The Behavior Gap – book review

In his book – The Behavior Gap, Carl Richards puts his thoughts out by listing simple ways to stop doing dumb things with money. What hits the point home are simple graphs drawn on a tissue with a sharpie.

One of the few personal finance books that do not list out elaborate plans and outcomes – there are exactly zero investment ideas or avenues mentioned in this book. What the book wants us to understand is that there is no secret sauce, no next hot stock, no perfect investment. But what this book wants us to understand is that financial planning is simple and depends a lot on common sense.

While listing every important point I have read in this book would be second to none, I would be focusing on the more hard-hitting points in this post –

We do not beat the markets, the markets beat us

The titular reference of the behaviour gap, i.e. the difference between investmentreturns and investor returns. Greed and fear make the best of us abandon our investment ideas at the first sign of weakness or contrarian market movement. All of us, be it dumb money or smart money are guilty of entering and exiting investments on multiple occasions over the course of time. One of the smarter investors I know, has experienced this over the period of 6 years from 2006 to 2012 where he entered and exited Titan Company on at least 4 occasions instead of holding onto his dear investment. While I am sure this mistake has made him wiser, but I am confident that had he held onto his investment instead of the churn, he would definitely have been a lot wealthier. You can read about his blog here.

But how can you beat the market?

We have all read extensively about Warren Buffett – the Oracle of Omaha. Possibly read all of his letters to shareholders, analysed every interview dating back decades. It might interest readers to know that Warren Buffet has made 99.7% of his wealth after the age of 52. You can read the article here. In reality, while it looks like he beat the market (which he definitely has), the bigger point is that he actually beat time! Warren Buffett started investing at the age of 11, and in about 4 months, he will be 88. That’s a little under 8 decades of investing. Talk about long term. As shown in the chart below – a dollar invested in 1941, when Mr Buffett started investing, returning 10% over 78 years would grow to a little under $1,700 today! You wouldn’t have made much money till 1982, but so didn’t Mr Buffett!

Carl Richards makes a very small, yet significant statement which will remain with me for the rest of my life – “Slow and steady capital is short term boring, long term exciting”.

Long term memory loss & the recency effect

Now that we are aware of our behaviour gap, we logically look for ways to close the gap. One of the biggest and ever-changing factors that affect market movement, and in turn investor behaviour, is investor expectation. As Carl Richard says – “Boom-and-bust cycles are largely a function of our collective expectations.”

Our most recent experiences dictate our near-term expectations. I would like to bring to the readers’ notice of this news article on 5th October 2018, where an analyst predicted the Nifty 50 index would fall to 9,900 levels from 10,514. It was also a prediction of a very painful next one-and-a-half months for equity investors. No doubt, the index fell to lows of 10,004 on 26th October 2018; However, contrary to the prediction, exactly 45 days after the article, instead of pain, the index reached highs of 10,740 on 20th November 2018, which is a gain of 2.15% from the day of the article.

On a similar note – I would like to talk about Symphony Limited. This asset-light, negative capital employing company has a disproportionate market share in the Indian air cooler industry. You can read about our investment thesis here. It is end of FY19, and the company has faced two consecutive bad summers (in terms of an air cooler company, a mild summer which isn’t hot enough for air cooler sales – is a bad summer!). Even worse, the company has had 4 consecutive quarters of YoY earnings degrowth. Our limited recent knowledge would persuade us to allocate our capital elsewhere – in businesses which can deliver earnings growth. We extrapolate recent past as a precursor for long-term thought process. However, it would behoove the readers to know that the company faced a similar situation in FY97, when, due to a bad summer, revenues dropped 32% and earnings de-grew by 69% YoY. What followed is a strong pullback in revenues, and earnings growth. The same company has grown its earnings at a CAGR of 36% between FY97 and FY18.

Just as historian and philosopher George Santayana said, “those who cannot remember the past are condemned to repeat it”. If we let recent occurrences dominate our long term thought process, getting caught in the cycles of boom-and-bust is a no brainer. Carl Richards suggests a too-simple-to-be-true way of avoiding this mistake – “lengthen our definition of the past”.

Chasing income is bad for your assets

Debt instruments are vehicles to invest capital with the least amount of risk. Debt mutual funds are pooled investment vehicles that invest in different risk profiles within debt instruments.

Bond risk is denoted by ratings – with Sovereign being lowest risk, followed by AAA, AA and as we go to letters B and C, risk increases manifold.

Below is the table of three similar Corporate Bond schemes from three different fund houses.

Source – https://www.valueresearchonline.com

What we understand from this table is that- to earn a little over 100 bps over an HDFC Corporate Bond Fund scheme over 5 years, an investor would have to be willing to take on higher risk by investing in the Franklin India Corporate Bond Fund. Readers should note that while the HDFC scheme has over 91% of its assets in AAA and above, the Franklin scheme has just 53% of its assets in a similar safety bucket. We can see that over a 1-year time frame, an investor is just compensated with an extra 70 bps over the HDFC scheme by the Franklin scheme in spite of taking a higher overall risk.

This makes me question – is incremental 1% return on capital worth taking a risk of 40% of the return of your capital? We should note in Carl Richards’ words – “if potential returns are high, the risk is also high”.

Concluding this post, I can reasonably believe that I am not dumb money. Nor can I confidently say that I am smart money. But as long as I can make decisions that are simple and safe and makes me secure about by money, I can reasonably reach that 52nd year of Mr Buffett by my 70th year. And even then, it wouldn’t be that bad.

This book would be a recommendation to any and everybody planning their finances. I would be happy to have a conversation. Do share your thoughts on this topic!