To minimise risk invest in a diversified portfolio of quality assets for the long term
Posted by: Uma Shashikant on Jan 02, 2017, 06.30 AM IST
By Uma Shashikant
My neighbour has a simple question: Is it necessary to take risks? She has been a diligent saver all her life and is quite happy with her financial position. While she is sometimes enamoured by all the talk about multi-baggers and extraordinary returns that take place when her children visit, she is fine with what she has.
She thinks that there is no need to take risks with money. This view has not changed despite having children who work in private equity firms and investment banks. So are there risks that we need not take?
By investing purely in bank deposits, my neighbour has taken on an unintended risk. That of her return falling short of the inflation rate. Even if she chose very well and held deposits in strong and healthy banks, she might not have got an interest rate that compensates for inflation.
For instance, a few years ago, consumer inflation in India was well over 10% per annum, while the banks were offering 8% on their deposits. And then we have the present time, when deposit rates have fallen to 6%, making my neighbour quite upset. However, she is actually better off since the consumer inflation numbers have fallen off to less than 4%.
Most of us are unable to grasp the impact of inflation on our finances, except for being shocked by the way prices are moving up. We compare the cost today to what we paid years ago, and lament the perils of inflation. To a saver and investor like my neighbour, what does matter is the rate of increase in inflation and the rate of return on her investment. Unless we are in a recession and a really bad place, the absolute price of goods won’t come down, at least not across the board.
Therefore, if prices in general are increasing by 10% a year, but her bank is using her money and giving her only 8%, she is actually worse off, as she is losing real value of her money. That is a risk she should avoid. And that is a risk she takes even if she assumes that there is no risk associated with bank deposits. A very common type of senior citizen I meet is one who favours high interest yielding products—bonds, company deposits and NBFC deposits. They like the idea of earning an interest income and the higher it is, the happier they are. They think an investment avenue that protects their principal, while providing an interest income that is higher, should be a good one.
There are also investors who like to buy bonds issued by PSU firms or financial institutions, as long as the interest rates are high. They are assuming credit risks, which they may be ill-equipped to manage or monitor. The common explanation they provide is that the finance companies they have lent to have been regular in paying out interest. Or that the PSU business is run by the government and therefore might not default. What they do not see is that given their need for protecting capital, they are exposing it to default risks that are higher than they can bear.
An entity with a good standing in the market, and a strong balance sheet that signals low default risk, would actually be borrowing at a lower cost. Therefore, the combination of high interest rate and low credit risk is not a plausible one. This is a risk investors, especially those who have to protect their capital, need not take.
Then I meet eager investors who like to buy IPOs and equity shares off the screens using their share trading accounts. Many are first-time investors who see themselves as willing to take risks that come with investing in equity shares. I would urge them to spend one day at the research departments of a brokerage or a mutual fund. They will find that selecting a stock for investment purposes is quite a complex, detailed and intensive task. They will also find that it is both an art and a science.
It is very common for these first-time investors to take offence when I point out to them that they are gambling with their money and hoping to turn lucky. They like to depend on a few pieces of free research, recommendations of media experts, and self-fulfilling arguments about the prospects of their picks. Business risk is something investors with limited data, and even more limited capability for analysis, should avoid. There is always the lure of the flavour of the season.
Sometimes investors are enamoured by the prospects of a specific commodity or sector. Everyone they meet is telling them how good the future is for an investor in gold, or oil, or technology stocks, or banking stocks. Except that no one is around to tell the investors when the ride is over and when the time to get off has arrived. Or worse, the din gets too loud when the prices have peaked, luring investors to come in just before a crash. Investments that ask the investor to take a highly concentrated exposure to a specific type of business are risky and avoidable. It is tough to keep away from the exotic.
Every now and then, there are new propositions in the market. Someone tells a story about how investing in Brazil, Italy or Chile is fantastic. Sometimes complex products are presented with an “exclusive” tag, where sellers hold forth about experts managing an underlying structure created using derivatives, but delivering a protected rate of return. Then there are “smart” solutions that sell art by the inches, farms by the square feet, and emus by the eggs. Investors do not lose anything by choosing to stay off untested investment propositions.
Good ones that sustain the test of time will be around to participate in, and there would be enough evidence to see if they worked at all. A proposition presented as “never before” or “invest before it is gone” has risk written all over it. I told my neighbour that good investing habits are quite boring. There are time-tested principles that work for investors, and they require a diversified portfolio of good quality assets held over the long run. Inflation risk, credit risk, business risk, sector risks and risks from opaque structuring are risks a common investor should not be too eager to embrace. There is no remedy to choosing a plate of pickles for a meal.
(The author is Chairperson, Centre for Investment Education and Learning.) This article appeared in Economic Times dated Jan 02, 2017, 06.30 AM IST