October 28, 2005

It is easy to know what will happen in the market, but difficult to know when

The above comment is from warren buffet. He has also written in the annual letters that he prices the market, rather than time the market. The difference is substantial between the two approaches. The first one, is based on valuation and understanding when the market price is way above the intrinsic value and then going ahead and selling the overvalued security.

The second approach of timing the market is based on psychology of the market and is very difficult (at least for me) to do consistently. People try technical analysis, charts etc to time the market and there could some investors out there who could be good at it. But I have never tried it, as it is too difficult and not really productive for me.

The approach in ‘pricing’ the market works in areas beyond the stock market too. Let me give a personal example

Interest rates in India have fallen for quite some time. From a 10% in 2001 to around 6-7 % by 2004. This was the time to be an investor in debt as debt funds gave good returns. In 2004 I was looking at a housing loan and had an offer of 7.75 % fixed versus 7.25 % Variable. The loan officer ofcourse was very enthusiastic about the variable loan and kept pushing it. I however was keen on the fixed loan and had worked the following math (with assumptions)

Long-term inflation – 5-6 % (assumption on the lower end, can be higher)
NPA – 0.5-1 %
Cost of loan servicing for an HFC – 0.25 – 0.5 %
Return on asset – 1.5 % (for an HFC to earn a reasonable return on equity)

The effective cost (rate an HFC should charge me) should be around 7.5 % - 9 %. So with all the optimistic assumptions built into the ‘value’ of the funds, it should not be priced below 7.5%.

As the bank was offering 7.75 % fixed for a tenure of 20 years, I felt the loan was underpriced and opted for a fixed rate loan.

I could be wrong in my decision if
  • Inflation for next 20 years remains below 5 %

  • NPA for most of the HFC are below 0.5 %

But the odds are that over a 20-year period, we could have periods of high inflation and high NPA. So I went ahead with the fixed rate loan. At the same time I moved out of debt funds and into floating rate funds.

I found the approach of pricing (and working on odds) the market much more productive. I am not right immediately and so there is no instant gratification (all my friends in 2004 kept saying that floating rate is the way to go). But if my logic is correct and I make a rational, informed decision, it has worked out for me.

Please share any such experiences you would have had

1 comment:

Prasanth said...

I locked my interest rate on the home loan at 7.5 % fixed for 20 years (i Got a .25 % reduction because of the special rate to my company) at the time when all my collegues were going for Variable rates. Was lucky.