Investing
sensibly
Last time I
identified the three variables which govern rational investment decisions:
liquidity, reward and risk (I made a mistake; if the rate of interest rises
from 8 to 10 per cent, the return on a fixed-interest security such as a bond
would be minus 20 per cent). Today I would like to show how they can be used to
make investment decisions.
All of us need
cash to make purchases. We should hold enough cash to tide us over till the
next payday. Those who do not have fixed paydays – for instance, businessmen –
will have to carry some more cash to cope with the uncertainty of their income.
We must hold further cash to finance contingent expenditure which could strain
our resources if it did occur – for instance, an accident or an illness. We do
not have to hold cash for predictable future cash requirements such as
children’s education. If their magnitude and timing are predictable, we can
make investments that can be cashed at that time.
And finally,
there are cash holdings that no one thinks of, but which may be the largest for
investors – cash held to buy investments in the future. In particular, if one
anticipates a fall in the capital value of an asset, then even if one wants to keep
it, it is best to sell it off now and buy it back when its value has gone down.
I have been
talking of cash holdings, but they do not have to be in cash. They only have to
be in quickly cashable assets. All financial assets can be realized at short
notice, and are therefore cash-substitutes. But some are closer substitutes
than others. Long-term bank deposits and liquid mutual funds are the closest.
Fixed-interest securities and debt funds are less close; their value can vary
with a change in interest. Shares and equity funds are even less close, since
their value can change with interest, market sentiment and company performance.
Cash should be held only for immediate requirements; but in addition, liquid
funds must cover contingencies.
Whatever does
not have to be held in cash or liquid assets is available for investment. Here,
the first choice to be made is between fixed-interest securities and
variable-dividend securities, or bonds and shares. The market price of a bond
varies with changes in interest. But this interest-rate effect is greater on
longer-term bonds than on short-term bonds. At the moment when a bond matures
and is repaid, it is fully liquid. The closer it is to maturity date, the
closer will its market price approach its redemption price, the lower will be
the capital risk attaching to it, and the more liquid it will become. To meet
unforeseeable contingencies one must hold liquid funds; to meet foreseeable
contingencies – for instance, income requirements – one must hold bonds that
mature just before those contingencies.
In this respect
one does not have much choice in India. The government does not let public hold
its securities directly, so one has to hold them through mutual funds. And the
private sector borrows little for longer than three years. So long-term
fixed-interest assets are not really available. But as far as one can, one must
hold fixed-interest assets to finance foreseeable cash requirements, and match
their redemption pattern to the schedule of cash requirements.
This does not
have to be done for all time in the future. One could also sell shares to get
cash. But the capital risk attaching to them is high, so their use may turn out
to be expensive. If the prospects of return on risk are high, one can use a
blend of bonds and shares to match foreseeable cash requirements – hold only
bonds to fund short-term needs, say over the next couple of years, and hold an
increasing proportion of assets in shares for requirements that are further
away.
The money that
is available after providing for both foreseeable and unforeseeable cash
requirements is fully available for taking risk. It is when one has this kind
of surplus that investing becomes a challenge, a game, a gamble; that is when
it can be fun.
It is perfectly
possible to speculate in real estate. Those who specialize in property swear by
it. And they have a point. Value of property varies with location. Locational
improvements are to some extent predictable; and if one buys property early and
sells it after its location improves, one can make good money. I have speculated
on property, but since I never had enough money to do this on a large enough
scale, I took on disproportionate risk, and my overall return was unimpressive.
Since property investment is lumpy, it is too risky for people with a little
money.
Coming to the
stock market, laymen invest in it because they think it will go up. Beyond this
they have no idea of the prospects or risks; they do not really know the
companies whose shares constitute the stock market. They are the ones who
invest in equity funds. They ignore three factors. First, the management fees
of equity funds are high. The norm would be 1½ per cent; but the actual charge
could be higher. More important, the performance of an equity fund depends on
the skills of the investment manager. Some of them are good, some mediocre; on
the average, they perform neither better nor worse than the market. And
finally, there is the risk of an investment manager being dishonest.
One strategy,
then, would be to identify the best investment managers, and follow them
wherever they go – to move one’s money if they move from one asset management
company to another. This requires constant research, since no source readily
gives such information in India.
The other would
be to abandon the ambition of doing better than the market, and to take a bet
just on the market going up by investing in an index fund. Here one has much choice these
days. There are funds that track not only the major indexes, but also sectoral
indexes – for instance, madcap – sorry, midcap. All these will charge
management fees; the costs of some are exorbitant. So I favour exchange-traded
funds. The management effort involved in investing in shares in the proportions
of an index is negligible, so the costs too are low.
If that is not
exciting enough, the best option is index futures. One buys these futures at
their current market price, and can sell them at a profit whenever the index is
above one’s purchase price. They are similar to index funds, except that one
puts up only a quarter of the investment, so gains – and losses – are four
times the change in the index. Index futures are available only two months ahead
at a time; if one does not sell them in that period, one gets or pays the
difference between the spot price at its end and one’s purchase price. In my
view, index futures are the best option for those who have money to play around
with and nothing beyond a hunch that the market will rise. If they start to
follow individual shares and want to bet on them, they can play stock index
futures.
