Investment Criteria

Investment Criteria

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The most preferable way of dealing with ones residual income is to save it. One can keep that tucked away at a corner of almirah and forget about it. But then, this is not a good way of dealing with ones savings.The reason is that the money you hold in your hand also has its value (called ‘time value of money’). If you are holding a Rs. 10 note today, and if you continue to hold that same Rs. 10 note in your hand even after one year, then the value of that Rs. 10, would have diminished by the amount of inflation. So, while the nominal value of your money / currency, might still continue to be Rs. 10, if the inflation rate is 10%, then the value of your Rs. 10 would be only Rs. 9 compared to the previous year.

The primary motivation of investment stems from the necessity to counter this ‘natural’ economic phenomenon of inflation. Inflation simply means rise in prices. However, when there is rise in prices, it also means that the value of currency depreciates.

For any investment, the expected return = risk free return + risk premium + inflation. The classic risk free return is obtained in Government bonds, which gives a return somewhere around 3% to 5 % depending on the economic situation.

(In Indian situation) There are various options of investments: Governments Bonds, PPF, NSC, KVPs, Bank FDs, Company Bonds or debentures, Mutual Funds, Securities / Share Markets, Land, Housing estates and Flats, Gold, jewellery and ornaments, etc.

Often, it is advised that one should invest taking into account ones ‘risk profile’ or simply, the risk taking abilites – and the need for liquidity. The world of investment is as vast as ones imagination can go – we would only take a few examples to expalin things like ‘risk’, ‘return’ and ‘liquidity’.

‘Risk’, simply stated it is the frequency and amount of deviation from a given standard. Risk and ‘Return’ are intricately linked to themselves. One must have heard the adage – ‘high risk, high gain‘. If one invests in something risky, then the expected return is high. In contrast, if the investment is in low risk product then the gains are also low. A simple example would be investment in a company bond and a public sector Fixed Deposit. The return promised in the former is always higher than that of the latter. This is because the former is considered more risky.

Similarly when one invests in share capital of a company, then the expected return is much higher. The shareholders get their return in form of dividends declared by the company at the end of financial year. The reason for such high appetite for return from investment in share capital is because, the capital invested is the risk capital and does not carry any guaranteed return.

Then the other important consideration is ‘liquidity’. This is important because money in currency is much better than a promise by someone to give such money. For example, people take gold jewellery as a good investment (while gold may be considered as an investment, gold jewellery is not really an investment) – yet taking the common perception – if one has gold jewellery of Rs. 5000, it is not necessary that if the need arises – firstly that someone would be ready to take that jewellery to pay the money, secondly the money received would be less than the actual value, and thirdly for converting the gold jewellery to cash, one would have to spend time and effort. In contrast a bank FD of that same amount is much more liquid than the gold jewellery.

These three concepts of ‘risk’, ‘return’ and ‘liquidity’ should be the primary criteria to determine the kind of investments one wishes to do. Professional investment advisors speak about the ‘risk profile’ depending on age and other factors of ones life. Such profiles are based on these three criteria ‘risk’, ‘return’ and ‘liquidity’ and these form the fundamentals of any investment decisions – including the personal investment decisions.

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