Foundation — Saving, investment, speculation and the four objectives

1.1 Why investment exists at all

People earn money and spend money. They pass through various phases in their life cycle. During some phases, they earn more money than they spend. In other phases, they earn less than they spend. Therefore, sometimes they have to borrow money to meet the shortfall and in other times they end up having surplus money.

People have, broadly, two options to utilise their savings. They can either keep it with them until their consumption requirements exceed their income, or, they can pass on their saving to those whose requirements exceed their income with the condition of returning it back with some increment.

Therefore, those who consume more than their current income must be willing to repay more than what they received, to those who have provided the funds. Essentially, people make a trade-off between postponing their current consumption, and an expected higher amount for future consumption.

Read that last sentence carefully — it is the seed of everything else in this chapter. A trade-off between postponing current consumption and an expected higher amount for future consumption. The price of that postponement is what section 1.4 will call the pure time value of money, and the compensation for uncertainty on top of it is the risk premium.

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1.1.1 Saving versus investment

It is common to use the terms Savings and Investment interchangeably. However, they are not one and the same.

Saving is just the difference between money earned and money spent. Investment is the current commitment of savings with an expectation of receiving a higher amount of committed savings. Investment involves some specific time period. It is the process of making the savings work a.k.a. investment to generate return.

Three elements distinguish investment: a current commitment, an expectation of a higher amount, and some specific time period. Money lying in a drawer satisfies none of them.

Where the money goes:

Hence when people are saving, they may save in variety of instruments or securities like cash or gold but mostly they use the short-term deposits/short-term securities which are highly liquid assets. On the other hand, when people are investing, they commit funds to specific asset classes or goals with longer term time horizon like real assets, capital market securities such as stocks and bonds, and other long-term commitments that may not be as liquid as short-term assets.

And the difference in purpose:

Secondly, the objectives of savers and investors are different. Savers tend to accumulate funds to address short-term goals, whereas investors have longer-term goals, such as building retirement corpus or funding children's college education expenses.

The conclusion — memorise this line, it is a ready-made exam sentence:

Those who save funds have the choice of investing. Hence, every investor is a saver but not vice versa.

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Box 1.1 — financial assets versus real assets

Assets can broadly be categorised as financial assets such as shares, debentures, bank deposits, public provident fund, mutual fund investments and others, and real or physical assets (tangible assets) such as gold, diamonds, other precious metals, infrastructure and real estate.

Financial assets have the advantage of greater liquidity, flexibility, convenience of investing and ease of maintaining the investments. They are primarily income generating investments, though some of them, such as equity-oriented investments are held for long-term capital appreciation. There is greater ease of investing in such assets as it allows for small and frequent investments.

Four advantages of financial assets: greater liquidity, flexibility, convenience of investing, and ease of maintaining the investments — plus a fifth practical one, that it allows for small and frequent investments. You cannot buy one-thousandth of a flat every month; you can buy Rs 500 of a mutual fund.

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1.2 Investment versus speculation

Another term which needs to be distinguished from "Investment" is "Speculation". Investment and speculation activities are so intermingled that it is very difficult to distinguish and separate them. An attempt can be made to distinguish between speculation and investment on the basis of criteria like investment time horizon and the process of decision making.

The time horizon test — and why it fails

Financial transactions occur on a time continuum ranging micro milli-second, micro-second, second, minute, hour, day, week, month, year, decade, century and perpetual time period. There is a tendency to describe short-term activities as speculative in nature and long-term ownership of assets as investments, which is not appropriate.

Which is not appropriate. That is the workbook's own verdict, and it is examinable. Holding period alone does not settle the question. A trader who has carefully valued a mispriced bond and sells it in three days has invested; a man who buys a fashionable share and holds it for ten years without ever asking what it is worth has speculated for a decade.

The real test — process of decision making

Another popular way to define speculation is by extending the dictionary meaning of the same. Dictionary meaning of the term speculation is "the forming of a theory or conjecture without firm evidence".

The activity of investment involves carrying out any exercise or process to determine the value of the asset and then buying the one whose value is determined to be higher than the current market price.

However, while speculating, one is motivated to undertake risk which is not commensurate with the return, in anticipation of gaining higher returns, with minimum research and analysis on the true value of the asset.

Three markers of speculation in that sentence:

1. risk which is not commensurate with the return
2. in anticipation of gaining higher returns
3. with minimum research and analysis on the true value of the asset

And the corresponding definition of investing: carrying out any exercise or process to determine the value of the asset and then buying the one whose value is determined to be higher than the current market price. Value first, price second, and buy only when value exceeds price.

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1.3 Investment objectives

Most of the investors invest with a goal in mind, regarding the value of the investment at the end of the investment period. Investment objectives are investors' goals expressed in terms of risk, return and liquidity preferences.

Three dimensions: risk, return and liquidity preferences. Not return alone.

Why return alone is a dangerous way to state a goal

Some investors may have the tendency to express their goals solely on the basis of return. They must be encouraged to state their goals in terms of both risk and return, as expressing goals only in terms of return may lead to inappropriate asset allocation and adoption of risky investment strategies.

Given to themselves, an investor may want her wealth to double up by the end of the year. However, she must be made to understand that such a goal would entail excessive risk.

And then the sentence that is the heart of the chapter:

The investor must be explained that "risk leads return" and not the other way around. Hence a detailed analysis of the risk appetite of the investor i.e. her willingness and ability to take the risk should proceed any discussion of the desired return.

"Risk leads return" — not the other way around. Learn the phrase exactly. And note the two components of risk appetite the workbook names: her willingness and ability to take the risk. They are different things. A young software engineer may have the ability to take risk — decades of earning ahead, no dependants — and no willingness at all. An elderly widow may be perfectly willing and have no ability.

The four objectives

Capital Preservation means minimizing or avoiding the chances of erosion in the principal amount of investment. Highly risk averse investors pursue this investment goal, as this investment objective requires no or minimal risk taking. Also, when funds are required for immediate short term, investors may state for capital preservation as the investment objective.

Two situations, not one: highly risk averse investors, and when funds are required for immediate short term — even a bold investor preserves capital for money he needs next month.

Capital Appreciation is an appropriate investment objective for those who want their portfolio value to grow over a period of time and are prepared to take risks. This may be an appropriate investment objective for long term investors.

Regular Income is an investment objective pursued when investor wants her portfolio to generate income at regular interval by way of dividend, interest, rental income rather than appreciation in the value of the portfolio. This investment objective is mostly pursued by people who are retired and want their portfolios to generate income to meet their living expenses.

Note the three named sources of regular income: dividend, interest, rental income.

Tax Saving: Sometimes investors do invest in some select investment alternatives, to reduce their tax burden. This is because the IT authorities provide tax benefits in terms of deductions from taxable income, or as tax rebate from the tax payable.

Two mechanisms, and they are different: deductions from taxable income reduce the income on which tax is computed; a tax rebate from the tax payable reduces the tax itself.