Famous Folks - Alan Greenspan

#18

Who?

• American economist
• Chairman of the Federal Reserve from 1987 to 2006

Career and Personality

• Came to the Federal Reserve Board from a consulting career
• Subdued in public appearances, but media and followers considered him a rockstar
• Criticized by Democratic leaders of Congress for increasing the deficit via his support for Social Security privatization and tax cuts
• Called 'inflation hawk' because of his inflation policy, wherein critics claimed he was focusing on controlling prices rather than achieving full employment
• Blamed in part for both the 2000 dot-com bubble and 2008 financial crisis
• Known for being adept at gaining consensus among Fed board members on policy issues and for serving during one of the most severe economic crises of the late 20th century, the stock market crash of 1987

Views and Contributions

• Greenspan was found by the Financial Crisis Inquiry Commission to have contributed to the 2008 financial crisis for his failure to curtail subprime mortgage loans during the housing bubble
• In a 2004 speech, he suggested that more homeowners should consider taking out adjustable-rate mortgages (ARMs) where the interest rate adjusts itself to prevailing market interest rates
• He argued that the housing bubble was not a product of short term low-interest rates but rather a worldwide phenomenon caused by the progressive decline in long-term interest rates
• When interest rates rose, it reset people's mortgages to higher payments causing even more distress for homeowners, exacerbating the impact of the crisis
• He advocated for slashing interest rates after the 1987 stock market crash to prevent the economy from sinking into a depression
• After the 9-11 World Trade Center attack, Greenspan led the FOMC to reduce the Fed funds rate from 3.5% to 3% and subsequently to 1%; despite this, the economy remained sluggish
• The easy-money policies of the Fed during his tenure such as the Greenspan put have been suggested to be a leading cause of the dot-com bubble
• He used the phrase "irrational exuberance" to imply a warning that the stock market might be overvalued

Objectivism

• Greenspan met novelist and philosopher Ayn Rand in the early 1950s, who nicknamed him "the undertaker" because of his penchant for dark clothing and reserved demeanor 
• He was initially a logical positivist before he converted to Rand's philosophy of Objectivism by her associate Nathaniel Branden
• During the 1950s and 1960ss Greenspan was a proponent of Objectivism and wrote essays and articles for Rand's 1966 book Capitalism: The Unknown Ideal

The 'Greenspan Put'

• Trading strategy popular during the 1990s and 2000s
• Greenspan attempted to help the U.S. economy by actively using the federal funds rate as a lever for change
• This encouraged excessive risk-taking leading to put options being lucrative
• The 'Put' referred to a reliance on a stock market put option strategy that would aid investors in mitigating their losses, thus profiting from deflating market bubbles
• It suggested that informed investors could expect the Fed to act predictably and make put option derivative strategies profitable during crises

Fun Facts

• Greenspan’s interest in facts and figures began at age 5 when he took a liking to recite baseball batting averages of players, which helped him figure out calculations in his head
• Studied music at Juilliard and toured the country playing tenor sax and clarinet with The Henry Jerome Orchestra
• Served under four presidents, starting with Ronald Reagan and ending with George W. Bush
• Describes himself as a "lifelong libertarian Republican"

Timeline of events

• Stepped down as Federal Reserve chairman in 2006
• Global financial markets began to unravel
• Few financial institutions collapsed while governments experienced massive bailouts 
• The worst economic downturn in three-quarters of a century ensued
• Lots of people blamed Greenspan for some or all of this
• He claimed to have found a flaw, so to speak, in how the world works, in a Congressional hearing in October 2008

Awards and Honours

• U.S. Senator John Heinz Award, 1976 (Greatest Public Service by an Appointed Official)
• Fellow of the American Statistical Association, 1989
• Commander of the Legion of Honour in France, 2000
• Order of the British Empire (Civil), 2002
• Dwight D. Eisenhower Medal for Leadership and Service, 2004
• First recipient of the Harry S. Truman Medal for Economic Policy, 2005
• Presidential Medal of Freedom, 2005 (Highest US civilian award)
• Thomas Jefferson Foundation Medal in Citizen Leadership, 2007

Quotes

"It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown so enormously."

"I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant."

"Government regulation cannot substitute for individual integrity."

"Unless you are willing to compromise, society cannot live together."

"I have found no greater satisfaction than achieving success through honest dealing and strict adherence to the view that, for you to gain, those you deal with should gain as well."

"Anything that we can do to raise personal savings is very much in the interest of this country."

"The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake."

"I'm not denying that monopolies are terrible things, but I am denying that it is readily easy to resolve them through legislation of that nature."

"The very nature of finance is that it cannot be profitable unless it is significantly leveraged... and as long as there is debt, there can be failure and contagion."

"History has not dealt kindly with the aftermath of protracted periods of low-risk premiums."

"Revolutions are something you see only in retrospect."

Notes

Harsh criticism of his tenure at Fed Reserve:

Some of Greenspan’s harshest critics point to his earlier association with famed philosopher and novelist Ayn Rand. The essay he wrote for Rand, which also appeared in her book attacked the Federal Reserve and supported the gold standard to back the money.

Former Congressman Ron Paul of Texas once confronted Greenspan about his turn away from Rand’s ideas of free-market economics and the gold standard, but Greenspan stood firm with his change of views on economics.

Although Greenspan saw the nation go through tremendous economic growth through the 1980s and 1990s, his last five years as Fed chairman witnessed a 13% plunge in the S&P 500.

Greenspan featured as one of the "25 People to Blame for the Financial Crisis" Time magazine article, which also suggested that Greenspan's advocation of low-interest rates combined with the unregulated financial system may have sparked the mortgage and banking crisis.

Analysis of Franklin Templeton's Closure

 #17

Overview

• Franklin Templeton Mutual Fund closed 6 of its debt schemes in India:
• Franklin India Low Duration Fund (62.8% of assets invested in bonds rated below A+, 45.76% rated AA)
• Ultra Short Bond Fund (82.8% in AA rated, 23.9% in A rated)
• Short Term Income Plan (58.6% in AA rated, 57.5% in A rated)
• Credit Risk Fund (60% AA rated, 49.6% in A rated)
• Dynamic Accrual Fund (52.7% in AA rated, 44% in A rated)
• Income Opportunities Fund (63.97% in AA rated, 41% in A rated)

Reasons

• Illiquidity in bond markets
• Severe redemption pressure
• SEBI's opening of a window for AMCs to borrow to meet redemptions

Cause

COVID-19

What happened?

• The above 6 schemes of Franklin Templeton Mutual Fund (FTMF) took aggressive credit calls in their portfolios in the recent past
• Despite getting higher returns by taking on these high risks, the debt funds and a few liquid funds (safest of the lot) experienced tremendous volatility
• In the last 18 months due to COVID, worried investors withdrew money and exacerbated the problem

Which led to

• Shrinking of the portfolios
• Funds left with a higher proportion of less liquid (riskier) investments
• FTMF having to keep borrowing money to pay off the redemptions but reached the borrowing limit as per regulations

Outcome

Investors unable to:

• Withdraw or transfer their existing investments
• Start any SIP in those schemes
• Make fresh investments

Let's talk numbers

Debt funds:

• Outflow: Rs 1.94 lakh crore (March 2020)
• Inflow: Rs 43,431.55 crore into liquid schemes, corporate bond funds, banking and PSU funds, overnight funds, and gilt funds (April 2020)

Category-wise outflows:

• Medium duration funds: Rs 6,363.53 crore
• Short duration funds: Rs 2,309.05 crore
• Money market funds: Rs 1,210.35 crore
• Low duration funds: Rs 6,841.07 crore
• Ultra-short duration funds: Rs 3,419.32 crore

Credit risk funds:

• Outflow: Rs 19,238.98 crore (April 2020)
• Inflow: Rs 6,279.23 crore (March 2020)

What all did FT try before winding up?

Borrow

• FTMF AMC borrowed continuously to fund redemption requirements
• But were unable to repay the borrowings by selling bonds
• Will lead to gross asset-liability mismatch in the long run

Restrict redemptions

• Current terms for restrictions under the regulatory framework:
• Maximum suspension period of 10 working days limited to once in a 90-day cycle
• AMC needs to honour redemptions up to Rs 2 lakh per day per investor
• The above terms made this approach infeasible

Elongate redemption payments

• Redemptions pay-outs were being made on a T+1 basis with a maximum of 10 working days
• This approach too was unviable because it would only handle the short-term liquidity issues and not the sustained impact of the crisis

Distress Sale

• In a distress sale, the AMC would have to sell the securities at a discount to meet redemption requests
• If so, investors staying invested would have borne significant losses

Winding up was the only forced choice for FTMF.

So, when will the investors get their money?

Once:

• The macroeconomic situation improves
• Cash-flow pains will be relieved
• FTMF makes good on their debts
• Investors are allowed to withdraw their investments
• FT does an orderly sale of their investments in order to return the money to investors
• FTMF communicates an exit strategy for their schemes

Bright side

Debt fund redemptions slowed after RBI announced a Rs 50,000 crore credit support for MFs

FT can attempt to retrieve the value invested in those schemes either by selling the underlying assets (e.g. corporate bonds), or wait for them to reach maturity, when those companies will have to pay back what is owed to them.

Article: Risk in MFs

#16

This post compares the risk between equity funds and debt funds.

Risk: volatility aka fluctuation in price

Equity

• Equity funds are riskier in the short to medium term
• They have a propensity to swing more intensely in either direction

Debt

• Two aspects of risk: interest risk, credit risk
• Interest risk: 
• Interest rates may move up or down
• Rise in interest rates --> fall in bond prices (and vice-versa)
• A fund comprising long-duration bonds is subject to high risk
• Credit risk:
• Risk of default by the bond issuer
• Debt funds investing in low-rated paper are subject to credit risk

Fund types and their risk grade

Equity funds in increasing order of risk:

• Aggressive hybrid funds (least risky) (35% of assets invested in debt)
• Large companies (don’t fluctuate erratically)
• Mid and small caps 
• Thematic and sectoral funds (undertake theme-specific bets, hence riskiest)

Debt funds in increasing order of risk:

• Liquid funds (least risky)
• Ultra short-duration funds
• Short-duration funds
• Medium-duration funds
• Credit-risk funds
• Dynamic-bond funds
• Long-term gilt funds

How to take risk into account while investing

Solution: Diversify.

• Invest across fund houses and schemes
• This decreases fund-house-specific, fund-manager specific and scheme-specific risks
• Lessen portfolio risk by investing in multi-cap equity funds

Lessons from Freakonomics

#15

While you’ll find my latest book summary on the key takeaways from the book Freakonomics here, which I’ve also recommended as a good book here, let’s understand some of the other lessons mentioned in the book via simple anecdotes.

Lesson 1:

Economics is mostly about incentives, which can backfire if you don’t understand how they work

Anecdote 1:

There was a daycare that was subject to late pickups. Despite sending home notes and arguing in favour of having respect of children and their caretakers at home, there was no change. So, the daycare decided to send another note one day, saying that a financial penalty would be levied for late pickups. Instead of remedying the situation, the number of late pickups increased exponentially! This was because the guilt had been removed and the financial penalty was so low that the late pickup was now a perk accessible to most parents.

Lesson 2:

Men will lie about their height on dating websites due to information asymmetry

Anecdote 2:

Asymmetry of power refers to someone having or knowing considerably more than the another party. The ability to awe, intimidate, lie, or otherwise affect the outcome of a decision is vast. Susie’s love life moved from real life to the Internet. What was once known upfront became reported information. Though Susie checked several boxes declaring that she didn’t care about height, income, weight, or race, deep down she knew she did to some extent, just like the old times. Looks like her man too, adjusted his online response accordingly! What he lacked in reported stature, he made up for with charm and wit in person, as we would assume. Did Susie go on a second date? I guess we’ll never know.

Lesson 3:

Parenting experts are fear mongers who moonlight in product placement

Anecdote 3:

When experts rely on not knowing and use intimidation to defend their theory, some poor clueless parents fall prey to such tactics, as outlined below:

Bob and Lucy bought car seats for $200! Statistics clearly show that despite buying expensive car seats, this does not actually save more lives. 

They then purchased a 'family bed', since the salesman convinced them that they were the only parents who really cared. Unfortunately for them, they were unaware that all they had to do was advocate a parenting style that nurtured self-reliance and self-soothing. They were also oblivious to the below factors which do and do not correlate to higher test scores:

Factors correlating to higher test scores

1. Highly educated English-speaking parents with high socioeconomic status
2. Low birth weight of their child
3. Adopted child
4. Parents involved in PTA
5. Mother being 30+ at the time of their first child’s birth
6. Child surrounded by books at home

Factors not correlating with higher test scores

1. Intact family who moved to a better neighbourhood recently
2. Child watching television daily
3. Regularly spanked child
4. Mother not having gone to work between birth and kindergarten
5. Parents reading to their child often

Barbell strategy

#14

What?

• Formed when a trader invests in long- and short-duration bonds, but not in intermediate-duration bonds
• Focuses on the maturities of the securities in the portfolio by ensuring the maturity dates are either very close or at a distant date

Philosophy

• The best way to strike balance between risk and reward by investing in both extremes of high risk vs no risk assets while avoiding middle-of-the-road choices
• Be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative

When?

• Useful when interest rates are rising
• More frequently applied to bond portfolios

How?

• When short term maturities are rolled over they receive a higher interest rate, raising the value
• If an investor's money is tied up in a long-term high-quality bond, he or she won't be able to put that money in a higher-yielding bond if one becomes available in the meantime

Benefits

• Allows for a quick turnover of a significant amount of the assets in the portfolio at one time
• Reduces interest rate risk since short-term bonds can be reinvested
• Includes long-term bonds, which usually deliver higher yields than short-term bonds
• Offers diversification between short-term and long-term maturities
• Can be customized to hold a mix of equities and bonds

Limitations

• Long-term bonds held till maturity tie up funds and limit cash flow
• Inflation risk exists if prices are rising at a faster pace than the yield of the portfolio
• Mixing equities and bonds can increase market risk and volatility

Etymology

Investment strategy looks like a barbell with bonds heavily weighted at both ends of the maturity timeline

Example

Portfolio created with: 

• Speculative stocks (high risk): initial public offerings (IPOs)
• Blue-chip stocks (less risky): unprotected against ups and downs of the economy
• Bonds (safer)
• Bank certificates of deposit aka CDs (safest)

Asset allocation based on types of investors:

• Risk-loving:
• 40% in speculative stocks
• 40% in blue-chip stocks
• 20% in bonds
• Risk-averse:
• 80% in bonds
• 20% in blue-chip stocks

Related

• Contrast: bullet strategy
• Involves investing only in intermediate-term bonds
• This approach allowed Nassim Taleb, an essayist and mathematician to thrive during the 2008 economic recession while his fellow Wall Streeters floundered

Article: Intro to Debt Funds

#13

What is a bond?

• Not James or covalent, but fixed-income instruments!
• It’s like a certificate of deposit or IOU
• Issued by the borrower to the lender
• Similar to setting up a fixed deposit in a bank
• When you make an FD with a bank, you are essentially lending money to the bank

Types

Corporate bonds, Government bonds, corporate debt securities

What is a debt fund?

• A fund that invests in bonds or other debt securities
• Can be contrasted with stock funds or money funds
• Usually pay periodic dividends that include interest payments on the fund’s underlying securities + periodic realized capital appreciation

Advantages:

• Relatively stable returns
• Relatively high liquidity
• Reasonable safety
• Low cost structure

Who should invest?

• Investors aiming for regular income
• Risk-averse folks - because they are less volatile and hence less risky than equity funds or stocks

How do debt funds work?

• They are similar to other mutual funds, but they lend money and earn interest on it
• Interest earned determines the basis for the returns generated for investors

Why debt funds?

• They are able to invest in many types of bonds that are not available to individuals
• For example, the Government of India, (largest borrower and bond issuer in the country) issues bonds which individuals cannot purchase
• Mutual funds also invest in bonds issued by large and medium-sized businesses
• The funds pass on the interest income they receive from the bonds they invest in

Notes:

Additional info on bond prices

Reasons for bond prices to rise or fall:

• Change in interest rates
• Expectation of change in interest rates!

Example:

If:

• A bond pays out interest at a rate of 9% p.a.
• Interest rate in the economy falls 

Then:

• Newer bonds start getting issued with a lower rate (e.g. 8% p.a.)
• Old bond would now be worth more than before
• Its price will accordingly rise 
• Investors will see the value of their investments go up

Implications:

Mutual funds that hold this bond will find their holdings worth more, allowing them to make additional profits by selling it.

The reverse is true as well. 

If interest rates rise, mutual funds holding older bonds would see the value of their investments fall and they could lose money.

Famous Folks - Raghuram Rajan (RR)

#12

Who?

• Chief Economist at the International Monetary Fund (IMF) from 2003-2006
• RBI Governor from 2013-2016
• ‘James Bond’ of the Indian economy
• Finance Professor at the University of Chicago Booth School of Business

Tidbits from his personal life:

• RR was born in Bhopal into a Tamil family
• He was appointed as Chief Economic Adviser to India's Ministry of Finance for a year before he served as the RBI Governor
• RR is an active crusader of the free market system
• Due to his interest in math, he read Asimov's Foundation series after his friend told him about econometrics
• His other inspiration is John Maynard Keynes, whose work he finds extraordinary
• RR is an avid quizzer and enjoys reading the works of Tolkien, Tolstoy, and Upamanyu Chatterjee
• RR was extensively interviewed for the award-winning documentary Inside Job
• He suggests that capitalism serves as a handy tool to abate poverty and provides equal opportunity for all
• He believes that there is nothing more motivating than the drive to deliver better

What he did as the Governor of RBI:

1. UPI (Unified Payments Interface) was launched to reduce the cost and time taken to make simple payments for transactions up to Rs. 1,00,000. It avoids the long-winded payment transfer procedure. All one requires is a UID (unique ID) and a mobile pin to authenticate the payment.
2. Payment Banks would accept only deposits and not be involved in lending. This initiative was aimed at providing banking facilities to those deprived of them. The RBI licensed 2 universal banks and approved 11 payments banks for providing banking services.
3. RR successfully managed to curb the retail inflation from 9.8% (September 2013) to 3.78% (July 2015), and Wholesale inflation from 6.1% (September 2013) to a historic low of -4.05% (July 2015).
4. When RR joined office, the currency was at Rs. 70 against the US Dollar. During his tenure, he successfully managed to pull up the rupee.
5. On his very first day as the Governor of RBI, he spoke about a new approach to formulating monetary policy, and in the same month also picked Deputy Governor Urjit Patel to examine the monetary policy framework, which stated the objective of maintaining inflation under 6 per cent.
6. RR initiated a total restructuring of the RBI from the inside. He organized the RBI central office departments into five groups namely, Regulation and Banking Services, Operations and HR, Supervision and Risk Management, Financial Markets and Infrastructure, and Monetary Stability.
7. Indian banks hold more than $110 billion of corporate stressed debt, which result in preventing fresh loans to be given, dampening a quicker economic recovery. RR focused his efforts on cleaning up the banks' balance sheets and put pending projects back on track.

Fun fact:

RR was in the running for an Economics Nobel Prize for the following reasons:

• RR, at 40, became the youngest ever Chief Economist of the IMF.
• He predicted the financial crisis of 2008 three years before the economic meltdown actually happened. He was greeted with laughter and disbelief when he highlighted unsustainable banking practices and risky financial instruments such as mortgage-backed securities and credit default swaps that could lead to economic collapse.
• RR's book Fault Lines garnered global attention to income inequality, where he warns against the reforms not addressing the stagnating middle-class earnings, which in turn played a role in the 2008 meltdown.
• His subtle handling of the rupee crisis in 2013 that helped bring back foreign investors to India. He made handing out new bank licences transparent and controversy-free, and also fought against inflation by targeting CPI (consumer price inflation) rather than WPI (wholesale price inflation), the index traditionally targeted by the RBI.

View on demonetization:

• In 2014, RR stated in a speech that demonetization was not an effective enough measure to curb black money, because to him, “clever people find ways around it.”
• In 2017, RR mentioned that the RBI was against demonetization and warned the Indian Government about its negative impact.
• RR wondered if currency notes ban would result in economic success or not.
• Some people speculate that this conflict regarding a difference of opinions in terms of the demonetization policy was the reason for his exit from the RBI Governor’s office.

A few of the awards he's won:

• Fischer Black Prize in 2003
• Awarded by the American Finance Association
• For contributions to the theory and practice of finance by an economist under the age of 40
• Financial Times and McKinsey Business Book of the Year Award in 2010
• Fault Lines: How Hidden Fractures Still Threaten the World Economy
• Deutsche Bank Prize in Financial Economics in 2013
• For his ground-breaking research, which influenced financial and macroeconomic policies globally
• Governor of the Year Award from London-based financial journal Central Banking in 2014
• Yashwantrao Chavan National Award in 2019
• For his contribution to economic development

One of his books which I'd like to read, which explores the causes of the 2008 financial crisis:

Fault Lines: How Hidden Fractures Still Threaten the World Economy

Some of my favourite RR Quotes:

"Strong government doesn't mean simply military power or an efficient intelligence apparatus. Instead, it should mean effective, fair administration - in other words, 'good governance.'"

"Central bankers have had enormous responsibilities thrust on them to compensate, essentially, for the failings of the political system. And my worry is we don't have sufficient tools to do that, but we're not willing to say it."

"How do we get more politicians to move from 'fixing' the system to reforming the system? The obvious answer is to either improve the quality of public services or reduce the public's dependence on them. Both approaches are necessary."

"Everyone may have some advice for the RBI. Some may advise, 'Cut your lending rates and raise the deposit rate.' How will a bank function? We take a medium-term view. The bank has an 80-year-old history. I don't want to destroy it for a few decisions."

"We should make sure that unscrupulous schools do not prey on uninformed students, leaving them with high debt and useless degrees."

"Perhaps the hardest challenge has been to persuade the public, impatient for rapid growth, of the need to ensure stability first. Growth, it is argued, is always more important, regardless of the looming economic risks."

"Democratic accountability means that governments must be popularly accepted, with citizens empowered to replace corrupt or incompetent rulers."

"If economists were to wait for careful studies before offering opinions about policy, we would never have anything timely to say."

"It is not because of the benevolence of the baker that we eat fresh bread in the morning but because of his desire to make money."

Article: SIPs and rupee cost averaging

#11

Concepts

Rupee cost averaging

• Approach wherein you invest a fixed amount of money at regular intervals
• Ensures that you buy more shares of an investment when prices are low and less when they are high
• You avoid the manual, complex task of researching the best time to invest
• Averages out the costs of your units 
• Lessens the results of short-term market fluctuation on your investments

SIP

• Systematic Investment Plan
• Facility offered by mutual funds to investors
• Helps you invest in a disciplined manner
• You invest a fixed amount of money at pre-defined intervals in the selected mutual fund scheme
• Amount can be as low as Rs. 500
• Intervals can be weekly, monthly, quarterly, semi-annually, or annually 
• Investor need not worry about market dynamics or timing
• Stands to benefit in the long-term due to average costing and power of compounding

Gist

• SIPs help you lower your investment cost and hence maximize returns
• When you invest through SIPs, you automatically experience the benefit of rupee cost averaging
• When you invest, you accumulate units at various prices called net asset value aka NAV
• You get more units when the market is down and the fund's NAV is lower and vice-versa

Why it works

Markets are volatile, hence it makes sense to spread your investments over a period of time to benefit from the lows that frequently occur

How it works

• Say you invest Rs 10,000 in a fund at each of these NAVs: Rs 100, 150, 200, 250, and 300
• Number of units accumulated (amount/NAV): 100, 66.66, 50, 40, and 33.33
• Total amount invested = Rs 50,000
• Total units = 289.99
• Average NAV = Rs 172.41 (This amount is less than three of the five NAVs at which you bought the fund!)

Conclusion

• SIPs: psychological tool of discipline
• By nature, investors are tempted to invest more when the market is racing and stop investing altogether when it is falling, which hurts returns
• SIPs automate the entire investment process and delink sentiment from investing
• Via SIPs, you benefit from rupee cost averaging to get a good return

Article: How to buy the right health cover?

#10

Let's look at the types of plans commonly offered. What they do and don't cover should help you determine which one is suitable.

Individual Health Plans aka  'mediclaim' policies

Covers:

• Hospital treatment expenses provided the treatment is on an in-patient basis and lasts for at least 24 hour
• Expenses include hospital bed and room, nursing, surgeon's fees, consultant doctor's fees, blood transfusions, oxygen and operation theatre charges

Does not cover:

• Pre-existing diseases or complications arising from them for the first four years of the policy
• Specific conditions that may not be covered for a certain initial period

There is generally an enhancement for every year during which no claim is made.

Family Floating Policies

The sum insured can be used for the treatment of any or all members of the family and not a single person. Rather than buying an R2 lakh health cover for each member of the family of four by spending for a total cover of R8 lakh, if you buy a Family Policy for R8 lakh, each person covered under it can avail benefits up to R8 lakh as opposed to R2 lakh in the earlier instance.

• Comes at a lower premium than individual policies would have done
• Can be bought by an individual who becomes the proposer along with spouse, including dependent children up to 25 years or even unmarried, divorced, widowed daughter and dependent parent

Critical Illness Plan

• Not a substitute for the basic individual or family policy
• Designed to be added as an addition to the former (The fact that these have to be bought separately is a major flaw in the way health insurance is sold in India)
• Provides financial assistance if the insured develops a serious ailment, such as cancer, or has a stroke
• Each cover has a list of ailments, usually 9-12 of them
• Can get it in the form of a rider attached to a life insurance cover, or as a standalone policy from either a life insurer or a non-life insurer
• If critical illness occurs, it pays the entire sum insured and terminates and can happen only once for any particular illness
• To get the payout, the insured has to survive for 30 successive days after the diagnosis
• No claim can be made during the first 90 days of the inception of the policy

Medical Cover From Life Insurance Companies

Life insurance companies, too, have started offering health plans. Most of these are, however, defined benefit plans - the pre-specified amount which is the sum insured is paid as compensation, irrespective of the actual amount of expenses incurred. Also, these are long-term, having a fixed premium for, say, three, five, or even 10 years. 

If you opt for a good combination of basic mediclaim, family policy and a critical illness plan, then these are not needed.

Types of Accounting Statements

#9

Topic:

Financial statements - consolidated reports of thousands of individual transactions

Function:

They summarize a company's

• Operations
• Financial position
• Cash flows over a period

“Show me the money!”

Types:

Income statement

• Aka Profit and Loss (P&L) Statement
• Reveals the financial performance of an organization for the entire reporting period
• Income: what the business has earned over a period (e.g. sales revenue, dividend income)
• Expenses: cost incurred by the business over a period (e.g. salaries and wages, rental charges, depreciation)
• Net profit or loss = Expenses - Income
• Begins with sales, then subtracts out all expenses incurred during the period to arrive at a net profit or loss
• Earnings per share (EPS) may also be added if the financial statements are being issued by a publicly-held company
• Usually considered the most important financial statement, since it describes performance

Balance sheet

 

• Aka Statement of Financial Position
• Shows the financial position of a business as of the report date
• Covers a specific point in time
• Aggregated into assets, liabilities, and equity
• Assets: something a business owns (e.g. cash, inventory, plant and machinery)
• Liabilities: something a business owes (e.g. creditors, bank loans)
• Equity: what the business owes to its owners or stakeholders
• Balance sheet must balance: Assets - Liabilities = Shareholder's Equity
• Line items within the asset and liability classification are presented in their order of liquidity: most liquid items stated first

Cash flow statement

• Reveals cash inflows and outflows experienced by an organization during the reporting period
• Broken down into operating activities, investing activities, and financing activities
• Operating Activities: represents cash flow from primary activities of a business
• Investing Activities: represents cash flow from purchase and sale of assets other than inventories (e.g. purchase of a factory plant)
• Financing Activities: represents cash flow generated or spent on raising and repaying share capital and debt along with the payments of interest and dividends
• Can be difficult to assemble
• Issued usually only to outside parties

Scandalous - Charles Ponzi

#8

What?

Origin of the Ponzi Scheme

Who?

Charles Ponzi (1882–1949) - an Italian immigrant living in Boston.

When?

It happened in 1919.

Crime in one line

Ponzi conned investors into giving him millions of dollars and paid them returns with other investors’ money.

What did he do?

He came up with a scheme to get rich by purchasing international reply coupons (IRC) for a low price abroad and then selling them for profit in the US.

What’s a reply coupon?

It’s a coupon that can be exchanged for several priority airmail postage stamps from another country.

What was the problem?

Though Ponzi was able to repay his investors their money, via subsequent investors, he had not yet figured out a way to actually convert the IRCs to cash. He then realized that changing the coupons to money was logistically impossible.

What this led to

The ‘Ponzi scheme’

In short:  “robbing Peter to pay Paul”

Damages and Impact

In order to cover the investments made with the Securities Exchange Company, 160 million postal reply coupons would have to be in circulation. However, only about 27,000 were in circulation.

In August 1920, Ponzi was declared hopelessly insolvent, reporting at least $2 million in debt. It was later found that he was actually $7 million in debt.

Magnitude of losses

Ponzi’s investors were essentially wiped out, receiving less than 30 cents to the dollar. They lost about $20 million in 1920 dollars (approximately $196 million in 2019 dollars). By comparison, Bernard Madoff’s similar scheme that collapsed in 2008 cost his investors about $18 billion, 53 times the losses of Ponzi’s scheme.

Typical Characteristics of a Ponzi Scheme

Scheme:

• Guarantee of high returns with low risk
• Consistent flow of returns regardless of market conditions

Investment:

• Unregistered investments with the Securities and Exchange Commission (SEC)
• Investment strategies described as too complex to describe

Customers:

• Clients unallowed to view official paperwork for their investments
• Clients facing difficulties removing their money

Stay tuned

We’ll later look at some of the Ponzi scheme scandals that took place more recently, like Bernie Madoff, whose name this scheme is synonymous with, and also the Ponzi scheme employed by Sahara’s Subrata Roy to dupe thousands of poor investors.

Related

Pyramid scheme

Article: How ELSS scores over other tax saving avenues

#7

Fact

Under Indian tax laws, savers have a complete range of tax-saving instruments like Public Provident Fund (PPF), Tax-saving fixed deposits (FDs), National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS) and others

Question

Yet, individuals often take sub-optimal investment decisions with their tax-saving investments. Why does this happen?

Answer

There is a confusion of goals between saving tax and making investments.

Equity Options

There are two options other than ELSS that give equity-linked returns - Unit-Linked Insurance Plans (ULIPs) and the National Pension System (NPS)

ULIPs

Longer lock-in period of 5 years, coupled with high costs and poor transparency.

Traps:

1. Mix of investment + insurance 
2. Savers don't have clear cost-vs-benefit understanding of either 
3. Both transparency and liquidity relinquished
4. Terminating the policy early affects returns adversely (instead of 5-year lock-in, it becomes a 10-15-year commitment)

ULIPs aren't suitable for investment due to:

1. High costs
2. Difficulty in evaluation
3. Lack of transparency
4. Low liquidity

NPS

Retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age.

ELSS

3-year lock-in period

Short-term vs long-term: 

1. Equity investment carry higher risk over the short-term. 
2. However, for investment periods of five years or more, the risk on equity investments is considerably lower. 
3. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation.

The best way of investing in an ELSS is through monthly SIPs (Systematic Investment Plan) throughout the year. SIPs also give the dual advantage of avoiding any last-minute rush.

 

At the beginning of every year, estimate the amount you have leftover from the Rs 1.5 lakh limit after statutory deductions, divide it by 12 and start an SIP. 

Simple.

 

Accounting Principles

#6

This post attempts to help you remember the 10 principles of accounting.

1. Separate Legal Entity Assumption

Accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions.

Note: 

For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes, they are considered to be two separate entities.

2. Monetary Unit Assumption

Generic version:

Money itself is treated as a unit of measurement and all transactions or economic events recorded in the accounts of a business can be expressed and measured in monetary terms by a currency.

Specific version:

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.

Note: 

It is assumed that the dollar's purchasing power has not changed over time. As a result, accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2019 transaction.

  

3. Time Period Assumption

This principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2019, or the 5 weeks ended May 1, 2019. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2018, the amount is known; but for the income statement for the three months ended March 31, 2019, the amount was not known and an estimate had to be used.

Note:

It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labelling one of these financial statements with "December 31" is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2019, the month ended December 31, 2019, the three months ended December 31, 2019, or the year ended December 31, 2019.

4. Cost Principle

"Cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.

Note: 

Asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements–you need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement.

Example:

A company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared, it is not clear whether the company will be able to defend itself or lose the lawsuit. As a result of these conditions and the full disclosure principle, the lawsuit will be described in the notes to the financial statements.

Note: 

A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue, the accountant is required to disclose this assessment.

Note: 

The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting to match expenses with revenues.

Example:

Sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid).

Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2019 revenues as a bonus on January 15, 2020, the company should report the bonus as an expense in 2019 and the amount unpaid at December 31, 2019, as a liability.

Note:

Since we cannot measure the future economic benefit of things such as advertisements and thereby not be able to match the ad expense with related future revenues, the accountant charges the ad amount to the expense in the period the ad is run.

8. Revenue Recognition Principle

Under the accrual basis of accounting, revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

Example:

ABC Consulting completes its service at an agreed price of $1,000.

ABC should recognize $1,000 of revenue as soon as its work is done. It does not matter whether the client pays the $1,000 immediately or in 30 days.

Note: 

Do not confuse revenue with a cash receipt.

9. Materiality

An accountant can violate another accounting principle if the amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.

Example:

Purchase of a $150 printer by a highly profitable multi-million dollar company. Since the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.

Note: 

This principle allows financial statements to show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.

Example:

Potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported.

Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

Note: 

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains.

Here's an interesting tutorial explaining the fundamental principles.

Intro to GAAP

#5

Let's close our knowledge gap by knowing about GAAP!

WHAT

GAAP - "generally accepted accounting principles"

Three types of rules:

• Basic accounting principles and guidelines
• Detailed standards issued by FASB (Financial Accounting Standards Board) and APB (Accounting Principles Board)
• Generally accepted industry practices

WHEN

• When a company distributes its financial statements to the public - it has to follow GAAP during the preparation of those statements
• When a company's stock is publicly traded - financial statements have to be audited by independent public accountants as per Federal Law

WHERE

• Primarily used by businesses reporting their financial results in the United States.
• International alternative to GAAP:
• International Financial Reporting Standards (IFRS) - set by the International Accounting Standards Board (IASB)

WHY

• Useful - attempts to standardize and regulate accounting definitions, assumptions, and methods
• Consistent - in the methods used every year to prepare a company's financial statements
• Compare - one company to another, w.r.t financial statistics
• Improve - clarity, consistency, comparability of the communication of financial information

HOW

• Accountants commit to applying the same GAAP guidelines throughout the reporting process, from one accounting period to the next, to ensure financial comparability between periods (principle of regularity)
• Accountants must strive to fully disclose all financial data and accounting information in financial reports (principle of good faith)
• Accountants have to fully disclose and explain the reasons behind any modified standards in the footnotes of financial statements (principle of consistency)
• Accountants strive to provide an accurate and impartial depiction of a company’s financial situation (principle of sincerity)
• Accountants must report positives and negatives with full transparency and without the expectation of debt compensation (principle of non-compensation)
• Accountants must assume the business will continue to operate while valuing assets (principle of continuity)
• Accountants must distribute entries (such as revenue) across the correct accounting periods (principle of periodicity)

Types of accounting

#4

Let’s look at the three types of accounting in brief: financial, managerial, and cost

Financial Accounting

Objective: 

Generate interim as well as annual financial statements 

Process:

Summarize financial transactions that occur during an accouting period

Outcome:

Balance sheet, income statement, and cash flow statement

Additional task:

Annual audit (legal requirement for some companies)

Managerial Accounting 

Objective: 

Generate reports used by the management team of the business to make decisions about their operations

Process:

Organize and utilize information from financial statements

Outcome:

Monthly report, quarterly report

Additional task:

Budgeting, forecasting

Cost Accounting

Objective: 

Help businesses make decisions about costing

Process:

Organize and utilize information from financial statements

Outcome:

Cost center report, distribution report

Additional task:

Determine what the products of a business should cost

Fun fact

In cost accounting, money is an economic factor in production, whereas in financial accounting, money is a measure of a company's economic performance.

Into to Accounting

#3

Welcome to the introductory post on Accounting.

In this section, I hope start out with the basics, an Accounting 101, if you will, and move on to advanced topics as and when I study them.

Here’s a gist of Accounting 101 topics:

• History of accounting
• Ten Principles
• Accounting terms
• Accounting cycle
• Assets, Liabilities and Owners' Equity
• Financial Reports
• • Income statement
  • Balance sheet
  • Cash flow statement
• Credits, Debits, Balance Sheet, Double Entry Accounting
• COGS, Inventory, Cash flow
• Accounting Ratios: Liquidity, Solvency and Profitability
• Auditing

Here's accounting in six words:

Record, analyze, summarize, report - financial transactions

What all does an accountant do?

• Financial information for organizations
• Collect
• Organize
• Track

• Prepare financial reports
• Revenues
• Expenses
• Assets
• Liabilities

• Conduct audits
• Check if legal practices followed
• Check if company policies followed
• Prepare reports
• Recommend remedies
• Reduce risk of lawsuits

• Prepare tax returns
• • Minimize tax liabilities
  • Ensure income reported according to IRS

Designations:

• Chartered Accountant (CA)
• Certified Public Accountant (CPA)
• Certified Management Accountant (CMA)
• Certified General Accountant (CGA)

Now, let's throw some jargon around before getting into detailed concepts:

That's enough overview for a first post. Check out the subsequent ones for detailed dive-deep!