers because the value of the money they owe reduces.

How Does The Government Control Inflation?

If the rate of inflation in the economy goes beyond a rate that is uncontrollable, the government has to intervene with policies to help stabilize the economy. Since inflation is the result of too much expenditure on the economy, the policies are created to restrict the growth of money. There are three ways the government can control the inflation- the monetary policy, the fiscal policy, and the exchange rate. They are discussed as follows.

— The Monetary Policy

Monetary policy is a tool used by the government to control the amount of money circulated in the economy. This includes paper money, coins and bank deposits held by businesses and individuals in the economy. Monetary policy uses interest rates to control the quantity of money in the economy.

— Open market operations

When there is high inflation in the economy, the amount of money created by financial institutions needs to be restricted. The Federal Reserve Bank lowers the supply of money by selling their large securities to the public, specifically to security dealers. The buyers pay for the securities by writing checks on the deposits they hold in the commercial banks. This is an effective way to control the supply of money as the deposits of the commercial banks at the Federal Reserve Bank are the legal reserve for the banks. With the sale of securities, the banks are forced to restrict their lending and security buying, therefore reducing the quantity of money in the economy.

— Increasing the reserve requirement

The reserve requirement refers to the amount of money that the commercial banks are required to have on deposit with the Federal Reserve Bank. A low reserve requirement means banks have more money to lend out which can increase the money supply. But when there is high inflation in the economy, the government increases the reserve requirement which restrains the growth of money and even reduces it.

— The rediscount rate

The rediscount rate is the rate of interest charged by the commercial banks. The commercial banks borrow from the Federal Reserve in exchange for a promissory note. In exchange, the Federal Bank increases the deposit of the bank. The rediscount rate controls the cost to banks for adding additional reserves. When inflation is high the bank increases the rediscount rate, which makes it more expensive for banks to buy reserves. This cost is usually translated to customers in the form of high interest rates on loans borrowed from commercial banks which ultimately reduces the supply of money in the economy. In order to control the supply of money in the economy with the monetary policy, the rediscount rate is used in conjunction with the reserve requirement and sale of securities.

— Fiscal policy

The Fiscal policy uses government spending and taxation to control the supply of money in the economy. The policy was designed by John Maynard Keynes who studied the relationship between aggregate spending and the amount of economic activity in society. He also claimed that government spending can be used to control aggregate demand.

— The decrease in government spending

Sending by the government constitutes a large part of the circular flow of income in the economy. During periods of high inflation, the government can reduce the spending to decrease the amount of money in circulation. In many instances, high government spending is the root cause of inflation. However, it is often hard for governments to differentiate between essential and non-essential expenditure so, the spending policy should be augmented by taxation.

— Increase in taxes

An increase in the level of taxes reduces the amount of money that people have to spend on good and services. The effect of the tax can vary with the kind of tax imposed, but any increase in tax would reduce spending in the economy. An increase in tax combined with a decrease in government spending can have a double-barrelled effect on the supply of money in the economy.

— Increase in savings

Another theory derived by Keynes was his belief in compulsory savings or deferred payments. In order to achieve this, the government should introduce public loans with a high rate of interest, attractive saving schemes and provident or pension funds. These measures lock people’s income into savings accounts for an extended period of time and are an effective way to control inflation.

Also read:

Conclusion

Inflation can have a major impact on the economy and can affect the government, investments and the purchasing power of people. A high rate of inflation for an extended period of time can lead an economy into a recession. Fortunately, the government has the ability to use the monetary and fiscal policies to help control the supply of money in the economy. When used in the conjunction, the policies can help achieve a lower rate of inflation and a more stabilized and balanced economy.

how to retire early

Want to Retire Early? Now You Can!

Retire early, get financial freedom and travel the world!- It’s the common cubicle dream. But there are in fact many ways a person can make this a reality. Joining the FIRE movement which stands for ‘financially independent, retire early’ is not that hard provided you make the right financial moves while working a 9-5 job. FIRE has defined early retirement as not just leaving work but as gaining the financial freedom to pursue your passion projects and follow your dreams.

Retiring early, however, takes a lot of work and therefore many people find it challenging to achieve this. Contrary to popular belief, you don’t need to work in a certain high-salaried job or industry to retire early, anyone who has the long-term goal of retiring early can make it happen. With strong resolve and the right strategies, you can turn your dream into a reality. The key steps to early retirement are discussed below:

Track your expenses and make the necessary changes to your budget:

One of the most important things to do in order to meet all your financial goals, be it early retirement or buying a new home, is to analyze your current spending.

No matter how you look at it, you need to make changes to your current spending in order to achieve your dream of retiring early. This could even mean drastically reducing your spending. There are a slew of apps today that can help you track your expenses such as LearnVest or Penny. Most people with the goal of retiring early, aim to spend less than 50% of their income and put the rest into savings.

There are many ways you can work towards increasing your savings. If you are in debt, work towards aggressively paying off the loans so that any income you make in the future can be put directly towards savings. In addition to this, you can also cut back on unnecessary expenses such as that excessive coffee or those frequent restaurant dinners. You can also try and increase your income through side gigs or freelancing opportunities. If your goal is to retire early, frugal living should be your motto.

Also check: 10 best Android budget apps for money management

Make your money work for you:

In other words, invest aggressively! The longer the amount of time, you allow your money to grow, the greater the rewards. Hence, it only makes sense that you start investing at the start of your career. Early retirement essentially means that you have a shorter amount of time to save money but a longer amount of time that the money has to last you so make investment your best friend.

Design your portfolio in a way that will generate long-term returns. While stocks can be a risky investment, in the long-term they produce very high returns. If you look at the historic analysis of the Indian stock market, taking into consideration its various downturns, the market barometer NIFTY 50 has averaged a little higher than 10.84% annually since inception. This means if you put a majority of your savings into an index fund, there is a good chance you’ll receive an annual return of 10.5%.

Many people assume you should look for low-risk investments options when investing for the retirement fund. But this is an inaccurate assumption. Investing in low-cost investment funds is recommended when you are near the retirement age, as you need to move some of your money into more liquid investments so that you don’t have to worry about the investments selling options when you need it.

Calculate how much money you need for retirement:

Planning for the future is the most important strategy when it comes to retirement. That is you need to estimate what your retirement spending will look like. To do this, you should analyze your current spending and look at what expenses will go up, down, added, subtracted or eliminated completely.

A few things to consider are your health insurance and rent. Many companies offer health insurance as part of the employment package, but for retirement, you need to make sure to factor in this expense. Another large expense is your monthly rent. If you hope to own a home before retirement, this should not be a problem but if you plan to rent, you need to make sure to include this in your retirement expense.

Also read: 6 Reasons Why You Should Get Health Insurance

financial freedom

Start saving as early as possible:

The earlier you start saving money, the more you would have accumulated when you decide to retire. Hence, if you start putting money away from the start of your career, there is a higher chance you can exit the workforce earlier. There is a rule of 25 that states that you need to have 25 times your planned annual spending when you retire. That is if you plan to spend $35,000 during the first year of retirement, you need to have a total of $875,000 when you retire.

The second rule of saving is the 4% rule which states that you can take out 4% of your invested savings during your first year of retirement and continue to draw out that same amount adjusted for inflation for the following years. This strategy was developed in the 1990s and was based on historical market conditions.

While neither of these strategies is fool-proof, they are considered reasonable when it comes to saving. Moreover, it is imperative to remain conservative with your savings when it comes to retirement.

Conclusion

The FIRE (financially independent, retire early) dream may seem a distant reality for many but with a little planning and smart financial moves, it can become a reality. But it also helps to rethink what early retirement means, it’s not always fancy cruises and dinners. For some, it could mean spending more time with your grandchildren or significant others.

Whatever it may be, as long as it is important to you to live by your own schedule and not that of the employers, you should diligently work towards getting out of the workforce early using the strategies listed above. Remember to start saving early because running out of money means running back to work.

deep value investing cover

What is Deep Value Investing?

Deep value investing is an intense version of value investing which focuses on buying stocks at a much higher discount to intrinsic value in comparison to value investing. This results in an increase in the potential reward and risk of the investment.

Background

Traditional value investors have the belief that the market will misjudge stock prices in the short-term and hence they prefer to conduct their own fundamental analysis on stocks that they feel may be undervalued. They first determine the intrinsic value of these stocks and compare it with their current market value. Value investors usually invest in stocks where the market value is below its intrinsic value.

Nonetheless, value investors don’t invest in every undervalued stock they come across as each investor has a different level of margin of safety with regards to the market price and intrinsic value. The major difference between value and deep value investing is that deep value investors require a higher margin of safety.

This high margin of safety means that the return potential of the stock will be high but the risk associated with the stock increases as well. Hence deep value investing is usually followed by those investors who understand their strategies and can fully trust their investment decisions.

Benjamin’s Graham’s deep value investment philosophy

Benjamin Graham defined intrinsic value as the value that a businessman places on a business. He believed it was more important to assess the true value of a company based on the numbers present on financial statements such as the assets, earnings, and dividends. He would use these figures to come up with the fair value of the stock. (Also read: How to Find Intrinsic Value of Stocks Using Graham Formula?)

However, Graham would only buy the stock if it was discounted at 1/3rd (or more) of its intrinsic value. For example, if the intrinsic value of a stock calculated by Benjamin Graham turns out to be at $162, then he would only consider purchasing that stock if it is trading at $108 or less.

Anyways, there are multiple calculation methods that investors can use when valuing stocks such as Discounted cash flow (DCF) analysis, dividend discount model (DDM) and relative valuation tools like the price to earnings, price to book value or price to sales.

How do deep value investors assess the fair value of the stock?

Deep value investors usually buy stock in companies that trade below their liquidation value-although finding such companies is rare. In assessing the fair value of the stock, deep value investors use valuation methods that range in their level of conservativeness. Following are the ways, deep value investors assess the fair value of a company’s stock:

  • Most of the low conservative deep investors look at the future earnings of a company ignoring the fact whether the company has a competitive advantage or not. However, there are also a few investors in this group who look at the firm’s competitive advantage which can be used in the future to earn much higher returns.
  • Slightly conservative deep investors look at the firm’s ability to produce a profit. The earning power of the company is mostly determined based on past earnings with reference to price to earnings (PE) ratio.
  • Highly conservative deep investors look at the book value which involves looking at all the assets held by the company to determine its fair value. They also check Net current asset value, Networking capital and dividends.

Deep value investors use highly conservative strategies the most when looking for stocks that are traded at very low prices.

Deep value Returns

If you are a new investor, you need to use simple strategies that yield the highest return. In other words- deep value is the way to go. Deep value investing in coherence with traditional investing can help an investor earn very high returns. When conducting a conservative assessment of stock value, those stocks with a low price relative to book and current asset value generate very high returns. But remember with higher reward come higher risk.

Deep value Risk

The major risk involved in deep value investing is ending up in a value trap. This is where a stock may seem to be a good investment based on a quantitative analysis with financial ratios like low PE, low price to book value. However, the investor may overlook the ‘qualitative’ factors associated with the stock.

There is often an underlying reason why such stocks trade at a low price. It could be the result of problems with the management of the company or the lack of growth potential. There can be a fundamental problem in the company that is not reflected in its finances. Whatever it may be, an investor needs to be able to spot the reason for the low stock price. If they fail to do so, they end up in a value trap.

Also read:

Conclusion

Deep value investing can reap high rewards if you are willing to take the risk. A deep value stock usually exists when the company is in a difficult situation. It may take time for the company to recover and eventually generate returns. However, as with any investment, you need to be patient.

Monte Carlo Simulation Cover

Monte Carlo Simulation -How can it help investors?

We face an element of risk in almost every decision we make which often leaves us feeling uncertain and ambiguous. Although we have unparalleled access to information, we can never predict the future. A method that can help ease this risk is the Monte Carlo simulation that allows you to see all the possible outcomes of a decision and its associated risk. It can help you, as an investor, to make better decisions at uncertain times.

Background

The Monte Carlo simulation was developed in the 1940s by Stanislaw Ullam, a brilliant Polish-American mathematician who was in charge of the Manhattan Project (R&D for WWII nuclear weapons). While recovering from a brain surgery Stanislaw spent many hours playing solitaire. He was soon drawn to trying to devise the game through the distribution of cards and predict the probability of winning.

Stanislaw’s analysis of trying to predict the outcomes led him to develop the Monte Carlo simulation. It was named after the glamorous gambling casinos of Monaco, France.

What is the Monte Carlo Simulation?

The Monte Carlo approach is a computer-based method that uses statistical sampling to build a model of a possible range of results (a probability distribution) for those factors that have an element of uncertainty.

The results for the uncertain elements are calculated over and over using a set of random values at each time. The values entered as samples into the simulation as input ate chosen at random from the probability of income distribution. These sample sets are called iterations. The simulation produces a distribution of possible outcomes and these outcomes are recorded.

The Monte Carlo simulation is used by many different sectors and industries from project management to energy and engineering. But it is especially applicable to the finance and business sectors due to its emphasis on random variables. The simulation can be used to calculate the probability that the costs of a certain project will exceed its budget and the probability that the price of an asset will go up or down.

In addition to this, the model can be used to determine the investment default risk and assess the performance of derivatives such as options.

Why should we use the Monte Carlo Simulation?

Simply put, the Monte Carlo simulation helps you make better decisions. It helps predict future outcomes based on different scenarios. The technique used in the simulation allows us to measure the risk in quantitative analysis. In addition to providing the outcomes in a given scenario, it lets us know the likelihood of each outcome occurring.

In terms of investing, the Monte Carlo simulation lets us identify all the risks associated with a particular investment. It gives us a range of outcomes so it can show you outcomes for conservative investments and incredibly risky ones. There is also a middle ground for the portfolio which is the outcome of a neutral investment and is particularly useful to investors who want to assess the risk of options.

How is the Monte Carlo Simulation useful to investors?

The Monte Carlo simulation helps investors assess their portfolios and make investment decisions. Modern technology has now made it easy to perform a Monte Carlo simulation with the just a few clicks. The investor needs to enter a relevant time period between 1-25 years along with a downside floor constraint or an upper target value.

The simulator then generates 10,000 possible outcomes by playing out each simulated version in the future from the lowest to the highest risk based on values entered. However, it is important to remember that the simulator does not take into consideration real-world events such as crashes or unexpected events. Reality can differ from the simulator but it is still a powerful tool in understanding the trade-off between risk and the upside.

There are many websites that can help you perform a Monte Carlo simulation such as Vanguard that offers a ‘Retirement Nest Egg Calculator’. Vanguard uses the Monte Carlo simulation to provide the possible outcomes of a retirement portfolio. It takes into account your balance sheet, spending, and asset allocation and tries to determine the probability that your investment revenue will last the duration of your retirement.

Vanguard Monte Carlo Simulation Retirement Nest Egg Calculator

(Image Credits: Vanguard)

Another great website is Personal Capital that also uses the Monte Carlo simulation to assess portfolios. The tool calculates the standard deviation and annual returns on the portfolio based on set targets. The result provides you with three market scenarios, the best possible case, the worst possible case and midpoint between the two. The tool aims to show how a diversified portfolio can be catastrophic when there is a bad market.

Disadvantages of the Monte Carlo simulation

Like all things, the Monte Carlo simulation has its shortcomings as well because no one can predict the future. The simulations are particularly disadvantageous during a bear market. This is because the outcomes are based on constant volatility and can create a false sense of security for the investors. In reality, however, stock markets are very unpredictable and the Monte Carlo simulation does not hold good for these scenarios.

Moreover, the simulation is unable to factor in the behavioral aspect of the stock market. The Monte Carlo simulation could not predict accurate outcomes during the volatile stock markets of 2008. Therefore the simulations only show an approximation of the true value and can sometimes show very large variances.

Also read: The Ultimate Guide to Walter Schloss Investing

Conclusion

The Monte Carlo simulation is used by many investors to gauge the performance of their investments so they can make more informed decisions.

While you cannot trust the outcomes of the simulation with complete certainty, they do provide a viable way to understand the trade-off between risk and investment. It is a great tool for advisors when assessing the potential risks associated with the client’s portfolio. By changing the investment horizon and the upper and lower targets of the simulation, you can have a better understanding of how you can affect and change the outcome of your future investments.

The Ultimate Guide to Walter Schloss Investing cover

The Ultimate Guide to Walter Schloss Investing

When you think of investing, the first name that comes to your mind is Warren Buffet- and with good reason. Buffet has a legendary track record and has generated very high returns for his investors since the ’60s. But a lesser-known investor who was just as good and referred to as ‘Big Walt’ by Buffet is Walter Schloss, one of the most legendary investors in the investment world.

Background

Walter Schloss’ investment theories are most applicable to small value investors and were based on the teachings of Benjamin Graham (another icon in the investing world and also known as the father of the value investing).

Schloss’s studies helped gain an insight into how to perform deep value investing that is still relevant in today’s market. While the basis of Walter Schloss’s principles were based on Graham, he developed his own strategies while staying close to the fundamentals. His theories earned him the title ‘Superinvestor’ in 1984.

The Investing Playbook

Walter Schloss’ investment strategies involved a more ‘play by the book’ approach of investing in undervalued stocks. He focused on the quantitative factor and instead of following every stock he owned, Schloss decided to follow stocks based on valuation and buying at a discount to the intrinsic value. In 1994 Schloss listed the factors he believed were required to make money on the stock market. I have discussed the most important factors below:

1. Price is the most important thing when it comes to buying stocks

Walter Schloss’ believed Ben Graham’s philosophy that ‘a stock well bought is half sold’. He felt that every stock will become an attractive buy at a certain point as long as the price dropped low enough to provide a safety margin.

2. The price of a stock in relation to its book value is the most important factor in valuing stocks

Walter Schloss never bought stocks that had a premium to book value ratio. Instead, he bought it at a discount to book value as it provided a margin of safety. The investors who remained patient in the short run would be rewarded in the long run if they systematically bought discounted stocks.

3. Buy stock in companies that have been in business for a while

Schloss preferred to invest in stocks of companies that have a long history of being in business. The fact that these businesses have been in operation for so long gives the investor the confidence that the company will continue to operate long into the future as well. It can also help identify their business cycle and compare the book value earnings. Walter Schloss’s also invested in companies that were going through a downturn in their business cycle if he believed that the asset portfolio was strong and the chances of the company performing well in the long-term seemed favorable.

4. Maintain a diverse asset portfolio and stay fully invested

Walter Schloss usually traded a 100 different stocks at any given time and he was a 100% invested. During a high market valuation, he would adjust his price to book value upward if the company was paying a good dividend. But he relied on dividends rather than earnings as an indicator of a company’s profitability.

When analyzing the quality of the management in the company you choose to invest in, Walter Schloss believed that being ethical was more important than just being smart. In an interview, he said: “In a choice between a smart guy with a bad reputation and a dumb guy, I think I’d go with the dumb guy who’s honest. Of course, you can’t always protect yourself there, either. I guess the choices we’ve made are probably in those areas.”

The ‘rules of investing’ were written by Walter Schloss many years ago but they still remain relevant today. If an investor learns to stick to a small value approach, it will benefit them in the long run. Keep it simple.

Also read: Why Warren Buffet Suggests- ‘Price Is What You Pay, Value Is What You Get’?

Walter Schloss and Portfolio Management

Walter Schloss did not invest too much time assessing the details of a particular stock to the very last detail rather he studied the company financials and did not overanalyze each investment opportunity. He spread his risks evenly and sometimes invested just $10,000 in a stock. His portfolio consisted of a hundred stocks.

In the initial investment, Schloss would take a small position and eventually buy more if the difference between the trading price and intrinsic value continued to widen. In particular, he preferred to invest in companies with a higher margin of safety and focused on stocks with low leverage.

Walter Schloss’s deep value investing

As a small value investor, the strategies used by Walter Schloss are extremely relevant. Walter Schloss’s investment strategy was incredibly old-school, he was a simple man and operated more like a small-time investor rather than a professional financial advisor. Schloss never aimed to reach new heights as an investor and continued to use and search for new deep value investing ideas till the very end.

Value investing are stocks that trade lower than their book value and while it is hard to find these stocks in today’s market where ‘money never sleeps’, this old school strategy developed by Walter Schloss is still important. Here are the key takeaways of this investing style:

  • The main criteria of the investor should be to discount your stock to a tangible book value
  • The quality of the management is also important, if the company is not confident in their management, then neither should you
  • Having a diversified portfolio is incredibly important. In the long term, it is the valuation of your portfolio that helps you earn large gains in the stock market.

Also read: #5 Things Warren Buffett looks for before investing.

BONUS: 16 Investing Rules from Walter Schloss

(FROM A 1994 LECTURE)

  1. Price is the most important factor to use in relation to value.
  2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.
  3. Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity. (Capital and surplus for the common stock).
  4. Have patience. Stocks don’t go up immediately.
  5. Don’t buy on tips or for a quick move. Let the professionals do that if they can. Don’t sell on bad news.
  6. Don’t be afraid to be a loner but be sure that you are correct in your judgment. You can’t be 100% certain but try to look for the weaknesses in your thinking. Buy on a scale down and sell on a scale up.
  7. Have the courage of your convictions once you have made a decision.
  8. Have a philosophy of investment and try to follow it. The above is a way that I’ve found successful.
  9. Don’t be in too much of a hurry to see. If the stock reaches a price that you think is a fair one, then you can sell but often because a stock goes up say 50%, people say sell it and button up your profit. Before selling try to re-evaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and P-E ratios high? If the stock market historically high. Are people very optimistic etc?
  10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it attractive. 3 years before the stock sold at 20 which shows that there is some vulnerability in it.
  11. Try to buy assets at a discount than to buy earnings. Earning can change dramatically in a short time. Usually, assets change slowly. One has to know much more about a company if one buys earnings.
  12. Listen to suggestions from people you respect. This doesn’t mean you have to accept them. Remember it’s your money and generally, it is harder to keep money than to make it. Once you lose a lot of money, it is hard to make it back.
  13. Try not to let your emotions affect your judgment. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.
  14. Remember the work compounding. For example, if you can make 12% a year and reinvest the money back, you will double your money in 6 yrs, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.
  15. Prefer stock over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.
  16. Be careful of leverage. It can go against you.

Conclusion

The Walter Schloss investing style is great for anyone looking to invest in small companies. The strategies help reduce risk with the promise of high returns.

Unlike Warren Buffet’s investing style which requires the ability to identify a competitive advantage and do thorough research into a company’s financial statements that most people don’t have the know-how to do. Schloss provides a great alternative to this- focus on assets rather than earnings.

Many small investors are in the habit of solely investing in a company based on its annual earnings but they are more likely to succeed if they focus on the assets in the balance sheet. Walter Schloss investing is a time-tested lesson that still holds true today.

stock market cycle cover

The Stock Market Cycle: 4 Stages That Every Trader Should Know!

From the changing seasons to the different stages of our lives, cycles exist all around us. These cycles are often influenced by numerous factors at each stage. Likewise, cycles also affect the movements of stocks in the market. Understanding how these movements work can help a trader identify new trading opportunities and lower their risk.

In this post, we are going to discuss the four stock market cycle stages that every trader should know. Let’s get started.

Stages in the Stock Market Cycle

The movement of prices in the stock market can often seem random and hard to follow. Prices may go up on certain days, and down on others. To an average person, these shifts are often confusing and the prices can resemble a casino game.

The reality, however, is that the stock market cycles move in similar ways and go through the same phases. Once an investor understands the phases, the markets will not seem so random anymore. The trader can recognize each phase and change their style of trading accordingly. There are four phases in the stock market cycle as follows:

four stages of stock market cycle

(Image Credits: Investopedia)

1. The Accumulation Phase

accumulation phase

(Image credits: Investopedia)

This phase of the stock market can apply to an individual stock or the market as a whole. As the name suggests this phase does not have a clear trend and is a period of agglomeration. The stock tends to trends at a range as traders accumulate their shares before the market ‘breaks out’. It is also known as the basing period because the accumulation phase comes after a downward trend but precedes an uptrend.

The moving average does not provide a clear indicator at this point as the market is not following a particular trend. The longer the accumulation phase the stronger the break out in the market when the stocks start to trend.

How to trade:

The accumulation phase may last a few weeks or a few months. So use this time to study the market and anticipate the right time to enter. The price range during this period is small and not particularly advantageous for day traders. It is advisable not to make large trades at this time until a market trend is confirmed. A current event in the economy can take stock out of this phase as you begin to see an uptrend. Once this accumulation phase is broken, you begin to see highs and lows in the market as we move on to the run-up phase of the market.

2. The Run-Up Phase

Just as the accumulation phase is defined by its resistance to the changes in stock prices, the run-up phase is defined by the price going above this resistance level. The breakout of the accumulation phase results in a high volume of shares as the traders who remained silent during the accumulation phase aggressively purchase stocks. As this period progresses we begin to see a trend in the prices. The highs and lows in the market attract more traders as they begin investing. This result in an upward trend as the market becomes stronger and moves on to the next phase.

How to trade:

This is the best time for a trader to make money. There is a lot of upward movement of prices which is great for momentum traders. Any downward trend during this period is not viewed as a bad thing but rather an opportunity to buy shares. When the market goes down, the shares will get bought up as the market begins to trend again. The run-up phase is best for swing or short-term traders. As this phase progresses, the volatility in the market decreases as prices move slowly every day.

3. Distribution Phase

distribution phase

(Image Credits: Investopedia)

This phase, also known as the reversal stage, is when traders who purchased stocks during the accumulation phase begin to exit the market. A prominent feature of this phase is an increase in the volume of shares but not in its price. The market is usually bullish but the demand does not exceed the supply of shares enough for the prices to increase. There are usually hard sell-offs but not enough to make the market trend downward.

How to trade:

There is a lot of volatility in the early stages as investors begin to pull out of the market which presents a good shorting opportunity as the market reaches the bottom it will bounce back with velocity. The distribution phase is identified through certain chart patterns like the head-and-shoulders top or bottom top. As the phase progresses the market starts to lose its volatility as a range begins to form. This is not the best situation for momentum traders.

4. Decline or Run-down Phasemark down cycle

(Image Credits: Investopedia)

This is the last stage of the stock market cycle and is not a favorable time for most investors. Those traders who bought stocks during the distribution phase hastily try to sell as they are underwater on their positions. However, there are few buyers to meet the sale of shares. This lack of demand drives down the prices of stocks. If there are higher lows in the market for a long period of time, it signifies that the market is headed towards the accumulation stage.

How to trade:

During this phase prices of stocks fall lower than expected so ‘don’t try to catch the falling knife’. A bear marker provides a good opportunity for long trades if the right strategies are used. It is important not to panic and sell during this period because these phases don’t last forever.

Also read:

Conclusion:

Understanding each of the phases in the stock market cycle is essential to making the right decisions when it comes to buying and selling stock. A good way to study these phases it to study the past chart trends of particular stocks. You can identify certain indicators at each phase. Finally, always remember this quote by Yvan Byeajee- “Trading effectively is about assessing probabilities, not certainties.”

How do oil prices affect the stock market cover 2

How do oil prices affect the stock market?

Crude oil is considered to be one of the most important commodities in the global economy. It is versatile in its uses and helps industrialize economies. A variety of things from plastics to rubber and machinery uses crude oil or its byproduct, making it a crucial element in the raw materials for many businesses in the economy.

Hence it is no surprise that the stock market is often influenced by the price of oil. It can affect an individual investor or have a domino effect on the stock market. Here are some of the ways oil prices affect the stock market:

How do oil prices affect the stock market?

– Profitability of oil companies

The oil business has two main components to it, the upstream and downstream business.

The upstream business is involved in the drilling of oil wells and the manufacture of crude oil in industries. Examples of such businesses include Oil India and Shell.  When these companies are profitable it usually results in high stock market prices because the crude oil manufactured by these companies is the raw material for many businesses.

If upstream companies find it hard to drill for oil and face an increase in research and development costs, it could have an adverse effect on the value of the oil company’s stock.

The second type of oil business is the downstream business. These are corporations involved in the distribution and retail function of crude oil. They are in control of your local gas stations such as Indian Oil and Bharat Petroleum. These companies find low crude oil prices beneficial as they can now purchase crude oil at a low price from upstream companies.

– Consumer Demand

Almost everything that a person consumes is tied to oil such as electricity or fuel for their cars.

An increase in the price of oil can raise the daily living costs for people, reducing the amount of money they have available to spend on other goods and services such as electronics or clothing. The revenue of these companies decreases as consumer demand for their goods and services falls. The negative effect on the earning of firms lowers the value of their stock.

Alternatively, a decrease in oil prices has the opposite effect. When consumers spend less on fuel, it gives them more money for other goods and services. The increase in demand raises earnings and has a positive impact on the stock market.

How do oil prices affect the stock market cover

– Profitability of other industries

Since all businesses use a byproduct of oil, an increase or decrease in the price of oil can indirectly affect them as well.

If the price of oil increases, a delivery services company will face higher fuel costs. These costs will be translated to consumers as high prices for their services. The low earnings of the company will result in low stock prices for the industry.

Likewise, if oil prices decrease, the companies can charge lower prices to consumers and have high profitability and higher share prices. In reality, however, companies rarely lower the prices of goods and services if the price of raw materials has decreased.

– Impact on Inflation

The price of oil can directly or indirectly increase or decrease costs of goods and services in the economy and can result in inflation. In the United States, the price of oil is not considered a factor when the inflationary rate is calculated but its price can cause a ripple effect in the economy through industries that use crude oil as a raw material.

If oil prices rise, it can increase the cost of living for individuals, putting a pressure on wage rates to make up for this. The high labor costs increase the costs of goods and services and increase the rate of inflation in the economy as each dollar can now buy fewer goods and services. When inflation rises the stock prices of the industry decline.

Also read:

– Effect on Imports

For countries such as India that import almost 80 percent of its crude oil, a decrease in the price of oil is beneficial because it decreases imports expenditure and stabilizes the exchange rate of the currency.

However, a reduction in oil prices isn’t always great for the stock market. There is a positive relationship between the Foreign Direct Investment and the price of oil. When the price of oil goes up, oil-rich countries invest in emerging oil markets like India. However, when prices go down, they withdraw their investments.

Hence with a fall in oil prices, few foreign investors will invest their money in the Indian stock markets resulting in a negative impact on stock prices.

Conclusion

The versatility of the crude oil has made it an influential factor in the increase and decrease of stock prices. The price of oil not only affects the stock of oil companies but also the stocks of industries that use it a byproduct of it.

While the exact amount of influence it has on stock prices cannot be calculated, the price of this commodity can increase or decrease the total costs of production of many goods and services. This can affect the amount of goods people consume to exchange rate and the level of foreign direct investment which collectively affect the stock prices in an economy.

Needless to say, the price of crude oil has the ability to affect the level of investment in the economy and influence stock prices.

wpChatIcon