Investing income in economic environments of low interest rates and rising inflation

Undoubtedly, many countries are faced with challenging economic situations with negative implications for various sectors of their economy. In most instances, every aspect of society has been disturbed. The personal income and the spending power of ordinary citizens have been affected due to the general increase in inflation. Basic necessities have become unaffordable to many, especially the working class citizens. The banking and investment sectors are forced to offer low interest rates on personal savings and other forms of investments as a result of this global crisis. These ongoing financial difficulties have led people to seek various means by which they can counteract the growing effects of the situation. It is not uncommon for individuals to resort to investment opportunities that promise high returns. Unfortunately, quite often they are disappointed with the outcome of their investments mainly because they were not sufficiently knowledgeable of what they should be aware of prior to the undertaking of any investment.Investors who take the decision to make a financial investment into any business venture need to consider all relevant factors, including the risk and return (reward) factors, which underpin or influence all forms of investment.

When investing, either short term or long term one can never tellfor certain how much their investment will yield unless there isa predetermined rate of return prior to investment.Despite normality being an underlining principle in finance literature, it has proven in recent times to be flawed, and not realistic to use as a basis in determining investment return.

It is not wise to borrow money from financial institutions (e.g. bank) to pursue a deemed lucrative investment opportunity. Achieving a return that will enable you to pay the institution back and in excess of your investment may be unattainable.

As a prospective investor, one must determine the duration of their investments and how much they expect or want from these investments. The investor needs to ensure that the money they are committing to an investment is excess disposable income. In other words, it should not be something that is essential for their basic survival, so that in the event of a loss they will not experience great financial distress. Someone who decides to make a financial investment must always be mindful that investment is not guaranteed. Making an investment into any business venture can be risky. A rational investor should conduct analysis on their income before embarking on any investment, especially the risky ones.Due to the risk in investment, yields or return are not certain. This is why an investor is compensated with return in line with the risk undertaken.

Having established the amount of income to be invested, (i.e. fund) the individual investor should then decide the time duration of his or her investment. If one decides to make a short-term investment, he/ she should know that they are not taking up high risks; therefore, should not expect high returns. Due to uncertainty (risk) investment returns may vary. Risk could be influenced by the time duration of the investment. Short-term investments yield low returns because of the minimal risks involved whilst long-term investments yield high returns due to high risks. In the short term, because the investor forgoes income for only a short duration, the factors that affect returns (interest rates and inflation) are not expected to vary significantly, therefore, compensation for risks is low (return). Likewise, with long term investments, because individuals have invested for a longer duration which increases the risk, they will be compensated for the greater risk involved.This could be caused by changing economic factors, either internal or external to the investment environment.

A founding notion of Modern Finance Theory known as Time Value of Money, states that it is better to have money now rather than later.For example, one Dalasi today will be worth more than one Dalasi next year due to growing interest rate and inflation. For instance, one may enquire about how much goods were bought from 100 Dalasi (either to buy food or clothes) last year compared to this year.Most would agree that one would have brought home more bags last year with the same amount than this year.Because of this analogy, compensation of risk differs from short term to long term as investors have to be compensated for not holding on to their money and pursue an investment opportunity – the opportunity cost of undertaken investment. Therefore, if that same amount is now invested, it should be able to yield an attractive return that is able to buy the same and extra; otherwise it would be a worthless investment.

What is short term or long-term investment is subjective, but for the purpose of this article, 0-1yr will be used for the former and 1yr or more for the latter. This information regarding investment which has been discussed is for periods less than 10years. So, do not be fooled by any fund or investment manager who promises returns of high magnitude such as 30%. Since returns are highly correlated with risks (moves in the same direction), not only is it unrealistic but could be fraudulent or deceptive, especially if it is a short term investment.

A low risk investment will not yield you high returns except by luck in an efficient market as widely documented and agreed by academics. The notion of arbitrage is a fundamental concept in Modern Finance Theory, which states that there is no arbitrage - “free lunch”.Investment cannot make excess profit without extended risks. In order words, arbitrage opportunities rarely exist in efficient markets unless by pure chance or luck. Academics and practitioners defer in their views regarding this theory of arbitrage. Academics argue that in an efficient market, abnormal profits cannot be achieved whilst practitioners argue that technical or fundamental analysis could detect mispricing thereby gaining abnormal profits. Abnormal profits in this sense refer to taking lower or no risks and achieving higher returns. This is illustrated by the story of a finance guru who was walking in the streets of Manhattan with his granddaughter when suddenly she saw a fifty (100) dollar note on the footpath and wanted to run for it as many of us would have done. The grandfather told her that if it was real someone would have noticed and picked it up before her as it was a busy route. Therefore, it is pertinent that you ask yourself this question: How many times have you found a D50 note in the streets of Banjul or Serekunda? Arguably, very few of us have. It is important, therefore, to always remember that in investments, high returns are not achieved without taking risk, - i.e. you don’t get something for nothing.

The risk that is being elaborated on is crucial in investment as it’s the key to the return, although risk can be minimised by diversification. Diversified portfolio in investment means “do not put all your eggs in one basket”. Be mindful of this and be slow in considering offer(s) of tempting investment propositions offered by some investment managers. Be always aware that, there are many so-called investment fund managers and institutions exploiting vulnerable investors by defrauding or advising them to invest unrealistically only to leave them bankrupt. Invest your income responsibly and seek investment advice from experts if you do not have the skills and know-how.

In my next article, I will endeavour to discuss the mechanics an individual investor could pursue when investing income, how and in what to invest (investment vehicles available to an individual investor).

Key word

Risk- uncertainty involves in the investment and the possibility of gains or losses

Return - compensation of the risk undertaken