Wednesday, July 22, 2009

Part 3: Starting to worry about investments

Have you nominated one of your bank accounts as the "Third Bank Account"? (We can refer to this as the TBA going forward).  Have you made it investment-ready by linking it to a Demat and Trading account?  If you have not done so yet, you should seriously consider acting on it soon.

Now that we have resolved to set aside some money every month, the next problem is what to do with it?   Before addressing that question however, let us first talk about inflation.

What exactly is the meaning of ten thousand rupees?  It has no meaning except in relation to what it can buy.  What this money bought for you five years ago, is far more than what it buys today.  What it buys today will be far less than what it will buy five years hence.  Inflation, or the rise in the general level of prices eats up your money - it erodes it away slowly and imperceptibly - and before you know it, you are poorer than when you started out! 

The level of inflation keeps changing with time.  The official government statistics report inflation based on wholesale prices of a pre-defined basket of commodities.  This may be quite different from the inflation you face in your daily life since you shop in retail and your basket of consumption is different.  In the last one year, you would have noticed that prices of essential food items have increased far beyond the inflation figures reported in the newspaper.   Just check the price of Tur Dal in case you have not noticed.  Or the price of idly-wada at the local Darshini.

The technicalities of how inflation is caused and how it is computed need not bother us at this moment.  What we need to note is that money kept under the mattress, though high on the sense-of-security scale, is quite low on the sensible-thing-to-do scale!  You have to make your money grow or it becomes useless with time. 

If you have invested your money in a Fixed Deposit (FD) with a bank and the rate of interest that you earn is 8% p.a. and if inflation is, say, 6% per annum, then your nominal rate of interest/return is 8%, while your real rate of return is just 2%. The real rate of return is the actual increase in purchasing power.

You need to invest your money in assets that will grow in value over a period of time. Before diving into the different assets, let us first pause and think. Do we know what is an asset? 

Your car is not an asset.  It drops in value by 30% the moment you drive it out of the showroom and then keeps depreciating.  You also have to spend money on maintaining it.  Gold ornaments are not assets. Try selling the gold chain you bought yesterday, and you will know; you will get at least 25% less for it.  Buying a sofa for the house is not an asset.  You will probably get less than 20% of the value when you go to sell it, if you are lucky.  Since they are not assets, none of these items can be bought out of the money in the TBA; nor can the emi's on loans taken for buying them be paid out of this account.  If your regular expense account supports it, by all means go buy it.

Do stocks increase in value?  They may or they may not; but you invest in them on the expectation that they will.  It’s just that the risk of losing part of your principal is high since their prices are volatile and they don’t respect your purchase price.  Do Fixed Deposits increase in value?  You bet they do.  At a steady predictable rate without any volatility. If someone offered you an option to invest in an 8% FD vs. investing in a stock that is likely to yield 8% over the long term, what would you do?  You would obviously invest in the FD.  Since the expected rate of return is the same, you would (and should) prefer the certain cash flow to the uncertain one.  Assuming FD’s return 8%, what should your expected rate of return be, on equity stocks to compensate for the additional risk, which includes losing your capital?  You need not quantify the number; you just need to understand that volatility of return means risk; risk of losing part of your capital constitutes risk; and you need a premium over the normal return on debt to compensate for the additional risk.

What we spoke about above is the risk due to variability of return. The other and more fundamental risk is the risk of default.  Even within debt instruments, why does an unknown finance company offer more return than a co-operative bank, which yields more than an SBI deposit? The additional interest rate that you get is default premium.  Debt instruments are usually compared with SBI rates, or Government bonds, since all other instruments need to pay a premium over sovereign risk.

Higher the risk, higher the return you should expect.  In real life, the returns do not match the risks involved in direct proportion thus making certain financial decisions easier.  You should not invest in a plantation scheme since the promised rate of return may be high, but the probability of seeing your teak tree after twenty years is close to nil.  You can lend to your brother-in-law to maintain peace with your spouse; but from a risk-return perspective it is unlikely to pass muster.

Reflect on that.  If you have lent money to your brother-in-law start thinking about how to get it back.  We’ll meet again in the next issue.


Dinesh Gopalan
Fidelity India Finance
mobile: 9845257313

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