Reblog – Behavioural finance: Money illusion


Money illusion describes the tendency of people to think about money in nominal rather than in real or inflation-adjusted terms. In other words, it’s when people focus on the absolute amount of money rather than what that money can buy.

The concept of money illusion was first discussed by Irving Fisher and later popularised by John Maynard Keynes. Fisher defined it as “the failure to perceive that the dollar, or any other unit of money, expands or shrinks in value”.

In behavioural psychology terms, the issue of money illusion is an example of a broader cognitive failing known as frame dependence where perceived losses tend to have undue prominence in our decision-making.

One classic behavioural finance text showing the existence of money illusion was written by Shafir, Diamond and Tversky in 1997. It was based on experiments and real situations. Participants, for example, were presented with the following scenario:

Imagine that Adam, Ben and Carl each receive an inheritance and buy houses for $200,000.  Each sells their house one year later, but under different economic conditions. Adam sells his house for $154,000, 23% less than what he paid for it. When Adam owned the house there was 25% deflation. Ben sells his house for $198,000, 1% less than what he paid for it. When Ben owned the house, there was no change to prices. Carl sells his for $246,000, 23% more than he paid for it. When Carl owned the house there was 25% inflation.

When subjects were asked to rank these transactions in terms of success, the results showed that they were influenced by nominal values. The majority of subjects (60%) ranked Carl as having done best, Ben second and Adam third.

In real terms, the reverse is true. Adam did best because he made a real gain of 2%. Ben did second-best, making a nominal and real loss of 1%. Finally, Carl did worst, making a real loss of 2%.

The behavioural explanation for money illusion suggests that people’s thinking is driven by automatic, emotional reactions to the perceived changes in nominal values. While the calculation to account for inflation is not difficult, it involves an extra step and at least part of the brain seems strangely anchored to nominal values.

There are financial implications with this. One of the key problems is the situation where nominal increases in income are mistaken for genuine gains in purchasing power, when inflation may be diminishing the real worth of money. In fact, money illusion has been cited as why small levels of inflation are desirable for economies at least in terms of earnings growth. Having low inflation allows employers to modestly raise wages in nominal terms without necessarily paying more in real terms. As a result, many people who get pay increases make the mistake of thinking their wealth is rising, since they fail to adequately account for inflation.

In periods of rising inflation, income and prices tend to be correlated and there have been wage-price spirals where the two factors feed off each other. In periods of deflation, in theory, the process should work in reverse with downward wage price spirals, but in reality this tends not to happen. The reason is that labour is resistant to nominal wage decreases, partly due to money illusion. Unemployment tends to be the outcome because firms react to falling prices and declining profits by cutting staff.

In investment, the challenge is to make a real return on an outlay. If inflation is 3% and your investment gives you 5%, the real return is 2%. With the ability of inflation to act as a tax that erodes purchasing power over time, the best way to counteract inflation is to invest money in assets that can provide a return above inflation.

With record low interest rates, keeping money in a bank account or a money-market fund may not generate enough return to keep pace with even moderate inflation.

Despite this, the evidence suggests investors are more averse to nominal risks than real ones. Consider the “flight to safety” that occurs during most economic and stock-market downturns. Investors flood into safe assets such as bonds, which do not keep pace with inflation, while ignoring equities, despite the fact they may have cheapened considerably.

While the idea of holding cash may be emotionally appealing as it feels like a safe trade in nominal terms, such conservatism runs the risk of reduced purchasing power.

Assuming we do not strike deflation, in the prevailing environment of historically low interest rates, some analysts believe that cash and government bonds run the risk of providing negative real returns. This is encouraging many investors to look for real returns in high-yield bonds, real estate and equities.

Investors with a time horizon of five or more years should consider shifting surplus cash into assets where there is a prospect of a real return. Equities can offer attractive inflation-proofing characteristics as many companies can pass price increase onto consumers to protect their profits.

The original article appears on bull.com.au and appears here.


Reblog: Frank Martin of Hummingbird Partners on Cyclical Investing


This month’s issue of Value Investor Insight contains an interesting interview with Frank Martin of Hummingbird Partners.

Since his Martin Capital Management embraced equity investing in 2000, Frank Martin has achieved a truly impressive record of outperformance. His firm’s equity composite has beaten the S&P 500 by some 700 basis points per year since inception. However, thanks to his cautious stance, Martin has underperformed. Throughout the period he has only been 30% to 70% invested.

Still, Martin’s new venture, long/short hedge fund Hummingbird Partners, which he co-founded with Peter Wong, promises to replicate his strategy and help investors recognize his stock-picking acumen. Hummingbird is looking for opportunities in such areas as jet engines, agriculture and industrial and auto supply. Here are some of the key takeaways from the Hummingbird Partners interview.

Hummingbird Partners
Hummingbird Partners

Frank Martin of Hummingbird Partners on Cyclical Investing

Martin starts the conversation by discussing what makes a good business. He believes, along with many other investors that the key to a lasting business model is “structural competitive advantages, those inherent features that prevent rivals from entering a company’s business and/or competing effectively with it.” He goes on to give some examples such as “monopolies or oligopolies, razor/ razorblade businesses, enduring brands, network effects, high switching costs and economies of scale. Perfect business models don’t exist, but many come close to varying degrees.” An example of which is Gentex, which owns the market for auto-dimming mirrors and lights:

“It has such a strong position in a small-enough niche that companies trying to wedge their way into the market are likely to have a terrible return on capital for many years. It’s run by an owner-operator, Fred Bauer, who founded the company in 1974 and is just a first class operator who funds very-productive R&D and maintains a balance sheet with what some might call too much cash, but which we love because of the optionality it provides. That’s part of being anti-fragile.”

But Hummingbird’s co-founder isn’t just attracted to good businesses in niche markets; Martin is also interested in large companies trading at attractive valuations where he can act as a contrarian:

“For instance, we took advantage of the fairly recent break in oil prices to invest in energy-services companies like Baker Hughes. Rather than try to figure out which of the exploration companies to bet on, we went for “picks-and-shovels” type companies…We will also at times walk toward controversy when others are running away. In 2010 I bought BP in this case primarily as a trade, right in the middle of the Gulf-oil-spill mess…Sometimes the impetus is less dramatic. With Wal-Mart, we’ve seen sentiment ebb and flow over the extent to which Amazon is going to eat its – and everyone else’s – lunch. Our basic view is that there will continue to be space for Wal-Mart, especially given that 50% of its revenues come from groceries, which has proven a tougher sale online.”

Cyclical businesses are also an area of interest for Martin. While most investors would shy away from cyclical businesses fearing earnings volatility, Martin and team like to make the most of volatile earnings and the favorable share price movements they produce:

“Many people associate cyclical businesses with bad businesses because they don’t produce stable, consistent cashflows like bonds. We disagree. A good business to us is one where we can assess its earnings power over a full cycle and buy it when its shares are attractively priced relative to that earnings power.”

Agriculture is one such industry. The sector is currently suffering from an earnings recession “since the cycle turned in 2013, farm income in the U.S. is down approximately 40%, ” yet the “U.N. projects that world population by 2050 will grow by a third, to 9.7 billion. Nearly all of the increase will come from developing countries, where income levels are growing.” Farms will have to think up new ways to increase yield to get meet this growth. “Estimates are that crop production will have to grow by at least 60% from current levels to meet estimated demand by 2050…all of the 60% increase in crop production will have to come from increasing yield.” The best way to play this trend Martin believes is via “agricultural companies that reliably prove capable of facilitating yield growth.” Hummingbird’s goal: buy the best ones when they’re out of favor.

Martin’s entire investment strategy is based around business cyclicality. When it comes to valuation and timing acquisitions, he says:

“I’ve always found the best place to start is where the company has been priced over its history, relative to itself and to its industry. From there, we try to buy against some reasonable estimate of earnings power when it’s out of favor and to sell when it’s in favor. We use as a threshold that the price can at least double in five years through a combination of business performance and improved valuation.”

From all of the above, it’s clear Hummingbird’s investment strategy is a contrarian one so it could come as no surprise that the fund currently owns some down-and-out businesses. On top of Gentex above, Martin likes Rolls-Royce and Fastenal, both of which have seen their shares slide recently.

The original article appears on ValueWalk.com and is available here.


Sensex ends on Friday marginally higher ahead of RBI policy meeting


The benchmark indices on Friday ended flat as investors preferred to stay on the sidelines ahead of the Reserve Bank of India’s policy meeting next week. The S&P BSE Sensex settled the day at 28,240, up 14 points, while the Nifty50 quoted 8,740, up 7 points at close. In the broader market, BSE Smallcap index outperformed the frontline indices and BSE Midcap to gain 1%. BSE Midcap added 0.6%. The market breadth, indicating the overall health of the market, was strong. On BSE, 1,600 shares rose and 1,187 shares fell. A total of 159 shares were unchanged.

Shares of Bombay Stock Exchange (BSE) made a strong debut on Friday, with the scrip listing at Rs 1,085, a 35% premium over the issue price of Rs 806 on the National Stock Exchange (NSE). The stock hit a high of Rs 1,200, up 49% against its issue price within minutes of listing. The stock eventually settled the trade 33% higher at Rs 1,070 against its issue price.

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Reblog: ‎The 10 Key Takeaways From Arun Jaitley’s Fourth Budget


Perhaps the biggest plus of this budget is that it brought no negative shocks. And no bad ideas like farm loan waivers.

Hence the massive relief rally on Dalal Street. And the economists are relieved that foolish ideas have been given the go-by.

Arun Jaitley’s Union Budget for fiscal 2017-18, his fourth, is notable precisely for its lack of fireworks. Given the context of demonetisation and the need to stimulate growth, the budget did not propose major concession to too many sectors, barring real ‎estate. In fact, Jaitley passed up the opportunity provided by DeMo and a forthcoming shift to a goods and services tax (GST) regime to break out of the fiscal deficit straitjacket. He accepted the 3 per cent target for 2017-18 as one he will try to achieve while giving himself leeway up to 3.2 per cent, which is lower than 2016-17’s target of 3.5 per cent. The direction of fiscal consolidation is consistent and prudent.

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Reblog: 20 years of demat – A move that transformed share trading in India


Along with electronic trading, introduction of dematerialization—conversion of physical shares into electronic form–in the mid-90s was the other radical move that changed the character of the Indian market forever, and for the better.

It gave another leg-up to the Indian market in its quest to rub shoulders with its global counterparts, eliminate frauds by companies and brokers, improve the efficiency of stock exchange clearing houses, reduce brokerage rates and attract more FIIs.

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Reblog: The ABCD and the Three-Drive


The ABCD

Let’s start this lesson with the simplest harmonic pattern.  So what could be more basic than the good old ABC’s? We’ll just pop in another letter at the end (because we’re cool like that), and we’ve got the ABCD chart pattern!  That was easy!

To spot this chart pattern, all you need are ultra-sharp hawk eyes and the handy-dandy Fibonacci tool.

For both the bullish and bearish versions of the ABCD chart pattern, the lines AB and CD are known as the legs while BC is called the correction or retracement. If you use the Fibonacci retracement tool on leg AB, the retracement BC should reach until the 0.618 level. Next, the line CD should be the 1.272 Fibonacci extension of BC.

Simple, right? All you have to do is wait for the entire pattern to complete (reach point D) before taking any short or long positions.

Oh, but if you want to be extra strict about it, here are a couple more rules for a valid ABCD pattern:

  • The length of line AB should be equal to the length of line CD.
  • The time it takes for the price to go from A to B should be equal to the time it takes for the price to move from C to D.

Three-Drive

The three-drive pattern is a lot like the ABCD pattern except that it has three legs (now known as drives) and two corrections or retracements. Easy as pie! In fact, this three-drive pattern is the ancestor of the Elliott Wave pattern.

As usual, you’ll need your hawk eyes, the Fibonacci tool, and a smidge of patience on this one.

Bearish Three-DriveBullish Three-Drive

As you can see from the charts above, point A should be the 61.8% retracement of drive 1. Similarly, point B should be the 0.618 retracement of drive 2. Then, drive 2 should be the 1.272 extension of correction A and drive 3 should be the 1.272 extension of correction B.

By the time the whole three-drive pattern is complete, that’s when you can pull the trigger on your long or short trade. Typically, when the price reaches point B, you can already set your short or long orders at the 1.272 extension so that you won’t miss out!

But first, it’d be better to check if these rules also hold true:

  • The time it takes the price to complete drive 2 should be equal to the time it takes to complete drive 3.
  • Also, the time to complete retracements A and B should be equal.

Here’s a forum thread discussing the ABCD pattern and a trade setup with the three-drive pattern.


Sensex, Nifty post biggest weekly gain in 8 months; Airtel rallies 4.8%


Benchmark indices settled the day on a higher note, extending gains for the fourth day straight, as investors remain optimistic ahead of the Union Budget next week. Better than expected corporate earnings also aided the sentiment.

Nifty, Sensex posted their biggest weekly gains since May 27, led by gains in banking and financial stocks.


Reblog: Investing is not Rocket Science! Here’s Why…


Owing to its irrational nature, people often assume that investing in the stock market is a rather difficult affair. Many even compare it to gambling and consider it impossible. With the amount of negative opinions regarding the stock market, it seems like a place where everybody loses. We have to set the record straight, once and for all.

Investing is not rocket science and investing in the stock market is relatively easy to manage if you do it the right way. Your mindset is the one stopping you from investing and it will be the one that will help you invest. Everyone has their own opinions about the market and a lot of people make it difficult for themselves, more than necessary.

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Reblog: BSE Ltd IPO review


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Issue Summary

After demonetization, the market went for tail spin with standstill activities in the primary market. However, the long waited IPO of BSE is taking a lead to break the ice for CY 2017 as well as final quarter of FY16-17 as the first main board IPO.

BSE LTD (erstwhile known as The Bombay Stock Exchange) is the premier and the oldest stock exchange of Asia (established on 9th July 1875) and has become the most trustworthy brand as far as stock market is concerned and has become the synonyms with its Sensex and Dalal Street.

Today BSE is the world’s largest exchange by number of listed companies (5,329), India’s largest and world’s 10th largest exchange by way of market capitalization, with US$ 1.7 trillion in total market capitalization of all listed companies and the world’s fastest stock exchange. It has now also become the first stock exchange to go public in India and has thus become the first mover. BSE has diversified products for trading is also providing IT services and solutions, listing business, marketing business, data business etc.

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Reblog: 2 Moving Averages that Beat Buy and Hold


2 Moving Averages that Beat Buy and Hold

Most the investing establishment considers buy and hold investing the Holy Grail that always works out in the long term. For long term buy and hold investing your entry time frame matters, whether you got in at good prices and if you have time after bear markets to get back to even. NASDAQ buy and holders waited a long time from March of 2000 and buy and holders from 2007 also had to wait many years to get back to where they were. The most simple long term moving average systems can beat buy and hold by getting and keeping you in during bull markets and getting you out before big drawdowns. You are capping your downside risk and keeping your upside potential profits open by simply having an entry and exit strategy based on price action not opinions or predictions.

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