Financial market volatility on the scale that we are witnessing today can be the intelligent investor's best friend. As equity markets go belly up and yesterday's investments disappear into a hole in the ground, the natural tendency of the risk-averse investor is to stay as far away as possible – to squirrel away cash under a mattress.
Instead, try the contrarian approach taken by expert investors. Stay away when others are celebrating a high, and get in when others shy away.
Given the state of the equity markets, global appetite for risk seems to be disappearing at the fastest pace in history. At the same time, however, providers of relatively risk-free investment options are quietly celebrating as the demand for their product soars worldwide.
There are a limited number of such options, though. Bank deposits, corporate deposits and fixed-return bonds and derivatives are some of them. In the past, such instruments have been unable to maintain the value of the cash you invest in them. The relative safety and stability of such instruments compared to the extreme volatility of equity investment has meant a lower return – historically as well as geographically. And a return that is lower than the rate of inflation where you live means the purchasing power of the money you have invested in and earn from such instruments is always shrinking.
It's simple mathematics – if inflation is at 5.5 per cent and your return on investment is 3.5 per cent, the value, or purchasing power of the cash you have invested in such instruments is being eroded every year by a factor of two per cent. Snowball this into a five-year deposit, for example, and you are looking at cumulative erosion that is pretty substantial. As a rule of thumb, remember that a guaranteed return on investment will seldom beat the erosion impact of inflation on that instrument.
But let's look at ways to maximise returns from such safe-harbour instruments this year – because 2009 has brought with it some serious fixed-return investment challenges as well as opportunities.
ARBITRAGE IS YOUR FRIEND
Expatriates have an unusual advantage over the rest of humanity. They can invest in interest-bearing deposits in one or both of two countries. For example, an Indian in the UAE can open a fixed deposit in a UAE-based bank to earn upwards of six per cent interest, or do the same in India for 9.5 per cent.
However, watch out for inflation rates as well. In comparing the inflation rate in each country, you will be able to conclude which investment gives you best value for your dirham.
Purists will tell you this is not arbitrage in the true sense of the term. Ignore them – semantics never made anyone much money. Arbitraging implies borrowing at low rates in one economy and investing at higher rates in another. What is the personal loan interest rate in the UAE? Is it lower than the bank deposit rate in India? Yes? Then you're singing. And the song is called arbitrage.
Arbitrage is a very powerful investing tool and it is available only to people who have the option of investing in multiple markets. Be aware, however, of issues such as taxation and the cost of fund transfers between economies.
Your parents and grandparents swore by bank deposits. Unfortunately, in the era of interest rates dipping, this avenue lost some of its lustre. Now, with interest rates rising on fixed deposits, you should consider it.
The greatest thing about this form of investment is the tenure, or term, of investment. It could be as short as 15 days and go as long as 10 years. The interest paid is determined by the tenure; and entry and exit are both easy. If, for instance, you have a large paydown coming up three months from today, don't let your cash sit idly by as it waits for the date. Let it do some work and earn you some interest in quick-exit deposits.
SHED YOUR DEBT BURDEN
If you have outstanding debt, consider allocating the fixed-income part of your portfolio to reducing it. It makes mathematical sense, it improves your credit score and you feel simply reducing your debt quicker than planned.
Fixed-income investments, such as bonds, are the closest thing to, say, a mortgage. In light of the risk-adjusted return calculations, it is possible to get an acceptable return on investments in equities but highly unlikely that an investment in bonds or other fixed income instrument could beat the return from paying down debt. These come with a modicum of risk attached, but they can help your fixed-income portfolio beat inflation.
BUY CORPORATE DEBT
As strong companies solid balance sheets also face funding problems as they seek ways to finance operations and expansion, they are offering attractive attractive returns. Larsen and Toubro in India and Siemens around the world, for instance, are among these. And medium term yields on corporate paper are in double digits at the moment.
But be very careful. We are only at the beginning of an economic slowdown, and it is still unclear in which direction corporate defaults lie.
Again, being an expatriate offers the chance to pick and choose the best-performing and rated companies in two separate economies, with the added advantage of adjusting the risk over two economies. A good investment advisor will guide you through the intricacies of risk mitigation and spread.
A word of caution
A major benefit of fixed-income investing is the opportunity to predict income over a period of time. Even though fixed-income investments typically do not result in enormous financial returns, they also do not come with the high degree of risk associated with more aggressive investment strategies.
Including several types of fixed-income investments in your financial portfolio can be an excellent way to limit the element of risk. But it should not be your whole strategy.
As part of your portfolio, fixed-income options help you know with certainty how much income you can expect on a monthly, quarterly, or other specified basis. But in most cases, such investments will not beat the inflationary degradation of your finances.
All of this implies that, while the safety of such investments is an extremely attractive feature, they cannot be your sole means of investment. A predetermined portion of your investible wealth would necessarily need to be deployed in higher-risk, higher-return instruments simply to beat inflation.