Premium

The amazing story of Kat Cole (President, Cinnabon) has several important lessons:

  • Raised by her mother with her 2 siblings on an administrative support role salary, she started selling beer and chicken wings at Hooters, her second job, when she was still in high school. 
  • First of her family to go to college, she started working on engineering coursework at the University of North Florida, but dropped out because Hooters was sending her all over the world to open franchise locations.
  • At 19 when she was asked to go to Australia on her first assignment, not only had Cole never been out of the country, she had never been on a plane. Her only trip out of Jacksonville until that point was to Savannah, on a girls trip in high school.
  • Cole was taking in close to $45,000 a year as a Hooters girl when she accepted her first corporate job with the company in Atlanta, which only paid $22,000. The pay cut was worth it to Cole to get her foot in the door. 
  • She rose through the corporate ranks so quickly that that by the time she was 26, Cole was an executive vice president. Mind you, this all is without a bachelor’s degree.
  • Three years ago, Cole, now 35, accepted the role as president of Cinnabon, the sweet-indulgence franchise with 1,100 stores in 56 countries and which is approaching $1 billion in annual sales. 

She took her risks; maybe there was a plan, maybe there wasn’t one;

However the rewards she got were exceptional;

Along-with all the hard-work, competence etc., what’s so important is to take an opportunity, even when it looks inherently risky, is what makes the mix interesting.

Often as investors we raise the question of premium for taking the risk;

The risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. In the process, it affects the expected return on every risky investment and the value that we estimate for that investment. Consequently, it makes a difference in both how we allocate wealth across different asset classes and which specific assets or securities we invest in each asset class.

That a higher return is expected by investors for a higher risk is highly intuitive.

Technically a lot of work goes around calculating risk premium, creating portfolios, advising clients, etc.,

What we see in practice is how often, investor perception plays the biggest role ignoring all models but listening only to the inner voice driven by “Greed” or “Fear” with an “acceptance/ignorance of the risk”.

This intuitive process cannot be assigned a “Value”.

We see the success of Kat Cole, however she might have gone completely wrong in her choices, is a probability that can’t be ignored.

That just shows how the risk-premium so often is an after-thought and not a design.

More often then not its an effective story playing to the right emotions that gets a decision and not the complicated equations that display favourable “risk-premium” and “risk-reward”.

Our challenge always is to separate the emotions or at-least accept that our emotions and our perception of the factors drive our acceptance/ignorance of risk and hence the premium is only an outcome and not a design of our decision.

Till we can understand, accept and remember this-our acceptance the outcome will have a bright chance. 

Know your RISK

Courtesy Joetheitguy.com

The Poet should Prefer Probable Impossibilities to Improbable Possibilities

Every criminal takes a “Risk” knowing that there are more chances of being caught than not.
It is not the fear of being caught but the confidence of “I will never get caught” that pushes them.
The moment individuals get into a fight mode-they gain this whole “illusion of Control” which makes them believe that they know everything that can happen, can go-wrong and just go with their plan even though there are always events/happenstance beyond one’s control that can surprise “the best laid plans”.

In the famous 2001 paper on “Illusion of Control”, the authors Francesca Gino cites how pedestrians in NewYork city continue to believe that by pressing the walk button nears light signals, they can make the “walk” signal appears faster when the whole system, is computerised and none can control it.

Individuals are often thought in “self-help/motivational” programs that when the choice is “Flight/Fright/Fight, they should fight.
When we all know that “FIGHT” is not a game plan-its just a positive feeling.
Positive feelings about ability to succeed are very important, however you need much more to succeed than just a positive feeling.

Success has so many ingredients-
Knowledge;
Competence;
Discipline;
Patience;
Opportunity
so on and so forth.

Even in this limited list it is easier to Notice how few things we control.
While knowledge can be controlled, competence can’t be.
Discipline and patience are virtuous not everyone possess.
And “Opportunity” is just pure chance.

The story of Phil Hellmuth (A record 15 time world poker champion) is legendary.
Phil was known for his temperamental personality as even mentioned by his Wikipedia page.
His break-downs are available on youtube with several million views.
How then did he manage to win 15 championships in a game of pure chance.
This is the story of “discipline and behaviour control”.
The biggest factor in his success is “how he has chosen to play fewer hands -Top 10 hands only in the initial stage.
He avoids risking his entire pot at the early stage of the game

For someone who is legendary for being temperamental, the discipline in his game is a complete contradiction.
However when you are there to win, you need to play the game, you need a strategy and you need to be in the game.
No-one has won by being out of the game ever.

Risk in Investing

This gets so easily co-related to how investment decisions are taken that one feels “why am I not following it”.
In a recent interaction with the client, the crux of the discussion was “take risk-however before you do that, know your risk”.
The biggest challenge faced by individual investors can be easily summed up below:

1) Stay out to long;
2) Get in the market in “FIGHT MODE”;
3) Keep putting “good money behind Bad” in hope of recovering what’s lost

These are nothing but issues of
1) Knowledge;
2) Competence;
3) Discipline;
4) Patience;
5) Opportunity

When the market suddenly runs-up, everyone preaches “how one should have invested and should remain invested” because that’s the only way to make money, it is still driving “long-term behaviour” using short-term phenomenon.

It is always difficult to teach patience, discipline and making the opportunity rather than waiting for it or jumping at the opportunity that’s already passed (looking at past great returns to make today’s investing decisions).

It is difficult to teach patience and discipline when the advisor is “chasing short-term rewards” not aligned with “investor interest”.

Steps for the Investor to be “Disciplined” and “Control of Behaviour” :
1) Know the Risk;
2) Know your Risk-tolerance;
3) Appoint an Advisor and “Develop an Understanding that you can review”
4) Have a PLAN-Define your investment goals;
5) Define and stick to your asset-allocation;
6) Keep investing in a discipline manner-Systematic Investment Plan is a great way of discipline investing;
7) Draw money from investments per your plan;
8) Don’t be “driven by FEAR/GREED Factor;

AND REMEMBER “UNLESS INVESTING IS YOUR CORE ACTIVITY-REVIEW YOUR PORTFOLIO ONLY PERIODICALLY; IDEALLY ONCE A YEAR”

UNCOMPLICATE

According to a recent NewYork Times report-the fire warning system at Notre-Dame took dozens of experts six years to put together, and in the end involved thousands of pages of diagrams, maps, spreadsheets and contracts, according to archival documents found in a suburban Paris library by the Times.

The result-a system so complicated that when it was called upon to do the one thing that mattered-warn “fire!” and say where-it produced instead a nearly indecipherable message.

Perfectionism is a kind of “Ego” state for most of us.

Realisation of own competence is an even bigger challenge.

It is not necessary to create a masterpiece to be a master.

However the urge to display “competence” and be commended as a master is a need that complicates human thinking.

For majority of investors discipline of saving, simple thought process, even simpler asset-allocation and the simplest of product solutions are enough to meet their financial goals.

However instead everyday we see the following play-out:

  1. Mortgage backed securities;
  2. Collateralised mortgage obligations
  3. Collateralised debt obligations
  4. Asset backed securities

So on and so forth.

In the name of capital protections; hedging; higher yields, life is made complicated on a regular basis.

Most of the time these products end in the hands of investors who have no recognition of what they are getting into and there is no appreciation of underlying risk.

What are the drivers of this product selection:

  • I bought something unique-I am “SMART”
  • The “In-THING”
  • “GREED”

Actual Results:

Here is a chart that’s really revealing:

In-fact in 2008, Warren Buffet had put in a wager that over a 10 years net of fees hedge funds shall under-perform index funds.

Lo & behold, 2008-2016, hedge fund returned an average of 22% against 85% for the s&p500.

Closer home all categories of exotic funds-real-estate structures; REIT, hedge funds have not only not been able to justify the high fee and are in-fact illiquid to the extent that investors have been waiting for exits for years.

Lot of funds have extended tenure with one fund even transferring illiquid securities to investors personal DMAT account to close their fund.

While I can go on, lessons for general investors are simple:

  1. Create a plan;
  2. Have clear goals;
  3. Recognise your risk-profile;
  4. Save regularly with discipline and invest as per your asset allocation
  5. Find simpler product instead of being driven by what’s in or exotic;

Begin With Self

“Understanding is deeper than Knowledge;

There are Many People who know you but very few who understand YOU”

Buddha

I will add to the quote “not only very few people, but even you don’t understand yourself”.

Author Timothy Wilson in his sublime work “Stranger to ourselves” writes about the Temple of Apollo in Delphi, where almost two thousand years ago was written the maxim “Know thyself”.

One of the most powerful but underscored truth of all times.

It was left to Sigmund Freud to tell us that most of our mind operates unconsciously making it difficult to know ourselves.

There were several thinkers way beyond Freud who had talked about how a lot of our thinking is not only automatic but way beyond the realms of rationality as there are so many things that we just do despite what we think about them.

Explaining this complex phenomenon Mr. Wilson explains how our 5 sense take-in over 11,000,000 pieces of information per second with an ability to process only around 40 of them;

So where does the rest go.

The rest of it goes down the drain, hidden in our adaptive consciousness

From where it tends to influence our judgements, feelings and behaviour.

David Mcraney says in “You are not so smart” that:

“You are often ignorant of your motivations and create fictional narratives to explain your decisions, emotions, and history without realizing it.”

Our mind tells us stories to justify the reason for our actions.

So much of this becomes automatically applicable to the field of “investing” even without being expressed in as many words.

There is a process, a critical part of many a investment profiling questionnaires that talks about “Risk-profiling” which can be used to advice suitable asset-classes and products to investors.

More-often than not we find risk-profiling work very well till the time “everything is positive”;

The moment its negative compared to an alternate scenario, “risk-profiling” fails miserably.

They are nothing better than a journalist on TV telling us “Why did the market fall today”; or “Why would it go up tomorrow”.

The crucial question at this stage is how to use this information whether you are an “investor” or an “advisor”.

Viktor Frangel said “As long you have a goal, you can recover from anything”.

This is important. Till the time we can divest a situation from the “emotional power” that it has on us, we can overcome the effects of the same.

This is what I suggest:

  1. Set a process for each decision; especially important for the advisors;
  2. Understand “what you are trying to achieve” through a decision-Have a “GOAL”;
  3. Document the rationale for accepting or rejecting a decision;
  4. Review your decision periodically against the rationale and till the time the rationale stands

“KEEP AT IT”

“STAY THE COURSE”

The Ownership Choice-II

 “We can’t control our greed”;

“You need to regulate us more”

This is what the CEO of a big bank told Henry Paulson-US Treasury Secretary in 2008.

Dopamine, both a hormone and a neurotransmitter, is used by the brain to send signals to other nerve cells.

While it has several uses, its most publicised impact, has been found in reward-motivated behaviour.

Any anticipation of reward increases the level of dopamine in the body.

Whether its Drugs like cocaine or physical Pleasure through sex, they have the same impact on the nerve system.

The interesting thing however is that the same activity doesn’t increase the dopamine the next time, and that’s where a lot of “rewards systems” tend to fail.

The anticipated outcome (read: reward) determines the acceptance or rejection of the reward induced motivation.

Unless the reward increases/alters substantially, dopamine levels don’t change dramatically, thereby determining the outcome of a motivator.

A study done by Henry W. Chase and Luke Clark, presents another interesting aspect that turns, the whole dopamine theory on its head.

Among Roulette players, dopamine levels increased, not only when the won a big stake but also when they had a near miss, prompting them to play the game again.

The other interesting, but underplayed outcome, that dopamine has as a neurotransmitter is its ability to help avoid “unpleasant experiences”.

Most of the financial advisors can by now relate to this basis their interaction with the clients.

There are 2-prominent categories that you always encounter:

The client who tells you, “I am ready to take RISK, but I want high returns”;

And the other that tells you “I am happy with low returns till the time my capital is safe”

Now as a Wealth Manager, you can use “Dopamine” very effectively by catering to the clients’ nerves by “telling them what they want to hear”;

That can be counter-productive as it might get an initial sale; however the low once the effect of “Dopamine” recedes will risk your relationship;

The important lesson is to use the tool with a defence mechanism that helps reduce the impact of the fall.

As a “Client”, this is even more interesting as most individuals find it difficult to control their impulses when “Dopamine” kicks;

Remember “Cocaine” and “High returns” potentially have the same effect.

The recommendation always is to have your own process; For example

  • Questions to be asked on any proposal;
  • Documenting the theory for agreeing as well as rejecting a proposal;
  • Sleeping-over a proposal before taking a decision either-ways

The proposition might still be compelling;

However at-least you have something to refer to before you make a choice and then you can own that choice.

The Ownership Choice

rightwisconcin.com

23 Jews were killed in Iran on Asura day in 1839 only because some people thought a Jewish women washing her hands in a dogs blood to cure herself of skin disease was making fun of the martyrdom of Husyn. The idea of Asura is to commemorate the sacrifice of Husyn and is definitely not sacrificing others.

Yual Noah Harari describes this in his book as a matter of choice:

When you inflict sufferings on others

“Either the story is true or I am a cruel villain”

Similarly when I inflict suffering on my self, there is a choice:

“Either the story is true or I am a fool”

As human beings don’t like to admit themselves as either fools or villain, they choose to believe that their story is true.

Most of the human life decisions can be slotted in these 2 boxes.

As Yual describes elsewhere in his book, if you buy a second hand fiat for 2000USD and it breaks down, you can just junk it but if you a Ferrari for 200,000 USD you need to go around talking about it to justify your decision.

Financial advisors and fund managers definitely relate to this.

Clients will come down hard when an advisor/fund manager decision goes wrong leading to under-performance, even if its in the short-run.

However when they have personally bought a stock, they are not just happy to stick to the decision, even though they lost money in the short-run, but are even willing to expand their holding.

How engaged one is to the decision thus impacts how an individual will react to the downside of the decision.

In behavioral science this is know as choice-supportive bias.

Individuals tend to downplay the faults of the choice that they make versus ascribing new negative faults to the option that they ignored.

There are important lesson for advisors as well as investors here:

  1. Risk is part of the risk-reward payoff whosoever makes the decision; just because the payoff was calculated doesn’t mean-risk is taken care of; 
  2. Risk is not only real-it plays off at some point in time-you got to prepare yourself for that.
  3. The key is engagement with the decision, which means:
  4. Did I understand the product, process, philosophy, 
  5. The inherent risks related to where I am in the market/economy/earnings cycle; 
  6. Am I just driven by short-term performance ignoring the short-term pain
  7. Pain is part of Patience-since 1914 when Dow was 66 points, the world has seen 2 world wars; 4-5 major recessions including 1929; 1997; 2008; 9/11, US war on terror etc., but still Dow has gone to 26000 points;

If you can be as patient with your Fund Manager as you are with your own decisions, your patience will pay-off

  • Essential is to have a written thesis prior to investing; unless that thesis has changed adversely, you need not change your path-whether managed by an FM or yourself

Own Your Decision & Just Stay the Course

Art & Craft

Leonardo Da Vinci dissected over 30 bodies during his life-time by his own accounts. There was a period in his life where he virtually lived in a morgue.

Why did he have such fascination with human body dissection? What did he gain out of these dissections? How did it improve his art?

The portrait of the Old Man with Ivy Wreath and Lion Head took over 15 years to paint.

Some of the written accounts around this period describe a perceptible change in muscle and nerve formations in this painting during these 15 years.

This obviously was a result of the body dissection exercise that Leonardo went through over these years.

While Leonardo’s Art was a mixture of experience, learning, intuitive skills and in-born genius, the way he honed his craft with his work around human bodies, use of light, reflection etc., holds several lessons for those learning to excel.

Lessons for the Lesser Mortal

Any professional looking to excel is thus looking to not just rely on the innate intuition but to hone the craft related to the job.

Technique, Process, Technique, Process………Outcome

Developing the technique to do things better and outing together a process that keeps you on track is the key.

The recent challenges faced by the Fixed Income market in India throws a great example:

Portfolio construction has always been a mix of art and craft.

Even when the objective is the maximize the return, the craft of “risk management” has to take its rightful place to ensure a balance.

What seems like a great idea on paper might increase the risk disproportionately for a product where the customer expectations are of stable returns.

Portfolio Construction and Management has always been a bit of art and craft challenge.

While intuitively a Manager or advisor can advice on a asset allocation, the underlying the asset classes and how the risk is being managed is really a matter of craft/science.

Which asset classes is adding to the risk and which one diversifying the risk is a calculation and that’s where the advisor/manager’s craft plays a role.

Investor’s Dilemma

The investor’s dilemma then is to find the manager who has mastered the craft rather then purely mastering the art.

Any Advisor/manager can impress you with knowledge, however there are several clues for the investor while listening to them:

  1. How many times does the discussion hover around the portfolio rather than the product?
  2. How many times are you advised against an asset class which the advisor has on platform and not only as underselling someone else’s advice?
  3. How balanced is the advisory vis-à-vis the questions being raised?

The bottom-line is don’t just expect the Advisor/Manager to have the “Art & Craft” but develop your own “Art & Craft” while taking a decision.

Beware though that you don’t get bogged down by details.

Keep it simple.

The above few questions are of-course a way to think.

You can do a few more things:

  • Develop your method;
  • Don’t focus merely on the outcome;
  • Think about the process and what’s the process that makes you comfortable;
  • Develop your time-horizon and review mechanism to track progress of the process that you have agreed to;
  • Have a written thesis for every decision of yours so that review becomes easier

Happy Investing