Demystifying Contemporary Finance Theory and other lessons in investment

An excerpt from Anirudh Rathore’s ‘Investing Decoded’, a valuable guide for all investors

GN Bureau | November 24, 2023


#Investment   #Stock Market   #Finance   #Economics  
(Illustration: Ashish Asthana)
(Illustration: Ashish Asthana)

Investing Decoded: Simple Path To Building A Portfolio In Millions
By Anirudh Rathore
Penguin India, 320 pages, Rs 499

‘Investing Decoded: Simple Path To Building A Portfolio In Millions’ is a very accessible guide for learning about the risks, benefits, methods, and tools required to start building a good equity portfolio on one’s own.

Anirudh Rathore, a banker turned entrepreneur, brings together his long experience and research in this book, offering simple tools and mindset tips to help you understand stock markets, manage risks, and follow trends.

The author believes the stock market is for everyone—you shouldn’t need a degree in finance to be able to invest and grow your money. Led by this tenet, he distills his learnings in ‘Investing Decoded’, based on classic treatises on value investing and years of experience from growing his own portfolio.

This book is the definitive beginner’s guide to acquiring the tools and mindset required to decipher and understand the functioning of the stock markets, while also developing a firmer grasp on the risks involved and trends, and how they impact your portfolio. Whether you are a business person, a working professional, or a student of the stock market with a focus on wealth creation, Investing Decoded will equip you to start securing your financial future.

As a bonus, the last chapter in the book offers the author’s stock recommendations as well.

Here is an excerpt from the book:

Demystifying Contemporary Finance Theory

Modern finance theory was built on the foundations of the capital asset pricing model, random walk theory, the efficient market hypothesis and the modern Portfolio Theory.

The Capital Asset Pricing model or [ERi=Rf+βi(ERm−Rf)]—don’t worry, was just writing it to scare you a little bit—tried to answer what returns should be expected whenever a security was bought. The random walk theory (Burton Malkiel) hypothesized that all stock prices took an unpredictable path and that any fundamental analysis of a stock was futile. The efficient market hypothesis (Eugene Fama) claimed that all available information will already be factored into the stock’s price. Modern portfolio theory (Harry Markowitz) is about maximizing the return that investors could get in their investment portfolio by considering the risk involved in the investments.

All the above theories are taught at business schools throughout the world. The objective of this discussion is to give students of value investing a peek into alternative hypotheses that have emerged over the decades. One can only strengthen their understanding of value investing after comparing the other styles with it. What emerges is the simplicity and clarity of the Graham and Dodd approach, which serves to build up its convictions further. These other theories were flying in the face of the Graham and Dodd style of value investing. Students have been indoctrinated in the above theories only, leading to complication of a simple price versus value approach into abstract mathematics used to support the other theories. The underpinnings of all these theories was that, basically, a person can most definitely not outperform the markets. They argued that the stock market is an efficient system and the prices are reflective of all the available information relevant to them. They further argued if an investor beat the market year after year, then they were just pure lucky. They also emphasized the ‘beta’ characteristics of stocks as well as ‘covariance’ of securities, which value investors have no interest in defining. Value investing, on the other hand, gives us a framework for embracing ‘risk’ and using it to see if a good enough margin of safety exists to achieve superior portfolio performance.

Luckily, we know that the market swings between optimism and extreme pessimism, which distorts the value of the stock and most certainly allows for outperformance from an investor as they can buy stocks during periods of pessimism and possibly selling stocks during periods of optimism.

The point is that we can immerse ourselves in trying to understand all theories and hypotheses. One can spend a lot of time in practically trying to make investments on the basis of these theories, but the simple fact is that very frequently, the markets misprice various securities at lower rates than warranted and that is when an investor should look into buying those securities to get larger returns.

The academic approach is a bit like assuming that the investment future is more or less already decided. Their prognosis is to instil in students that a narrow range of potential results is what an individual could hope to attain. It is a bit like going to your family astrologer, who sees your janampatri (birth chart) and predicts your future life events, and you readily accept and abide by making all your life’s decisions based on his ‘findings’. As in astrology, once your life events unfold, you are free to react and respond based on your personal choices and predilections, in the same way, markets are constantly bombarding us with different prices of securities. We can use our own insights, discipline and courage to decide what securities we would like to purchase and neglect.

The discounted cash flow method articulated by John Burr Williams, is another popular method used by finance professionals to estimate the value of an investment based on its expected future cash flows. Discounted cash flow analysis is widely used in investment banking, real estate projects, corporate finance and patent valuation. The key feature of the formula is the discounting at an appropriate interest rate. While interest rates a year or two ahead are difficult to predict, imagine how a single interest rate assumption can alter the entire present value. For example, recently, Adani Enterprises’ fair value was calculated by Professor Aswath Damodaran at Rs 948 by assuming cost of capital to be at 10 per cent. If we were to input 12 per cent as the cost of capital then the fair value drops to Rs 645. [Tweet by Devina Mehra (@devinamehra), Twitter, 8 February 2023.] One small change in the assumption creates a huge variation. Further, trying to assume future cash flows can lead to false estimations which could prove inaccurate as it is very difficult to predict long-term cash flow growth rates in companies. Working on a small range of interest rates in addition to cash flows can provide us with a better estimate of the value that we are seeking.

There is this perverse tendency in humans to overcomplicate straightforward conditions and throw a spanner in the works. It is observed that a lot of fresh investors like to straight away dive into futures and options trading strategies. They are pursuing the latest algorithm trading fads and even test arcane quant trading strategies. There is nothing wrong with attempting to adopt all these complicated investing approaches and there are some participants who have a good record in adopting such investing styles successfully. However, these are very few. When far simpler methods whose efficacy has been proven over decades, are available to us—such as value investing—for growing our portfolios, then why take to esoteric game plans?

[The excerpt reproduced with the permission of the publishers.]

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