Why are we the way we are?
The human mind spent most of its evolution time while we were hunters. Compared to the period of evolution from alligators to humans, only a small fraction of that time has been spent as ‘human beings’. Moreover, a tiny fraction (about 5000 years) has been spent in migrating from jungle hunters to Investment Bankers. Divide 5000 years by about a billion years and you get 0.0005% of the time.
So a brain that spent its time, evolving in an animal world dominated by tigers and dinosaurs for 99.9995% of its time, is now expected to adapt quickly to a world dominated by Goldman Sachs and Alan Greenspan, in the remaining 0.0005% of its time. Can you see the ‘culture shock’ it is in? How quickly would you adapt, in the first 2 seconds of your existence on Mars?
The Flaws in Our Thinking
This is to give you some idea of just how inappropriately we are designed for the modern world. First, we can’t stop thinking of money as ‘prey’; we confuse income with wealth because it is the same money, isn’t it? But one is a flow and the other is a corpus…don’t you get it? Is a tub full of water to be managed the same way as a tap?
It leads to very strange mental paradigms…for example, the earning of money is often confused with the possession of wealth. In the real world, the two do not have the same correlation that our soppy brain thinks. Behavior that creates one does not necessarily lead to the other; in fact, under certain conditions, one is antithetical to the other.
For starters, most of us cannot think in terms of Discounted Value, Net Present Value, or Compounded Value. This is why we will compare Real Estate bought in 1971 with 1971 Rupees, and today’s prices calculated with today’s Rupees. And come to bizarre conclusions, like ‘Real Estate is the only good investment in the long run’.
What is not an asset?
When we buy a car, we classify it as an ‘asset’, because Accounting rules permit us to do so. But a car is never worth what you paid for it, and it represents Liability. If we were to take into account the commitments on account of fuel, maintenance, Insurance, and EMI payments, the car would come out to be one hefty liability. Yet, just because the car has been bought for cash, it is classified as an asset. Does a father-in-law think of his groom as an ‘asset’, just because he paid a dowry? We all know from painful experience, that this is just the first installment of a lifelong liability; why don’t we think of cars the same way?
In the same manner, we do not NPV a liability stream and provide for it. We will buy a second vacation house, with no idea that we have to pay for security, upkeep, and repairs for the rest of our life. Almost all the ‘assets’ that we count in an accountant’s Balance Sheet are hidden liabilities, but we don’t know it.
Rarely can we sit on cash, or even more rarely, can we evaluate and invest in income-earning assets. Mostly, such assets (i.e. bonds and equity) derive their income from complex organizational systems, which are difficult to evaluate. If we define an asset as something that earns an income above the rate of inflation, then only a few asset classes would qualify: gold, equities, and volatility are 3 that I can think of. Bonds can sometimes also make the list, provided they are bought at a discount, at or near the top of an Interest Rate Cycle.
Gold (and some other precious metals) have preserved their value over a long period of time, so a long–term investor would do well to trade gold volatility. The same goes for equity in long-term value-creating cos.
The problem with the physical assets
Notice that all physical assets take maintenance, and produce no return, especially if they are passively held. Only those physical assets that are put to use, sometimes produce a net return, but rarely beat inflation (especially when measured in inflation-adjusted current Rupees).
The other problem with most physical assets is that their value is invariably derived from the value of the underlying income, with which the customer buys the assets. That is why certain macroeconomic ratios (like house prices-to-disposable income) don’t vary much across countries, after allowing for levels of leverage. That makes it easier to locate a bubble. Here is one case where there is a relationship between flow (income) and corpus (wealth).
Based on the cost of capital (which itself varies with macroeconomic variables like the savings rate, liquidity, and capital flows), equities also discount income into an NPV, the equity price. Here is another case where a flow of income is converted into a corpus of wealth. In both cases, the investor has to estimate the trajectory of income growth and the discount factor. The latter is arcane and is the source of most investor mistakes.
Real Estate and Gold
One would think that in the case of real estate, investors would find it easier to get it right. After all, one can always work out a Rule of Thumb: in India, real estate prices vary between 4-7 years. Anything above that, except in South Mumbai, is bubble territory. Abroad, real estate prices vary across the same range, but with much lower savings rates and far higher leverage. In India, savings rates are typically 40-50%, and leverage is almost never above 50%. That means the typical housing mortgage is paid off in 10-12 years, while it takes 15-30 years abroad.
Gold is the joker in the pack. It has no intrinsic value of its own, hence the earnings potential of gold is only the value of its Volatility. Valuing gold would take an understanding of the Money Supply and the availability of ‘sweat’; it is difficult to evaluate it accurately, which is why gold is often called the alternate currency. But at least gold does not soak up capital in its maintenance, hence it qualifies to be called an asset.
Volatility as an asset
A third asset that you might at first find intriguing, is an intangible asset called Volatility. (I’ve written an article on Risk and Volatility) The sum total of all the zigs and zags on a stock chart is many, many times the amplitude of such a (stock) chart. If you can harness Volatility towards reducing your investment cost, you get the Cashflow (from such Volatility) for free. That translates into a whopping return, unbelievable to those who are used to working for money.
Harnessing Volatility is an art, the el Dorado of investing. If you can catch even 2-3 cycles in your life, you will do well for yourself. This is truly a complex art, considered simply unfathomable by most ordinary people. Yet it allows a huge margin for error and rewards its proponents handsomely.
Volatility is relative, we often see in gold prices rising because the Dollar is weak, or vice versa. Some approximate mathematical relationships do exist between correlated assets, but one must be careful that such relationships do not break down. A good strategy for the novice investor would be to set himself a certain ‘daily’ income and trade with a fixed but small movement every day. The actual risk taken is very little, but as the strategy compounds, it can deliver very good returns. If we pick an asset whose (relative) value to paper money does not change over time, the money earned by the volatility is real. As it compounds over time, it will outperform almost any other value-creation mechanism.