Turtle Talk - 10th December 2012

• Is it 'compulsory' to invest in equities?
• Sector Mutual Funds: From the WMG Desk

You may remember the time when, as children, you were forced by your parents to eat your vegetables. When you quizzed them for a reason, they simply said "Well, you MUST eat them because they are good for you". Today, stockmarket 'experts' have taken the place of parents, by screaming to all within earshot that everyone's investment portfolio MUST contain equities. They lament that Indian investors do not know what is good for them. That is why, equities (including equity mutual funds) comprise only around four per cent of their portfolios.

They chide them for choosing gold, real estate and fixed income instruments, implying time and again that none of these possess the one magical quality that stocks apparently possess and that is, the ability to provide 'real returns' on a sustained basis. Some are also adamant that investors will 'be compelled' to invest in stocks. Despite so much advocacy for equity, why have Indian investors not flocked en-masse to the stockmarkets? Here are a few probable reasons:

Delayed feedback mechanism: All investors would like clarity on two things - (A) The returns that they can expect (B) The downside that they are likely to suffer. In case of investments other than equities, either the expected returns are known in advance or the volatility of returns is locked in a tight range.

Unfortunately, stocks do not offer comfort on both these aspects. Neither is the return fixed nor is there a floor to the downside (Investors may not find quips such as "The price cannot go below zero", very funny). In other words, in the case of stocks, the feedback mechanism is delayed far into the future. Hence, they are less attractive.

It ain't the numbers alone: While I believe that one can choose any sample set to prove one's point, it is a fact that there are several studies that show that stocks have outperformed many other asset classes over long periods of time.

However, this alone is not enough. While a rational investor may be convinced by such statistics, real-world investors are more emotional than rational. To most, investing is much more than mere numbers. Softer aspects such as 'comfort' and 'familiarity' play a big role. Gold and fixed income options instill a 'warm and fuzzy' feeling inside most Indian investors. That is why they choose them. They do not mind losing out on a few percentage points of return in the bargain.

The 'touchy-feely' aspect: For many investors, the term 'investment' should connote something 'solid'. A gold bar or an apartment provides that solidity. We could extend this to the figurative solidity provided by a fixed deposit with any Government owned bank. Unfortunately, to many, stocks are mere pieces of paper. In other words, you exchange one piece of paper (that is, money) for another. Now with demat accounts, even this piece has been replaced by a book entry. Also, it is likely that one may suffer monetary losses even if one purchases the stocks of 'blue-chip' companies. Hence, solid companies need not necessarily be 'safe-and-solid investments', unless one has impeccable timing.

The trust factor: Stockmarket 'experts' often counter the above apprehension by saying that stocks must be held for the long-term. But time frames of short, medium and long are too nebulous for most investors. Besides, there is a feeling that often, advice from such 'experts' lacks accountability. Also, they notice that most of the talking heads advocating investment in stocks are associated with the stockmarket in some form or the other, be it as brokers, money managers, investment bankers etc. Hence, even though their advice may be well-intentioned, investors tend to look upon it with a degree of suspicion.

Lack of peer pressure: Investors are often driven by the 'Herd Mentality'. If your friends and acquaintances have been making money in gold and real estate and 'preserving' their capital in fixed deposits and bonds, you would prefer to follow them rather than be the outlier in the group. The implicit pressure exerted by your peer group, has a big impact on your investment psyche. It certainly is far more influential than some stranger extolling the virtues of stocks.

Predictably incorrect: Just as economists have failed to predict most of the recessions, for the past decade (at least since 2004), gold and real estate bears have predicted crashes that did not happen. On the other hand, investors have witnessed at least three big falls in the stock market (2006, 2008 and 2011), the impressive point-to-point increase notwithstanding. Hence, investors are pretty sanguine that there is going to be no crash in gold or real estate. Of course, only time will tell whether they are right or not.

Indifferent to cash flow: Sure, most purists do not treat gold bars and locked-up apartments as 'investments' as they do not generate any cash-flow. However, many investors are indifferent to this. They purchase it merely for steady capital appreciation, and are, therefore, not willing to stomach the price volatility inherent in equities, even though they may receive dividend income.

Also, on many occasions, gold and real estate serve as better collateral than equities while borrowing, as the haircut on them is lower. This is due to the fact that bankers, too, are wary of equities.

It does not happen only in India: It is only in the USA and (probably) England that equities form a substantial chunk of investors' net worth. In most parts of Europe and Asia, equities only play a peripheral role in most retail investors' portfolios. Hence, Indian investors seem to be the rule rather than the exception.

All this does not mean that Indian investors will shun equities forever. The current nibbling may increase to a bite-sized chunk in due course. However, this may happen due to more mundane asset allocation considerations, rather than the 'compulsion' that many experts so glibly suggest.

Disclaimer: Most of my wealth is invested in equities...

This article was first published in Business Standard newspaper on December 9, 2012.

Sector mutual funds are those mutual funds that restrict their investments to a particular segment or sector of the economy. Also known as thematic funds, these funds concentrate on one industry such as infrastructure, banking, technology, energy, real estate, power, FMCG, pharmaceuticals etc.

Advantages:

These provide the opportunity for focussed investments and also the facility to construct your own portfolio in terms of sectoral preferences. It allow investors to place bets on specific industries or sectors, which have strong growth potential.

Disadvantages:

These funds tend to be more volatile than funds holding a diversified portfolio of securities in many industries. Such concentrated portfolios can produce tremendous gains or losses, depending on whether the chosen sector is in or out of favour. Sectoral mutual funds come in the high risk high reward category and are not suitable for investors having low risk apetite. They don't always follow general trends in the stock market, and are often considerably more volatile.

Sectoral funds as they are seasonal in nature and do well only in cycles. Since these funds focus on just one sector of the economy, they limit diversification and the fund manager's ability to capitalise on other sectors, if the specific sectors aren't doing well.

Sector funds vis a vis diversified funds:

Sector funds tend to be riskier and more volatile than the broad market because they are less diversified, although the risk level depends on the specific sector. Sector funds are riskier than equity diversified funds. Equity funds can be diversified by investing in different sectors and across companies based on their size.

Conclusion:

One should have only a small allocation to such a fund. It is not suitable to be a core holding of one's portfolio. The fund still holds promise, but one should not get overloaded. Unless a particular sector is doing very well and its long term growth prospects look bright, it advisable not to trade in sector funds. A long-term investment horizon may not be suited for sector funds. Sectors move in cycles. Since sector funds invest within a limited scope, it is imperative to exert more caution. You must study the business cycle to get more clues about the industry performance.