I believe this particular article is the best that I have written so far. Sometimes I think you are very lucky because what you are reading is the outcome of my hard work and a hundreds of hours of study and analysis. You are just receiving the result. For you “There is a gain without a pain”. However, the purpose of this article is not to just build your theoretical knowledge of investments but I want you to implement this and think strategically and if not strategically then at least use basic common sense which I put it as “Finance Sense”. I hope this will help you a lot.
People have different attitude towards risk. Some like to take risk and some avoid it. Usually we can safely assume that one who prefers to have a job rather than start his business is someone in a latter category. Because starting business is very risky, but working 8-10 hrs/day, insure that you will receive your cheque at the end of the month without any “risk” which means you know at the start of the month how much you will get at the end of month. However, in a business, you are not that much sure, any thing can happen, at the extreme levels you could make millions or you could loose everything that you have. Since most of the people in our world belong to this second (risk avoiding category) I can safely assume that most of my readers also belong to this second category. This article is written in keeping their views in mind. However, that does not mean at all that this article is not for business people.
The fact of the matter is that even those who want to avoid risk cannot avoid it all. They can lose their job, the inflation is 10-15% here in Pakistan and they would not be able to save enough for their retirement, they might not be able to reach their goal like purchasing new home etc, accumulate enough wealth and the last but not the least there is a mortality risk and in order to manage these risks efficiently you need to invest efficiently, i.e. invest where you have an ability & desire to invest. If risk avoider is not planning his financial matters then I believe that he is actually unknowingly taking a huge risk.
Now I am coming to the point, here are some of the basic ways of investing:
1) Invest in a Company
2) Invest directly in a Country/economy
3) Invest indirectly in Country’s economy i.e. invest in Stock Mutual Fund
4) Invest in Corporate Bonds/Fixed-Income Mutual Fund
5) Invest in a Commercial Bank/National Savings
If you are risky and young then you can choose a first option, (I would suggest you to read my previous article “Young Investor: Minimum Diversification” to apprehend this article completely). When you invest in just two or three companies there is a fair amount of risk (and hence return, remember the basic premise of finance: higher the potential risk higher the potential return). However, since you are a relatively risky and most importantly you are young and you have stable income you can certainly take this risk because this risk could be very rewarding for you in a long term.
If you consider yourself as risk avoider (risk averse) then you can choose a second option. Invest in 15-20 companies from different sectors, which should be the representatives of country’s economy. If you believe your country will survive then we can safely say the risk in this investment is much less than the previous one. Put it simply; instead of investing in few companies invest in the economy.
If you consider yourself as high-risk avoider (highly risk averse) then we still have a solution, buy a stock mutual fund. Stock Mutual Fund invests in stock market but their investment is much diversified and the money is managed by professionals. So if you are afraid of stock market and do not want to directly invest then this should be the right option. Remember they charge a fee. As per my knowledge there are around 27 Asset Management companies working in Pakistan.
If you are very high risk avoider then believe me, we still have a solution. There are two ways to invest in a company, you can buy its equity (shares) or you can give it debt, which means you can buy bonds. We all know very well that company first pay its creditors and then what is left over is paid to shareholders. Therefore, if you have bought a debt of a company then you should be rest assured that this is the least risky option of all. Because this is a fixed-income. Now let me also tell you that you can buy company’s debt directly if you can get an opportunity (Engro has recently launched Engro Rupiya offering a rate of 14.5% and even small investors can purchase this bond) but directly investing in company debt is not that much easy for small investors. Nevertheless, you can still invest in debt market by investing in a Fixed-Income Mutual Fund. These mutual funds invest in fixed income instruments and you can get a decent return, however, the expected return is less than a Stock Mutual Fund.
Finally, If you are the “Maha Risk Avoider” then actually you don’t need any advice because I hope you would have been very happily invested in an commercial bank or national saving scheme at the rate of 7%-11% which is not very bad for “Maha” risk avoider.
I thank for your patience but we are not done yet. What I really want is that one should be able to understand the importance of categorizing oneself in term of how risky he is and then invest accordingly. If you have ability and desire to invest aggressively then you should not end up investing in commercial bank for just 10%. I have no problems with “Risk Avoiders”, as far as they behave like Risk Avoiders as I stated earlier that even they sometimes unknowingly take a big risk.
Consider a simple case of how mismanagement of your wealth through not recognizing your risk category can lead you to invest inappropriately.
As an example, consider the after tax return from three strategies:
1) Stock Market Return for an “average” diversified Investor/Mutual Fund = 20%
2) Fixed Income Return/Bond from Corporate Sector = 15%
3) Return from commercial bank = 10%
Remember the return of stock market is used as a proxy of what an average investor could achieve, the return for different investors may be different i.e. for some investors it could be 40% and for some it could be 10% but over a long-term 20% return should not be a big deal if you or your stock mutual fund is an average investor.
Now suppose you have 100,000 Rupees, which you want to invest for 35 years for your retirement. Just check out the payoff of these different strategies after 35 years:
Stock Market = 59,066,823
Fixed Income = 13,317,552
Bank = 2,810,244
By showing these payoff (where the payoff of Stock Market is 4.5 and 19 times more than fixed income and bank respectively), I am not implying that you should invest in Stock Market. But what I want to tell you is that if some one had the ability & desire to take risk but end up investing in bank then his payoff will be just 4.7% and 21% of what he could had by investing in stock market and fixed income respectively. If you are “Maha Risk Avoider” and invest in bank then there is no problem at all. However, if you had marginal ability & desire to take risk but did not invest in fixed income, or you had good ability & desire to take risk but did not invest in stock market, then there is a problem.
Note that the calculations are shown for 35 year but the conclusion would be the same for any time horizon. Secondly, I am not implying that one should have a horizon of 35 years. You could have a different investment horizon e.g. 10 yrs or 20 yrs. However, remember this study is for long-term investment only (10yrs-35yrs). Let me stress this again, I am not saying that you should invest for 35 years.
Finally, the fact is, most people use a combination of these investments. Thus, the question should not be “Should I invest in Stock Market or Fixed Income or Commercial Bank? The correct question should be “In what proportion should I invest in Stock Market, Fixed Income and Commercial Bank/National Saving”? The answer of this question as described depends on you risk taking ability and desire. As an example, you could choose the allocation of 40%-40%-20% in Stock Market, Fixed Income and Commercial Bank respectively or if you have ability and desire to take risk then your allocation could be 70%-20%-10%.
Note: As an investment professional, I try to share as much as possible of what I have learned from my short experience of two and a half years or so. I believe field of investment is very dynamic and there is a lot of room for further discussion. Even investment professionals might disagree with me on some points. However, this is how this field is.
You can post a comment if you have any question or you can send me an email at firstname.lastname@example.org.