Familiarity does not Equal Safety

Publication: The Times Of India Mumbai; Date:2007 Nov 13; Section:Your Money; Page Number: 40
Just because you understand how a particular investing option works, that doesn’t mean it’s the best place to park your money
People often confuse familiarity with safety. This is evident in many choices we make in life—especially in investing decisions. Senior citizens generally prefer fixed deposits (FDs), because they are familiar with how they work, and sometimes put nearly their entire savings in FDs and bonds. Similarly, many people equate insurance with LIC, and even when they opt for private insurers, their focus is always on investment-oriented insurance policies. This is because, until private insurance companies appeared on the scene, LIC did not have a single term plan. So people are far more familiar with investment-oriented insurance plans.
The key drivers here are tax saving, returns, and—in third place—life insurance cover. Try this little reality check: ask your friends about their insurance policies. Chances are, they will know the premiums they pay each year, the tax they save, and the returns they expect at the end of the term, but are less likely to know the sum assured in case of an eventuality. A customer’s familiarity with a particular insurance company does not make that company’s products better than those of its competitors.
Builders can only think of real estate as an investment. They may not be able to tell you the exact percentage of returns they made net of costs and tax, but they know for sure that they will not lose money in real estate. Similarly, diehard equity investors will vouch that there is plenty of money to be made in stocks, and that you just can’t lose money in equity if you choose well and have a long time horizon, say, 10 years. People familiar with race horses would rather bet on horses than in a game of teen patti. This bias persists even if it can be proved that the odds of winning or losing are identical in both options. It’s no peculiarity of Indian investors; it holds true globally. Investors are generally comfortable with domestic investments because that’s what’s familiar. A classic example is non-resident Indians, especially those based in the United States. They are familiar with the dollar appreciation scenario, from the 1980s to the early part of the 21st century, and they find it difficult to move away from it and into Indian investments, despite getting pathetic risk-adjusted returns on their 401k (retirement fund) and on US investments generally.

Ignoring opportunities?    Does this mean that people are right in making such assumptions? Absolutely not, and the reality is quite different from perception. Bungee jumping may be an adventure for some people, but for others it could be a nosedive into the grave. Similarly, different types of investments are exposed to different types of risk. Some risks are discussed below (the list is not exhaustive).

Inflation risk:One of risks that all of us face is the eroding effect that inflation has on wealth. This causes us to lose purchasing power, and to outlive our money. The purchasing power of our money may not match the pace of inflation. This could happen when we choose to either not invest at all, or invest insufficiently in growth products and end up with a negative real return on our money. An example is keeping one’s money in a savings bank account, at the rate of 2.45% a year (net of tax)—an increase that is much lower than the inflation rate.

Liquidity risk:There is the possibility that you may not be able to readily access your funds, or that you may have to make a distress sale to liquidate funds when you need them, because they are invested in illiquid assets. This could be true of investments in real estate, art, and so on.

Market risk:This refers to the possibility that movements in equity markets may cause your investment to decline (or increase) in value.

Interest rate risk:A rise in interest rates could cause bond prices to decline. There is an inverse relationship between interest rates and bond prices.

Credit risk:It is possible that the institution (borrower) holding your capital (for example, a debenture issuer) could fail to pay interest and /or return your capital. Credit risk is very high in case of institutions with low credit ratings. Government of India bonds are, of course, free of credit risk. Funds in scheduled banks are guaranteed by Reserve Bank of India up to Rs 1 lakh only.

Reinvestment risk:If you invest in fixed-rate investments (bonds, for example), you may have to reinvest coupons as well as maturity value at a lower rate of interest, if rates decline during the life of that investment.

Concentration risk:If you invest all or too much of your capital in a single asset class (say, stocks), a fall in that market will adversely affect all of your capital.

Regulatory risk:It is possible that government policy changes could affect your financial strategy adversely. Examples are changes in superannuation and retirement income policies, and tax laws.   Being familiar with a particular form of investment does not in any way make it safe. No investment is completely safe. One must fully understand the risks that each type of investment is exposed to and then make a prudent decision. Amar Pandit is a Certified Financial Planner and Director, My Financial Advisor

Amar Pandit  – The father of one of my friends once declared, “The stock market is full of CHORS. It is a zero sum game. It is risky and you can never make money in it.” Later, I learned that he had never experienced any loss; indeed, he had a multi-bagger in the form of his own bank in his portfolio, but his boss often used to tell him this. The notion had been ingrained in his mind, so he never dared to invest in the stock market except for the stocks of his own bank. So I asked him, “Why do you say that you can’t earn good returns in equity, when in fact you have never lost money but made 40 times what you put in, in about 15 years?” He reflected on my question, and seemed to have got the point I was driving at. He then started asking insightful questions on what kind of equity exposure he should be taking.

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