Meet the Trimurti
Are you ready for equities?Last time around, we discovered how investing in equities helps preserve and enhance wealth considerably, compared to FDs/bonds or any other investments. We explored the vital question of ?Why? invest in equities, and now we will endeavour to answer the ?When? and ?How much? questions. We will also delve into ?debt? to understand how it could upset the best of equity investment plans.
A farmer in remote Bihar borrows heavily from his zamindar to pay the dowry for marrying off his 11-year-old daughter (an extreme form of debt that we know will turn the farmer into a bonded labourer forever).
A newly married yuppie buys a car, TV, fridge on his credit card?(another form of debt that the yuppie hopes to repay with his zooming salaries).
In these instances we see that ?debt? has been incurred to spend beyond one?s current means. We learnt last time that typically whatever we earn either goes into buying food, clothes, or assets like a TV, car, etc. Or we save with the intention to use our savings during our retirement or buy a house, etc. In other words, we spend our earnings today or save it to spend it later. ?Debt? brings in a third element?while we postpone consumption when we save, we spend future savings when we borrow! In simpler terms, ?savings? and ?debt? are like day & night?they can never exist together unless it is twilight. Take the case of Nagesh, who we met up with last time. Nagesh is a very practical person who has learnt from the tough times in his life. Nagesh, just like any other human being, has dreams of buying a car, a big house for his family, but realises that he will only be able to get there in stages as his current earning capacity is too limited. He has been keeping his desires in check while continuing to save regularly and investing a part of it in shares of good companies. Nagesh bought a car last month by selling part of his holding in Zee Telefilms (about 100 shares @ Rs3500 that he had bought over a year back @ Rs100).
Manish has been Nagesh?s colleague for the last four years. Manish believes in living life king size. In his very first year he exceeded the credit limit on his credit card. He has been paying through his nose, shelling out interest at 3% per month on his credit card outstandings. Two years back, he availed of a car loan to buy a Maruti 800, at a monthly installment of Rs8000 when his post-tax salary was just Rs14,000! Last year, envious of Nagesh?s newfound wealth in shares, he decided to dabble in shares too. His broker recommended Blue Information Technologies Ltd. as a hot tip that would double in 3 months? time! Full of fervour, without even checking the background of the firm, Nagesh pledged his wife?s gold and borrowed to buy this stock at Rs150. A week later, he discovered that the stock had fallen 35% from his purchase price. When he called up his broker, he was aghast to find out that the stock had been suspended. His interest meter was ticking on the money he had borrowed while his principal was down the tube. Talk of the power of compounding!
Moral: Never stretch borrowings to invest in the stock market. Shares are long-term investments that cannot be matched with short-term borrowings. Ideally, one should repay all borrowings and then invest the surplus in equities. So, when we are debt free, we are ready to invest in equities! By the way, one is never too old or young to invest as long as one understands the investment one makes.
OK, we have understood that in the long run equities offer the highest returns. We have also learnt that one can invest in equities any time provided one has surpluses after repaying debt and meeting one?s expenditure! But how much do we invest?
How much depends on two criteria. One, the risk profile of the investor and two, the liquidity requirements of the investor! Now that we know Nagesh, his father and friend Manish well, let us understand this better through their actions.
Risk profile! Yes, let?s face it. No equity investments are free of risk. There is no such thing as a free lunch, mind you! There are a whole basket of risks to contend with and we will understand all of them very soon. For now, we need to appreciate that there are risks of losing. Looking at our three personalities, we can straight away rule out Manish. He can?t afford to take any risks as he is buried deep in debt and can?t afford to lose a penny! Nagesh on the other hand is just 35 years old and has a long bright career ahead of him, so he can afford to take greater exposure in equities and in slightly risky shares too (for instance, some stocks from our ?Emerging Star?, ?Ugly Duckling? and ?Vulture?s Pick? categories). Nagesh?s father, on the other hand, has retired and has no source of income other than the savings he has amassed. So he will be able to afford very little risk. Hence, he should be looking at stocks in our ?Evergreen? or ?Apple Green? categories to choose his investments (which is why, if you remember, Nagesh had suggested HLL to his father).
Let us now move on to liquidity. Liquidity requirements signify the need of cash to meet one?s payment obligations (and don?t have anything to do with human beings? fluid intake). Manish needs all the money he can get as he has to meet so many of his loan obligations. Nagesh on the other hand has an idea of his monthly expenses so he has a better fix on his monthly cash requirements. He also needs to maintain a certain amount of cash in liquid savings (savings bank deposit, etc.) just in case there are some unforeseen medical expenses to meet or an unplanned visit to his father?s place. Beyond these requirements, he can look at investing in equities. Nagesh?s father, on the other hand, has to meet his entire expenses from his savings and would have large requirements for immediate cash. Hence, he can allocate a smaller portion of his savings to invest in equities.
Judging the actions of the small world of people we know, we have realised that risk profiles vary with age, current financial position, even one?s own personality. Liquidity requirements too depend on similar factors. These two criteria will be different for different people, but one should not lose sight of one?s risk profile and liquidity requirement while investing in equities.
Next time around, we will try to understand what we buy when we buy equities!
A long time ago when I was a kid...
On one sunny day that I still have fond memories of, my father came home in the evening with a toy pig. I turned it around and discovered that it had a hole in its back. My dad announced that it was my 'Piggy Bank'.
He fished out a 10 paise coin from his pocket and instructed me to put it through the hole in the pig's back. I did it eagerly, expecting the pig to start walking. Walk it didn't but my father patted me on my back and said,
"Son, this is your first saving. I will give you 10 paise everyday and when we have collected Rs50 we will go to the bank and get you a savings account."
Savings! suddenly a new activity had begun in my life that I understood nothing about.
My Dad noticed the puzzled look on my face. He scratched his head and suddenly a meaningful look came in his eyes. I think he remembered the ant menace that my mom had been complaining of for the past few days. He showed me the ants that were carrying grains in a line to their hiding place.
"The ants are carrying grains and saving it for a rainy day, he said.
He took out my World Book Encyclopedia and showed me various other animals that save food for a time when they may need it.
"You know that I go to office to earn money for all of us. But when I turn 58 years, I will have to retire and stop going to office. We will need money to buy food and clothing even after I retire from my job and stop earning. I need to save now, so that I can pay for our food and clothing later," he explained.
"Similarly, you can save the money I give you now to buy a good book or a paint box later," he impressed upon me.
That was my first lesson in 'saving'.
A few years later I learnt in my class that all of us have two choices. We can consume now or can consume later. Hence, savings is just postponing consumption.
Does it then mean that only what we consciously keep aside for a rainy days is called "saving"?
"No, what ever you do not manage to consume and stays as a surplus is also 'saving'. But that is a lucky state to be in," my teacher responded.
And that set me thinking...
"If I can 'save' to consume at a later date, I can also spend more now if I know that I can earn enough surplus to pay for it later..."
Just then my teacher's booming voice interrupted my train of thoughts...
"Borrowing is the opposite of saving," she announced.
Now that was easy to visualize.
I had a classmate who was fairly irregular to class, spent a lot of time in the school canteen and supposedly even bunked classes to watch the 'matinee'.
How did he manage to pay for all his nefarious activities?
Well, he used to borrow money from a few friends of mine who saved their pocket money.
During the break, I manage to accost one of those friends who had lent money to my classmate.
"I can understand why Ramesh (by the way, that was my classmate's name) borrows from you. But why do you lend him money? Can he pay back?"
"Look, I don't really intend to spend all my pocket money. I am saving up for a new cycle. Money always burns a hole in my pocket. Hence, I lend it to him," he answered.
"Ramesh has a rich father, who is a family friend," he explained. "I know that I can get my money back. Ramesh also knows that when he turns 18 he will look after his family business and earn well. And then he will have no time to have the fun he is having now. Hence, he borrows to spend," he added.
Learning for me again
'Saving' is not consuming everything today and leaving something for tomorrow whereas 'Borrowing' is consuming more than what one has today, expecting to save more later to pay up for the excess consumption now.
While 'saving' is being conservative and wise, 'borrowing' is being risky and foolish unless for a basic need. Hence, it makes sense to borrow only when one is sure that in the future he will be able to save enough not only to pay up for his borrowings but also to see him through the days when he cannot earn.
What is 'investing' then?
This question bothered me till I had my first mug of beer from some bottles that we had smuggled in from my friend's place (it belonged to his father who owned a liquor shop).
Oh boy! I loved it so much, the beer I mean. But soon an idea suggested itself to me. If everybody starts liking it, the demand for beer is definitely going to rise. The growing population will ensure that the demand sustains. Wouldn't then it make a lot of sense to set up a company to manufacture beer? If demand drops then my friends and I can very well step in!
I had grown up finally from the days of aspring to be a bus conductor to wanting to own a beer factory now!
The next day, I started discussing my ambition with my friend's father. During the course of our conversation I learnt of the money needed to buy the fermenting equipment that can produce beer for years to come.
By selling all the beer that can be manufactured, I can recover the initial money spent on the business by the end of three years. Beyond that, the money that I'll make will be surplus. That would be an awful lot of money.
Of course, I remembered that as 'Investment' from my economics textbook.
In other words, 'Investing' means building up to meet future consumption demand with the intention of making surpluses or profits, as they are popularly known.
Investments are risky
True, what if tomorrow everybody decides that 'beer' is yuck. Maybe the government will ban beer consumption. Or your plant might develop a big problem for all you know. Hence, there has to be a reasonable profit expectation to motivate an investment.
Also, when you or I 'invest', we forego our present consumption or do it out of our surplus. In other words, 'savings' again supports 'investment'.
Interesting isn't it?
We started with three things that looked as different as chalk, brick and wood, but discovered that the three ('saving', 'borrowing' and 'investing') are related.
But then, I have a few questions in my mind already. I am sure you would have some too.
What if I save Rs1000 over 10 months to buy a cycle and the price of the cycle shoots up by 20% by then? I am losing the 'purchasing power' of my Rs1000. Is there some way I can make up for the risk of losing my purchasing power?
Getting a little complicated for now. Let us unravel it later.
A calculated risk
Only those who risk going too far can possibly find out how far one can go
- T.S.Eliot
'Investing is risky business'
We have all come across this statutory warning or have learnt it the hard way while investing in the stock market. Let us take a step back to understand what is 'risk'.
The word is commonly used to describe the chance of a loss.
Chance: the Webster Dictionary defines this word as 'something that happens unpredictably without discernible human intention or observable cause' In other words, risk in the financial context stands for the uncertainties associated with future cash flows.
We have learnt earlier how savings transform to 'Risk Capital'. We have taken a hard look at equity risks and figured out that 'Khel risky hai'.
But did you know that 'Risk' owes its origin to the Italian word risicare that literally means 'to dare'? Risk as a verb is used to imply 'taking the chance'. In other words, as Peter Bernstein observes in the introduction to his magnum opus 'Against the Gods',
'... risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being...'
If 'risk' is all about choices, it is time to know how to factor this in our investment decisions.
Let us learn how these choices are made from the actions of Mr. Savvy Investor. Needless to say he is the smart guy who makes the smartest choices when it comes to investing.
Mr. Savvy Investor has Rs1,00,000 to invest. He has two investment options.
The first option is a government bond that pays an interest of 10% per annum for the next three years.
The second option is investing in a particular stock. A leading analyst expects this stock to go up by just 2% in the first year as the company is still expanding capacity. But he expects the stock to gain 28% in the next two years.
Mr. Savvy Investor fishes out his pocket calculator and gets down to business.
The bond option is fairly easy to calculate. His Rs1,00,000 investment would be worth Rs1,30,000 in three years. In other words, it would fetch him a return of 30% in three years.
He works out the returns for the second option.
His investment would be worth Rs1,02,000 at the end of the first year. A gain of 28% over the next two years means that his investment would be worth Rs1,30,560. Thanks to the 'power of compounding. his 2% gain in the first year will earn a return too. In the end, he would earn a 30.56% return in three years.
Two investment options with almost the same returns in three years. Which option does Mr. Savvy Investor choose?
Our Mr. Savvy Investor chooses to invest in the government bond.
It is easy to figure out why Mr. Savvy Investor has chosen the bond option.
Though investing in the stock meant marginally higher returns. There were lots of uncertainties. Remember, investment in the stock is based on expectations, expectations of a leading analyst, in this case. On the other hand, the government bond gives a fixed return with no question of a default.
What if the analyst got it all wrong? For all you know, a competitor might increase capacities and kill the market in the second year. Hence, the expected 28% appreciation might actually turn out to be a decline! As Murphy's law states 'If anything can go wrong, it will go wrong'.
Hence, Mr. Savvy Investor does not even bat an eyelid while deciding to invest in the government bond.
Let us now add a twist to the second investment option and see if it makes a difference to Mr. Savvy Investor's choice.
The leading analyst expects the stock to go up by 12% this year as the company has finished expanding its capacity six months before time. He also expects the stock to gain 28% in the next two years.
Mr. Savvy Investor does his calculations to figure out that his investment, in this case, would fetch a return of 43.4% in three years. A good 13.4% more than the government bond.
Like earlier, the uncertainties still remain. However, since Mr. Savvy Investor earns 43.4%, he can still take the chance. If the stock fails to go up by 28% in the next two years and instead goes up by just 17%, he will still make a return of 31%! In other words, the higher return provides a margin of safety.
Hence, the higher rate of return over the government bond for the same period makes Mr. Savvy Investor prefer the second option of investing in the stock.
What made him go for the second option?
The 13.4% extra return over the government bond. This 'extra return' that induces our Mr. Savvy Investor to choose the more uncertain investment option is called 'Risk Premium".
A financial textbook will tell us that
Risk premium is the 'reward for holding a risky investment rather than a risk-free investment.
The extra return that the stock market or a stock must provide over the risk-free rate of return to compensate for the market risk is called "Equity Risk Premium".
In case of Mr. Savvy Investor, the extra return of 13.4% over the risk-free 30% rate of return on the government bond defines his "equity risk premium"
How do you determine 'equity risk premium'? What is the right premium to settle for? What is 'Beta'? More of this next time as we brace ourselves to risk the stock market and brave the uncertainties.
As one great statistician wrote, "Humanity did not take control of society out of the realm of Divine Providence...to put it at the mercy of the laws of chance."
