Risks and the Stock Markets - Part 3 of 7

In the last part, my closing view was that money under our pillows / beds / piggy banks were the safest places :-).

Arguments I have received in response to the above are:

• Money under pillows (and other options) is not ‘investing’ as money does not grow and it still has the risk of being robbed.

• Money in a bank (savings, FD, et. al) is ‘invested’ as money does grow and the risk of the bank going bust is minimal.

We all know that ‘risk-reward ratio’ implies a higher risk is an opportunity for higher gain (and also loss :-)).

And hence, the rationale for the views from people is driven by:

• One would rather keep the money in a bank than under a pillow as the ‘risk’ (the chance of loss to burglars, IT Department) for the latter is higher.

• Banks rarely go bust

• Keep your risks as low as possible as long as the principal is safe

Here’s a fact – there have been atleast 6 banks in the last decade which have been forced by RBI to be merged or acquired by larger Indian banks as the banks went bust or were on the verge of it (E.g. Global Trust Bank was force merged into Oriental Bank of Commerce).

Indians, by virtue of our social training, have a ‘saving’ mentality and are focused on preservation of capital even at the expense of being in a low return (low risk) investment. Unfortunately, rarely do we realize that other important macro-economic factors (inflation, government administered interest rates, etc.) are reducing the purchasing power of our savings.

The incentive for investing is not the safety of the capital (though people do not realize this fact). The BIGGEST DRIVER for people to ‘invest’ money under pillows, FDs, PPFs, NSCs, (all the safe investments) is because the fluctuations of expected return is the least in all these forms. In any or all these investment forms, we know the final return for the tenure the capital is invested. This is not true for any investment form linked to the stock market.

If an FD gives you a 10% pa return on your capital, and if a stock can give you 3% return in a quarter (approx. 12% pa) then given a choice, where will you invest your money?

Food for Thought: If we know what return we want / are expecting from an investment class / form for a given tenure, then why not use the same tenet in the stock market.