Do you understand the risk involved in your investments? Do you know how the returns are calculated? Are you able to track these returns? If the answer to most of these questions is no, take heart. You do not necessarily have a low investment IQ. The complexity level of the investment may be too high for an average investor like you to understand—yet it may be the right instrument for you. How do you judge whether a financial product is simple or complex?
Credit Rating Information Services of India Limited (Crisil) has the answers. It has classified 77 financial products as simple, complex and highly complex. As the names suggest, instruments rated as simple are easy to understand while the highly complex ones require a thorough knowledge of the market and financial analysis. These ratings should help investors assess whether they understand the risk and rewards of an investment instrument.
However complexity must not be confused with risk. A risky investment can be simple, especially if you know it as one. For instance, stocks. Investors are aware that returns on shares can swing either way. So it isn’t a complex instrument. Similarly, a low-risk investment like guaranteed bonds can be complex.
On the following page MT Basics gives you the complete list of ratings. But there is more to learn from the Crisil initiative. Below are four parameters on the basis of which the instruments have been categorised. Understanding each criterion individually provides a perspective on evaluating the worthiness of a financial product. So if you want to put your savings in an instrument not covered by Crisil, consider these factors to arrive at your personal complexity meter.
Q: Do you understand the CASH FLOWS?
Uncertainty about the time of receiving returns makes investing tedious. It disrupts the financial plan of investors and can even affect returns of the financial product.
Q: Can you calculate the PAYOUT AND RETURNS?
The easier the better. If it is simple to calculate payouts and returns offered by a financial instrument, it adds to the simplicity quotient. This means investors are aware of the gains from the investment and are unlikely to get nasty surprises. A good example is corporate bonds. The interest rates and debt repayment schedule is pre-determined and investors can easily calculate the payout. On the other hand, computing payouts for equity-linked debentures requires some effort.
Q: Do you know the number of PARTIES INVOLVED?
The lesser, the merrier. Too many entities involved with an investment complicate the process of analysing it. The risk associated with each party must be assessed individually. Plus the relation among them needs to be evaluated too. Overlooking any one aspect can lead to a wrong investment decision. This is an important reason why a simple bond is easier to analyse than a guaranteed corporate bond for which investors must evaluate both the guarantor and issuer of the bond.
Q: Is it a new type of FINANCIAL PRODUCT?
A known financial instrument is certainly better than an unknown one. Investors are aware of both the advantages and disadvantages of instruments which have been in the market for sometime. Since new products are yet to be tested by the markets, its implied complexity is higher. Overtime, as investors understand a financial product they become more comfortable with it and the product’s complexity reduces.
