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Opinion

On Yahoo: Four Investment Myths Busted

I write in at Yahoo: Four Investment Myths Busted.

We’re led to believe various myths about investing, and some of them fly in the face of investing logic. They deserve clarification, so here we go.

Myth 1: A lower-priced share is preferable to a higher-priced one.

I get this a lot. If a company’s share is at Rs. 40, it’s so much cheaper than a company whose share price is Rs. 1,000, is it not? This makes no sense. Each company has a different share base; the total number of shares issued is different. Take two very similar companies – Bharti Airtel and Idea, which trade at Rs. 300 and Rs. 65 respectively. Does that mean Idea is a far cheaper company to buy?

Idea has 330 crore shares issued and Bharti, 180 crore shares. Bharti made 9100 crores in net profit last year, to Idea’s 954. Their earnings per share are Rs. 24.12 (Bharti) and Rs. 3.06 (Idea). In one measure of comparative value, Bharti’s Price-to-earnings ratio of 13 makes it look far less expensive than Idea’s 21. Still, the differential in prices makes Rs. 65 look like a cheaper buy compared to Rs. 300.

Any time someone compares share prices of two companies, make sure they understand that it only makes sense if “all other things are equal” – meaning the companies have the same share-capital base and similar metrics (profit, employees, capacity etc.). What you can compare is total market capitalization, or price-to-earnings, or revenues.

There is one scenario intuitio though where absolute prices matter. If you have only 5,000 rupees to invest, you may be only able to buy 1 share of an Infosys priced at Rs. 2800. In such a situation, a lesser price helps allocate money better. This excuse falls flat if you have larger sums to invest, or if you invest in mutual funds, where they give you fractional units also. So a fund with Unit Value of Rs. 10 per unit – advertised heavily to seem cheaper – is in no way better than a fund with a unit value of Rs. 190 per unit.

Everything in the stock market is relative. It’s just as easy (or difficult) for a stock to go from 60 to 120 as it is for an L&T to go from 1,000 to 2,000.

Myth 2: The Face Value of a share is important.

An email states, “I want to sell Company X because it’s at Rs. 300 and that’s too high for a Rs. 2 share”. The Rs. 2 is the “face value” of a share, a concept so outdated in the stock markets it surprises me why people bother about it at all.

The concept, in brief: Assume I start a company with a few friends, and we all put in Rs. 100,000 each – the sum total of the money being put in being Rs. 500,000. This we divide into 50,000 shares, each of which has a “face value” of Rs. 10. This company grows without needing any further capital, because, let’s face it, my friends are darn good at what they do. After five years, it has built up Rs. 1 crore in accumulated profits, and is sitting on some assets and fat bank balances.

My friends and I would be insulted if you asked us to sell our shares at a value of Rs. 10 each. Or even 20. Or 50. The minimum price is – you guessed it – Rs. 200. Because we have a crore in assets, and there are just 50,000 shares. You will actually need to bid a lot higher than Rs. 200, because this business will generate cash as it goes on. Anyone thinking “How can I pay Rs. 200 for a Rs. 10 share” is a loser.

This ‘face-value’ concept is ridiculous as a valuation measure, especially where companies have accumulated profits. So an Infosys being traded at Rs. 2,800 per share should not make you think – but it’s only a Rs. 2 share!

Myth 3: You should reduce equity investing as you grow older.

(Or a formula like: “You should have 100 minus your age as the percentage of portfolio in stocks.”)

This is the kind of logic some investment advisors use to justify their existence. It’s a grey area – not black and white.

If you’re retired and have only enough money to survive for the next twenty or thirty years, don’t invest ANY money in stocks. How do you find that out? I have posted a retirement calculator that helps you calculate this amount. If you have this much money, it should be in safe investments when you retire. If you don’t, your problem is not asset-allocation, it’s finding that money. Do not attempt to punt the stock market on money you can’t afford to lose.

And if you have much more money than that, you can do whatever you want with the rest of the money. Invest it in stocks if you like, take a world holiday, or gamble with some of it; whatever makes you happy. After all, you didn’t slog for 40 years to not make yourself happy. (As a matter of principle I do not favour leaving a lot of money for your children, especially if you have to live frugally to do so.)

At the other extreme, when you’re young, you probably don’t have enough money in the first place. You’ll want to travel, read, or spend some money. I would encourage you to do so, even if means saving lesser, because the money will come. Of what you do save, your short-term needs will determine how much of it is in stocks – a 25-year-old person who has 100,000 in savings but needs to buy a car soon should not be putting 75% of it in stocks.

Don’t bother about predetermined formulas, which should only apply to people who have left their brains in the toilet.

Myth 4: You need a ‘locked-in’ investment to save money for retirement.

The idea behind putting money in insurance plans, pensions or provident funds, where money is locked in for a very long time, is to ensure you don’t have access to the money until you retire. If you did, they assume you will somehow blow it all up, and in some way you need to be protected from yourself.

Life is less secure than that. If you get a heart attack at 50 and need extensive treatments, does it help that your money is locked in for another 10 years? A need for money can come at any time, from medical emergencies or loss of employment or any other reason at all. A “saving” is of little use unless you can cash in on it when you need the money.

One of the problems with our pension system is that they require you to buy annuities – and annuity returns are terribly low in our country. Also, an annuity gives you no liquidity – you can’t withdraw any part of your ‘forced saving’ even if you need it desperately.

Having said that, it’s sometimes useful to have money locked in. A person whose relatives tend to borrow money they have no intention of returning now might be happier to tell them he’s put it all in an insurance plan he cannot withdraw from. Many people may actually blow up money if they knew they had access to it. But you, dear reader, are not that kind, are you?

Real savings is amplified by knowledge, and liquidity is very useful to have. My personal preference is to manage my retirement savings in plans I can draw from when I like – from stocks to bonds to mutual funds. For one, this has allowed me significant independence and for another, I don’t have to succumb to the vagaries of insurance company annuity returns. Once I know enough, I don’t need to be protected from my own money, thank you.

As more myths are perpetrated, faulty assumptions made, and broad generalizations used to arrive at formulaic conclusions, I encourage you to question everything and seek answers. The financial world makes as much money from misinformation as from the act of information itself, so the keys to your money should be in your own hands.

  • Sambaran says:

    >On the myth-3, I can understand the logic against one-sized-fit-all formulas to determine the asset allocation ratio.
    However, an asset allocation ratio (we can arrive at it as per our individual requirement) is definitely required. No? I can calculate and deduce that in case of a stock-market swing (goes up and comes down again) an asset-allocation ratio helps. I believe that your grudge is against the predetermined formulas and not against asset-allocation per-se.

  • Deepak Shenoy says:

    >Sambaran: Yes everyone needs to asset-allocate or diversify at some level, I agree. Just that there isn't a standard formula for everyone..

  • Vinod Waghmare says:

    >Very informative post! It makes an interesting read for serious investors. Regarding myth number 3, I would like to point out that people’s risk taking ability may differ at different points in their life. For example, someone in his 20s may have a larger risk for appetite as opposed to someone in his 50s. On the other hand, a 20-something may not have enough money to invest in a lot of different instruments. So, I would think there is no one size fits all asset allocation formula and it all depends on individual goals of investors. But financial planning is important for everyone and whoever is thinking of making investments in the stock market may be well advised to get professional help. Online stock trading company GEPL has a team of trained investment advisors who work with clients to help them meet their financial objectives.