Money, Wealth & Charity -- An Islamic Perspective

In Islam, money is viewed as a tool or resource to benefit oneself, one's family, and society. However, it is also recognised that the love of money and material possessions can lead to greed and selfishness, which are seen as harmful to one's spiritual well-being. Therefore, a balanced approach is recommended.

To achieve this balance, one is encouraged to put in the effort to travel and earn; there is an implicit acknowledgement that some people will grow their wealth. And for this reason, they should share their wealth through charity, which is considered a loan to Allah (Surah Al-Hadid, verse 18). 

This forms the base of the money philosophy in Islam. Investing from an Islamic perspective involves following certain principles and guidelines based on Islamic law. These principles are designed to ensure that investments are made in a socially responsible and ethical manner.

First Principles

One of the key principles of Islamic investing is that investments must be made in businesses or industries that are considered halal (permissible) according to Islamic law. This means that investments must not involve any activities deemed haram (prohibited), such as gambling, alcohol, weapons manufacturing businesses or other prohibited substances, or any businesses that engage in unethical practices, such as fraud or exploitation.

Another important principle is the prohibition of interest-based transactions (riba). This means that any investment that involves earning or engaging in interest-based lending is not permissible in Islam. Instead, investors are encouraged to seek out investments based on profit-sharing models, where the returns are based on the profits the business earns.

In addition, Islamic investing principles require that investments are made in a socially responsible manner, with a focus on promoting positive social and environmental outcomes. This means that investors should consider the impact of their investments on society and the environment and should seek out businesses that are engaged in socially beneficial activities, such as providing jobs, supporting education, or promoting sustainability.

Overall, Islamic investing is a way of making investments consistent with Islamic principles and values and promoting ethical and socially responsible business practices. By adhering to these principles, investors can help to build a more sustainable and just economy while also earning returns on their investments.

Now, let us look in detail at the options of investing and giving. 

PART 1

How Can Muslims Invest?

Regarding asset classes, one can invest in equity, i.e. common stocks that are traded, gold and land or in mutual funds that invest in these asset classes correctly.  

Futures, Forwards and Options: 

• Generally, the majority opinion is that it is not allowed. 
• There is a minority opinion that these types of contacts are permitted under the condition that forward, futures and options are only valid when both parties agree on the stipulated duration and price, with no uncertainty in the transaction. 
• Then there is another minority opinion, which states that it is allowed only to hedge the portfolio, but trading or a naked position is not allowed. 

PART 2

There are different standards followed by Shariah boards. All scholars agree that businesses that are into non-halal activities cannot be invested in, i.e. banks, interest-based lending companies, insurance companies, alcohol companies, gambling/pornography companies, media & entertainment companies, tobacco, hotels, weapons manufacturing companies and companies that support them. 

In the second step, all the Shariah boards look into financial ratios and have developed their own screening criteria. Below is a table comparing them on similar financial parameters: 

Understanding the Methodology At a Glance

For a detailed study of the screening criteria - click here.

PART 3

Since all this is complicated, what should we do as individuals? 

There are five possible options, and they all have merit,. A simple way of assessment is to choose the path that you find more convincing, and it keeps your heart in a state of contentment. One thing you must not do is keep switching across them to maximise gains. 

1. Ask a Sharia expert from your area and your financial advisor to discuss and create a custom-made investment policy for you and review it every 3-5 years. 
2. Use one of the above methodologies to screen the stocks, as each has a shariah board and scholars supporting it; they are valid. Make it a habit to review their website and mirror their screening methodology. So that when they update any part of the process on their website, your method is also updated.
3. Purchase stock screening services from companies like Islamicly. Or you can mail Tasis to services@tasis.in and ask them. (Many years ago, they used to charge annually and send you a monthly list of approved stocks.)
4. You can go on a screener. In and follow my screen --  click here (This is absolutely free). 
5. Or mail me shoaib. zaman[at]foolishgenerous[dot]com and I will help you create a framework to approach money in a halal way. 

PART 4

When we benefit from society, we should also give it back. That would be a simplistic argument in favour of why to give Zakat. You can also take the religious answer that it has been commanded by Allah.

There are a few great resources on the subject that you can read if you are interested in the details. 

• Wikipedia - It covers the Sunni methodology (https://en.wikipedia.org/wiki/Zakat)
• The five schools of Islamic Law - It's an easy comparative between the five major schools (https://www.al-islam.org/printpdf/book/export/html/42705)
• Compilation of all the major Hadith on Zakat in Sahih Muslim (https://www.iium.edu.my/deed/hadith/muslim/005_smt.html)  
• Fiqh of estimation in calculating Zakah - A book on the subject of Zakah from Kingdom of Saudia Arabia (https://www.iium.edu.my/deed/hadith/muslim/005_smt.html)
• For a Shia view on Zakat, this is one of the best articles to read up (https://www.al-islam.org/articles/zakat-shia-fiqh-sayyid-muhammad-rizvi)
• 
  

How much to give?

The minimum amount that we should give as Zakat would be as follows. 

• On all non-yielding and non-consumable assets (like gold or land that is not used in any way for any purpose): 2.5% of the value as of date if held for a year. 
• For yielding assets or generating profits from the sale of natural resources like water, air-waves, minerals or crops, it is 10% of the Sales Value. (as the underlying product is nature's gift)
• For a business that requires hard effort, such as engineering, capital goods, manufacturing, patents, and so on, it should be 5% of profit or 2.5% of stock in trade.

So, in modern parlance, for shareholders, it would be 5%-10% of the Profit, depending on the business.

Landowners will have to decide how they treat their land, as it can fall under either of the three methods depending on the intentions and how it is used. It is best to take help from a subject matter and then decide on the calculation methodology.

Who to give? 

The Quran explicitly mentions who we should give Zakat to. 

Indeed, [prescribed] charitable offerings are only [to be given] to the (1) poor and (2) the indigent, and (3) to those who work on [administering] it, and (4) to those whose hearts are to be reconciled, and to (5) [free] those in bondage, and (6) to the debt-ridden, and (7) for the cause of God, and to (8) the wayfarer. [This is] an obligation from God. And God is all-knowing, all-wise. - Al-Tawbah, 9:60

(These insertions are to make it easy to read) 

While the details can be read in the above link, a short help to decide on who to give Zakat can also be as follows. 

• Helping the Poor (the way to define poor would be those whose net worth is less than the value of 595grams of Silver or 85grams of gold, the lower of the two values) 
• Assisting with the education of children from economically weaker families
• Assisting the medical needs of economically weaker families
• Helping the Needy 
• Helping the old, i.e. 60+, who cannot earn and do not have the means to survive.
• Helping the widow who does not have a source of income.  
• Helping orphaned children who may get exploited if not supported
• Rehabilitating those who have to beg for circumstances beyond their control 
• Free slaves -- Modern equivalent would be as follows
• Education support for families with assets less than 80g of gold or 500g of Silver or equivalent wealth in any form 
• supporting NGOs registered with the central government and have a reputation for taking action against human/child trafficking
• Donating to the govt/UN/Private NGOs working for refugees globally and/or helping with legal fees of people in jail for lack of money to pay fines. 
• People who have become bankrupt need help getting back on their feet.

My approach to Zakat is, 'On the day of judgement, our deeds show that we gave less zakat than what we should have given by a small %age because of wrong calculation methodology or in our zeal for becoming rich and hence may not get the entry into heaven -- Is that savings worth it?.' 

I hope this helps. These are based on my understanding, and Allah knows best.

Disclaimer: Shoaib Zaman is a CFP and has completed all Ethica Institute of Islamic Finance certifications. All views are personal.

June 2023 - Shariah Compliant Mutual Funds

Mutual Funds in India in May 2023, which have shariah compliant portfolio. 

Guest Author: Real estate vs Equity— Which will give better returns in the long term?

Stocks and real estate are the two most popular asset classes for long-term investments since they both assist in creating long-term returns to become financially prosperous. Although there are significant differences between these asset classes, it's important to remember that real estate can be an excellent alternative to stocks due to its lower risk, higher returns, and a reasonable level of diversification. However, stocks have been shown to outperform more traditional investments like bank fixed deposits while also providing enough liquidity to buy and sell shares at any time, something that real estate investments do not.

An Overview in Real Estate vs Equity

 

Your financial status, risk tolerance, and investment goals all influence your decision to invest in various asset types. Let's instead have a quick discussion of the two asset types.

 

Meaning: Investing in real estate is buying, renting, and selling land or constructed housing units to generate wealth through consistent price appreciation when the property's value rises and rent collection, which can offer a regular stream of income. Additionally, investing in stocks entails buying and selling shares of companies, which entails earning returns and additional perks like dividends, bonus shares, stock splits, buybacks, and capital gains.

 

Risk: Investments in stocks and real estate are both influenced by market and economic conditions. However, there are concerns associated with real estate investments, including a lack of liquidity, the market's unpredictability, location and unforeseen property health. However, stock market investments also have price fluctuation, global cues, economic and market situations, interest rate risk, and inflation. In the stock market, short-term trading entails higher volatility than long-term investments.

 

Liquidity: Stock market investments have better liquidity than other investments since buying or selling shares at any moment is simple, regardless of the market situation. Technical analysis of the stock's chart pattern or fundamental analysis of the company's earnings can be used to buy or sell stocks. Technical chart patterns may be used to trade on a short-term or intraday basis, but fundamental analysis provides the company's long-term perspective. Contrarily, real estate assets are less liquid; as a result, it is more difficult to convert them into cash when selling a home or piece of land since a suitable buyer must be found, and registration and market value must be verified, among other things.

 

Cost: One must consider all expenses spent while possessing a property, including brokerage, stamp duty and registration fees, interest paid on money borrowed, maintenance and repair expenses, and municipal taxes, when determining return on investment or actual return. In contrast, no fees are associated with investing in the stock market. Thus all that is necessary is a demat account and a low initial deposit, which may be as little as Rs 10.

 

Taxation: You will be required to pay capital gain tax on the profit made after taking inflation and the indexed acquisition cost into account when you decide to sell your property. These gains can be categorised as either short-term or long-term gains. It is considered a short-term capital gain if you sell your land, house, or other property within 36 months (3 years) of buying it, and the amount of tax payable will depend on your income tax bracket. However, if you sell it after three years, it will be regarded as a long-term capital gain and taxed at 20%, plus a 3% cess with the added indexation benefit. Suppose listed equity shares are held for less than 12 months at the selling time. In that case, the gains are short-term capital gains (STCG) and are taxed at 15%, while capital gains from equity shares held for more than 12 months are subject to long-term capital gains (LTCG), which are taxed at 10% after an exemption of up to Rs. 1 lakh on all long-term capital gains in a fiscal year.

 

Conclusion

Here is where we will discuss the returns of the two asset types mentioned above. When invested over the long term, stocks and real estate are both known to yield acceptable returns. The returns over the past ten years have ranged from 370%, 100%, 140%, 320%, and 180% if we compare the stock prices of top real estate developers. However, according to the data of Magicbricks, the Residential Real Estate Prices in Gurgaon have risen from Rs 8000 to Rs 9150 per sq ft, the price in Mumbai has risen from Rs 3800 to Rs 7000 per sq ft, the price in Bangalore has risen from Rs 2630 to Rs 4750 per sq ft, and price in Chennai risen from Rs 7850 to Rs 10,950, the residential demand in Pune climbed by 9.5%.  91% of Pune homebuyers looked for multistory residences. 2BHK flats had the most demand (46%), followed by 3BHK and above units (40%)., representing a surge of 14%, 84%, 80% and 39%, respectively. These variations show how investments in real estate and the stock market performed in terms of returns over the past ten years, so one cannot anticipate exact returns from these asset classes over the long term. However, historically, real estate and stock market investments have been shown to have outperformed conventional investments like bank fixed deposits in terms of returns.

 

Authored by Gunjan Goel, Director,  Goel Ganga Developments

Detailed Financial Screening of various Sharia Boards

 Detailed Financial Screening of various Sharia Boards

• S&P Islamic Index (Global)
• Accounts Receivables / Market value of Equity (36 month average) < 49 %
• (Cash + Interest Bearing Securities) / Market value of Equity (36 month average) <33%
• (Non-permissible income other than interest income) / Revenue < 5%
• Debt / Market Value of Equity (36month average) < 33 %
  


• FTSE Islamic Index (Global)
  
  • Debt is less than 33.333% of total assets
  • Cash and interest bearing items are less than 33.333% of total assets
  • Accounts receivable and cash are less than 50% of total assets
  • Total interest and non-compliant activities income should not exceed 5% of total revenue.
    
    
• Shariah Advisory Council (SAC) of the Securities & Exchange Commission in Malaysia (Malaysia)
  They follow a two-tier screening: tier 1 is on business, and tier 2 is accounting measures.
  
  Tier 1: Business Activity Benchmarks
• The contribution of Shariah non-compliant activities to the Group revenue and Group profit before taxation of the company will be computed and compared against the relevant business activity benchmarks as follows:
  
  (i) The five-per cent benchmark: The five-per cent benchmark is applicable to the following businesses/activities:
• conventional banking and lending;
• conventional insurance;
• gambling; 
• liquor and liquor-related activities; 
• pork and pork-related activities; 
• non-halal food and beverages;
• Shariah non-compliant entertainment; 
• tobacco and tobacco-related activities;
• interest income from conventional accounts and instruments (including interest income awarded arising from a court judgement or arbitrator);
• dividends from Shariah non-compliant investments; and
• other activities deemed non-compliant according to Shariah principles as determined by the SAC.
• For the above-mentioned businesses/activities, the contribution of Shariah non-compliant businesses/activities to the Group revenue or Group profit before taxation of the company must be less than five per cent.

(ii) The 20-per cent benchmark: The 20-per cent benchmark is applicable to the following businesses/activities:

• share trading;
• stockbroking business; 
• rental received from Shariah non-compliant activities; and
• other activities deemed non-compliant according to Shariah principles as determined by the SAC.
• For the above-mentioned businesses/activities, the contribution of Shariah non-compliant businesses/activities to the Group revenue or Group profit before taxation of the company must be less than 20 per cent.

Tier 2: Financial Ratios

• Financial Ratio Benchmarks: For the financial ratio benchmarks, the SAC takes into account the following financial ratios to measure riba and riba-based elements within a company’s statements of financial position:
1. (Cash over total assets) <33%
   Cash only includes cash placed in conventional accounts and instruments, whereas cash placed in Islamic accounts and instruments is excluded from the calculation.
2. (Debt over total assets) <33%
   Debt only includes interest-bearing debt, whereas Islamic financing or sukuk is excluded from the calculation.

• In addition to the above two-tier quantitative criteria, the SAC also considers qualitative aspect, which involves public perception or image of the company’s activities from the perspective of Islamic teaching.

• Accounting and Auditing Organization for Islamic Financial Institutions (Global)
• The corporation does not state in its memorandum of association that one of its objectives is to deal with prohibited goods or materials as per Islamic principles. 
• Total debt (long-term or short-term debt) is less than 30% of the market capitalisation
• That the total amount of interest-taking deposits, whether short-, medium- or long-term, shall not exceed 30% of the short-, medium- or long-term, shall not exceed 30% of the market capitalisation of total equity. 
• The income generated from the prohibited component does not exceed 5% of the total income. 

• Tasis (India): Since their screening methodology is proprietary, it is not clearly established. By reading their paper, the idea is easy to follow. 
• Total debt (long-term or short-term debt) should be less than 10% of total assets.* (Note: For Nifty Sharia Index, where Tasis is the advisor, Interest based-debt should be less than or equal to 25% of Total Assets.)
• Interest income should be less than or equal to 3% of the total income.
• Receivables plus cash and bank balances should be less than or equal to 90% of Total Assets.

*As per our understanding of their presentation. Earlier, their methodology was industry-specific; depending on the industry type, the debt level was adjusted  

One Line Summary of Warren Buffet's Letter to Shareholders

 ChatGPT summarises the essence of Buffett’s Letter for each year.

• 1977: In his first letter to shareholders, Buffett discusses the concept of "owner earnings" and highlights the importance of measuring a company's ability to generate cash over the long term.
• 1978: Discusses the importance of reinvesting earnings into the business and avoiding excessive debt.
• 1979: Buffett focuses on the challenges of investing in inflationary times and highlights the importance of owning productive assets that can increase in value alongside inflation.
• 1980: The idea of "economic goodwill" is highlighted and how it contributes to a company's long-term success.
• 1981: Buffett emphasises the importance of understanding a company's underlying business model before investing and cautions against relying too heavily on stock market predictions.
• 1982: In this year, he discusses the benefits of long-term investing and cautions against making hasty investment decisions.
• 1983: Buffett emphasises the importance of maintaining a long-term focus and avoiding short-term market fluctuations.
• 1984: Buffett discusses the challenges of investing in an increasingly competitive market and highlights the importance of focusing on businesses with strong competitive advantages.
• 1985: Buffett discusses the benefits of owning shares in companies with strong earnings growth potential and highlights the importance of diversification.
• 1986: Buffett emphasises the importance of avoiding overpaying for stocks and highlights the potential benefits of investing in companies that are temporarily out of favor.
• 1987: Buffett discusses the risks of investing in highly-leveraged companies and highlights the importance of avoiding excessive debt.
• 1988: Buffett discusses the benefits of investing in businesses that require little additional capital to grow and highlights the importance of focusing on a company's underlying business fundamentals.
• 1989: Buffett emphasises the importance of avoiding overconfidence and sticking to a long-term investment strategy.
• 1990: Buffett discusses the risks of investing in highly-leveraged companies and highlights the importance of focusing on businesses with strong competitive advantages.
• 1991: Buffett discusses the challenges of investing in a rapidly-changing economy and highlights the importance of adaptability.
• 1992: Buffett discusses the importance of investing in businesses with strong economic moats and highlights the potential benefits of investing in undervalued stocks.
• 1993: Buffett discusses the risks of investing in companies with complex business models and highlights the importance of simplicity.
• 1994: Buffett emphasises the importance of maintaining a long-term investment strategy and avoiding short-term market fluctuations.
• 1995: Buffett discusses the importance of solid brand-name businesses and highlights the potential benefits of investing in emerging markets.
• 1996: Buffett discusses the challenges of investing in a rapidly changing technological landscape and highlights the importance of investing in businesses with strong competitive advantages.
• 1997: Buffett discusses the importance of avoiding excessive risk and cautions against making hasty decisions.
• 1998: Buffett emphasises the importance of investing in businesses with strong economic moats and highlights the potential benefits of investing in international markets.
• 1999: Buffett discusses the risks of investing in companies with overinflated stock prices and highlights the importance of maintaining a long-term investment horizon.
• 2000: Buffett discusses the challenges of investing in a rapidly changing technological landscape and cautions against relying too heavily on stock market predictions.
• 2001: Buffett emphasises the importance of investing in businesses with strong competitive advantages and highlights the potential benefits of investing in undervalued stocks.
• 2002: Buffett discusses the benefits of investing in businesses with strong economic moats and highlights the potential risks of investing in highly leveraged companies.
• 2003: Buffett discusses the importance of maintaining a long-term investment horizon and avoiding emphasises market fluctuations.
• 2004: Buffett emphasises the importance of avoiding excessive fees and costs and highlights the benefits of investing in companies with strong earnings growth potential.
• 2005: Buffett discusses the challenges of investing in a market with high valuations and highlights the importance of focusing on a company's business fundamentals.
• 2006: Buffett emphasizes the importance of investing in businesses with strong economic moats and highlights the potential benefits of investing in emerging markets.
• 2007: Buffett discusses the risks of investing in companies with excessive debt and highlights the benefits of investing in businesses with strong earnings growth potential.
• 2008: Buffett discusses the global financial crisis and highlights the importance of avoiding excessive risk in investing.
• 2009: Buffett discusses the importance of maintaining a long-term investment horizon and emphasises short-term market fluctuations.
• 2010: Buffett emphasizes the importance of investing in businesses with strong economic moats and highlights the potential benefits of investing in undervalued stocks.
• 2011: substantial discusses the importance of investing in businesses with strong competitive advantages and highlights the potential risks of investing in rapidly changing technological landscapes.
• 2012: Buffett discusses the risks of investing in companies with complex financial structures and highlights the benefits of investing in businesses with simple, understandable business models.
• 2013: Buffett emphasises the importance of maintaining a long-term investment horizon and avoiding short-term market fluctuations.
• 2014: Buffett discusses the potential risks of investing in businesses with high debt substantial and highlights the importance of investing in businesses with strong competitive advantages.
• 2015: Buffett discusses the importance of investing in businesses with strong economic moats and highlights the potential benefits of investing in emerging markets.
• 2016: Buffett emphasises the importance of avoiding excessive fees and highlights the potential benefits of investing in businesses with strong earnings growth potential.
• 2017: Buffett discusses the potential risks of investing in rapidly changing technological landscapes and highlights the importance of investing in businesses with substantial competitive advantages.
• 2018: Buffett emphasises the importance of maintaining a long-term investment horizon and avoiding short-term market fluctuations.
• 2019: Buffett discusses the importance of investing in businesses with strong economic moats and highlights the potential benefits of investing in undervalued stocks.
• 2020 emphasises discusses the impact of the COVID-19 pandemic on the global economy and emphasizes the importance of maintaining a long-term investment horizon.
• 2021: Buffett discusses the performance of Berkshire Hathaway's investments during the pandemic and emphasises the importance of investing in businesses with substantial competitive advantages.

Understanding ETFs

First thing first, what is an index? 

In simple terms, an index is a record that can be used for navigating and understanding the key information in a set of records. For a book, an index is a list of keywords with page numbers to find information associated with that word. 

In the world of investing it is a combination of stocks that are looked together to decide on how the market, sector, theme or idea is doing. Therefore, it functions as an indicator, since it is showing the impact of the underlying. 

What is an ETF?

Now if someone decides to make an instrument from this index to invest in and make it available on the stock exchange then that instrument will be called Exchange Traded Funds. 

It is a fairly simple product that just tracks an indicator. Therefore, by investing in an exchange-traded fund, you're efficiently investing in the underlying index. Your returns will also be near to that indicator.

For example, in case you have invested in a Sensex or even a Nifty Exchange-traded fund, you'd get comparable returns as people from all of these indices. A look at available exchange-traded fund options in India reveals that there are 26 ETFs monitoring the Sensex or Nifty indices.

You might ask, what is the distinction between them? If all of them track the same index, should not you pick one randomly? Well, not really, since there are differences among the ETFs that track the same index.

Here are the different parameters you should bear in mind while choosing an ETF.

Underlying indicator: An Exchange-traded fund tracks an index, so first choose which index you want to put money into. Sensex and Nifty include large-cap stocks. Therefore, by investing in ETFs that track them you are investing in massive caps. There are ETFs monitoring small and medium caps as well. Then there are those who follow international indices. 

Ease of replicability: Large-cap indices constitute the majority of liquid stocks and therefore it is easy for the finance manager to imitate them. On the flip side, ETFs monitoring mid and small caps must fight more difficulty to replicate their inherent, given that these segments have a tendency to be liquid.

Liquidity: While buying an ETF, it's very important to ensure you can purchase and sell its components with ease. Therefore, it's very important to choose an exchange-traded fund that trades with a pretty large trading volume. This is comparable to investing in liquid or illiquid stocks. A liquid inventory gives you the ease of selling and buying. However, with illiquid stock, your order can remain unexecuted for quite a long time.

What would be an underlying challenge to the ETF?

Brokerage costs and illiquidity can be a great problem for any ETF. 

If your broker has a high cost for buying and selling the ETF then it can increase your transaction costs. Thus, it could create a challenge for investors. 

Should we invest in ETF?

Only if the individual understands the risk and the kind of opportunity that the product allows. For Indian investors, an index fund is a superior option from a liquidity perspective, as there are regulations on mandates in terms of dilution of portfolio and meeting the redemption requests. Those who are still confident of their prowess may choose it. 

The multi-cap fund fiasco

SEBI is a market regulator. And hence, setting the broader policy is important and correct but micro-management tends to reflect a loss of confidence.

The recent order telling AMC's on how to position their multi-cap funds leads to some pertinent questions and warrants some reflective suggestions.

Questions:

1. Why do the index S&P BSE 500 and Nifty 500 have 80% weight in large-cap stocks, if these are supposed to be Multi-cap Index. 

2. So which is the one equity fund category where the fund manager can buy irrespective of market cap restriction? (A multi-cap fund that has fund manager’s discretion). 

3. Why not launch a new category with this criterion rather than making changes to an existing segment?

4. Who will bear the loss that is likely to happen in this category due to their action? The valuation in mid-cap and small-cap will become insane and speculation in this market has historically been punished. Or the other way of putting it is that these categories tend to make more money with more volatility.

5. Has SEBI's mandate moved from investor protection, in general, to ensure that some investors make money and perhaps everyone loses eventually?

Instead is it not feasible that the the regulator should also seek input/discuss with respective ministries and other fellow regulators to implement the suggestions, as follows, which might potentially have far-reaching benefit for both the market and investors.

Suggestions that are under SEBI’s control:

1. Change market cap definition to global standards, wherever it is dynamic (rather than the current hard numbers since it is mentioned in percentage terms) and it needs to be updated every month.

2. Ensure the main index is not based only on market cap. And that there are stricter caps, stock wise and sector-wise, even an index. This one measure will make the markets more sanguine as momentum stocks would not become an avalanche distorting the market.

3. Constitute study groups to understand the impact of majority investing moving into passive space. (Analysis by independent experts in the USA shows that it increases volatility. Hypothetically, I reckon, it should show high volatility in stocks and higher polarisation)

4. Study the Canadian & Australian stock exchange and their venture exchange to bring balance between compliance cost and capital raising via capital markets. Some element of originality will be required here because our legal structure and governance standards are not favourable to investors. Additionally, our system has a high backlog of cases.

5. Fast track cases at SEBI’s end and penalise wrongdoers heavily. Ensure that the effort is to be just for all parties. A task that may seem hard, but with proper training, it is possible to deliver at scale.

Suggestions that require co-ordination perhaps from the Ministry of Finance, Ministry of Corporate Affairs and RBI.

1. Dividend should be made tax free. People who get dividend will either spend or invest them, both of which support the economy. So, why double tax them? Let the power of circulation of money work. Transaction charges are already levied and now we even have the additional stamp duty. So why not, let the investors gain the tax advantage.

2. CIBIL score of businesses should be available in the public domain for a small cost. And if there are any remarks by any lenders, it should also be made available to investors. This is required, per se, on basis of the same logic that bankers get CIBIL score for people borrowing from a bank. So why shouldn't the investors have similar access, since they are lending for potentially higher risks?

3. Force companies to have a separate chairman and Managing Director. Power corrupts, and absolute power corrupts absolutely - this is a famous maxim that holds substantial weightage, so the logical premise is to reduce the power of the individual in order to maintain balance.

4. All listed companies should have a minimum public holding of 45%. It shall bring in greater transparency and also improve the liquidity ratio.

5. Companies that are listed in India should have lower taxes compared to private companies wherever their size allows them to be eligible for being listed since listed companies allow the public the advantage to earn additional wealth.

6. Long term capital gains tax for equity, debt and real estate should be the same and they should all be calculated for a holding period of 3 years.

Some of these suggestions will take time to show results. And some shall be difficult to implement because of the requirement of various inter-departmental working/approval sanctions. However, in order to help small investors and improve the economic standard in the country, eventually, these measures will have to be incorporated.

Author -- Anonymous 

Book: Two books on Bias

Humans as a species tend to use short-cuts to arrive at a decision. Using these mental short-cuts is what makes us biased. And we hate being challenged. While there are many books on the subject, hopefully I will end up reading more and learning more but to start with there are two books that anyone can start with.

The Art of Thinking Clearly by Rolf Dobelli. Herein, are 99 chapters highlighting the most common of mental short-cuts we use and it highlights the errors or benefits that we derive from them. Its been written in simple language, with lots of examples, thus, making it easier to understand.

If you don’t have interest in reading so many different biases, but would like to read about the common ones then The Little Book of Stupidity: How We Lie to Ourselves and Don't Believe Others by Sia Mohajer. In this book, the author highlights just the 10 biases and then gives a chapter to exercise by identifying. The book is again written in simple language.

"The failure to think clearly, or what experts call a ‘cognitive error’, is a systematic deviation from logic – from optimal, rational, reasonable thought and behaviour. By ‘systematic’ I mean that these are not just occasional errors in judgement, but rather routine mistakes, barriers to logic we stumble over time and again, repeating patterns through generations and through the centuries. For example, it is much more common that we overestimate our knowledge than that we underestimate it. Similarly, the danger of losing something stimulates us much more than the prospect of making a similar gain. In the presence of other people we tend to adjust our behaviour to theirs, not the opposite. Anecdotes make us overlook the statistical distribution (base rate) behind it, not the other way round. The errors we make follow the same pattern over and over again, piling up in one specific, predictable corner like dirty laundry while the other corner remains relatively clean (i.e. they pile up in the ‘overconfidence corner’, not the ‘underconfidence corner’)."
– The Art of Thinking Clearly

Meanwhile, 

"Q1) Cindy is sick of arguing with her boyfriend. They are both stubborn people and have an itchy trigger finger for anything they deem to be unfair. They often get into huge arguments that build into shouting matches that can last for hours. They are both exceptionally talented at recalling previous incidents where one of them was overly unfair or biased. Cindy thinks her boyfriend, John, lacks the ability to see how ignorant he is about certain points which are crystal clear to her. She feels that if John had the same level of clarity and honesty as she has, they wouldn't argue as much.

Q2) John works in the sales department. He likes his job but he likes his lunch break even more. He usually spends his lunch break chatting with his coworkers. Last week, John noticed how awkward one of his coworkers was toward him. She didn't look at him when she spoke and she only responded to questions with a few words. John later spoke about this to several people. John told them that he thought she was impolite, unprofessional and not very friendly. His later interactions with her were slightly tainted by this impression."

-- Guess the Bias, The Little Book of Stupidity: How We Lie to Ourselves and Don't Believe Others

Another resource worth reading is Wikipedia on biases. 

Book: Open The Door To A Wealthier Life

Open The Door To A Wealthier Life, has been written by Farhan M. Khalid. This book is appropriate for Muslims in the USA and who would like to pursue sharia-based investing. It deals with many of the elementary topics of personal finance, including how to track your expenses. The book also delves on various sharia-compliant investment options and briefly discusses the differences of opinion.

Those who would want to touch briefly on the following topics may consider the book.

• How to maximize your income
• How to minimize your expenses
• What investment choices are available
• Why to even bother investing your money
• The difference between various investments
• Which investments are considered halal and which are not
• How to get started in investing on your own with minimal cash
• How to finance a home without paying interest

For everyone else, it's a book they can choose to miss.

Book: Non-Consensus Investing

Rupal Bhansali is chief investment officer and portfolio manager of Ariel's international and global equity strategies. In this capacity, she oversees global research effort and manages multi-billion dollar portfolios. She also co-manages the global concentrated strategy at Arial Investments.

In Non-Consensus Investing: Being Right When Everyone Else Is Wrong, Rupal makes a case for active investing when the world is favouring more of passive investing. In the book, she shares her perspective and her learnings. It is definitely a book worth reading at least once. For new investors, it is a must-read book.

Below are some of the sections and the most interesting statements, observations, learnings, and views of Rupal Bhansali. The words in Italics are my words to give additional clarity where required.

How My Passion Became My Profession

• This experience of thinking about both the long and short sides of the trade has become the signature element of my upside-down investment process: it focuses on what can go wrong (and how much the stock can go down), not just what can go right (and how much the stock can go up).
• Non-consensus investing is not simply doing the opposite of what everyone else is doing. It is deeper and broader and requires its practitioners to develop skills to recognize when widely held investment views are likely to be wrong.
• Non-consensus thinkers are not simply contrarians in a psychological or behavioural sense. They are analytical and independent thinkers who try to figure out what is misunderstood about the business and mispriced in the stock.
• Instead of trying to select companies, I look for reasons to reject them. By first and foremost looking for things to dislike and identifying what can go wrong, I proactively try to reduce the risk of being blindsided if adversity arises.
• The worst thing is being poor after you have been rich.
• Few people realize that investing is a paradox: to enhance returns one must reduce risks.
• Chapters 4 through 11 dissect the core principles of non-consensus investing, ranging from the need to stand alone to stand apart, to how misunderstanding quality can be the mother of all mistakes but also the mother lode of all opportunities.
• The concluding chapter 12 summarizes the core facets and tenets of non-consensus investing. Think of these principles as a north star, pointing you toward success.
• Keeping with the spirit of the contrarian theme that permeates this book, I often discuss what not to do and how not to do it.

“And” Not “Or” -- highlighting the different kinds of risk associated in investing.

• Who will buy the expensive stocks owned by passive investors when they want to sell? A wide divergence between what active investors are willing to pay (based on fundamentals) versus the price (bid up by flows) at which passives have valued their portfolios could set the stage for big markdowns, aka losses.
• Redemption risk. If everyone rushes to exit at the same time, how will passive easily liquidate its underlying assets into cash? Who will take the other side of the trade? Will a liquid asset class turn illiquid, causing passive managers to curtail redemptions?
• Liquidity risk. To avoid restricting redemptions, passive managers may have no choice but to dump stocks in a disorderly fashion, causing them to gap down, which I describe as the cost to exit positions.
• Front- running risk. In bull markets, nobody notices or complains about front running because it pushes prices up, creating the illusion of making money. On the way down, it can turn into a house of cards, as selling begets more selling by the front runners, paving the way for larger losses.
• Permanent- impairment- of- capital risk. Cheap beta (which is the promise of passive) is only desirable in bull markets. Passive cannot protect you against capital loss.
• Behavioural risk. Passive is not the negation of human neuroses or biases, but the aggregation of all neuroses and biases that exist in a market.
• Momentum risk. Lacking self- correcting mechanisms, indices can swing wildly from greed to fear as momentum cuts both ways. On the way up, it turbocharges returns; on the way down, it turns into a vicious downward spiral. Such roller coasters can be nerve-wracking, and investors may feel compelled to redeem instead of riding it out, exposing them to many of the risks described previously.
• Reflexivity risk. If you think that passive is unemotional, objective, and rational, think again. Going passive is itself an active decision. It is humans who make the decision to choose or quit passive, and they can be every bit as emotional and biased (which are accusations typically levelled against active managers).
• Market-inefficiency risk. Because passive does not care whether a market price reflects fair value or not (and therefore the efficiency of the market itself), all of society suffers.

Stocks or Bonds?

• You win or lose by chance, not a choice. In investing, you have the power to alter the odds, if you are willing to do the work. This means you win or lose by choice, not chance. This is a crucial distinction. If you play an active role in investing, you can influence the outcomes through skill. In speculating, you are reduced to a passive position where luck prevails, and skill does not matter.
• What exactly do those two words, “risk” and “reward,” mean? I think of risk as to the potential for permanent loss of money, and reward as the compounded rate of return over a full market cycle, typically ten years or more.
• This leads me to address a big question that should be on everyone’s mind: Should I invest in stocks or bonds? Which give better returns? Which have lower risk?
• Just as a brief illness builds your immune system, learn to think of volatility as a healthy interlude on the road to a stronger market eventually.
• If the fundamentals of the business have not materially changed and its intrinsic value— what the business is worth— is not impaired, a sinking stock price is an opportunity to gain even higher returns at a lower risk.
• Note, too, that the greater the discount to intrinsic value, the larger the margin of safety and the greater the reward. As the price falls, there is a bigger reward and lower risk.
• Conviction (aka confidence or hubris) will lead people to make a decision about a certain stock based on some sort of gut feeling— a whim, a hunch. But investing is not a confidence game; it is about being more correct, not being more confident.
• Free cash flows represent the surplus cash flows a company generates after: 1. Paying all expenses of the business 2. Reinvesting in the business to support ongoing operations or growth 3. Setting aside money to pay back long- term liabilities
• This is exactly what my investment approach strives to do. It tries to take advantage of both the volatility and the value- creation potential of equities and helps me choose well, to make higher returns without taking a higher risk.
• Then, as interest rates go up and risk appetite goes down, many borrowers may have difficulty repaying their debt. This is called a default risk.
• For sixty years, interest rates were range-bound between 2 and 5 per cent; then, in just over twenty years, they shot up to 15 per cent (see figure 3.2). The UK never regained its former glory.
• Most bonds, especially corporate bonds, are far less liquid than equities. If you need to sell them, you may not find a buyer right away, and you may have to offer significant discounts to their fair value to entice bids.
• You will only know their true value when you sell them. This takes us right back to the illiquidity risk. If you cannot liquidate, you cannot establish real value. Illiquidity risk exacerbates valuation risk.
• In November 2016, rating agency Fitch warned that a mismatch within open-ended bond funds offering daily liquidity while holding less liquid securities had increased to a record high. Fitch analyst Manuel Arrive cautioned, “Drawdowns resulting from fire sales in illiquid markets increasingly put fund capital at risk, as bond carry returns have become insufficient to offset volatility.” 2
• There’s one more type of risk, and it is a big one: Bonds can expose you to large losses but cannot offer large gains (unless you buy them in the secondary market at a huge discount to their face value).
• That is because a bond’s upside is capped at par. 3 Let’s say you hold a bond with a par value of $ 100. At any point before its maturation date, that same bond can fall in price to $ 70 or $ 60 or even lower.
• Bottom line: It is naive to think that bonds do not come with any risk. They just come with a different risk.
• Think of owning stocks of quality businesses akin to raising a child whose best days are still ahead of her. Sure, she may act up now and then, but you do not give up on a child just because of a few stumbles. Children, like stocks, may not offer joy every day, and on some days, they may bring pure nuisance and annoyance, but you would not decide not to have kids because some bad comes with the overwhelming good.

To Stand Apart, You Must Stand Alone

• That is, you must be right and prove others wrong. To achieve exceptional results, you must do something that makes you stand apart from the rest.
• To succeed, not only must you be right, you must prove everyone else wrong. That kind of asymmetry can be tough to understand, let alone accept, so let us take a deeper look.
• If research does not uncover anything original or differentiated, it is not value-added research but simply regurgitation, the investment equivalent of reinventing the wheel.
• Active investors who are unskilled in their research efforts are rightly facing an existential wake- up call: differentiate or die.
• This is what makes investing not simply different but asymmetric. You may not make any money for being correct if your correct views are consensus, but you will lose money for being incorrect. Figure 4.1 depicts this asymmetry:
• What I learned was that to find a treasure instead of a trap, an investor must first be a business analyst and then a financial analyst.
• Note that nobody in this gravy train questions whether their activity results in price discovery or price distortion. Is the stock trading above, at, or below its intrinsic value? Everyone blithely skips that part. Quant doesn’t calculate it (“ algorithms compute relative value not intrinsic value”), trend followers don’t care about it (“ don’t let facts get in the way of a good momentum story”), growth investors rationalize it (“ the high growth assumptions justify it”), and passive ignores it (“ theirs not to question why theirs but to do or die”).
• As the years rolled by and active managers continued to underperform in a strong upmarket, investors did what they often do— top ticked a trend (bought at the highs). In 1999– 2000, many clients withdrew money from their active managers and ploughed it into passive by investing in vehicles such as the QQQs (an ETF which mimicked the movements of the Nasdaq 100), which had doubled.
• A paper published in the Financial Analysts Journal in 2017 concludes that there is no evidence of underperformance among a group of funds with a high active share (those whose holdings differ substantially from their benchmark). Indeed, those who are also patient (withholding duration of more than two years) have outperformed, on average, by more than 2 per cent per year. Earlier studies showed similar results.
• The underperformers fell into two categories: closet indexers (benchmark huggers who called themselves active but were not) and pseudo active (those with a low active share between 60 and 80 per cent who pretended to be active but were not).
• When you look underneath the covers, there is a very compelling difference and argument in favour of truly active and against pseudo or closet active, not all active.

Score Upset Victories

• However, I want to make it clear that investing is not about gambling or betting or playing games, but about conducting serious, differentiated research which uncovers information that proves both correct and non-consensus.
• Investing is a pari-mutuel endeavour, where you are betting against other people since every share you buy is being sold to you by someone else. Unlike gambling, where the odds of winning and losing are preset by the casino and no gambler’s bets can alter those predetermined odds, in investing, each investor’s decision alters the preexisting odds. And as the odds change, the payoffs change. Of course, investing is not a zero-sum game, but one in which everyone can win something. However, those who score upset victories win way more, and that makes all the difference because the goal of an active investor is to beat the market, not just match it.
• If the companies did not generate free cash flows, we were told to look at earnings. • If they did not make any earnings, we were redirected to revenues; earnings would come later. • If there wasn’t much in the way of revenues, we were told to look at eyeballs; it was all about user engagement. • If there weren’t enough eyeballs, we were redirected to the founder’s vision; the eyeballs would follow.
• The arguments boiled down to buying concepts instead of companies. It felt surreal because it was. Eventually, investors began to realize that the emperor had no clothes, and the Nasdaq (which was heavily weighted in TMT stocks) crashed, losing 78 per cent of its peak value. What took five years to make took less than three years to lose (most of it anyway). What is worse, many of the concept stocks in the Nasdaq went out of business, causing permanent losses. In investing, it is not what you make but what you keep that matters. Your checks will bounce if you write them based on what your portfolio used to be valued at its peak but is no longer worth that high- watermark.
• Incidentally, this speaks to the power of global research: when you cover fifty countries around the world, as I do, you see fifty times as much. So even when pundits such as Alan Greenspan and Ben Bernanke debunked the notion of a nationwide housing crisis, I took the opposite path, selling many of my financial stocks in 2006. Two years later, the financial crisis of 2008 sent markets into unprecedented turmoil. Many financial institutions went under or had to be rescued at taxpayer expense.
• They say you can tell the experts are wrong when they unanimously agree on something. In all the preceding examples, the crowds believed their investment theses to be foolproof bets resting on solid ground— until they were not. In my experience, at best, crowded trades won’t make you much money, but at worst you could end up losing a lot of it (if not initially then eventually). On the other hand, at its best, the lonely trade can often help you score big, but if it doesn’t work out, you won’t lose much money either. This asymmetric risk/ reward tips the scales in favour of lonely trades and against crowded trades. This is where correct fundamental research comes into the picture. If the correct research is also non-consensus, you have all the makings of an upset victory.
• The bottom line is that betting on the underdog can improve the odds of making a lot of money while betting on everyone’s favourite increases the odds of losing it. (A prerequisite is that your research on the underdog must be correct.)

Do No Harm

• You always lose money from a higher number but gain money from a lower number, which is why incurring heavy losses proves more damaging than missing some gains. Investors are better off researching potential for failure and avoiding losers than chasing success stories and picking the winners. The main reason to invest in equities is to compound capital, and losing money is the albatross.
• For one thing, risk comes in many forms: financial-leverage risk, corporate-governance risk, currency-devaluation risk, regulatory risks, low-barriers-to-entry risk, and on and on. For another, the risk is often hidden from plain sight or comes in a disguise, not revealing its true character or intensity until it is too late.
• There is ample statistical data on default rates to help you handicap future expected losses. You would be benefiting from underwriting experiences of the past. However, there is another, more sinister type of risk you should be on the lookout for, and it can be vastly different from risk experience. I’m talking about risk exposure.
• In bull markets, where the focus is on returns, there is a greater tendency to become complacent about risk. This is dangerous. At precisely the time when investors should be paying more attention to risk, they pay less.
• This feeds a self- fulfilling cycle of ignoring risks which multiply unabated and finally blow up in our faces (as we all confronted in 2008).
• It is not that regulators, central bankers, management teams, rating agencies, and money managers were not looking at risk reports on the banking sector. The problem is that they were looking at misleading metrics such as value at risk, or VAR. 2 The formula for calculating VAR relies on measuring volatility experienced, which was of little help in 2008 because the securities were often new and had limited trading history (data). Therefore, to understand risk exposure, investors needed to use judgment, not statistics. If they had, they would have realized that the facts, taken out of context, were misleading. They would have seen that during a persistent bull market with an upward trending bias, volatility was likely to be understated, and thus would give a skewed sense of risk exposure.
• I researched a whole range of risk factors and exposures in the banking sector and foresaw the high-risk exposures such as asset/ liability mismatch risk, maturity-mismatch risk, wholesale-funding risk, counterparty-risk, and so on, that had eluded many.
• For instance, I examined the corporate-governance incentives of CEOs and found that their compensation packages often incentivized them to expand their banks and maximize short- term returns rather than walk away from risky assets.
• Think of stock- price volatility as the minor heart- rate fluctuations that we routinely experience when we move from resting to walking to running. They are not significant, and you can usually ignore them. On the other hand, chronically high blood pressure, for which you may see no obvious outward signs of fluctuation, is a huge risk. You would find it absurd if your doctor measured your heart rate all day long and completely ignored measuring your blood pressure. But this is exactly the absurdity we indulge in when we focus on beta or volatility instead of risk. Unfortunately, because we cannot easily measure or visualize risk before it happens, while measures such as historical beta, volatility, or tracking error are precise and tangible, people fall into the trap of measuring something that does not matter because they can, not because they should. Measuring risk is right but not easy; measuring beta and volatility is easy but not right.
• Just as not all cholesterol is bad for you, not all deviations from the benchmark are bad.
• A well-meaning but equally damaging form of swapping risk comes from the recent obsession with owning stability at any cost and avoiding volatility at any cost.
• What is more worrisome is that instead of focusing on fundamental improvements in corporate strategy or execution, many activists now overwhelmingly focus on what they call “maximizing capital structure.” It’s nothing but a euphemism for leveraging up the balance sheet to fund share buybacks.
• Expensive share buybacks funded with “cheap” debt are nothing but a form of doubling down on risk.
• Many investors encourage companies to buy back their shares in bull markets only to cut those programs in bear markets when they should be doing the opposite.
• Long- term stock- price performance arises from value creation in the underlying business, not from tinkering with the capital structure via financial engineering.
• To add insult to injury, the companies and money managers who have the guts and grit to stay out of this fray find themselves in the unfortunate predicament of having to apologize for their conservative risk management. Cash has become a four-letter word, while debt is not. It has become fashionable to ridicule companies holding cash (which is nothing but a form of risk management) while taking on debt is encouraged.
• I am not for management teams hoarding excessive cash, and obviously deciding what level is excessive is a judgment call. But I would rather the board and long- term shareholders make that decision than short-term traders or fly-by-night activists.
• Debt is a double-edged sword; it can amp up your returns in the good times but wipe you out during the tough times. Such binary outcomes make a highly indebted company very speculative. My advice: avoid it.
• Acquisition risk is a special form of denial in which inferior risk management is indulged in the name of superior return management. Invariably, management teams and investors justify their expensive forays with arguments of faster growth and immediate profit accretion. The downside emerges much later, when accounting regulations force them to confess to their mistakes by impairing the value of the asset. Once again, focusing on short- term gain and ignoring long- term pain proves to be a losing investment strategy in the fullness of time. Overpaying for an asset in the name of the strategy is simply obfuscating the valuation risk.
• Another form of doubling up on risks comes when a company with operating leverage takes on financial leverage. That is a deadly cocktail in times of adversity. Many financially leveraged energy companies went bankrupt when oil prices crashed unexpectedly in 2014 because their bonds and shares plunged simultaneously as investors priced in both bond default and equity- dilution risk. At exactly the time that the company needed to raise money to get through the downturn, both equity and debt markets closed their doors because of this layering of risk upon risk.
• Risk is absolute, not just relative. A lot of small risks with low probabilities can add up to a gigantic fat- tail risk. Layering risk upon risk ensures multiple ways to lose, instead of multiple ways to win. Doubling up on risk means that a humdrum downturn can explode into a full-blown crisis. Do not put yourself in such a vulnerable position in the first place.
• Risk is omnipresent. There is no denying it or avoiding it. Your only choice is to find it and deal with it. Equity investors need to be especially vigilant about risks because they are the risk- bearers of first resort. Risk management is not an attempt to eliminate all risks (that is impossible) but to distinguish between those risks that are minor— in which case the equity is worth buying at a good price— or major, meaning you should steer clear at any price.
• If the risks in the business are outsize, unquantifiable, or of a binary/ speculative nature, stay away. Do not own the stock at any time or any price. This is an absolute standard, not mitigated by a low or falling price. Warren Buffett put it best in his 1996 annual letter to shareholders: “If you wouldn’t own the business for ten years, don’t even think of owning it for ten minutes.”
• In other words, when markets pay you to assume the risks of a high- quality business, you should bear them. When markets do not pay you, you can sit back and wait for a setback in the business or pullback in the share price. Let the opportunity come to you, and only engage when the risk/ reward balance becomes attractive. Thus, risk management is not only about risk reduction but also about return enhancement. You can take advantage of risk to generate returns if a stock is mispriced.
• Investors can reduce the risk of large losses by insisting on a large value spread between the price of a stock and its intrinsic value.
• Part of astute risk management is to not be afraid because excessive fear can cause you to miss out on opportunities. I call this risk an error of omission, and I too have fallen into this trap.
• In life, we don’t give up striving for success because some struggles or sacrifices come with it. We figure out how to manage and overcome them, so they do not overwhelm us. Similarly, in investing, you must not give up the pursuit of any return just because it comes with some risk. Instead, you learn to identify risk, manage it proactively and prudently, and insist on getting paid for it.
• They are just not in plain view or have not materialized yet. I refer to this out-of-sight-out-of-mind risk as a blind spot.
• Risk is a virus that can mutate unpredictably, not a bacterial cell that multiplies predictably. Your doctor would not confuse a bacterial infection with a viral one, and neither should you. Like a potentially deadly virus that keeps morphing, risk requires you to be constantly vigilant and stay a step ahead. This requires judgment, foresight, and multidimensional approaches, not reliance on rote checklists or static metrics. Managing risk is an ongoing process, not a one- and- done task.
• Remember that being risk aware does not mean you should be risk-averse.
• In his 1921 book, Risk, Uncertainty, and Profit, Frank Knight, an economist, formalized a distinction between the two. He understood that an ever-changing world brings new opportunities for businesses to make profits, but also means we have imperfect knowledge of future events. Risk, according to Knight, applies to situations in which we do not know the outcome but can accurately measure the odds. Uncertainty, on the other hand, applies to situations in which we cannot know all the necessary information to set accurate odds in the first place.
• If you do not know how to tune into risk, or do not want to, that’s fine. Outsource it. You do this in many aspects of your life, by finding the best doctor to avoid the risk of dying from some disease or the best lawyer to avoid the risk of losing a lawsuit. Apply the same logic in investing. Find the money managers or financial advisers who know how to manage the risks of your investment portfolio, not just its returns. As Peter Bernstein, the guru on risk management, rightly noted: “Risk is a choice, not a fate.”

False Positives and Negatives

• Porter’s Five Forces: industry rivalry, threat of new entrants, threat of substitutes, bargaining power of suppliers, and the power of customers.
• its moat became irrelevant, and the company became marginalized in the marketplace.
• The question is not “What is their market share?” but “Why do they have that market share?” Not “What is the profit margin?” but “Why do they have that profit margin?” “Why” provides the missing link that goes past the symptom to the source.
• Business model is understanding the change in trend or technology that can impact the business.
• They repeated this mistake when they bought bank stocks as they were falling in 2008, using the same circular logic of cheapness. Historical financial numbers or naïve valuation metrics such as low price- to- book or price-to-earnings ratios will not tell you that the quality of the underlying business is about to deteriorate. Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
• Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
• Knowing how to correctly distinguish quality from junk is a prerequisite to generating higher returns with lower risk— which is a central aspiration of non-consensus investing.
• Familiar but flawed Real and reliable Indicators of low-quality Indicators of high-quality Competitive advantage Darwinian1 advantage Leading market share Growing market share Pricing power Price disrupter Captive customers Loyal customers Brand Value proposition Results Process Buzz model Business model Luck Skill Patents Know-how High tech Proprietary tech
• It is those who are most capable of adapting to their environments over time who gain the upper hand.
• While expanding market share is better than not, it is a means to an end, not an end in itself. The pursuit of market share should not come at the expense of developing a strategic advantage and pursuing long-run profits. Markets are dynamic, and winners and losers are continuously shifting.
• They mistook captive customers, who had nowhere else to go, for loyal customers. The moment those customers got a choice, they shifted their business en masse, exposing the business model for the low quality that it was. Captivity is not loyalty. High- quality businesses are those where customers willingly do business even if they could go elsewhere, because they are getting real value for their money.
• The worst offenders are those that rely excessively on their brands to do the heavy lifting of increasing revenues.
• Another red herring that keeps investors going in circles is looking at the quality of outcomes when they should be looking at the quality of the underlying decisions a company makes.
• Leverage in any form— operating or financial— is a source of risk to equity shareholders, and therefore highly leveraged companies fall squarely in the low- quality camp.
• The lesson here is that winning by default (being in the right place at the right time) is not the same as winning by design (strategically positioning yourself to win against the odds). Luck, in the form of tailwinds and externalities, may confer a fleeting victory to a company or industry but it will not stand the test of time.
• Did you know that some of the worst-performing stocks over the past several years, such as Xerox, IBM, and Canon, are some of the largest patent owners? In my experience, patents are overrated, know-how is underrated.
• Know-how is accumulated knowledge about a process or technique that is hard to decipher or reverse engineer. That means it can yield a competitive advantage for a long period of time.
• I was right about the facts but wrong about the conclusion. A petrochemical- manufacturing plant is indeed very sophisticated and complex. However, the technology and expertise to build and install the process- automation equipment in the manufacturing plant is owned by their suppliers, such as ABB, Siemens, and Emerson Electric, and they sell it to anyone who wants to buy it. There is nothing exclusive or proprietary about it. This explains why, despite being high- tech, petrochemical plants do not generate good returns on capital invested, which makes them low- quality businesses with poor value- creation prospects.
• This underscores the importance of distinguishing high tech from proprietary tech. They are not the same.
• In assessing quality, you must be vigilant about circular logic, in which you confuse cause and effect or conflate numbers with the narrative.
• A genuinely high- quality business is one that offers exclusive and enduring value propositions to consumers and generates a fair return to justify both the costs and risks of lawfully engaging and reinvesting in that business.

Ditch the Database, Embrace the Search Engine

• Research is not merely about knowing a lot; it is about understanding a lot and, more importantly, applying what you know. Unfortunately, from kindergarten through college, most people are spoon-fed questions that lead them to “right” answers. We need to rewire these bad forms of learning, because they give us a knack for accumulating knowledge, not applying it.
• Where has apathy or pessimism degenerated into neglect?
• Where is failure priced in, but success is not?
• You are better off researching failure. Two benefits: it will sharpen your antennae for what can go wrong; but also, if it has already gone wrong and your research tells you a reversal is at hand, you can score an upset victory.
• My unconventional view is that for the companies rooted in science and skilled in doing R& D, the industry’s challenges are also their opportunities.
• Where is the future better than the past?
• Where is secular growth hiding behind cyclical volatility?
• Disruptive business models or technologies can be fertile sources of upset victories, provided one knows how to conduct such research. It often takes deep domain expertise about the industry and years of training and practice to parse the reality from the hype, so be sure to stay within your circle of competence.
• Where are the setbacks that are due for a comeback?
• if a turnaround company belongs to a bad industry, its problems are likely to be more chronic than transient.
• Where are the second-order impacts being ignored?
• This instant payoff may feel gratifying, but it is chump change compared to the big payoffs that come from figuring out second-order impacts, where one change results in another change, like a domino effect. Focusing on second-order effects is like watching a stone thrown into a still pond; take your eyes off the stone and instead note where the ripples go. Let’s look at an example.
  Where are the “and” propositions?
  The leader will be working and exploring various aspects of the customer needs.
  Companies that deliver products with “and” propositions tend to succeed for a long time because what they do is exceedingly difficult to replicate.
  Two attributes— high quality and low cost.
• Non-consensus investors are always on the lookout for companies that make or deliver a product, service, or solution in such a compelling way that customers don’t even think of trying an alternative because none exists. Such companies epitomize high quality and exude the “and” proposition on a multitude of vectors:
• They possess exclusive and enduring Darwinian advantages.• They offer higher quality and lower cost, delivering unbeatable value propositions.• They generate surplus cash to reinvest in the business and distribute regular dividends to shareholders.• They succeed in the present and build momentum for the future.• They play good offence and defence.• They perform well in good times and hold up better in tough times.• They offer upside potential and provide downside protection.

From Victim to Victor

• Flaw #1. Jumping to False Conclusions: The Availability Bias.
  Academic papers, interviews with key division heads in speciality trade publications, books written by former employees of companies I was researching, memoirs of former CEOs, case studies of analogous challenges faced in other industries, and so on.
• Flaw #2. Falling Victim to Vividness: The Recency Effect
• Flaw #3. Monday- Morning Quarterbacking: Hindsight Bias
  To give yourself a much- needed reality check down the road, take time to investigate before you invest, write down your investment theses and quantify your qualitative expectations in a spreadsheet. Then track how things are going in the business versus how you modelled it. This will enable you to separate out the luck from the skill. Most professional investors do this.
• Banking on Best-Case Scenarios: The Planning Fallacy
  We all know that when the stakes are high, we should not count on the best-case scenarios, but instead plan for the worst. Yet most of us hope for the best and tune out the rest.
  I had fallen for the planning fallacy. I had not considered the possibility that they would satisfy their growth envy through acquisitions, no matter how expensive or risky. I had assumed that because the management was also the largest shareholder, they would be excellent stewards of capital. But simply being aligned with shareholders is not enough for the best outcomes. Even well-intentioned, well-incentivized management teams can make mistakes in allocating capital. It was clear that I should have considered worst-case scenarios, not just planned on the best case.
• Overvaluing What You Possess, or Denial on Steroids: The Endowment Effect
  Complacency is not a good reason to continue owning overrated stocks well past their prime.
  “If I didn’t own the stock already, would I buy it today?” 1 This is known as zero-base thinking.
  Many hedge- fund managers guard against the endowment effect by forcing preset stop-loss limits on trades. They automatically sell the stock when the limit hits. The manager can then reassess whether to reinstate that position by buying it back. Some would regard this as suboptimal from the standpoint of transaction cost: it costs money to liquidate and reinstate a position. But the smart money considers it a small price to pay to guard against the larger cost of suffering from the endowment effect. In fact, because the benefits can outweigh the costs, in many hedge funds this is a standard risk-management policy.
  Cutting your losses ensures two salutary outcomes: you learn from your mistakes, and you spare your portfolio further damage from an investment that is headed south. The best way to figure out if one is wrong, rather than simply ahead of others in an investment call, is to compare how the underlying business is performing (as opposed to how the stock is performing) versus one’s expectations in the original investment thesis. If the business (not the stock) is tracking my expectations, I hold onto or even average down on my investment. However, if it is performing worse than my expectations, I force myself to rethink my thesis and apply the fix.
• Clinging to the Past and Being Slow to React to Change: Anchoring Bias
  Many companies generate high profits when times are good, not necessarily because the company itself is good. When the tailwinds turn to headwinds, the company flounders. The mind takes time to process this changed reality. Academics call this anchoring— the tendency to adjust prior estimates insufficiently when presented with new information. In simpler terms, it means human beings are slow to react to change and prefer to cling to a point of view even though it is no longer valid.
  To overcome this bias, it is best to appoint someone else to do clean- slate research so that original or contradictory points of view emerge. That person needs to be ruthless and relentless in looking for information that invalidates, refutes, upends, or discredits any or all beliefs about company X.
  This Emperor Has No Clothes: Relying on Intuition Over Data
  Listening to your gut instead of checking the facts is what academics describe as intuition bias: relying on intuition over data.
• Knowing Less Than You Think You Know: Overconfidence Bias
  In fact, you might call overconfidence the original sin of investing. Thinking we know more than we do, certain that we are right, works against having the humility— or the common sense— to know when our judgment is off.
  Human beings are prone to overestimating what they know and underestimating what they do not know. Confucius put it best when he described knowledge as knowing the extent of one’s ignorance. The worst part of this behavioural flaw is we do not know what we do not know. So we underestimate the uncertainties of the future and invest as if we knew all there is to know. Such blind faith leads us to bet the farm on investments that appear to have great promise because we ignore what can go wrong.
  The lesson learned is that investing comes with uncertainty. No matter how much you to try to handicap all outcomes, unexpected things happen. No amount of research would have uncovered this accident. Sometimes all you can do is reassess the risk/ reward of an investment as new facts emerge and then take appropriate action.
• Believing What You Believe Instead of Questioning It: Confirmation Bias
  However, in investing, we need to do the opposite. Figure out what does not add up, instead of what does. Actively look to invalidate rather than validate.
  Too many investors inadvertently set themselves up for confirmation bias by favouring companies that score well on a checklist of desired attributes.
  When you seek out information that does nothing more than confirm what you already “know” to be true, you have swapped confidence bias for confirmation bias.
  Here is a summary of the top five mental states a non-consensus investor would do well to cultivate: 1. Scepticism (poke holes, insist on triangulated validation) 2. Optimism (consider what can go right) 3. Pessimism (stress- test what can go wrong) 4. Pragmatism (don’t bet the farm on some hunch or belief) 5. Stoicism (be equanimous amid adversity or euphoria)
• Flaws Fixes 1. Availability bias Go outside the sandbox 2. Recency effect Think long term. 3. Hindsight bias Parse luck from skill. 4. Planning fallacy Play devil’s advocate. 5. Endowment effect Practice zero- base thinking. 6. Loss aversion Acknowledge reality and cut bait 7. Anchoring bias Adopt clean- slate thinking. 8. Intuition bias Collect and connect information. 9. Overconfidence bias Accept what you do not or cannot know. 10. Confirmation bias Look to invalidate, not validate.

Value Investing = Margin of Safety

• The first negotiation ploy (someone offered $ 125 in the past) appeals to “reversion- to- mean” investors who believe that if the stock traded at a higher price or multiple in the past, it will do so in the future.
• The second negotiation ploy (someone else was willing to pay $ 100) is designed to deceive you with the “greater fool theory,” or what I call “optical value.” Just because someone else was willing to pay a higher price does not mean you should.
• The third negotiation ploy (compared to $ 100, you can have it for $ 80) appeals to “relative value” investors. In relation to something else, it can be made to look cheap, so it appears to be a bargain even if it is not. You have seen plenty of “relative” value traps even if you didn’t know the name.
• The fourth negotiation ploy (if you want this, you must buy it right now) is to trick you into making a hasty decision without having all the necessary information. Investing before investigating is risky; you are playing the game blind and relying on luck rather than skill. Do not fall for this ruse.
• The fifth negotiation ploy (offering you more for less) appeals to “distressed value” investors.
• Value is driven by what you are getting, not just by what you are paying.
• In good times, people focus unduly on what can go right and ignore what can go wrong. In troubled times, people dwell unduly on what has gone wrong and overlook what can go right.
• Investors who were betting on Sony’s continued dominance paid the price. Over a decade, Sony went from being a growth stock to a “reversion to mean” value trap to succumbing to the “greater fool theory” to being perceived as “relative value” to finally being regarded as “distressed value.” Frankly, it never represented value but a value trap, as all these value frameworks are false ways to assess value.

Sizzle Fizzles, Patience Prospers

• Confusing luck with skill is endemic in investing because the short term and the long term often diverge and investors tend to confuse frequency and severity.
• “What Matters May Not Be Measured and What Is Measured May Not Matter.” (Albert Einstein)
• Worse still, frequent measurement of performance is not only futile, it actually proves counterproductive.
• The ideal scenario is a money manager who has built an investor base with common investment philosophy, time horizon, resolve, and tolerance for underperformance. Only then can a manager maintain the stable capital base required to see his contrarian philosophy through to a successful conclusion.
• This is about managing expectations rather than managing money.
• In his book Active Portfolio Management, published in 1995, Ronald Kahn demonstrated through a series of equations that it takes sixteen years’ worth of performance data to prove skill over luck with a high degree (95 per cent) of statistical confidence.
• I would also seek managers who have been baptized in the school of hard knocks and not given in or given up. It takes character and fortitude, not just calibre and intellect, to succeed in this profession.
• Often, strategies appear compelling because they are easy to explain and understand, not because they are sound or effective in practice. When launching a new product, it has become easy to impress investors with backtesting statistics that predict high-performance potential. That kind of statistical evidence can seem very convincing but be careful. It may be none other than fanciful data mining that fails in practice because implementation costs are too high, or the targeted inefficiency is so small that it is unlikely to produce any meaningful returns. Evaluating skills and capability has predictive power; looking at historical performance does not.
• Leverage turbocharges performance in a bull market but decimates it in a bear market.
• However, exactly when the opportunity to make money is highest, investor interest is lowest. An out-of-favour asset class, sector, geography, or stock offers rich pickings for those who are willing to be contrarian. 

North Star

• Conducting differentiated research to identify what is misunderstood and therefore mispriced by the consensus. 2. Taking advantage of excessive pessimism that focuses unduly on negative developments in the near term while ignoring what can go right in the long term. 3. Investing countercyclically to other people’s investment appetite when the sentiment swings from greed to fear or reverence to repulsion. 4. Looking at pockets of the market suffering from sheer neglect. 5. Arbitraging differing time horizons, taking advantage of people’s inability or unwillingness to think long term.
• Whenever investors pursue a fad or a fetish, there is usually money to be made by looking at the opposite end of the spectrum.

A Special Message from Me to You

• Everywhere, I encountered people, practices, and cultures that seemed vastly different from one another. But on reflection, what my travels really revealed is not how different we are, but how similar: the same aspirations, if not the same ideals; the same values, even if not the same religion; the same basic human needs, wants, emotions, and vulnerabilities, even if expressed in different forms.
• However, in most situations, in-depth analysis or painstaking rigour is simply overkilled.