The title of this month’s column is from a groundbreaking book on investing. The Intelligent Investor by Benjamin Graham has inspired and shaped the behaviour of several high profile investors, including Warren Buffet. It is a must read, if you want to learn how to invest wisely in stocks.
In our last column, we saw that one of the fundamental differences between savings and investment is the degree of risk involved.
When you save money in a real bank, or even a piggy bank, your money is safe. You can also invest in government bonds, which are nothing but IOU (I Owe You) given by the government, when it borrows money for various purposes. Thus, lending to government is the same as investing in government bonds.
Safer options
Lending to your government is actually safer than even parking money in your bank. How so? When you lend money to someone, there are two things to keep in mind. The first is the borrower’s ability to pay; the second is their willingness to pay. Take the case of Government of India. If you are lending to the government, how will you ascertain the borrower’s ability to repay the loan?
The Government has the ability to generate lot of cash based on its ability to tax the residents. This power to tax makes loans to government a top risk-free investment. The next best and least risky is lending to banks.
Do you know that the deposits with your banks are insured? What this means is: should you have a deposit of, say, Rs. 50,000 and the bank subsequently goes bankrupt, your money is still protected by the deposit insurance. So you will get your money back. Technically, you can consider lending to either the government or a bank as savings — and not as investment — because of the very low credit risk (risk of the borrower not repaying the loan).
You will have seen several advertisements in which corporates promise attractive interest rates for lending money to them.
Lending to corporates is an investment, not a saving. There is a real risk of the borrower getting into business difficulties and being able to or even willing to repay the loan.
Can you recall an example of a company that has been in the news lately because of its inability to pay back loans? Kingfisher Airlines, the troubled airline of Vijay Mallya group, is not in a position to repay its lenders.
High returns
If lending to businesses is so risky, why do people do it? The answer is high returns. Take the case of fixed deposits with the Sundaram Finance group, one of the most trusted business groups in South India. There are a number of depositors who keep fixed deposits with Sundaram Finance. They have a choice of depositing with their neighbourhood bank; yet they keep the money with the Sundaram Finance group. This is because Sundaram Finance pays a higher interest rate than a bank for the same maturity. The investors believe that the extra risk of lending to a corporate is offset by the extra return they get with the higher interest rate. Thus investors demand higher returns to compensate for higher risk taking. We will see more about this risk return trade off in our next column.
Venkatesh is the co-founder and Director of Money-Wizards, a company engaged in financial literacy and money education for adults and college students. E-mail: Info@Money-Wizards.com
