Risks and the Stock Markets - Part 5 of 7

Continuing from my previous part of  the current series.

Now, if one invested Rs. 1,00,000/- and there was an opportunity to generate a profit or loss scenario as below, which one would you chose:
o Option A - Max profit of Rs. 10,000/- and max loss of Rs. 10,000/-
o Option B - Max profit of Rs. 20,000/- and max loss of Rs. 10,000/-
o Option C - Max profit of Rs. 50,000/- and max loss of Rs. 50,000/-
o Option D - Max profit of Rs. 1,00,000/- and max loss of Rs. 1,00,000/-
o Option E - Max profit of Rs. 2,00,000/- and max loss of Rs. 1,00,000/-

How many of you would change your choices compared to the previous illustration?

The question to all who changed their choices – the percentage gain or percentage loss was the same in both the illustrations, then why have different choices?

The reason for the change in choice is called ‘behavioral accounting’. For most of us, Rs. 100/- is an amount we are fine to run a risk of 100% loss. If one can get over this problem of mental accounting and based on your risk profile, you CAN INVEST in options linked to the stock market.

Risks and the Stock Markets - Part 4 of 7

Over the last 3 parts, I have touched upon the following:
• Perception of ‘Risk’ as the measure of ‘gain’
• Money can never be completely safe – its ‘purchasing power’ diminishes
• Zero ‘Risk’ is Zero ‘Gain’
• Governments don’t have the mandate to keep your money ‘safe’ and keep it ‘growing’
• Saving is not investing

Let’s now identify the degree of risk aversion one is comfortable with:
If one had Rs. 100/- and there was an opportunity to generate a profit or loss scenario as below, which one would you chose:
o Option A - Max profit of Rs. 10/- and max loss of Rs. 10/-
o Option B - Max profit of Rs. 20/- and max loss of Rs. 10/-
o Option C - Max profit of Rs. 50/- and max loss of Rs. 50/-
o Option D - Max profit of Rs. 100/- and max loss of Rs. 100/-
o Option E - Max profit of Rs. 200/- and max loss of Rs. 100/-

In the above illustration, inflation is considered as money value destroyer. Hence, profit and loss scenario can occur at the same time.

Global Events, Global Markets, Global Turmoil

Events like The World Wars, Great Depression, Lehmann Crisis, get etched in our minds by the sheer uniqueness or the magnitude of their occurrence.

Also, by virtue of the huge advances made in technology over the years, information (rumours, lies and truths) get disseminated ever so quickly.

Fortunately or unfortunately, in this ever increasingly connected world, making decisions for our investments becomes much more harder.

Today, among many other events, the global markets crashed. Over the last few months, every government, central banks, financial markets, commodity markets are clueless about the real problem, a probable solution, effectiveness of the solution and time period within which the solution will take effect.

Some countries are fighting high inflation, others are focusing on improving growth of their economies, some others fixing their debt crisis and a few are recovering from natural calamities . Since, all countries are not facing similar issues (pretty much expected at any given time), ‘One Size Fits All’ solution does not work.

Surprisingly, despite the varied issues countries are facing today, at the time of writing, stock markets across the world have fallen anywhere between 2% and 6%. Currencies have fallen between 2% to 7% against the dollar. Crude oil has fallen 3% to 5%, gold has fallen by 4%, silver by 10% ALL IN A SINGLE DAY.

Few of the key reasons for the current chaos (and at all other times :-)) and the root for the ‘negative perception of risk’

• Fear

• ‘Following the Herd’

• Greed

• Knowledge is power, ignorance is bliss – little of both is a recipe for disaster

If we can control the above reasons and ‘react’ better with our behaviour, global events will become less unique and smaller in magnitude.

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.

Risks and the Stock Markets - Part 2 of 7

I’ll like to keep emphasizing through these series that one needs to look at ‘risk’ as the measure of gain / opportunity.

We all by training are conditioned to risk in almost everything we do which also includes our views about investing.

To invest (especially money) by definition is always about a profitable return. If you notice, ‘investing’ has no risk!!

Essentially, the problem lies not with investing but with the latter part of the definition, ‘profitable return’. This brings the concept of the risk-reward ratio.

From childhood, we are trained to save. The simplest form of saving was not to spend the money but to keep it aside in a ‘piggy bank’. Our parents saved in a slightly organized manner – they saved in PPFs, FDs, Savings Accounts, NSCs, etc. Fortunately, all these gave very ‘profitable returns’ and since most or all these instruments were backed by the government, there were ‘safe’.

But in our childhood did we realize that the money in our ‘piggy banks’ grew only if we saved more? By saving we only postponed our impulse to spend.

If I told you that the ‘Deposit Insurance & Credit Guarantee Corporation’ (a wholly owned subsidiary of RBI set-up in 1962) guarantees ONLY Rs. 1 lac regardless of the number of accounts (or type of accounts) held by a person in same capacity and the same right.

Essentially, if you held a savings account and / or current account and / or fixed deposit with one / more branches of the same bank, AND if the bank went bust, the MAXIMUM amount RBI will compensate will be Rs. 1 lac or the sum total of your money in all accounts whichever is LESSER.

With the above new input, is money in the Bank really safe? Is the return risk-free? Shouldn’t we just keep money under our pillows / beds (like the big politicians do) or just keep it in a PIGGY BANK!!

References –

www.dicgc.org.in

www.dictionary.com