Measure the return properly, name the risks you took to earn it, and judge the return per unit of risk. Then watch your own biases.
An investor expects two things: a return, and, more importantly, the capital back. Safety of capital matters as much as return. Judge a return by its level, its volatility and its nature (periodic income or capital gain).
A return in rupees means little on its own; compare it with the capital that earned it.
Higher is better, and it is simple to use. But be careful with investments whose returns are not known in advance, such as equity and mutual funds: their ROI is an estimate built on past returns and assumptions.
A return measure should help investors judge whether the return is enough for their goals and risk, compare investments, and compare against a benchmark. Total return = periodic income (interest, dividend, rent) + change in value, whether realised or not. Gold and other commodities give no periodic income at all.
150 × 25 + 20 = Rs 3,770
Sale 150 × 30 − 20 = 4,480. Dividend 150. Total Rs 4,630
4,630 ÷ 3,770 − 1 = 23%
(23% ÷ 15) × 12 = 18.4%
Divide by months (or days) held, multiply by 12 (or 365).
(4,630 ÷ 3,770)1/5 − 1 = 4.2%
Counts compounding.
Risk is the volatility and uncertainty of returns and, at the extreme, loss of capital. An investment is also risky if actual returns differ from expected ones. A bank fixed deposit is low risk; equity is risky because dividends are uncertain and values swing. Higher return comes only with willingness to take higher risk. Investors should know which risks they face: a retired investor may accept low returns but not loss of capital.
| Risk | What it is | Book's example or note |
|---|---|---|
| Inflation (purchasing power) | Money received is worth less after inflation | Highest in fixed-return instruments: an 8% bond with 7% inflation earns 1% real. Lower for equity, as profits rise with prices. Venezuela 2018: inflation 65,370%; bonds became almost worthless; the Caracas index rose over 1,000 times |
| Interest rate | Bond prices fall when rates rise and rise when rates fall | Also hits equity: higher cost of capital lowers present value, borrowing and profits |
| Business | Risk in operations; measured as the standard deviation of EBIT or EBITDA | Includes commodity, operations, competition, supply chain and currency risk. Reduced by holding varied businesses |
| Market | Loss from adverse price moves in a traded asset | Affects equity, bonds, gold, real estate. Deposits and small savings have none, but also do not appreciate |
| Credit (default) | Issuer may not pay interest or principal | A sovereign has no default risk on local-currency debt (it can tax or print). Measured by credit ratings: AAA and A1 highest, D is default. Reduced by diversifying |
| Liquidity | Cannot sell when wanted, or only below value, or at high cost | Indian corporate bonds, property and art; lock-ins. Book: a Sovereign Gold Bond order book on 17 July 2020 had a bid-ask gap above Rs 80 (about 2%) |
| Call | A bond is called before maturity | Most common when rates are falling: issuers replace high-coupon bonds. Goes with reinvestment risk |
| Reinvestment | Coupons may have to be reinvested at a lower rate | Rates rise: risk falls. Rates fall: risk rises. A cumulative option avoids it (but a bond may then swing more in price) |
| Political | Unfavourable government action: nationalisation, tax or licensing changes | Almost all businesses are exposed |
| Country | Socio-economic-political-cultural risks of a country; it may not honour its commitments | A country default affects all securities issued there |
Felt across investments: government policy, external factors, wars, natural calamities.
Market, inflation, exchange rate, interest rate, reinvestment risk.
Specific to one security or a small group. Reduced by adding other assets.
Credit, business, liquidity risk.
Risk is the variability of possible outcomes, both up and down, though we usually mean the downside. The book separates risk from uncertainty: when we know nothing about a cause (like a tsunami or COVID before they happened), it is uncertainty; once research explains the cause, it becomes a measurable risk. Risk is "known uncertainty".
Variability of returns around the mean. For a sample: s = √[Σ(X − mean)² ÷ (n − 1)].
Maximum loss over a period at a given confidence level. VaR (1%) of 12%: 99% confident the loss will not exceed 12%; a 1% chance it will. Confidence level = 1 − significance level.
Beta measures systematic risk relative to the market index: the risk that cannot be diversified away. It is used in CAPM (Chapter 10).
Moves with the market. Market +10%: stock +10%.
Less volatile than the market.
More volatile. Beta 1.2, market +15%: stock +18%.
A valuation model is only as good as its inputs. Identify the critical variables and see how the value changes when one variable changes and all others stay constant. That is sensitivity analysis. Example: in a DCF, run the valuation at several discount rates and tabulate the results. Scenario analysis instead takes a best case, a worst case and the most likely case.
Popularised by Benjamin Graham, "the father of value investing", and followers such as Warren Buffett. Margin of safety is the gap between value and price when a security is bought well below its intrinsic value. The bigger the gap, the bigger the margin.
| Bonds | Equity | |
|---|---|---|
| Main source of return | Coupon income, plus some gain when rates fall | Appreciation in value; dividend is a small part |
| Assurance | Pre-defined coupon; may be secured | No assurance of dividend or appreciation |
| Risk and return | Lower risk, so lower return | Higher risk |
| Primary risk | Default risk: higher credit risk means higher interest | Company performance and the economy |
Buffett, as quoted in the book: compare the returns on bonds and stocks when deploying capital. If stocks offer more, buy stocks; if bonds offer more, buy bonds. In distress, rates fall sharply and equities may be "dirt cheap" even on dividend yield.
A high-risk strategy usually earns more in the long run but swings more. So compare portfolios on return per unit of risk. For all three measures below, higher is better.
| Measure | Formula | Risk used | Suits (as per the book) |
|---|---|---|---|
| Jensen's alpha | Portfolio return − [Rf + β × market risk premium] | Beta (systematic). Excess over the CAPM return | |
| Sharpe ratio | (Portfolio return − Rf) ÷ Standard deviation | Total risk (standard deviation) | Investors with much of their wealth in one investment, not adequately diversified |
| Treynor ratio | (Portfolio return − Rf) ÷ Beta | Beta (systematic) | Investors who have adequately diversified across asset classes |
Classical finance assumes people are rational. In practice, emotion and psychology drive decisions. Benjamin Graham, in "The Intelligent Investor", said markets are more psychological and less logical. Behavioural finance combines psychology with economics to explain irrational financial decisions. Simon Savage of GLG Partners, quoted in the book: "We were all born to be bad fund managers because of inbuilt behavioural biases."
Strongly preferring to avoid losses over making gains. The pain of a loss is about twice as strong as the pleasure of an equal gain. Leads to inaction: holding losers, avoiding equity when volatility is in the news.
Seeking or reading information so it confirms what you already believe. A trader whose reason for buying fails invents a new reason to hold.
Valuing what you own more than others would. You hold positions you would not buy at today's price.
Predicting random events from the past: believing something that happened often will now happen less, or the reverse, to "balance" things.
Winning a competitive bid by overpaying. A behavioural win, a financial loss.
Following others in the belief they know more. Leads to bubbles and crashes; small investors enter when markets are overheated. Keynes: "It is better for reputations to fail conventionally than to succeed unconventionally."
Relying too much on the first piece of information. Waiting for a "right price" to sell that is no longer realistic, and ignoring new information.
Projecting the recent past into the distant future, ignoring the more distant past.
Markets move in bull and bear cycles. Great investors teach discipline through both.
"In the short run, market is a voting machine but in the long run, it is a weighing machine."
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."
"Rule No.1 is never lose money. Rule No.2 is never forget rule number one."
"Invest at the point of maximum pessimism."
"Go for a business that any idiot can run, because sooner or later, any idiot is probably going to run it."
"Psychology is probably the most important factor in the market, and one that is least understood."
"If you can't find good value investing positions, park your money in cash."
"Understanding how to be a good investor makes you a better business manager and vice versa."
Stock exchanges exist to provide liquidity, but not every share is liquid: liquidity needs many buyers and sellers.
Shares traded in a period (usually a year) ÷ free float shares outstanding.
Free float: shares held by non-promoter shareholders.
Traded value of shares ÷ market capitalisation.
The book ends with real cases from market history. Its point: life is too short to learn only from your own mistakes, so learn from others'. It quotes Mark Twain: "We learn from the past that we don't learn from the past."
Nick Leeson headed derivatives trading at Barings Futures Singapore, a subsidiary of Barings Plc, London. He was a star trader and a favourite of top management. He ran both the front office (trading) and the back office (checking and reporting).
Sold many straddles (a call and a put sold together) on Nikkei 225 index futures, on SGX-DT in Singapore and the Osaka Securities Exchange. A straddle loses if the market moves sharply either way. It was a bet that Japan's market would stay stable.
A violent earthquake hit Kobe. The Nikkei fell and the put side of his straddles lost money.
Instead of cutting the loss, he bought huge long Nikkei futures on both exchanges to hold the index up. He told London it was arbitrage between the two exchanges, and told each exchange he had opposite positions on the other.
One trader could not turn the market. It kept falling, and Barings failed on both the futures and the straddles. The exchanges stayed safe because they had collected margins.
Lessons 1 to 3 are for trading firms, 4 for exchanges, and 5 is the one SEBI has acted on in India.
Lent to less creditworthy borrowers and loosened loan to value (for example from 80:20 to 85:15) to earn higher margins (NIMs). They assumed ever-rising house prices would cover any default: a view on real estate, which is not a banker's job.
To lend more, banks sold long-dated mortgages to investors at lower yields, booked the profit up front and earned bigger bonuses. They stopped caring about credit quality as long as someone bought: moral hazard. Lending became a fee business.
Got almost 100% financing, so they treated a house like a call option: if prices rose, sell and keep the profit; if prices fell, hand the keys to the bank.
Funds bought mortgage-backed securities and passed them on, like passing the pillow. Rating agencies gave them top grades (AAA kind) based on history and the hard assets behind them. Many credit derivatives were written on them too.
When prices began to fall, defaults rose and it came down like a pack of cards. The last holders were left with securities worth a couple of cents to the dollar.
Warren Buffett: "People with pen do much bigger thefts than the people with guns."
| Who | What happened | Outcome in the book |
|---|---|---|
| Enron | Power trading company. Massive accounting fraud wiped out $78 billion of market value | Bankrupt in 2001. Former President Jeff Skilling: 24 years in prison |
| WorldCom | Telecom giant. Top management manipulated the financials; once had over $100 billion in assets | Fraud-induced bankruptcy in 2002. Former CEO Bernard Ebbers: 25 years |
| Satyam Computers | Promoter Ramalinga Raju confessed in 2009 to inflating cash and bank balances by about Rs 5,000 crore, after a failed bid to buy Maytas, another promoter-owned company | Jailed on fraud charges. Satyam was later acquired by Tech Mahindra |
| Bernard Madoff | New York money manager. $65 billion Ponzi scheme, the largest financial fraud in US history, exposed in December 2008 | Sentenced in June 2009 to 150 years |
| Michael Milken | Drexel's "Junk Bond King" of the mid-1980s. Brought down by insider trading | 10 years in prison; $600 million fine |
| Raj Rajaratnam | Co-founded hedge fund Galleon Group in 1997. Arrested in October 2009 for insider trading | Sentenced in October 2011 to 11 years and a $10 million fine |
Tap the card to flip. On a keyboard: space flips, right arrow = got it, left arrow = again.
Scoring works like the real exam: +1 for a right answer, minus 0.25 for a wrong one, 0 for a skip. Skipping is allowed.