How to choose a prudent investment

B. L. Ariyatillake

"Money that is no where must be somewhere." Some say it is everywhere.

People generally keep money in cash form. In an inflationary economic situation keeping money in cash form is the most unwisest thing to do. Prices of goods and services are going up while your money remain the same in monetary terms. In the end it can so happen that inflation has eaten up most of your money in real value and terms.

People keep money in cash form for two good reasons -

1. Day to day spending;

2. As a precautionary measure in case one needs cash for some unexpected shortly term need.

Apart from above there is no need for people to keep money in cash form. People earn money by way of employment or otherwise. Some people earn below their consumption level in which case they forcibly forego consumption.

Some people may earn just up to consumption level with no room for savings. Then there are some fortunate people who earn more than consumption level with monies available for savings. There is another category who will postpone consumption and do some savings for future benefits or income. In the economy there are people who have money over and above their consumption and precautionary needs and who can spare their money for gain.

The extra money can be given to some entrepreneur at a price popularly known as interest who will use the money gainfully. The person who provides the money will get a price for his money which otherwise would idle with him without any benefit. So at any given time the economy will have a certain amount of money available for investment purposes at various prices.

In other words an investment is the setting aside of a certain amount of money in return for a future flow of income. This future flow may be in the form of interest, income dividend, capital appreciation and like wise.

It may be monthly, annually or at fixed or variable periods or as a lump sum. In a laissez-faire economy there are many investment avenues available to the public.

It may be mere lending by way of an agreement or otherwise in return for future interest payment to the person who provides the funds.

Then there are savings accounts, fixed deposits, Shares, Treasury Bills etc. It is for the provider of the finance to choose his investment which he should do wisely.

At any point of time the economy will have a certain quantity of money available for investment purposes. Different types of investment will compete with each other to get the money for themselves while the investing public will examine and scrutinize their merits or demerits before they take a decision.

The primary concern of the investor will be the income from the investment. It is not the gross income that matters but the net income. Income from investments could be compared only by way of net income and not by gross incomes.

Net income is not the sole criterion of a prudent investment. Of course the primary desire of the investor will be the highest net income he could obtain from investment. Apart from net income an investor should be highly concerned with the security of the invested money. He must be aware of the risks attached to that investment.

He must ensure that the other party would repay the money in all circumstances. Security should not be compromised with returns on investments.

Just as much the initial outlay, the income therefrom should also be safe throughout the period of investment. As such the criteria that applies to the initial security of the investment too applies to income from it and also the regularity of such income.

Security wise the following order of ranking is generally accepted.

1. Government Securities;

2. State Banks;

3. Semi-State Banks;

4. Private Banks;

5. Private Financial

Institutions;

If one examines the rate of interest paid by the above financial bodies on fixed deposits and other investments it is clear the Institutions with a higher order of security pay lower rates than those in the lower order of security. Institutions with government backing rank high securitywise, for the reason that people believe that the Government will never default the investors who have placed their trust in them.

The rule is higher the security lower is the rate of return. Lower the security higher is the rate of return expected by investors. All the agencies mentioned above compete with each other to obtain the investment money available in the economy. But institutions such as private financial bodies will have to pay a higher rate of return to stay alive in the competitive market. For example the National Savings Bank can attract money at a lower rate of interest and still compete with those with lower level security and who pay higher rates of interest.

The second factor that influence the rate of return from investments is the liquidity of the investment. By liquidity we mean how fast your invested money could be converted into cash. As far as liquidity is concerned savings accounts rank foremost in the market for the reason that money invested in a savings account is available in cash over the counter. Hence in this respect too the savings accounts can afford to pay a lower rate of interest and yet attract money in the competitive market.

Then comes the fixed deposits. Their liquidity is limited to the period of the deposits, may be three months, one year, five years of any fixed period. It is obvious that longer the period, liquidity is less. Hence shorter term fixed deposits liquidwise will command lower rates.

The rule is higher, the liquidity, lower will be the rate of return.

Lower the liquidity, higher will be the rate of interest expected by investors. The third criterion that will determine the rate of return from an investment is management of the investment. Monies invested in savings accounts, fixed deposits, shares and investments of a like nature will have practically no management. But investments like property, rentals etc. require high management. In a rental property the income will be in the form of rent. It is a gross income. The investor will have to bear costs of local authority taxation, do repairs and maintenance give it on rent to a suitable tenant, avoid voids and keep the premises continuously occupied all of which require management.

Collection of rent fall on the investor which all require management.

These are expenses their investor will have to bear in order to get a net income from the investment. The fourth factor that influences rates of return from investments is capital appreciation or depreciation. In investments like savings accounts and fixed deposits one's initial outlay in money terms remain the same throughout the period of investment while one enjoys the interest payment regularly.

But investments in property or shares one's initial outlay namely the purchase price of the property or shares can fluctuate.

One can realize his investment only by selling the property or share in the open market.

The price at which he could sell his investment may not be equal to the amount he has invested to purchase the investment. This price will depend on the market prices at the time of sale.

It may be less or more than the amount at which he purchased the investment. If the market has gone up he reaps such appreciations plus the income he enjoyed over the period of investment. But if the market has fallen during the period he has to bear the loss.

In a period of rising property values there is an increase in demand for investment in properties. Such investments are hedges against inflation. Inflation affects all investment alike.

But investment where there is a likelihood of expectation of appreciation of capital value are described sometimes as hedges against inflation for the reason that while inflation eats up your investment in money terms capital appreciation of the investment offset such loss to a certain extent or sometimes to more than inflationary rates. This is why property investments are sought after in periods of rising land prices. But in periods of declining land prices, investment in properties is not desirable.

In choosing an investment one must take into account his personal abilities and disabilities.

If he likes to enjoy a trouble free income investment in fixed deposits, savings accounts etc. are the most desirable. But if you can manage an investment, property investments would be more gainful. Property investments are more risky, less liquid and management is involved.

In periods of falling property prices investment in property should be avoided. But in periods of rising land prices, investment in properties is most desirable. Some people buy land blocks and keep for future sale and recoup the invested money with substantial capital gains. During the period of investment, the investor does not get any income but capital appreciation compensate such foregoing of income.

The writer is a former Chief Valuer