Mr. Shah walks inside one more bank manager’s cabin. He is carrying files containing his Project report, previous Profit & Loss a/c and Balance Sheets and other papers. He needs a loan for expanding his business. He has approached several financial institutions and banks for this loan. Everyone is willing to lend him, but there is one hitch. The rate of interest charged by all the lenders is higher than his profit margin. To put it in perspective, for every Rs 100.00 Mr. Shah deploys in business his profit goes up by Rs 10.00.  This means interest amount on borrowed Rs 100.00 has to be less than Rs 10.00. Suppose Mr. Shah has to pay Rs 15.00 by way of interest than he will suffer loss. His profit on deploying Rs 100.00 is Rs 10.00 but cost of borrowing Rs 100.00 is Rs 15.00 There is no way he will pay a higher rate of interest than his profit.

Rupees 100.00 which banks and financial institutions are willing to lend to Mr. Shah is actually borrowed from investors like you and me. When we place fixed deposit with bank or purchase bonds/debentures etc., we are lending to financial institutions. For lending this amount, we earn interest. Amount so collected by banks and financial institutions is further lent to business/corporates.

The rate of return from a debt product has to be less than the profit of business/corporate. Therefore, return from debt has to be less than return from equity. Equity is nothing but share in ownership of business and profit (loss) derived from the ownership.

Behavior of business is totally opposite to behavior of human beings. In our personal life, we know of activities likely to happen in next one hour, one day etc. e.g. if it is morning of a working day we are certain of our routine activities. We know at what time we will get up, time we will have our breakfast and time we will leave for work.  However, if someone questions us about our activity exactly at same time after one year, we are uncertain. It is totally opposite in business. In business, it is difficult to predict the quantum of sale or generation of profit in next the one-hour or day. If you ask shopkeeper how many customers will visit him in next one hour, he is uncertain. However, as time horizon increases predictability of profit margins, sales volumes etc. are easier to gauge. Shopkeeper will be able to tell you with reasonable accuracy his business turnover for entire year.

Any business faces tremendous hardships in initial years. In the beginning, one has to heavily invest in business. Initial investment is to create infrastructure. Next funds are required for working capital. If you are new to business and do not have goodwill it is difficult to generate sales. During this phase if there is economic down turn your will suffer additional losses.

As time passes by your goodwill builds up. Orders start flowing in. Your profit of yesteryears would have accumulated. All this will let you withstand volatility.

Therefore, in the long run, equity is the best bet.

An investor plays the role of a lender when s/he invests in debt products. Return from debt products is in the form of interest (in case of debt mutual fund return is in form of  dividend and in case of debt based insurance products return is in form of bonus.) Debt products rarely beat inflation – unless interest rate is artificially kept high. In India for last several years interest rate on 1 year fixed deposit is less than 1 year inflation. Assume 1 year fixed deposit rate is 6% and annual rate of inflation is 8%. If you keep renewing this fixed deposit for 15 years than every year, you would loose to inflation by 2%. In addition, there will be compounding effect. At the end of 15 years, you would have lost approx. 34% to inflation. Longer the investment horizon greater is the risk in debt products.

Composition of your financial portfolio across various asset classes is solely dependent on your financial goals. For financial goals, less than 2/3 years away choose debt products. You will lose to inflation but the impact will be negligible. For your distant goals, choose equity. There will be tremendous volatility initially but over a period of time Sigma (Standard Deviation) will reduce and you are likely get substantially higher returns.

The author is a Certified Financial Planner. He maybe reached at gmashruwala@gmail.com

Read more from the same author:
A risk free investment - does it exist?