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Ganesh, a client, wanted to allocate some money to BBB-rated high-risk debt instruments to earn higher returns. My response was quite negative. I led him through the three parameters of risk, return and liquidity that are relevant to evaluating any investment.
The IL&FS and DHFL cases have proved that a debt instrument’s rating can decline rapidly from AAA to default status. In addition, liquidity (the ability to sell) even a AAA-rated debt investment is not particularly good, but it dries up completely in the case of a debt instrument whose rating is deteriorating. The investor gets no opportunity to exit his position before the default occurs.
The additional 2-3 percentage points offered by such instruments over AAA-rated bonds do not make sense when weighed against the risk of the investment value turning nil.
Ganesh, who has considerable risk appetite, was convinced only after I had a long discussion with him on the risk-return ratio of such investments being inferior to equity investments.
The discussions with Ganesh forced me to re-examine my own convictions which had been cemented by a personal experience in 2014. I had invested some money in an arbitrage opportunity offered by the National Spot Exchange Limited (NSEL) through a “paired contract” mechanism on commodities. The arbitrage option offered 4-5 percentage points more than what liquid funds were offering then. It was being offered by an exchange that touted that it had an Investor Protection Fund.
The risk-return ratio appeared worthwhile. August 2014, however, proved I had grossly underestimated the risks as there was a default on pay-outs. The money has remained stuck for the past eight years and counting.
In 2007, I had booked a car with finance taken through the direct sales agent (DSA) of a leading non-banking financial company (NBFC). I made the down payment to the DSA while the NBFC paid the loan amount directly to the car dealer. The delivery of the car, however, kept getting delayed. I then discovered that the DSA had not passed on the down payment to the car dealer. I had to make the down payment again to get delivery. The risks from “structural vulnerabilities”, mentioned by the Securities and Exchange Board of India chairperson in her recent speech at a FICCI event, had just visited me.
I have used this hard-earned experience on many occasions, and most recently when we were evaluating international brokers. We closely examined regulatory jurisdiction, and the implication on client funds and securities lying with the broking firm (or the custodial firm) in the event of the firm going bankrupt.
I introspected on my reluctance to share the NSEL experience with Ganesh which would have made it that much easier to convince him. I realised the NSEL episode militated against my own self-image of being a smart investor. I was also apprehensive about what my clients would think of my investment advisory skills.
I chanced upon a podcast by financial therapist Rick Kahler (shorturl.at/isENQ ) who runs a financial planning practice in the United States. He speaks about how he nearly went bankrupt five times and the lessons he learned from these business mistakes (unrelated to his financial planning practice, which has always done well). Rick talks about clients relating to him better because he had the courage to display his vulnerability and talk about the lessons learnt from his mistakes.
I hope my clients and well-wishers agree that while learning from mistakes is good, the ability to share your mistakes is priceless. I eagerly await feedback.
The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; Twitter: @harshroongta
(A slightly different version of this column first appeared in the Business Standard on November 07, 2022)