This is my first article and my solemn attempt to the #GiveBack movement. I will be trying to distill basic financial concepts and markets while relying heavily on what little learnings and language of Graham and Dodd I have managed to inculcate. I will be assuming that the general audience is either aware of the basics of investing or is starting on their investing journey. I will try my best to tie these to the available instruments and investment vehicles in the Indian markets specifically, given my current position and interests. And, I will be starting from brass tacks initially to increasing complexity in later posts.

So, without much ado - what does today’s market look like? The S&P 500 is at or close to all time high price levels and so is the NIFTY. S&P 500 trailing PE is about 24 while NIFTY 50 PE is about 27. It will take 20+ years of last year’s earnings to pay me back the principal of my investment. These are rich valuations. Can they get richer? Sure they can. So what should an investor do? Depends. On one spectrum we have 25-yr olds, on the other end of the spectrum say 65-yr olds and everyone else in between. Their needs will differ. Their risk appetites will differ. And most importantly, their portfolio sizes will differ. When you are early on in your investing, you have a lot more time and can develop patience to allow failures to morph into stepping stones. As you get older and/or richer, you are looking for safety of your pedestal. So with the market here, what should you do? First – no sudden portfolio switches. If you are sitting on a lot of cash and want to enter the market even at this level (more on that later), you have to slide into your positions - buy stocks at regular intervals. This is Dollar Cost Averaging (or Rupee cost averaging for those tripping with patriotic fervor). This was one of Graham’s favorite points. We can never predict/ time markets. If we could, then we don’t share it.

DCA is also the concept behind SIPs (systematic investment plans) which are currently the rage in India. If you are not already sitting on a lot of cash (most of us are not) and have a regular cash inflow from our occupations, then we can invest our savings every month either directly or through SIPs. If the market is up, we will get fewer units of our favorite stocks/ Mutual Funds. If the market is down, we will get more units. Overall, we will average out the market’s joyride.

The second point is asking – should I invest everything in stocks? What about bonds? What about real estate? Welcome to asset allocation, folks. Let’s restrict ourselves to the liquid stuff here (and no liquid lunches, please). That leaves us with stocks, cash and bonds. When would we be all stocks, all cash or all bonds? The answer is – ideally never. Unless we have a divine edge or a crystal ball, we should have exposure to all three in varying proportions. Cash is typically the smallest proportion in an already invested portfolio, and serves best when both stocks and bonds have fallen (something like this is currently happening in India since the beginning of the year – NIFTY is off from its peak, broad markets are down for the year and bond yields are higher on the year, which means bond prices have fallen). Cash will give us an option to deploy it into either stocks or bonds at prices we like. Cash can and should also be held as cash equivalents (money market, short tenure, low interest rate risk funds) to earn some interest. But even if we are not sitting on a lot of cash already, we are assuming that we have cash inflows at regular intervals from savings, which means that our cash will build up over time if we choose not to invest in either stocks or bonds. So in both cases (sitting on a lot of cash, or regular cash inflows) the point is moving towards a suitable mix between stocks and bonds.

First, let’s understand that even if we invest in bonds, it does not mean that we are precluded from risks. Bond prices move inversely to interest rates. Interest rates are a function of inflation (which in India is a big function of oil prices since we import 80% of our oil needs, or the monsoons which affect food prices). Interest rates are also affected by our credit profile – how likely are we good to repay principal with interest. So, if we dole out socialist largesse without the required means, our credit is deemed riskier, thus increasing our interest rate. Finally interest rates also vary depending on the time duration of the bond. The longer the bond maturity, the more sensitive it is to changing interest rates. Sounds boring, complicated and depressing. Then why hold bonds. One word – income. Bonds give us a fixed income with an acceptably high probability of getting back our principal. Very topically, we had a company recently default in India whose bonds are held by a wide swath of bond mutual funds and institutions. But overall bonds are less risky than stocks due to their ‘legal contract’ nature. The bond issuer is legally obligated to send us our cash flows in the future. What is the case against bonds? Again, inflation. The value of our fixed income depreciates if inflation increases. We are capped on the interest and the principal. Inflation eats away the fixed cash flows (most of which come in the future) from our bonds

Stocks then provide a potential escape from inflation – so long as it is within reasonable limits. During periods of low to mid inflation, companies can earn profits which they can either return to stockholders as dividends or retain for future growth. This growth will compound earnings higher. There is no cap on our earnings. And our stocks will get more valuable as these earnings rise. Hence, we will earn from dividends and/or capital appreciation. Why are stocks risky, then? Firstly, when we buy a stock, we are not signing a contract asking for principal and interest payment – there is no obligatory note from the company. We are buying hope, or an option into the company’s future earnings. Sometimes, we are even buying a wing and a prayer.

When inflation is high (think India during 2009-2013, or Argentina as an extreme current example), then companies cannot conduct business profitably. There is a certain level of price inelasticity when it comes to increasing product prices for fear of losing market share in a competitive market. This leads to shrinking margins, lower profits and lower stock prices. In an extreme scenario, it also reduces substantially the value of the inventory that a company is sitting on. Thus, high inflation is also bad for stocks.

So what is the right proportion then between stocks and bonds? Again, without divine foresight (direction of inflation and interest rates, fertile environment for companies to grow et al.) it is exactly like a coin flip – 50/50. If we are ignoring the market level, and cannot say if it will go up or if we are ignoring the current high yields in the bond market and cannot predict whether they will rise or fall, the best we can do is to allocate 50% to stocks and 50% to bonds and walk away – until this allocation changes due to price movements. Say, if due to a stock market rise our allocation has changed to 55% in stocks and 45% in bonds (the stock market is up 10%, which means our 50 has become 55), we should sell out stocks and buy bonds with the receipts so that the allocation comes back to 50/50. If yields fall and the bond portion has risen to 55%, then we sell out our bonds and buy stocks till the allocation again is 50/50. This is a natural ‘buy low, sell high’ strategy.

What if both bonds and stocks are falling at the same time, like is happening in India recently. Well, this is where we tie in to the cash portion we are sitting on and we get in to a DCA mindset and start buying both stocks and bonds at regular intervals. Now, I am not saying that 50/50 is the best allocation for everyone. But it is the best that works for someone who does not have or want to form an opinion on the market. It is also the reference point to place yourself into a risk/ knowledge spectrum. A lot of advisors will advise you to be 100% in stocks (caveat emptor here – we should check how the advisor is benefiting from the advice). Now, if we have been in the markets for a long time and have an opinion about the current level, then we can change our allocation accordingly. Right now, if we feel the stock market is overvalued (NIFTY is at 11,200 – INR is weakening, oil is rising, Indian bond yields have risen to 8%, CAD is rising, there is an election coming up with associated uncertainty etc.), then we should look to allocate more to bonds than stocks – say 40% stocks and 60% bonds. With the benefit of hindsight, if we were sitting in 1999 or early 2000 with the S&P 500 PE at all time highs (like 40s), we would be 25% stocks and 75% bonds. Two years later, by the end of 2002 and early 2003, when stocks had given up a lot of their ‘hope’ component, we would have been 75% in stocks and 25% in bonds, thus tripling our exposure to stocks from earlier. Graham liked to put limits on the min/ max of stocks/ bonds. He advocated a 25%/75% min/max boundary for the two asset classes. I would think you can breach those limits to the extent you are well informed/ knowledgeable and self-aware of your risk profile. If you are 100% in stocks or 100% in bonds, then rationally you are betting that your position will only go in one direction – up. And that is when we need to remind ourselves of gravity.

Finally, as long as we are thinking in terms of risk – Graham also liked to think of risk in terms of the effort and time that we put in towards understanding our investments. The more we understand, the lesser the risk.

Until the next post … (Margin of Safety).