When current income exceeds the desired current consumption, we tend to save the excess. We can do any of several things with these savings. One possibility is to put the money under a mattress until some future time when desired consumption exceeds current income. However, the amount will remain the same. Another possibility is to give up the immediate possession of these savings for a future larger amount of money that will be available for future consumption. This trade off of present consumption for a higher level of future consumption is the reason for saving. What we do with the savings to make them increase over time is investment. The objective of pension funds where members either make voluntary or mandatory contributions is to ensure that in the long term the savings are invested in a manner where the contributing members would end up with a lump sum which would yield a real return of atleast 4% (nominal return – inflation) over time to spend in their retirement be it for a child’s education, to go on a pilgrimage and to live a comfortable life. However, if real returns are not earned over time can result in the contributing members’ monies allocated for their retirement being eroded over time. This would be counter-productive for postponing consumption decisions for later as one would not be able to purchase the desired commodities or services at the time as a result of one’s investments not keeping pace with the increase in the general price level.
Specifically, an investment is the current commitment of rupees for a period of time in order to derive future payment that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation, which is the continuous increase in general price level and (3) the uncertainty of the future payments (risk). The person who is engaged in investing, the investor, can be an individual, the Government, a pension fund, a mutual fund or a corporation. The investor can invest in a combination of financial assets depending on the overall risk tolerance level, tenor of investment and return expectations.
Financial markets and assets
Financial assets/instruments are the commodities traded in financial markets i.e. money market (market in which short term financial assets are traded) and capital market (market in which long term financial assets are traded). Common financial assets that a Sri Lankan investor could invest in include:
* Company shares
* Government Securities: T Bills and Bonds
* Corporate Bonds
* Unit Trusts (Mutual Funds)
Each financial asset has its own risk and reward profile. Usually, the higher risk assets ought to give higher returns. An investors’ choice of an investment is dependent upon (1) expected risk of an asset and its return (2) time horizon of investment. For example, a person who is 50 years old may need to ensure that he has adequate means for his retirement, thus needing greater focus on capital preservation and a stable income whereas a person who is 30 years could afford a greater exposure to riskier assets, expecting higher returns given the longer time horizon of investment. The Treasury bills/bonds are considered relatively risk free instruments and equity, relatively risky instruments. However, to minimize the risk of investments in equity a sufficient longer time horizon is recommended of five years and beyond in stocks that have fundamental value and good future prospects. An average investors who does not have the expertise to carry out fundamental analysis of stocks are better served investing in equity unit trusts that are managed by professional fund managers. Investing in stocks for short term gains is a high risk strategy which investors should engage in only after fully understanding the potential pitfalls.
Investment returns in Sri Lanka
Given the long term nature of the investment and relatively higher risk involved, the capital market of a country usually provides higher returns than money market returns over the long term despite short term volatilities. This phenomena is common in any market in the world if a time period of ten years or more is considered. Hence, equity should be considered as a long term asset class that would enhance returns of any portfolio of investments in the long run.
There are many benefits of investing in equity. Shareholders have the opportunity to earn dividend income as well as capital gains (which are not taxable), opportunity to buy shares at a discount through a Rights Issue and the possibility of being offered shares at no cost.The company you invested in will pay dividends based on their profits for an interim period or for the year. Dividends are declared by listed companies in Rupee terms per share.
Capital gain is the growth in the share price. For example if one had bought 100 shares in a listed company at Rs. 50 on 1 January 2012, and if the share price increases to Rs. 60 on 31st December 2012, your shareholding will now be worth Rs. 6000 (i.e. 100 x 60), providing you with a capital gain of Rs. 1000 (Rs. 6,000 – Rs. 5,000). Currently capital gains earned are tax-free.
A company may decide to offer additional stock to its shareholders which are generally at a discount to the market price, giving them a preferential right to subscribe for the shares. Usually the announcement of a Rights Issue increases the share price thereby providing the shareholder with a capital gain.
A Company may allot shares free of charge to its shareholders, when a company has large reserves and wishes to capitalise a part of these reserves. This is called a capitalisation of reserves.
Graph 1 shows the Rupee value of Rs.10,000 invested in year 2000 that an investor would have received as at end October 2012 on a compounded annual average basis.
However if we take into consideration the annual dividend yields of the CSE from year 2000 - 2012, the gross return of the ASPI would increase to 30% for an initial investment of LKR 10,000 made in 2000.
Graph 2 shows the real value of the same Rs.10, 000 after adjusting for inflation i.e. increase in the general price level. These graphs indicate that the equity asset class has provided the highest return whilst beating inflation during the period under review.
Graph 2 : Real value of Rs. 10,000 invested in 2000 (after adjusting for inflation)
Also, if we take into consideration the annual dividend yields of the CSE from year 2000 - 2012, the real return of the ASPI would increase to 19.6% for an initial investment of LKR 10,000 made in 2000.
Vision for the country through capital markets
Unlike developed countries, Sri Lanka’s investment habits are neither sophisticated nor well planned. The returns earned by a vast majority of small investors are unable to compensate for the value decline of money caused by inflation. Only a handful of investors have tapped the benefits of good investment opportunities available in the capital market. Populating healthy investment habits among all could lead to better management of income and a better future.
The national economy would also prosper in turn with the capital generated through investments contributing to economic growth in the country. A vibrant, well developed capital market to complement the banking sector will facilitate long term fund raising and investment which would lead to attaining of our national aspirations of higher economic growth and financial sector stability.
(Courtesy: SEC - Capital Market Development)