We often follow herd mentality and make investments. Though there is ample scope to evaluate things on a logical basis, investors tend to ignore them very often, as in the context of returns, these don’t make much difference
The world of investment runs on some popular beliefs. These beliefs have evolved a period of time. We often hear people say, “Invest for long period of time”, “Do not put all eggs in one basket”, etc. While some of these beliefs qualify the science of logic, there are many which are followed blindly as we often forget to apply appropriate logic to evaluate them. While going through an article published in a leading personal finance magazine, I came across a statement which stated that option buyer’s gains are unlimited while losses are limited. The statement sounds ok until it is dug deep. Let us look at this statement and many similar beliefs/ statements which are used in day-to-day conversation in finance but may not be logical.
Higher the risk, higher the return: This is the most used statement in the world of investment and finance. But is it appropriate to say that higher risk results in higher return? The statement somehow gives the impression that if an individual takes more risk, he will get more returns. Practically this does not work out like this. The appropriate statement should have been “Higher the risk, higher the expected return”. With usage of word, “expected return”, a clear-cut picture comes out. The statement now means that if an individual takes higher risk, he can expect higher returns while he is not assured of it.
Option buyers have unlimited gains but limited losses: It is very often said that buyer’s of option contract have unlimited gains but limited losses. While this is absolutely fine as far as call option buyers are concerned, it is inappropriate to say the same thing about put option buyer. When a person purchases put option his losses are indeed limited but so are gains. What is the maximum gain that an investor can make in case of put option? When the price of the spot falls, the put option buyer starts making profit. It is open secret that spot price cannot fall below zero, so the gains naturally become limited. For example, in case of put option on Ashok Leyland for a strike price of Rs27.50 the maximum gain that a put option buyer can expect is Rs27.50 per contract and not more than that.
PPF is a risk-free investment: Public Provident Fund (PPF) means safety and assured returns to almost all the investors. Very few would even bother to listen to you if you say that PPF investment has a risk element in it—but hang on. PPF indeed carries risk and that is called as “reinvestment risk”. The rate of interest on PPF deposits have been changing over a period of time and as a result of this an investor who opens a PPF account or an existing investor cannot expect the same rate of return every year. Because of this reason, PPF can be classified as an investment option which has a risk but only reinvestment risk. The credit risk in PPF can be ignored based on the history.
The problem in finance is that we have often follow herd mentality and make investments based on what masses do. Though there is ample scope of evaluate things on a logical basis, investors tend to ignore them very often as in context of returns these don’t make much difference. We should all try to be what we are assumed to be, “Rational Investors”.
(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)