Foundation — Saving, investment, speculation and investment objectives

A farmer collects rain in a tank. That is saving — simply what came in less what ran off, sitting there, doing nothing.

When he channels the water into his field to grow a crop, that is investment. He has committed it, for a specific period — until harvest — with an expectation of receiving more than he put in.

The workbook defines the two exactly so. 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.

Notice that the farmer cannot irrigate without first having collected water. Hence, EVERY INVESTOR IS A SAVER BUT NOT VICE VERSA — a sentence worth memorising in those words.

And notice what he keeps back. Some water stays in the tank for drinking and washing — needed soon, needed certainly. That is the saver's instinct the workbook describes: short-term deposits / short-term securities which are HIGHLY LIQUID assets, for short-term goals. The water in the field is the investor's: committed to longer term horizons, and not as liquid — you cannot get it back out of the soil before harvest.

Two men buy land on the edge of a growing town on the same day.

The first spends a month on it. He checks the title, walks the plot, studies the road alignment, compares four recent sales nearby, and concludes the land is worth Rs 38 lakh. It is on offer at Rs 31 lakh, so he buys.

The second hears at a wedding that a company may open a plant nearby. He buys the adjoining plot the next morning, at Rs 44 lakh, borrowing most of it.

They may both hold for ten years. Holding period tells you nothing about which is which. The workbook is explicit: 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.

What separates them is the process. 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.

The second man did none of that. 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.

And the dictionary sense the workbook quotes captures it in six words: the forming of a theory or conjecture WITHOUT FIRM EVIDENCE. The rumour at the wedding was a theory. It had no evidence behind it, and the borrowing made the risk larger still.

A passenger tells an auto driver he wants to reach the station in ten minutes. The driver does not reply with a fare. He asks where the station is.

The distance determines the fare. The passenger's wish determines nothing.

The workbook makes exactly this correction about investment goals. An investor may want her wealth to DOUBLE UP BY THE END OF THE YEAR — and, the workbook says, she must be made to understand that SUCH A GOAL WOULD ENTAIL EXCESSIVE RISK.

The principle is stated in three words: "RISK LEADS RETURN" AND NOT THE OTHER WAY AROUND.

Which produces a practical rule about the order of a client conversation: 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.

And the workbook names what goes wrong when the order is reversed. Expressing goals only in terms of return may lead to INAPPROPRIATE ASSET ALLOCATION and ADOPTION OF RISKY INVESTMENT STRATEGIES.

This is why the definition of an investment objective has three parts, not one: investors' goals expressed in terms of RISK, RETURN AND LIQUIDITY preferences. A goal that names only the return has left out the two things that decide whether it is achievable.

A man lends Rs 1,00,000 to a friend for a year. Ask him what he wants back and three separate thoughts arrive.

First, he is giving up the use of the money for a year. Even if nothing else changed at all, he wants something for that. The workbook calls this the PURE TIME VALUE OF MONEY — the compensation for investors who postpone their current consumption — and names it the REAL RISK-FREE RATE. Its illustration: postponing INR 1000 today for a guaranteed INR 1020 gives a pure rate of 2 per cent.

Second, things will cost more in a year. He wants his purchasing power back, not just his rupees. That is compensation for EXPECTED INFLATION during the period of investment for the change in the general price levels. Real risk-free rate adjusted for inflation expectation is the NOMINAL RISK-FREE RATE.

Third, his friend might not repay on time, or at all. That worry has a price too: RISK PREMIUM for the UNCERTAINTY OF FUTURE PAYMENTS.

Stack the three and you have the workbook's equation exactly: Real risk free rate plus inflation adjustment + Risk premium adjustment = REQUIRED RATE OF RETURN.

And note the four things the workbook says a required return is not. It is not a guaranteed return or assured return; it is different from expected or forecasted return; and it is different from realised return. It is a rate of return which an investor is LOOKING FOR in return from any investment he makes — a demand, not a promise.

A man wants to be able to buy Rs 102 worth of goods next year, having given up Rs 100 today. He reasons that he needs 2 per cent for the postponement, and if prices rise 6 per cent he needs 8 per cent in total.

He is wrong, and only slightly — which is exactly why the error survives.

The shopkeeper does not raise prices on the Rs 100 he lent. He raises them on the Rs 102 worth of goods he intends to buy. So the 6 per cent must be applied to the 102, not to the 100.

The workbook does the arithmetic and gives the formula: NRR = [(1 + Real rate of return) × (1 + Expected rate of inflation)] − 1, and 8.12% = [(1 + 2%) × (1 + 6%)] − 1.

8.12 per cent, not 8 per cent. The extra 0.12 is the inflation on the real return itself — small here, and far from small at Indian inflation rates over long periods.

The workbook states the consequence of getting it wrong: if investors do not increase the required rate by the expected inflation, they would be LOSING MONEY IN THE REAL SENSE rather than getting a real rate of return.

The same multiplicative structure appears throughout investment mathematics — it is the reason a real return is computed by dividing rather than subtracting, and candidates who add and subtract these rates will be consistently a little wrong in a way that compounds over long horizons.

Ask a farmer in Nashik about the rain and he will tell you a great deal — the usual onset, the bad years, what the forecast says, what he does when it is late. He does not know what will happen. But he knows the shape of what might happen.

Ask him about a meteor striking his field and he has nothing to say at all. Not a low probability — no framework whatever.

That is the workbook's distinction, and it is more precise than everyday speech. When one does not have any knowledge about the future variability in the expected outcomes or their causal factors, then such a situation is known as "UNCERTAINTY". However, when there is some existing or developing theoretical or empirical knowledge about the factors leading to uncertainty, then such situation is considered as "RISK".

And it compresses to four words: RISK IS KNOWN UNCERTAINTY.

The workbook adds a point that is genuinely interesting: the boundary moves. As research evidence or scientific advancements progress towards more clarity on the causal factors leading to some phenomena or event, then everyone begins to term that phenomenon as RISK AND NO MORE UNCERTAINTY.

It also corrects the everyday sense of risk itself. Risk is not exposure to danger; it is the VARIABILITY IN IMPACT when exposed to a danger — and technically, the DISPERSION AROUND THE AVERAGE EXPECTED RETURN. In investment terms, the possibility that the ACTUAL earnings could be DIFFERENT from what is EXPECTED to be earned — and note that different includes better as well as worse.

Two farmers grow the same crop on the same soil. One planted with his own money; the other borrowed heavily and owes a fixed instalment every quarter whatever the harvest.

The crop risk is identical. The risk to the two men is not.

The workbook keeps these strictly apart, and it is a distinction candidates blur constantly.

BUSINESS RISK is the VARIABILITY OF INCOME FLOWS CAUSED BY THE NATURE OF A FIRM'S BUSINESS. It is determined by SALES VOLATILITY and OPERATING LEVERAGE, and it exists whether or not a rupee has been borrowed. The workbook's illustration: an auto manufacturer incurs high operating costs vis-a-vis a retail food company, so its earnings and sales fluctuate substantially over the business cycle, leading to HIGH BUSINESS RISK.

FINANCIAL RISK relates to the MEANS OF FINANCING THE ASSETS with either debt or equity. When a firm borrows, it is required to make FIXED PAYMENTS to be paid AHEAD OF PAYMENTS TO STOCKHOLDERS. Thus, the use of debt INCREASES THE VOLATILITY OF STOCKHOLDER'S INCOME — and that increase is referred to as financial risk and also popularly known as FINANCIAL LEVERAGE.

Two different sources, two different remedies. Business risk is changed by changing what the company does. Financial risk is changed by changing how it is funded, and by nothing else — which is why a stable utility with heavy borrowing and a volatile manufacturer with none can end up presenting similar risk to a shareholder.

A family in Kolhapur has Rs 4,00,000 they do not need this year. A firm in Coimbatore has a machine it could buy that would double its output. Neither knows the other exists.

The securities market is the bridge, and the workbook describes the crossing in one sentence: the primary function of the securities market is to enable the flow of capital FROM THE POCKETS OF SAVINGS, WITH IDLE OR SURPLUS RESOURCES, TO THE POCKETS WITH DEFICIT OF RESOURCES BUT RICH WITH PRODUCTIVE IDEAS.

The arrangement it describes has four parts, each solving a problem the family would otherwise have: businesses ISSUE SECURITIES, RAISE MONEY from the household THROUGH A REGULATED CONTRACT, LIST the securities on a stock exchange TO ENSURE THAT THE SECURITY IS LIQUID (can be sold when needed), and PROVIDE INFORMATION about its activities and financial performance.

The regulated contract answers "what are my rights?" The listing answers "how do I get out?" The disclosure answers "how will I know what is happening?" Without all three the family keeps the money in a deposit.

Which is precisely the workbook's point: in the absence of a well-developed securities market, a household with surplus fund MAY HAVE TO HOLD ALL OF THEIR SAVINGS IN A BANK DEPOSIT EVEN IF THEY ARE WILLING TO TAKE ON SOME RISK FOR HIGHER RETURNS.

And the two halves of the market are inseparable for the same reason. An active SECONDARY market promotes the growth of the PRIMARY market and capital formation, since the investors in the primary market are ASSURED OF A CONTINUOUS MARKET where they have an option to liquidate or exit. Nobody funds the machine in Coimbatore if there is no way ever to get the money back.