Factors considered by individuals when they invest money

Individual financial decision making is based on the following important aspects.

1. Professional Trust: A customer needs to develop professional trust and confidence in you. It is not sufficient that you are his relative or friend. Suppose you tell your customer that he will get a monthly pension of Rs. 20,000 or that his children’s higher education will be financed by your proposal. The customer should believe that he will get what you are promising him.
2. Degree of Risk in the Investment: We now know that 90 % of all savings of Indians is in low risk and also know almost 100% of all investment for long term needs is in low risk. The degree of risk in the investment is a very important factor in the financial decision making of the customer. Individuals by and large would not like to take risks in their investments. It is hard earned money and once lost cannot be replaced, as the number of years an individual works is limited. Some individuals with a higher appetite for taking risks may invest a part of their savings in high risk investments.
3. Duration: Individuals are very keen to match their future liabilities with a financial asset that can pay for the liability in the future period. For example a person wants to make a provision for his children’s higher education, which is likely to occur after 15 years, he will be willing to listen to a proposition that creates a long term, low risk product which matures after 15 years.
4. Liquidity: Liquidity has two aspects to it. The first is the ability to sell the investment at any time during its period of holding in case cash is required in an emergency. For example you have a fixed deposit in a bank, in case of an emergency you can liquidate the deposit and get the cash. The second aspect of liquidity is a certainty that on maturity the money due will be available. For example the degree of certainty of getting money due on maturity on a 7-year private company debenture is much lower than say a 15-year life insurance endowment policy. For long term planning most individuals prefer to not have liquidity during the period of holding the investment, and are more concerned with the liquidity risk at the time of maturity.

You might observe that of the four issues in individual financial decision making we have not mentioned returns on investment. But we have! Read On to know where return on investment is mentioned in the points above.

In finance and economics, risk and return are two sides of the same coin. If you can somehow make an image of return and place it in front of a mirror, what is reflected back is risk. By talking of investment risks we are in effect talking of investment returns. It is one and the same thing.

So if we learn to talk of investment risks and not investment returns, we will close more sales.

What is the relationship between risk and return?

The higher the risk the higher the expected return. This is the relationship. When an investment is considered risky, investors would like to expect higher returns. If there is no possibility of higher returns, no one would invest in a higher risk investment. For example if a broker told the investor he can expect 7 % on the share, the investor will feel that he is better off investing in a bank fixed deposit, since bank deposits are much less risky compared to shares.

However expected return is not the same thing as actual return. Just because one expects a higher return does not mean that the investor will get the higher return. Just because the broker has said that you can expect 12 % on the share investment, you will not get 12 %. The rate you actually earn is subject to many types of risks: technology risk, finance risk, market risk, etc. You may end up earning more than 12 % or less than 12 %. You may also end up earning a negative rate of return, i.e. you could also lose the capital you have invested.

So if we say that on a certain investment you are likely to earn 12 % and on another you are likely to earn 7 %, it means that the investment with the 12 % expected return is more risky than the investment on which you are likely to earn 7 %. The higher the risk, the higher the EXPECTED return. The lower the risk, the LOWER the expected return.

Sell Risks Not Returns

We should, in our sales process, stick to our strengths. We sell life insurance – which is a financial product that provides risk cover for the risk of dying early or living too long. Our market is defined by risk protection, not only in terms of the insurance value but also in terms of finance. Life insurance endowment is a low risk financial product. Investing in life insurance endowment product is therefore a protection against investment risk. Life insurance endowment product is the only financial product that protects a customer from life risk and investment risk. No other financial product offers this combination.

When we discuss investments therefore with our customers we should discuss risk protection both for the life risks and the investment risks. We should therefore sell on the basis of risk protection and not returns. If a customer talks of returns, we should learn how to link the customer’s statement on returns to the concept of risks and take the discussion forward. SELL RISKS NOT RETURNS.

Remember risks are certain, returns are uncertain. Customers are more interested in managing risks rather than managing returns

What does the customer mean when he says he wants high returns?

Very often we come across customers who tell us they are looking for high returns. Of course he wants high returns on his investment. Everybody does. But does he also want high risks? Probably not. Recall that higher the expected returns, higher the risk. By changing the discussion to risks with such customers you will benefit a lot.

Just as investments are divided into high risk and low risk investments, so too are investors. Some investors want to take more risks, either for the entire investment portfolio or for a part of their investment portfolio. This is called risk appetite. Some investors have a higher risk appetite. They are more open to making investments in high risk investments. However you rarely come across investors who put all or a substantial part of their money in high risk investments. Even with those investors with higher degrees of risk, the risky investments would rarely exceed 20 % of their total investment portfolio. Hence each investor belongs to a risk-class. Suppose for simplicity we classify the different risk classes into 2 categories: Low risk investors and high risk investors,

So when a customer in the low risk category of risk appetite says he wants to invest in an instrument that gives the highest returns, what he really means is that he wants to invest in a low risk instrument that gives the maximum returns amongst all low risk options available. A low risk investor will not invest in shares just because more returns are expected. Similarly an investor with a high risk appetite will not invest in a low risk investment simply because the investment offers safety and security.

The principle therefore is: Investors look the the maximum returns within the risk class they belong to, subject to the considerations of duration and liquidity. Hence investors will not keep their money in a bank fixed deposit for their retirement planning, even though the bank fixed deposit is also low risk. The bank deposit does not meet the criterion of duration and no liquidity during the term of the deposit.

We shall be posting many more articles on investment risks in the days to come and show you methods of using the concept of risk to scientifically and ethically present to the customer.

In the meanwhile do write to us and let us have your feedback on this article.