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INVESTING SENSIBLY
- The risks and rewards of making investment decisions

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 the 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 1.5 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 indices, but also sectoral indices ' 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.

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