Understanding risk is more important now than ever

Jun 8, 2011

In this issue:
» Reforms for small investment schemes
» Are auditors keeping a close watch on PSU banks?
» The worst President of the United States
» Will education ensure employment?
» ...and more!
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The lure of the 'bottom of the pyramid' in India has certainly not waned. These households, typically residing in rural areas or with earnings in the lowest bracket of monthly wages offer huge scope for consumption growth. Hence the interest that manufacturers and financers have in their prosperity and consumption trends. But it seems that the 'top of the pyramid' is set to seek more attention in coming years. This segment of the population, as classified by CRISIL, comprises of high net worth individuals. Those with minimum capital of Rs 250 m to their name. Not that this segment does not already fetch the attention of the most high profile financers and retailers. In fact these consumers tend to be most adventurous when it comes to high priced consumables. However, a study by CRISIL suggests that most households in this bracket have shown an appetite for high risk in personal investments as well.

The report suggests that India's economic boom has spawned a new generation of rich. These households see savings and investments as two separate categories. Hence, they set aside one-fifth of their income for each. The 'investments' in these cases refer to exposure to a new array of financial products. This includes hedge funds, private equity funds, structured products and derivatives. Since most of the investors do not understand the risks attached to each of the complex investment avenues they seek financial advice. We believe that this trend will not just continue but also precipitate to households with more modest income levels in coming years.

The key risk here is that of financial advisors doing their duty in familiarizing the investors with the risk involved in each product. The crisis of 2008 showed that banks that advised companies to invest in derivatives did not do a good job of it. Most companies faced the reality only once they saw the massive losses on their books. If the same were to happen with individual investors the consequences could be disastrous. Hence it is paramount that the advisors not just educate the investors about the scope of returns but also the risks from each product. At the same time investors themselves should not get greedy and look for some steady returns over the long term.

Investors could be better off not touching even with an 8-foot pole anything that they do not understand. Finance, after all is not that difficult and it should stay that way. Secondly, an investment proposition that sounds too good to be true could well be just that. These two principles can go a long way towards protecting your portfolio against huge losses.

Do you study the risks carefully before choosing an investment option? Share your comments or post them on facebook page.

 Chart of the day
A good and early rainfall is expected to resolve the problem of inadequate supply of food grains in India this year. Farmers, economists and the government are all hoping for a good harvest to ensure adequate supplies and lower inflation levels at the consumers' level. However, as today's chart shows, the early showers need not necessarily be a confirmation of the Met department's prediction of good rains. In fact the average rainfall during the monsoon has fallen by 6% over the past 5 decades.

Data source: RBI, CSO

If one were to ask investors what were their preferred investment choices, equities and fixed deposits would probably top the list. Small investment schemes of post offices and banks would not find too many takers unless it is for tax saving purposes. But proposals made by a government panel set to review these small schemes, if implemented could provide some fillip to these investment options. For instance, the committee has proposed a 0.5% raise in the interest rate for post office savings account to 4%, reduction in the maturity period of National Savings Certificates (NSCs) to 5 years from 6, and raising the annual contribution limit in Public Provident Fund (PPF) to Rs 100,000 from the current Rs 70,000. These are positive changes indeed and signal the reforms which are much needed in small investment schemes. More importantly, this will ensure the benchmarking of interest rates to market determined rates and more transparency in the way these schemes are managed. This in turn will result in more investors investing in these instruments. However, these are proposals and it remains to be seen when these will be actually implemented.

Economist Marc Faber thinks that Barack Obama is one of the worst Presidents that the US has had. The reason is that the current US President has not at lived up to the promises he had made. Faber opines that Obama is simply playing a vote-bank politics by handing out money and higher transfer payments. Simply put, a transfer payment is a kind of payment where there is just one-way flow without any exchange of goods or services (read subsidies, social welfare schemes, pensions and so on). The business environment also seems to be growing hostile with more taxes and regulations. And apart from making the economic situation worse, Obama seems to have goofed up even on the geopolitical front.

We agree that the Obama administration has not done a good job at all. But putting the entire blame on them alone would be a bit unfair; because the economic crisis that America is currently witnessing is a cumulative effect of past follies.

'Education would be compulsory up to Class X'. The government has decided to work on this proposal and enforce the same in the future. As per the government, making education compulsory till class X would reduce the number of drop-outs at secondary level. Moreover, 10 years of compulsory education would bring India at par with other countries that have equal stress on higher levels of education. Such a proposal is definitely commendable. However, its enforcement would be a big concern.

Currently there are 123,265 secondary schools in the country, which cater to over 29 m students. As a result, the teaching capacity is stretched. Opening new schools remains an uphill task as the Central government pitches in only 65% of the funds. The balance has to be put in by the State Governments, who are reluctant to open up their purse strings for this. The States tend to encourage more private sector participation instead. And the private schools charge a bomb as fees, which naturally deter the economically weaker sections of the society. The government schools on the other hand are bursting to the limit. Therefore, even though education is imparted to all, the quality of education remains poor. So while the government may come up with such incredible proposals, their correct implementation is more important.

Does a new broom catch more dirt? Well, whenever a new public sector bank chairman joins office, he manages to find a lot of cobwebs in his predecessor's closet. The latest case in point being State Bank of India's (SBI). The bank saw a 99% drop in its fourth quarter profits in the financial year 2010-11, the quarter when the new chairman took over. But, such a stark difference in performance with is not coincidental. Rather it warrants a few questions.

One being, that maybe auditors of public sector banks are not doing their jobs well enough. They are supposed to keep an eye on the reported numbers year long, and raise a flag whenever there is anything fishy going on. Private sector banks on the other hand report predictable profits quarter after quarter. This stability is one of the reasons why they command high valuations.

Another issue facing public sector banks are the rising levels of non-performing assets (NPAs). Sure, these banks need to focus on the government's priority sector lending norms, by lending to the agri space. But, SBI's aggressive efforts to gain market share also led to the proliferation of bad loans. Economic slowdown, and rising interest rates seem to be just excuses. These banks need to focus on creating strong internal systems, and tighten their lending habits. Blaming the past chairman is not a solution.

Led by weak global cues and profit booking in commodity, energy and pharma stocks, the benchmark indices in the Indian stock market nosedived into the negative territory as the session progressed. At the time of writing, the BSE Sensex was trading lower by 123 points (0.7%). Major Asian indices closed lower, with the exception of China, Japan and Indonesia. Europe has also opened on a negative note.

 Today's investing mantra
"Proper accounting is like engineering. You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting." - Charlie Munger

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3 Responses to "Understanding risk is more important now than ever"


Jun 8, 2011

It is very important to know the risk attached to every financial opportunities available in the market for better return on investments. Even today the Europe and why not US also has not come out their 2007-08 financial debacle. Another fallout is Middle-East with many of them having surplus facilities remaining idle. As rightly said greed needs to be tamed and if one do not know that technique then it is better be where we are, rather than carried away by financial advisers who themselves are naive in the outcome of what they say.



Jun 8, 2011

Hello, thank you for all the information. Could you please mention/advise some good FMP, MIP, Equity, etc with approximate return possibilites in % in your 5 minutes wrapup.




umesh karkhanis

Jun 8, 2011

Do we really know what has caused such a dramatic drop in SBI's 4th Qtr results? Is it something that was always there and overlooked by Auditors in the past or additional provisions required as per new regulations?

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