What should a retail investor do? An interview in Intelligent Investor?

What's the easiest way for an investor to obtain low risk and high returns?

(Laughs) Pay off your credit card bill and all other consumer credit. This will give you returns above 16% without any risk. Most people make the mistake of carefully working on their investments, trying hard to obtain high rates of return, while ignoring the high cost of their own loans. If your credit card company charges you 2% per month, your best investment opportunity is to repay the credit card outstanding; this gets you 2% per month without risk.

Once this is done, what should a retail investor do?

Don't keep your money in the bank.

Why do you say this? Aren't banks the best choice for risk--averse people?

Even for people with a very limited appetite for risk, banks are inferior to alternatives. Money in savings accounts earns 4%, longer term deposits earn from 8% to 11%. Instead of lending money to banks, investors should lend their money to companies. Corporate bonds, as of today, commonly earn returns above 13%. The gain in returns is quite large. The risk of default, where a bond fails to pay back interest and capital, can be dramatically reduced by diversification. An investor who spreads his Rs.1 lakh across 10 corporate bonds is greatly reducing his exposure to any one of them. Diversifying across 20 bonds is even better.

This sounds like a free lunch? Isn't there a catch somewhere?

Firstly, it isn't a free lunch, in the sense that there is a greater chance of one bond defaulting as compared with repayment problems with a bank that is owned by the Government of India; to some extent, the greater returns do reflect this risk. However, through diversification, the investor can control his exposure to this risk.

To understand this large difference in the rate of return, let us pause to think about what banks do with the money that we lend to them. The bank has to put aside around 40% of the money into low--yield investments that are mandated by the government. The bank suffers administrative costs. The bank tries to lend the remaining 60% to companies in order to obtain good returns. By buying bonds on the market, the investor is short circuiting through this process. An investor who directly lends to companies avoids incurring the costs of running the bank and avoids the low--yield investments which banks are forced to make.

What about people with greater tolerance for risk?

Equities are the best investment strategy, in the sense of paying higher returns over long periods of time; however they do require greater risk tolerance.

When you say "risk" what do you mean?

When economists say "risk", we mean the month to month fluctuations of returns. When you buy bonds, you get around 1% returns each month; it does not vary much from one month to the next. Equity investments have a high variability; returns could be +7% in one month and -7% the next. However, for people who are willing to tolerate this ride, the rates of return over long time periods are extremely appealing; around 20% per year.

How does this choice change with different investment horizons?

The investment horizon makes a lot of difference. If you are 30 years old, investing in order to protect yourself at age 60, then the month to month fluctuations are simply not a problem. Suppose we start by thinking that bonds give a 14% rate of return. Over a 30 year horizon, bonds would translate Rs.100 into Rs.5100. Suppose equities give us just one percentage point extra; i.e. a long-run average of 15%. Over a 30 year horizon, this converts Rs.100 into Rs.6620. Hence a mere one percent per year difference makes the difference between 5100 and 6620; i.e. it generates a difference of 30% for your wealth at age 60.

Equities earn a higher rate of return in order to "pay for" their higher risk. Economists call this the equity premium, the premium that investors earn for suffering the fluctuations of the stock market. I believe that the long run rate of return on equities in India is near 20%. This rate of return converts Rs.100 into Rs.23,700 over 30 years. This is a huge difference as compared with Rs.5100 that is obtained using 14% bonds. To people who are willing to tolerate the month to month fluctuations of stock prices, this is a compelling choice.

This is really a tradeoff between investment horizon and risk tolerance. With long investment horizons, even highly risk averse people should find equities attractive. At shorter investment horizons, you have to either have greater risk tolerance to buy shares, or you should buy corporate bonds.

You talk about equity investing for horizons above a decade. What happens if we have a major political crisis, or a war, or some disasters of the sort? Won't equity investors get wiped out in this?

The two most interesting role models here are Germany and Japan in the Second World War. Equity investors who purchased shares prior to 1933 (when Hitler came to power) came out ahead of bond holders by 1955. It is hard to imagine a country that is more thoroughly destroyed than Germany (or Japan) in World War II.

Part of this is owing to the innate appeal of equity investing. But it's equally important to remember that bondholders suffer from inflation risk. If inflation goes to 15%, the 14% bond pays negative returns. Political instability and war have a way of generating episodes of high inflation that wipe out bondholders. Equities are relatively inflation proof.

In India, we do live in an environment with high inflation risk. It is quite possible that in the next decade, we may see episodes of inflation above 10%. Inflation risk is cruel on the elderly, who are often bond holders. It is a good reason to favour equity investing.

Okay, if we are to buy shares, what stocks do you recommend?

Stock selection is not important; indeed, a portfolio which is exposed to any individual stock is badly formulated.

Are you saying that any stock is as good as the other? That Infosys, which gave huge positive returns last year is as good as Century Textile, which has got huge negative returns?

Just because Infosys prices rose last year, this does not mean that the price will rise similarly next year. We should be very careful to not do such simplistic extrapolation. If, hypothetically, everyone knew that Infosys was going to rise by 50% next year, we would all rush to buy Infosys right away thus driving up the price right away. The price that we observe on a liquid market always contains reasonable possibilities of gains and losses.

My main recommendation is: form diversified portfolios, of liquid stocks. If a stock is liquid, it is trading a lot and many people are watching it. It's then unlikely to be unusually cheap or unusually expensive. If a stock is cheap, other clever speculators on the market will buy it! If a stock is costly, other clever speculators on the market will sell it! The efforts of the professional speculators makes prices "fair"; the normal investor benefits from their efforts at zero cost. It is always safe to buy a liquid stock without knowing anything about the company. It's price will reflect the risk and return; it's unlikely to be either unusually cheap or unusually costly.

How do you define "liquidity"?

A safe thumb-rule to use is that the bid-ask spread on NSE should be below 1%. If a stock quotes at 49/51, the spread is Rs.2 or 4%. That's a fairly illiquid stock.

So how should one do equity investing?

To harness the gains from equity investment, what you need is a broad, well-diversified portfolio of the liquid stocks in India. A portfolio is well diversified if you aren't particularly affected by any one company in the portfolio. Staying with liquid stocks eliminates the need to closely research a stock before buying it.

This can be done in two ways. You could pick a broad set of major, liquid stocks and form your own diversified portfolio. Alternatively, you could faithfully replicate the market index. The market index is an excellent investment choice. The NSE-50 index is well-diversified - it is not unduly vulnerable to any one stock. It is a liquid index, so that buying or selling stocks in the index is possible at low transactions costs. It is maintained, i.e. the composition of stocks evolves over the years along with the evolution of India's economy and corporate sector. An equity investor who simply mimics the NSE-50 index portfolio would fully harness the gains from equity investing.

What do you mean by "buying Nifty"?

I mean forming a portfolio, where the proportion of money invested in each stock is the same as the weight of the stock in Nifty (which is, in turn, proportional to the market capitalisation of the stock). For example, Infosys has a 2% weightage in Nifty. Then 2% of the portfolio should be invested in Infosys.

Won't the investor run into market lot problems? If I have a portfolio of Rs.1 lakh, then 2% is just Rs.2,000 or 1 share of Infosys.

Such an investor needs a Nifty index fund. Using an index fund, you can buy Rs.1,000 of Nifty. The mutual fund does the work of pooling money from many investors and buying into stocks which require large investments because of the minimum market lot. Index funds do not hire expensive staff; they faithfully mimic the work done at NSE in index management. When NSE says that Infosys comes into Nifty, the index fund manager buys Infosys. Normally, the index fund manager does nothing. This reduces the management fees and costs associated with an index fund. It is also easy for an investor to monitor whether the index fund is doing what it promises to do: the percentage change of NAV every day should be the same as the percentage change in Nifty every day.

How will this change with NSE's upcoming index futures and index options market?

All investment strategies that involve equities will be greatly assisted using index futures and index options. I will show a few cases of their applications here:

  • If you have an equity portfolio, and suddenly become uncomfortable about the stock market (for example, because you need the money within a few months), you can sell index futures and immunise your portfolio. While the futures position is open, you would not suffer whether Nifty goes up or down.
  • If you would like to invest in the index, as an alternative to using index funds, you can buy index futures. By placing a deposit of roughly Rs.10,000 you would get a purchase of Nifty worth roughly Rs.100,000.
  • You can cap your downside losses by purchasing index options. If you buy index options set to Nifty of 800 then your portfolio would suffer losses if Nifty drops till 800, but below 800 you would be reimbursed all your losses. This is exactly like buying insurance.
  • Conversely, you could be a fixed income investor and deploy 5% of your portfolio into buying index options which captures all Nifty gains above1000. Here, if Nifty stays below 1000, you get nothing, but when Nifty goes above 1000 you get the difference. I.e., if Nifty goes to 1100, you get Rs.100.

These are all remarkably useful things that become possible once index futures and index options start trading.

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