Financial
strategy
Ashok V Desai
Recently I gave
a talk in Calcutta. At its end, I met some of my audience – amongst them, quite
a few appreciative readers of mine. They all read me in The Telegraph, but many of them had not even heard of Business World. A number of them were
doctors. Despite a quarter century of communism, quite a few people have got
moderately rich in Calcutta. Medical practice was one of the paths to
prosperity; but Calcutta economists and even less useful characters have
prospered. Then there are people who have made money abroad, and have returned
to Calcutta because the money goes further there.
But they grew up
in a society that is not used to wealth; so they have not picked up the first
principles of investment. The first asset they buy is a house – as shelter, not
as investment. This preference for housing is behind the frenetic construction
boom in Calcutta. After that, one could buy a second and third house. But
landlordship is not a good idea in Calcutta. One has to make sure that tenants
pay rent and, if they do not pay, they get out; and that is not easy. So
large-scale property ownership is not common.
Nor is business
promising. Many of these newly rich people are in a kind of business – they are
professionals. But expanding business means employing people, and very soon
employees become a headache. Once they reach a critical minimum number – say, a
dozen – they indulge in the Calcutta pastime of getting together and shouting
abusive slogans. Then they join a trade union, usually CITU; the combination of
unionism and government can make things quite uncomfortable for an employer. So
people just grow their business to a size that gives them comfort, even luxury,
but do not use it to multiply money as other Indians do.
What do these
people do after they have got a house? Those I met apparently invest in mutual
funds. Mutual funds are now being marketed by banks; those with a bank account
yield to their bankers’ sales talk. And just now, when the stock market is
booming, many people have been investing in equity funds. But if I asked them
about particular shares – for instance, about Reliance – their faces went
blank. Like many of us who speak prose without knowing it, these people are
investing their savings without knowing anything about investment. They are
sleepwalkers in a minefield.
Unfortunately,
they have no better option. The profession of investment advisers or investment
managers is undeveloped in this country. Having grown up in Poona and Bombay, I
had friends who were sons of industrialists and stockbrokers, and was dabbling
in the stock market from the time I got my first job. And the stock market is
not just a gateway to equities; it is the gateway to knowledge about how
business in India works. This gateway is largely closed to my esteemed readers
in Calcutta.
So what can they
do? They need to make themselves familiar with three concepts: liquidity,
return and risk. Liquidity is the degree of an asset’s similarity to money.
Money is fully liquid; everything else is as liquid as it is easy to sell it.
Thus, a fixed deposit can normally be instantaneously converted into cash and
is therefore highly liquid, although breaking a deposit may entail some cost.
Mutual funds are also generally extremely liquid. What few people realize is
that shares too are extremely liquid. Stock exchanges are now on one-day
settlement, and one can get cash for shares the day after sale – two days if
the stockbroker is lax. Property, on the other hand, is extremely illiquid. It
takes months to cash it, after much hassle. A car is somewhere in between; now
that second-hand car dealers are coming up, cars are getting increasingly
liquid.
Return is the
change in the value of an investment. Interest or dividend is only a part of
the return. The other part is the change in the market value of the asset.
Thus, if the market price of a house goes up, the rise in its price is a part
of the return – and so is a fall in the price. Many are today seduced by the
way share prices are going up. They panic, thinking that if they wait, prices
will go up further, and they will lose a chance of making a killing. So they
buy in a panic. It is typical of the human mind that immediate events influence
it more than remote events. People forget that prices of assets can fall, and
that when they fall, their owners will try equally to sell in a panic.
That brings me
to the third concept – risk. Its measure is the probability of the return being
different from its long-term average. The probability is zero for cash. It is close
to zero for fixed deposits; the only risk is that the bank will fail. For all
traded assets, there is a risk that the market price will change; it can fall
as well as rise.
One reason why
asset prices rise or fall is that interest rates change. Take assets that give
a fixed rate of interest – bonds, debentures or government securities. For each
of these classes, there is a market rate of interest. It is the rate earned on
an asset whose market price is Rs 100. If the market rate of interest on securities
is 8 per cent, the price of an 8 per cent bond will be Rs 100. If the market
rate rises to 10 per cent, the price of the 8 per cent bond will fall to Rs 80,
and the return on it at that point of time will become Rs -20 – its holder will
make a loss of Rs 20. Conversely, if the market rate comes down to 6 per cent,
the price will go up to Rs 133.33; the bond will give an instantaneous return
of 33.33 per cent.
Interest is the
return one gets for parting with liquidity – by giving money to someone. Since
money is used to buy all assets, their prices go up and down with the price of
money – with the rate of interest. They can vary with other things also. For
instance, share prices vary with dividends, and, most important, with how
optimistic or pessimistic investors are about a company’s future performance.
One reason for the stock market boom is that foreign investors are insanely
optimistic about the Indian economy. But the interest rate is one parameter
that affects prices of all assets.
Investment strategy
entails working out what combination of liquidity, return and risk is right for
one, and translating the decision into holdings of various assets. One should
not be dazzled by the current return on equities; one should ask oneself how
much liquidity one needs, and how much risk one can afford to take. That
depends on one’s stage in life and financial circumstances. As one’s wealth
grows relatively to one’s needs, one can afford to reduce the share of one’s
wealth in liquid assets, and take more risk. Whether one can translate higher
risk into higher return depends on one’s understanding of asset markets. And
there are assets other than mutual funds; unlike mutual funds, one does not
have to pay a commission just to own shares or bonds.
