Simple Steps to Wealth - Part 2: The Do Not's

In Part 1 of this article, we discussed how often we educated folk are illiterate when it comes to personal finance, and often focus on things which are out of our control, without actually getting the basics right first. We then went on to discuss some of the basic To Do’s - to set us up in our personal finance journey.

However, sometimes it is even more impactful to focus on what not to do, rather than the to-do’s - Via Negativa. As Charlie Munger said:

It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

This article aims to focus just on that - what mistakes to avoid, what not to do, how to prevent the downsides, and let the basics work for you, rather than worrying about the Nth level of optimizing returns. Here go the DO NOTs:

DO NOT leverage / take on debt for investing

Debt is often used as a tool by investors (and traders) to amplify returns - hence called leverage. People buy stocks on margin money, use IPO financing to get listing gains, take personal loans and invest. In all cases the logic is always the same - “I will earn more returns than the interest cost I will incur, and this will help me amplify my gains”. (If I have Rs. 100, and borrow another Rs. 100 at 10% interest, and make a return of 20% on the Rs. 200 invested in 1 year - the actual return on my investment would be Rs. 30, implying a 30% ROI.)

While this looks good on paper, there is one fundamental issue here - while your (interest) cost is a given, and the tenor for repayment of the borrowed capital is fixed (and can be accelerated by the lender in case of a default), the return is not fixed. Equities in India have given negative 1-year returns over 30% of the time. So, debt has the potential to amplify your losses as well. Moreover, you may not want or need to sell when the markets are down, and you may be in it for the long term. However, this flexibility is lost when you have debt - you often become a forced seller at the worst possible moment to meet the ‘margin requirements’ of your lenders.

The second kind of debt to avoid would be the debt to fund your consumption / spending - the personal loans for funding vacations or appliances or other expenses, the credit card revolvers at 40%+ rates, the BNPL (buy now pay later) facilities which are becoming popular these days (which, on the face of it seem free, but actually aren't). This kind of debt is just too expensive to sustain your expenses, and eventually grows over time, effectively putting you into a debt trap.

Do note that debt is not inherently bad. It is a tool which fuels growth, and without debt, economies and companies as they exist today wouldn’t exist. We just need to be sure where to employ this tool. For most of us though, it would make sense using debt to a) finance a home loan - especially a home where you would want to live in b) education loan - to help grow our careers, and c) in some cases, a calculated call for a vehicle loan.

DO NOT mix insurance with investing

If you are over 35, there is a strong likelihood that you have been (mis-) sold an insurance product which would give you assured returns, and bonuses. You are told that “While the regulator prescribes showing only 4% and 8% return scenarios, this scheme guarantees X% returns, and here is the past track record”. Or you have the proverbial insurance uncle (distant relative, family friend, neighbor), who is extremely worried about your future, your child’s future or has this scheme, which invariably starts with “Jeevan” and is a must-have product in order to have a securement retirement. They are magical products which help you save taxes, and give you phenomenal guaranteed returns.

The fact is - in most cases, the product has made the agent rich with hefty commissions deducted from your premium, and left you with actual returns less than inflation. If anyone offers any product with guaranteed returns at rates higher than a bank FD, I have only one advice - Run. Run away, and avoid him / her like the plague.

Not all insurance linked investment products may be bad. There may actually be products which may suit your needs - but with the agents and brokers peddling products which maximizes their commissions, the odds of finding the right product are stacked against you. You are better off using vanilla term insurance products for the purpose they are made - to provide a cover if something untoward happens to you, and investing elsewhere.

DO NOT invest in products you don’t understand

The marketplace is filled with innumerable financial products - some as simple as FDs (Fixed Deposits or Term Deposits), which I am sure you are familiar with, to common equity where you own some part of a business for a price which will move depending on a number of factors including business performance, to complex derivative products which are contracts made upon underlying variables which themselves could be derived from other variables such as stock or commodity prices or interest rates, to over 6,000 different cryptocurrencies. Some of these products have so many dependencies that even the creators of these products are unable to fathom the potential risks arising from these products.

You will always hear about one or the other person making a killing in any of these products - be it penny stocks, cryptocurrencies, F&O trades etc. and this often creates a FOMO (for the uninitiated - Fear of Missing Out) which is hard to resist, invariably leading to a loss. Risking your capital by investing somewhere because someone else made money on it, without understanding the associated risks and nuances, is definitely not a sound strategy.

I know of a few people who invested in F&O or arbitrage trading because they were told it'll help them generate superior returns, and eventually lost almost 100% of their capital, and worse, became extremely risk averse and moved to avenues which eventually gave them sub-par returns.

As a simple rule of thumb - only invest in products you understand. There are plenty of avenues to make reasonable returns in the simpler products, while being aware of the risks you are taking. For most people, this would include - some active mutual funds, some domestic and global index funds / ETFs, direct equities (if you have the bandwidth to understand individual companies), maybe some Fixed Deposits (though MFs are better from a taxation perspective), and maybe some gold. I don’t understand (the value in) crypto, so I stay away from it. For instance, Index investing, one of the most passive forms of investing, has given ~14% over the last 20+ years. Your capital would have become 14x just by investing here over 20 years, with the magic of compounding. Several debt mutual funds have returned 7%+, and with favorable taxation policy with indexation benefit, the post tax return is not bad at all. Definitely better than losing your investment.

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DO NOT take rash decisions based on price fluctuations

Benjamin Graham, the father of value investing, came up with the analogy of Mr. Market. And disciple, Warren Buffett described beautifully in his 1987 letter to Berkshire Hathaway letter to shareholders - says more than anything I can add by writing myself:

“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him. Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.” Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”? The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind. Following Ben’s teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”

Most of us (reading this article, I assume) are investing for the long term. We have invested in a particular company or mutual fund scheme, because we believe over the long term (10 years or more) the particular investment will grow. If we don't believe this to be true, or learn something which changes our initial view), we should not own that investment any more. And that should be the logic / decision of buying and selling.

However, often buying and selling decisions are take based on emotions - greed and fear, which makes us err, buying at the top (or at high valuations with no margin of safety), when a stock is the most expensive, and selling at the bottom (or at low prices) because of panic and fear. We, supposedly rational beings, do precisely the opposite of what rationality dictates.

For the Scam 1992 fans - “Bhaav Bhagwaan Che” is true for traders. As investors your mantra should be “Bhaav Opportunity Che” (and most of the time - "Bhaav Noise Che")

Image Source: Scam 1992

DO NOT compare returns, especially the ones on social media / in social gatherings

Spend 1 hour on Twitter. You will come across at least 10 posts where someone is posting a screenshot of how much money they made in one or the other stock or trade, and how sure they were about their pick when they bought it (or maybe it is just me following the wrong people!). The point is that there is always going to be a lucky idiot (or a smart genius) who is going to make incredible returns - good for him / her. Comparing your returns (especially over the short term) with such people is certainly going to lead to disappointment - at best, and end up in rash decisions leading to loss of capital - at worst.

Imagine you are at a social gathering, which is of course a rarity these days given the pandemic, and someone asks you which stock to invest in - what would be your response? If I were to hazard a guess, you would take out that 1 gem out of your portfolio of 20-50 stocks, and say how well it has done for you over the last 1 year and how much more potential it has. I am pretty sure you are not going to disclose your worst performing stock where you probably lost 50% of what you put in or even your average performer for that matter. That is just the way it is - we like to put forth our best in front of others so as to be appreciated, liked, respected, envied etc. That is why Instagram and Facebook posts give us the impression that all our friends and acquaintances are living a picture perfect life, and Fintwit makes more money than the country's GDP. And comparing your life or returns to what you see in social media (or gatherings) is just wrong, given the inherent selection bias.

If you really do want to compare, look at annualized returns over a 5+ year (or better still, 10+ year) period. Over time, things have a tendency to average out the noise (luck) and settle at a more realistic level of skill. Better still, don’t compare!

A note of caution though - Don’t compare does not mean don’t measure. You need to measure how your portfolio is doing, and how it is faring based on YOUR benchmark, which could be very different from the guy yelling his returns on Twitter, or the person selling you coffee cans. How to measure portfolio performance? That’s a topic for another day.

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These are some of the important DO NOTs in my opinion, to avoid making mistakes in our journey of compounding wealth. I am sure there are a few which I have missed out on, and I would love to hear your thoughts in the comments.

Before concluding this 2 part series (Part 1 here) on Simple Steps to Wealth, there is one last point I would like to make - on what is wealth. Most of us restrict the definition to monetary wealth (and we have largely spoken about that throughout both these articles). However, a broader definition of wealth is - The ability to live life on your own terms, and be happy. Money is just a means, not the end. There are a number of people who are rich, but not wealthy. And then there are people who have a modest amount of money, much lesser than many others, but are happy doing what matters most to them. They are wealthy. It is as important to invest in yourself, invest in your health, and invest in your relationships as it is to invest money. Without the former, the latter is just a number in some accounts.

Hope you liked this set of articles. If you think it adds value to you, please spread the word, share this article with your friends, colleagues and family. And do subscribe to Investing in Rationality to get notified when the articles are hot from the oven.