Two big things to keep in mind while investing in company fixed deposits

by Manshu on May 17, 2012

in Investments

Rakesh had a comment on what parameters should be checked before investing in a company’s fixed deposit, and when investing in fixed income there are two big things that you should keep in mind, and I’m going to talk about them first before getting down to specific parameters in a subsequent post.

Investing too much money in just one instrument brings risk without reward

Unlike equity, there is no disproportionate reward for concentrating all your fixed income investments in one instrument.

What this means is that if you had Rs. 1 lakh today, and you invested all of that in a stock with the hopes that the stock triples in a year you could go broke but you could also get rich because there is no limit to how high a stock can go.

But the same thing doesn’t apply to fixed deposits. If a smaller, riskier company is offering you 13% per year, and a bigger more stable company is offering you 10%, when you put all your money at 13%, your upside is just that 3% extra and your potential downside is simply too much because if the company goes bust then you stand to lose not only the extra interest but the principal as well.

I first came across this idea in 2009 when GM defaulted and a lot of its bondholders who had invested their life savings in GM bonds were left holding worthless paper.

I think this is a very important thing to keep in mind while investing in any fixed income instrument whether a company fixed deposit or otherwise.

You don’t know what you don’t know

Manappuram is one company that recently came out with NCDs and their stock along with Muthoot’s stock (which also issued NCDs) recently tumbled when news broke out that RBI was putting some restrictions on gold loans.

This news itself doesn’t threaten the NCDs issued by these companies but it’s impossible for a retail investor to know about these kind of things before they happen and take precautionary measure. There are simply far too many things that you don’t know and only when the event occurs you realize that such a risk even existed.

This is just one example, but this can happen to any company, and just last week news broke out that TV-18’s losses widened which is another company that issued NCDs recently.  While that was not as out of the blue as the RBI announcement, I think a lot of retail investors would have been surprised by it.

The two things I wrote about above are nothing new and I’ve written about them earlier as well in different contexts but if you think about them specifically with respect to investing in company fixed deposits, the big lesson to me is that you should always be humble about what you don’t know and appreciate that there is a big risk lurking somewhere and the best way to deal with that risk is to play it safe and spread your money around so that if something does go wrong it doesn’t wipe you off completely for what will be a few extra percentage points of interest.

In a following post I will write about the specific parameters that can help you build a negative list of NCDs that you shouldn’t invest in.

{ 2 comments… read them below or add one }

bemoneyaware May 17, 2012 at 9:54 am

Very informative read. Really liked the advice -which I think holds for all investment plans
The big lesson to me is that you should always be humble about what you don’t know and appreciate that there is a big risk lurking somewhere and the best way to deal with that risk is to play it safe and spread your money around so that if something does go wrong it doesn’t wipe you off completely for what will be a few extra percentage points of interest.

Investing is such a complex topic-for it means different things to different people. With sensex tubling people are looking for fixed income options such as company fixed deposits . Quoting from my article Investing:Think about Liquidity,Safety,Returns,Risk,Tax

Investing is plan, a very personal plan based on your preferences, needs. And your investment plan will then determine the different types of investment vehicles you will need. Typically when we talk of investment we are at-times too focused on the returns. Any investment product should be bought with following things in mind: Liquidity, Safety, Returns and Taxation.

One has to be careful of investment choices. As the legendry investor, Warren Buffet, has said “Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1″

Looking forward to your post on specific parameters that can help you build a negative list of NCDs that you shouldn’t invest in.

Reply

Ams May 17, 2012 at 11:40 am

Very nice and informative article. Yes, apt for the current market situation when Debt instruments tend to usually start getting more popular.

Thanks

Amit

Reply

Leave a Comment

{ 1 trackback }

Previous post:

Next post: