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How safe is your money? Here's every investor's guide to risk assessment

Depositors queue up outside a PMC Bank branch to withdraw their money in Mumbai. File photo: Reuters
Depositors queue up outside a PMC Bank branch to withdraw their money in Mumbai. File photo: Reuters

Summary

  • A new year is a good time to understand the risks associated with different forms of investing and asset classes.

On 11 November, FTX, the third largest crypto exchange in the world at that point of time, went bankrupt. This led to many investors in the rich world, particularly the US, waking up to investing risks that they had never thought about before.

While cryptos by their very definition are a very risky way of investing, all investments have some sort of risk associated with them. The trouble is that many investors do not understand these risks at all or well-enough. In this scenario, the start of a new year might be as good a time as any, to understand the risks associated with different forms of investing in a systematic and well-informed way. So, here we go.

Bank deposits

Most people think that bank deposits are 100% safe. But, at least theoretically that’s not correct. The Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly owned subsidiary of the Reserve Bank of India (RBI), insures bank deposits to the extent of 5 lakh across all the branches of a bank. Hence, in case a bank goes bust, theoretically that’s what the recovery is likely to be even for depositors who hold deposits of greater than 5 lakh. But in the past, such a situation has rarely arisen in the case of commercial banks simply because the RBI has either decided to merge the bank in trouble with some other bank or arrange a rescue.

 

A few years back, when Yes Bank got into trouble, a consortium of banks led by the State Bank of India came to its rescue. Before this, the Global Trust Bank, a private bank which got into trouble, was merged with the government-owned Oriental Bank of Commerce. Despite this past precedent, depositors need to keep a few things mind.

First, having multiple bank accounts is a must. While commercial banks may no longer go bust, there are always periods when withdrawals are limited if a bank gets into trouble. Hence, it always makes sense to spread the savings across at least three bank accounts.

Second, it’s important to look at the bad loans rate of the bank one is dealing with. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more.

If the bad loans rate of a bank is in double digits—that is for every 100 of loans given by the bank, 10 have been defaulted on—it makes sense to withdraw money from that bank and deposit it in some other bank. While no commercial bank will be allowed to go bust, the point is that a bank which is in financial trouble isn’t really offering depositors anything extra. And given that there are so many commercial banks out there, it just makes more sense to deal with a bank which is in a good financial shape.

Third, it makes more sense to deal with commercial banks (private banks, public sector banks or foreign banks) and avoid cooperative banks. In 2022, the RBI cancelled licenses of 12 cooperative banks. This does not mean that all cooperative banks mean trouble. But given that there are so many cooperative banks out there, it is next to impossible for a depositor to figure out which cooperative bank is in a good shape and which is not.

The website of DICGC lists 1,505 urban cooperative banks and 352 district central cooperative banks. The asymmetry of information between the cooperative banks and the prospective depositors is way too much.

Debt mutual funds

Many investors think that debt mutual funds are almost akin to bank fixed deposits, and one can fill it, shut it and forget it. But that’s not how things work. First and foremost, there are many different kinds of debt mutual funds.

Many debt mutual funds carry what is known as an interest rate risk. What is this risk? Debt mutual funds invest in bonds of different kinds. Bonds are financial securities issued by governments and private companies to borrow money. These bonds pay a certain rate of interest. As interest rates go up, the newer bonds that are issued will end up paying a higher rate of interest than the older ones. In this scenario, investors are likely to sell out of older bonds and buy newer bonds. Hence, the prices of older bonds fall and so does the net asset value (NAV) of a single unit of many debt mutual funds. In a scenario where interest rates are going up, debt mutual funds, which aren’t managed well, can give negative returns or very-low returns for that matter.

Second, debt mutual funds carry a default risk. It is possible that a private company issuing bonds, defaults by not paying interest or not repaying the principal amount. Such scenarios have played out in the past. Also, fund managers have been known to invest in low quality bonds which pay high returns, in order to drive up returns. Some fund managers have even lent money directly to promoters and not their companies.

So, debt mutual funds carry several different kinds of risks, and hence, if you are not well-versed with different kinds of debt funds and their risks, it is best to stay away. Finally, it is worth remembering that debt funds are inherently more complicated than equity mutual funds, and anyone who equates a debt fund to a fixed deposit is essentially misleading.

Equity mutual funds

In the past, fund managers of equity mutual funds have been known to indulge in ‘front running’. In this case, they get into deals with shady promoters and pump up the price of a stock by buying it. Further, fund managers also tend to get carried away (or are even forced to) with stocks or sectors that are the flavour of the season. While the momentum is on, this works in their favour. But when the momentum goes away, as it eventually does, their returns do take a massive beating.

The best way to avoid these risks is to invest in index mutual funds or exchange traded funds (ETFs). In such cases, the mutual fund has to buy stocks that make up for a particular index, in the same proportion as their proportion in the index. Of course, large financial institutions can even pump up big stocks that are a part of the most popular indices. Hence, some risk always remains.

Stock brokerages

Stocks are bought and sold through stock brokerages. So, what happens in a situation where a stock brokerage goes bust? In India, stocks are held in an electronic form with either the National Securities Depository Ltd. (NSDL) or the Central Securities Depository Ltd. (CDSL). A stock broker, thus, only facilitates the buying and selling of stocks.

Hence, a stock broker going bust has no impact on the investments held by the investor. The investor only needs to open a new demat account with another broker. Of course, during the time it takes to do this, investors may not be able to sell the stocks they already own. That is a risk carried by the investor.

Further, stock brokerages also hold funds on behalf of the investor. What happens to those funds when a brokerage goes bust? The Investor Protection and Education Fund (IBEF) of the Securities and Exchange Board of India (Sebi) insures such funds to the extent of up to 25 lakh. The investor needs to apply for this within a period of three years of the stock broker going bust. A simple way around this problem is to transfer out any funds lying with a stock broker to a bank account on a regular basis. With so many different ways of transferring money now available, such transfers are fast, cheap and even free for that matter.

Commodity ETFs

ETFs are mutual funds that can be bought and sold directly like stocks on a stock exchange. In India, gold and silver ETFs, which invest in gold and silver, are available.

The idea here is to invest in gold/silver indirectly without the headache of owning and storing them physically. In fact, silver ETFs have only been launched in India recently. Silver has given great returns in the recent past (depending on the specific timeline one takes into consideration). It has given a return of close to 19% in the two month-period between end-October 2022 and end-December 2022. Further, it has given a massive 90% return between mid-March 2020 and end of December 2022.

Nonetheless, over the last decade, silver has given a return of just 1.8% per year, which is lower than even the savings account of a bank. A return of 1.8% per year over 10 years amounts to an absolute return of a little over 19%. Hence, silver has delivered a similar return over a period of 10 years as well as two months, meaning that the price of the metal is hugely volatile.

Given this, before investing in a commodity ETF, it is worth figuring out how volatile the commodity is. Silver’s price is known to rise as well as fall at a very fast pace.

Cryptos

First and foremost, the legal status of cryptos is still not clear in India. Second, it is worth remembering that cryptos are a synthetic risk which allow you to speculate—there is no underlying asset. When one invests in a stock, one is betting on the fact that the earnings of the underlying company will go up in the time to come and that will lead to a higher price. Similarly, when one invests in a gold ETF, the bet is that gold prices will go up. This logic does not apply to cryptos and is their biggest risk given that cryptos don’t derive any value from an underlying asset.

As RBI governor Shaktikanta Das said in a recent chat: “They [cryptos] have absolutely no underlying. Not only that, I am yet to hear any credible argument about what public good or what public purpose it serves. There is still no clarity about it."

In this scenario, the price of any crypto keeps going up as long as new investors keep investing more and more money into it.

As Darren Tseng, Stephen Diehl and Jan Akalin write in Popping the Crypto Bubble—Market Manias, Phony Populism, Techno-Solutionism: “In simpler terms: the only purpose in buying [a crypto] now is to find someone who will pay more for it in the future. It is an asset that needs to be traded ad infinitum to a greater and greater pool of fools, all of whom are willing to pay out early investors for more than they paid." As it happened in 2022, the world eventually runs out of fools.

Over and above this, many crypto exchanges are set up in weakly regulated countries (like FTX was in the Bahamas). As Tseng, Diehl and Akalin write: “The operation risk of engaging with these exchanges is unusually high. The risk of hacking on these exchanges is considerable and historically this has resulted in either the dissolution of the exchange or a complete loss of all customer funds."

Further, in case a crypto exchange goes bust, there is no facility like the IBEF of Sebi or the deposit insurance available in case of banks. Money gone is money gone.

Real estate

Honestly, this needs a separate piece on its own. Nonetheless, we will discuss a few big risks of investing in real estate here. First, the builder can take your money and disappear even before starting the project, as has happened with many investors over the years. Second, a builder can run into trouble during the building of the project, leading to an abandoned under-construction property. Third, the builder may not deliver the home on time and when that happens, a buyer who bought the property to live in it, will have to continue paying rent as well as the EMI on the home loan.

So, these are the risks that investors need to be aware of while investing in different assets. And hopefully, they will help you make better investment decisions in the year that lies ahead. Happy investing.

Vivek Kaul is the author of Bad Money.

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