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All Investments have risks - even Bank FDs
There is no asset class that can be termed risk-free. To take charge of your financial life, you can, at best, cut down on your risks by diversifying your investments
A frequently asked question is: what is the best investment choice for the ordinary investor? There is palpable disappointment when the answer is: there is no such choice. Everything is risky, from taking the road to choosing a partner. But we seem somewhat adamant when it comes to investing. We love to blame. We like to find conspiracy theories. We think someone has to take responsibility. Or, worse, we feel entitled to the best.
It is time to drop all this for good. We are responsible for our financial wellbeing. Risk, return and diversification are fundamental ideas that each investor has to learn, without protesting about entitlements.
There is nothing like a risk-free asset. But the good news is that financial structures can be created to come close to that ideal. Consider the much coveted bank deposit. Many of us trust the bank; there is little reason why we should not. The structure of a bank has been honed over the years to protect depositors. This despite the fact that the bank uses the depositors' money to make risky loans.
How is this possible? A bank cannot simply take deposits and make loans. It has to back its promise to its depositors with a solid balance sheet structure. There are four primary ingredients that make the bank deposit a nice and robust investment product. First, a bank cannot fund all its loans with deposits. It has to have its own capital. For example, if a bank wants to have a loan book of `100, it can raise `90 as deposits but, to do so, it must first raise `10 as equity capital. The equity capital has to be adequate to cover the risks of the loans.
What does this mean?
If `10 is equity capital and `100 has been lent out, the bank has allowed for a risk of `10 on its loans. Or, even if 10% of its loans go bad, it can still repay `90 to its depositors. When we speak of capital adequacy norms, we refer to the regulatory requirement, which weighs the loans based on each category's risk, and asks the bank to first raise equity capital, to provide the cushion, so that depositors are protected. This is why, when banks' non performing assets (NPAs) go up, we now talk of banks' need to be `capitalised'.
What are the other three ingredients of the bank's structure?
First, a part of the deposits is kept as cash with the central bank, to meet exigencies.
Second, a part of the assets have to be statutorily kept in safer government securities, only the rest can be lent as risky loan.
Third, if a bank finds that its loans have gone bad, it has to provide for them from its profits. All these ingredients make the bank's balance sheet a dependable structure for investors who deposit money, earn the stated interest, and access it when they like.
Why is the bank deposit still not risk free?
Though it is not very common, a bank can still fail. Hoping to earn a high return, in its quest to maximise profits, a bank may give very risky loans. The bank may be reckless in its lending practices, making loans to poor quality borrowers. The primary risk of all these events impacts the equity investor. In our example, if the loan book falls in value from `100 to `92, the deposit holder will still get back `90. But the equity investors' value has eroded from `10 to `2. If the bank hides its bad loans, or fails to provide, or does not get more equity capital to support the risky assets, it could default on its deposits too.
This is why equity is riskier than debt. But not all promises made by a borrower to a lender are good. It all depends on the quality of the assets and the structure of the balance sheet. If one bank has low NPAs and good equity value, it is qualitatively better than another bank with high NPAs and low and falling equity values. Many who assume that nothing can go wrong with PSU banks are not guided by the principles of finance, but by the blind faith that the government will not allow the banks to fail.
When a bank is stressed by bad loans, it needs equity capital--to make new loans and to price and service its depositors competitively. A bank with a weak balance sheet will have to pay more for deposits. It has to make riskier loans to make profits. Therefore, a weak bank is not a great place to be in. If the government has to step in, it has to find money to be an equity investor in the weak bank, or fund other equity investors. Both tasks are tough.
What about other investments? In each case, the structure is what matters. In a company deposit, the assets of the company matters. If it is a profitable business, and if it is adequately capitalised, it might be a good investment option. In a PSU, or any other company bond, the same principle works. In any debt investment, investors should take the time to see what is at work to protect their money. As a rule, lending to a business whose equity share prices are falling, is a bad idea. The risk of the assets is what the equity prices reflect.
How about equity? An equity investor is directly exposed to the risk of the assets. The only protection to the equity investor is diversification. All assets don't go bad at the same time. If an equity investor's shares are spread across different businesses, the risk of failure will be lower. For example, an investor holding PSU bank stocks and private banking stocks, might be better off than one holding only PSU bank stocks. An investor holding banking, pharma and IT stocks might fare even better. But the risk cannot be eliminated completely.
So what does taking charge mean? Three key things. First, there is no guarantee in modern finance. A promise about return is as good as the balance sheet on the basis of which it is made. Second, diversification is key to reducing risks arising from promises gone weak or bad. Third, there is no point trying to forecast the future. Even the best loans can fail, and great companies can fall. To invest means accepting that returns will always come with risks, and that diversification is more sensible than mindless speculation about the future.
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