Tuesday, October 23, 2012

Nobel Prize in Economics - 2012

Two US Economists, Loyd Shapley and Alvin E Roth shared the Nobel Memorial Prize in Economic Sciences for 2012.  Though, I haven't read the works of these Economists, I started reading about their work recently and thought of sharing some interesting points with my readers.  This year's Nobel Prize represents simultaneous recognition for theory and practice.  While Shapely's research along with David Gale in game theory developed the foundation for the theory of match making, Roth applied this theory to various practical situations.

The most interesting part of their research is that it deals with a slightly different aspect of economics compared to the traditional one.  We all learn in basic economics the theory of demand and supply with price as the meeting point.  But Shapley and Gale recognised many situations, where the matching of demand and supply is not done based on price, but other considerations.  Their most influential paper of 1962 discussed the cases of college admissions and stability of marriage.  We can see that in the decisions like marriage, choosing a college etc, the demand and supply interaction (or match making) is not based on price.  They started by asking 'can we develop an algorithm where, from a group of men and women willing to get married, the matching is done in such a way that no individual would have chosen any other individual as their partner?'.  In other words a perfect match making would be possible.  We may wonder, in what way mathematics could help in this process; but that is exactly what Shapley and Gale proved.  Needless to say, in practical life, the model had its own limitations in case of marriages.  However, there were many other situations of match making, where this model proved extremely useful.  That is what Roth did by applying the the above theory to various cases like school admission, kidney transplantation, placement of medical graduates to hospitals etc.  So, Roth was actually putting into practice, what Shapley had developed two decades ago.

There is another speciality for this year's Nobel.  Till now as many as seven economists have won Nobel Prize in Economics for research based on game theory.  But all of them represented research in non-cooperative games, where the objective is to develop strategies for one party to maximize his/her gain.  But this is the first time, two researchers have been awarded the prize for research on cooperative games.  Probably it is time the world starts looking for alternatives from the 'cooperative win-win game models', as Siddharth Singh wrote in Live Mint: 'I was a little surprised by the announcement, but perhaps, the Nobel committee is worried about the consequences of unfettered capitalism of the kind that usual game theory (non-cooperative games) celebrates'. 

Tuesday, October 16, 2012

Planning - the way to reduce Pain

A recent news item regrading the wife of an airlines employee committing suicide due to financial distress created lot of noise.  She claimed that her husband was not paid salary for 4-5 months and that created lot of financial problems.  The story of suicide by farmers has become a regular one.  But the heat of financial distress pushing the middle income families to take such drastic steps is a recent phenomenon, at least in India.

This brings to light the ignorance of 'personal financial planning' among most of the middle class families.  During the last decade or so the spurt in new-age technology related jobs, where the average salary of an individual was far above the other sectors, created a new section of middle class people.  When a young boy or a girl, in early twenties, is offered a fat salary, they tend to forget the importance of 'financial prudence' and indulge in acquiring assets like luxury apartments, high-end vehicles and develop a life style that demands lot of cash.  Most of these assets are acquired by taking loans against the fat salary.  As long as the salary keeps flowing in, the pinch of EMIs is not know.  But what they fail to realise is that these EMIs are here to stay, even if the salary moves downwards or even stops for a couple of months.  Debt is like a knife with sharpness on both sides.  When the fruit that is being cut is ripe and soft (read, good flow of income), it cuts the fruit easily; but when the fruit is hard (read, fall in income), it cuts your finger.   This is where the importance of financial planning lies.  The most important aspects of financial planning are:
(a) Investment planning
(b) Tax planning
(c) Risk Management & Insurance planning
(d) Retirement planning
(e) Estate planning

Today, there is no dearth for literature on financial planning.  There are many books, websites and even agencies offering this wisdom.  But what is more important is to take the advise from them and use one's own wisdom to plan the finances properly.  A step-by-step approach to financial planning is given below, which is taken from the book, 'Personal Finance' by Jack R Kapoor, Les R Dlabay and Robert J Hughes.


In the first look, this might appear cumbersome, but it is not so.  And moreover, it is not necessary that an individual goes through each step.  What is expected is that each individual is at least aware of these aspects and spends some quality time planning his/her finances.  This would make him/her better prepared to face financial adversities in future; and thus reduce the pain.

Friday, October 5, 2012

Markets on Fire - Boom or Bubble?

The SENSEX which stood at 17300 points about a month ago, has shown a steady rise to close above 19000 yesterday - a 15 months high.  The economic press was filled with the stories of this continued rally.  I started wondering, what is it that is pushing the markets high.  Did anything change fundamentally during the last few days to justify this rally?  But the markets have always been like this!  And this is where the greatest lesson for small-time retail investors lie.

Let us look at the stated reasons behind this rise.  A slew of announcements from the central government, like FDI in multi-brand retail, aviation etc. and increase in diesel prices and a cap on the number of LPG cylinders, which are expected to push the reforms further, is all that what we had during the last couple of days.  Keeping aside the increase in diesel prices, all other announcements are just announcements and yet to be implemented.  Yes, it is true that the Rupee has gained value against the dollar and the RBI has marginally reduced CRR.  Yet, the hardcore issues like inflation continue to haunt the policy makers.  So, what is it that drove the markets up?  The answer is simple - these announcements, or to be more precise, the news of these announcements.

What the small time retail investor should learn is that the markets do not necessarily react to events.  They react to news!  I keep giving the following example while teaching investments.  When you hear the news that your close friend is getting married, you jump out of excitement and reach out to congratulate him.  You do this immediately, though your friend is yet to get married.  And on the day of his marriage, however happy you might be, you would never experience and exhibit the same excitement that the news of his marriage brought to you when you heard it first.  If this is how individuals behave, can the market, representing a huge congregation of individuals behave differently? No.  Hence the markets almost always react to news and not events.  Barring few occasions, when an event as well as the news of the event comes together, in all other cases the news comes first and the event later.

So, the small-time retail investors have to be very cautious during this time.  Most of the times, they are the last to enter the market lured by the upward trend and after they enter, the markets start moving in the reverse direction!  While I am writing this, I can already see that the Sensex has fallen more than 100 points to close at 18939 today!  My suggestion to such investors would be to avoid speculation based on the short-term movements of the market.  I still believe that the economy is fundamentally strong and investments with medium to long term perspective (in good quality stocks) would definitely generate good returns.  All small investors should always look at equity as a long term investment.

Wednesday, October 3, 2012

Loss, Profit and Value - Facts or Fiction?

Thanks to the wide media coverage, today, the economic issues concerning the nation are discussed with such great interest, which was, perhaps never seen before.  The CAG's views and his loss calculations on a series of  issues like 2G, coal blocks etc. generated lot of heat.  Recently, the ex- Chief Justice of India, reportedly made a comment that 'the loss is a fact and the profit, a matter of opinion'.  The subsequent days witnessed lot of discussions around this statement.  Let us look at it from a corporate finance perspective.  The reported profit or loss of a company is not sacrosanct, as it is reported by the company itself!  One may argue that the accounts are audited by independent auditors; and hence, could be construed to be presenting a 'true and fair' picture of the state of affairs.  But the towering examples of Lehman Brothers and Satyam go against this argument.

There are many ways in which a company can manipulate its accounts to exhibit a totally different picture as against the reality.  On one side, we have firms which presented rosy profit figures before raising funds from the public; and on the other side, there are firms which kept making losses (intentionally) to attract certain benefits.   Few years ago, the government was forced to introduce Minimum Alternate Tax (MAT) to tax those companies, who had intelligently found ways of avoiding tax by exploiting the loopholes in the tax laws.  A recent issue of ET Wealth (24 Sept 2012) sums up various ways in which a firm dresses up its accounts, like not reporting certain expenses, capitalisation of revenue expenses, tampering with depreciation, over/under invoicing of revenues etc.  Swaminathan Anklesaria Aiyer says 'I know of no principle in economics or audit that says losses are real, but profits are not' ('Profits and Losses Are Not Facts, The Economic Times, 26, September, 2012).

Profits and losses are historical numbers, so let us look at the principles of Valuation.  Value of any asset is defined as the present value of the future benefits expected to be derived from the asset.  There are two important components that go into the valuation exercise - the expected future cash flows representing the future benefits and the required rate of return used to compute the discounted value (present value).  The first component, cash flows, as the name suggests are 'expected'; hence are subjective and a matter of opinion.  Same is the case with the discount rate, which is again, based on the expected rate of returns, and hence subjective.  So, any exercise of valuation is also subjective and not a matter of 'fact'.  As Aiyer says, the only matter of fact is the price that one pays to acquire the asset!  Market price is a fact, as this represents the actual payment made by the buyer to the seller.  But ironically, the market price keeps fluctuating almost on a real time basis!

I would like to go with Prof. V Raghunathan, who says '...CAG has not only shown his innocence of the principles of financial engineering involved, but also confused the entire issue, so that it is difficult for an average person to appreciate where the CAG may be right and where he may be wrong.' (Intent versus Fact, The Economic Times, 21 September 2012).