How Life Insurance Companies Profit from Our Innumeracy
Innumeracy is extremely common in India. From our childhood, our parents and peer group seem to think that if we do not know mathematics, we are useless. This, gradually, develops into a kind of hatred for mathematics and we dislike doing anything with numbers. I have seen many bright people getting diffident when it comes to numbers. 
 
Numbers have a lot to do with our lives. We...
Premium Content
Monthly Digital Access

Subscribe

Already A Subscriber?
Login
Yearly Digital Access

Subscribe

Moneylife Magazine Subscriber or MAS member?
Login

Yearly Subscriber Login

Enter the mail id that you want to use & click on Go. We will send you a link to your email for verficiation
  • Be Your Own Bank
    From childhood, we endeavour to teach our children the importance of savings and how to open and operate a bank account. When we get our first salary or earn our first income, we are likely to invest in bank deposits. This is fine for a start; but it is not a good idea to continue for all times. The monsters of inflation and income-taxes will eat up a lot of savings. When we decide to start a business, we look to a bank for financing our business ventures. When the economy seems to be in trouble, we park our hard-earned money in bank accounts little knowing that the banks themselves are bankrupt in the short run, saddled under the burden of large non-performing assets (NPAs). Today, we will proudly and tirelessly use the various modern technological banking facilities like Internet and mobile banking, ATMs, etc. 
     
    What is a bank? Simply put, a bank is a money-lending business. But it involves astute liability management, judicious credit appraisal and lending, intelligent treasury operations, appropriate cost set-ups, vigilant risk monitoring, etc. All of this results in good banking experience for customers, timely loans for borrowers, systemic stability for the regulator and enhanced shareholder returns for investors. In the good old days, there used to be barter system—goods and services used to be exchanged for goods and services. However, man created money as a medium of exchange and store of value. Over a period of time, the creator became a slave of his own creation—wage slave of the employer, tax slave of the government and loan slave of the bank. Banking is the riskiest of all businesses because it’s nothing but a sophisticated system-oriented money lending business. Banks work under the ‘fractional reserve system’—they borrow Rs100 as deposit and can multiply it by, say, nine times and lend Rs1,000 in the form of loans. For example, say, there is a bank called XYZ Bank. Now, the owners or shareholders put Rs100 of their own money called share capital. Based on this, the bank is now allowed to accept around Rs900 in deposits (like current and savings accounts, fixed deposits). So, the bank now has total available funds of Rs1,000. Let us assume it invests Rs400 in government securities and bonds which results in its having surplus funds of Rs600 which it then lends. The typical balance sheet of XYZ Bank would look as follows:
     
    To puts things into perspective, XYZ Bank has lent and invested Rs1,000 with its own money (capital) being just a fraction of it at Rs100 and the remaining Rs900 is depositors’ money. Therefore, if we assume that all the depositors of Rs900 simultaneously go to withdraw their money on a particular day, then the Bank just has Rs100 of its own capital to pay them off immediately. Therefore, in the short term, all banks are actually always bankrupt! Even in the long term, the ability of the Bank to pay off all the depositors of Rs900 depends on whether it is able to collect back the loans from the borrowers or realise the value of its investments. 
     
    If even some of the borrowers default, eventually the bank will be forced to default to its depositors. In reality, if such an eventually should arise, the government will, most probably, bail them out. And this bailing out will not happen by any magic wand but either through ‘money printing’ which will result in inflation and the rise in the prices of goods and services in the economy will eat directly into the stomach of the poor or through additional taxes which will further burden the already strained finances of the middle-class. This may sound scary, particularly when almost all people somehow or the other deal with a bank either by way of a borrower, depositor, employee, shareholder, regulator and so on.  So what will you look for in a bank?
     
    If You Are a Borrower: The bank should be promoted by a reputed institution or government and be in existence for a reasonable amount of time.
     
    If You Are a Depositor: In addition to the point of the borrower (above), you will also ensure that the bank has adequate capital and has negligible, or low, net NPAs or defaulters.
     
    If You Are an Employee: In addition to the points of the borrower and depositor (above), you will also ensure that the bank has good HR (human resource) policy for its employees.
     
    If You Are a Shareholder: In addition to the points of the borrower, depositor and employee (above), you will also ensure that the stock of the bank is available at below or close to book value, unless it generates a high return on equity for its shareholders which justifies it to quote at a premium to book value.
     
    Hence, the next time you look at a bank don’t just judge it by the number of its branches or ATMs or the amount of technology it uses or the quantum of people following or liking it on social media or the courtesy with which its sales people and relationship managers talk to you. Of course, these are added services which the bank is, nowadays, expected to offer, to improve its quality of service and overall customer experience; but these are just superficial services. Remember, choosing a bank is somewhat analogous to selecting a spouse and, in both cases, we should not look at outward superficial beauty but inner core and soul qualities for enhanced long-term relationship. 
     
    Be Your Own Bank
    We saw how a bank with just Rs100 of its own capital collects Rs900 from depositors and uses the entire Rs1,000 in lending and investments. Now, assume that the bank pays you 10%pa (per annum) rate of interest on the deposits and lends and invests money at 15%pa, then its spread or income is 5% (15 – 5). It earns Rs150 (15% on Rs1,000 lent and invested) and pays Rs90 (10% on Rs900 deposits) thus pocketing Rs60 (150-90). Hence, it earns a return on equity for its shareholders at 60% (Rs60 of profit / Rs100 of shareholders’ funds). In reality, it is not so straightforward and there are operating expenses and other costs; but the principle is the same. 
     
    Yes, with very little capital of its own, a bank borrows money from depositors and lends and invests; thus earning income on that money which is not its own. And the good news is that you can also be your own bank. Confused? Just do what the bank does. Borrow money from the bank at, say, 12%pa and invest it in your business or any other investment yielding, say, 15%pa and pocket the net 3% (15-12). The more money you can borrow and invest in business at higher rate, the more money you can make. Yes, it sounds straight and simple in theory and not easy to apply practically; but it’s not that difficult also. Otherwise, so many large business entities would not have been successfully able to follow this principle for years and ages. 
     
    Learn before you earn; protect before it’s taken away; budget before you spend; save before you invest; create cash flows as you invest; leverage before it grows; insure before you risk; live before you die; and create and be your own bank. Remember, if you can be a depositor in a bank or a borrower from a bank or an employee of a bank a shareholder in a bank, then you can surely ‘be your own bank’ as well. 
  • Like this story? Get our top stories by email.

    User

    COMMENTS

    Mentes

    2 years ago

    Interesting article..

    Eight Common Financial Mistakes
    We all are social animals and we remain the same social animals while thinking about money and investments. Let me discuss the common financial mistakes that we, human beings, make as social animals; to understand that, we have to turn to Behavioural Economics. This combines twin disciplines of psychology and economics to explain why and how rational people make totally irrational decisions when they spend, invest, save and borrow money.
     
    1. Sunk Cost Fallacy
    Imagine that somebody has given you a ‘free’ ticket for a play in which your favourite star is acting. Now, hours before the play is going to commence, you come to know that your favourite star may not be able to act that day; also, there is weather problem and going to the theatre and coming back might be risky. Now, imagine that you had actually ‘paid’ and purchased that ticket. It is likely that, in the first instance, you might not go for the play while, in the second instance, you might go for the play even though your favourite star is not acting in it and risk travelling in inclement weather. This is called ‘sunk cost’ fallacy. In the first instance, since you have not paid for the ticket, you don’t mind skipping the event. But, in the second instance, since you paid hard cash for the ticket, you don’t want to ‘waste’ the money which is actually already sunk. 
     
    The same way in investments, many a times, because we buy a stock of a bad company at a certain price and then it value declines to half, then, in the name of ‘averaging’, we invest more in it; throwing good money after bad. The lesson we learned from this example is that we should not sell winning investments more readily than losing ones and not take money out of the stock market just because markets have fallen.
     
    2. Loss Aversion
    One of the main tenets of behavioural economics is that people are loss-averse. The pain people feel from losing Rs100 is more than the pleasure they get from gaining Rs100. This explains why people behave inconsistently while taking risks. For example, the same person can act conservatively when protecting gains (by selling successful investments to guarantee the profits) but recklessly when seeking to avoid losses (by holding on to losing investments in the hope that they’ll become profitable). Loss-aversion causes investors to sell all their investments during periods of unusual market turmoil. If you had sold most of your equities during the bottom of any market cycle, then, probably, you are suffering from ‘loss aversion’.  
     
    3. Mental Accounting
    This term ‘mental accounting’ refers to people who treat money differently depending on from where it has been received. For example, a person may treat salary (earned money) as sacred and be over-cautious with it, while the same person might treat gifts, unexpected bonus, written off tax refunds, huge inheritance as ‘free money’ and be careless with it. The sacredness may lead the person to let the money remain idle in savings account and, thus, getting beaten down by inflation and the carelessness may lead the person to just spend the money or invest in risky ventures and, eventually, losing it. The lesson is that money is money irrespective of the source from which it is received. Deposit any windfall gains first in your savings account and mentally count them as part of your wealth. Then, there is less likelihood of your squandering away that money.  
     
    4. Bigness Bias
    Most of us try to think big as far as money is concerned but easily forget the small things which, when compounded over a period of time, result in much bigger losses. This is because of our ignorance of the basic principles of mathematics. For example, the tendency to dismiss or discount small numbers as insignificant can lead us to pay more than we have to pay for brokerage, commissions, mutual fund expenses, income-taxes; all of these have a surprisingly deleterious effect on our investment decisions over time. 
     
    5. Decision Paralysis
    Whether it is investments, insurance, spending or any other money matter, many a times, we are not able to make a decision and just maintain status quo. However, we don’t realise that not making a decision is also a decision in itself that we have voted in confidence for the way we are doing things. The lesson to learn from this behaviour is that by not taking the right decisions, often, we continue to, invariably, promote the wrong decisions, the opportunity cost of which may prove to be high over the long term.      
     
    6. Money Illusion
    Most of us have illusions about money—the more the money, the more we think we have earned and vice versa. But this may not always be the case. I explain this with a simple example. Suppose, an employee got a 10% salary increment when the inflation is 12% while, in another case, the same employee got 5% increment when the inflation is 3%—which one would he prefer? There are chances that he will prefer the first case of 10% increment, although in this case, the employee is getting negative real increment since inflation is more than the increment, while, in the second case, he is getting positive real increment since inflation is less than the increment.
     
    This is called money illusion and one of the main reasons why people prefer investment in fixed deposits (FDs) at negative real interest rates after tax than long-term tax-free gains and dividends through stocks.   
     
    7. Cash Fallacy
    Suppose we go to buy an expensive gift item for, say, Rs1 lakh. If we have to actually withdraw cash from our bank account and then pay for it, we will feel the ‘pain’ of losing cash and, therefore, we would think twice before buying it. In the same instance, if we just pay through our credit card, then we may be very comfortable and have the illusion of not experience the pain of losing cash. This is called ‘cash fallacy’ and is the main cause of a lot of unwanted and avoidable expenses in the modern plastic world. Remember, if you buy things you don’t need, soon you will have to sell things which you actually need. 
     
    8. Over- or Under-confidence
    These are the other two enemies of investors. If you are over-confident about your abilities, then you would only look at your successes and boast about them while trying to ‘explain away’ your losses. On the other hand, if you are under-confident, then you would not be able to take control of your finances, make investment and spending decisions based solely on the opinions of friends, colleagues or worse than that, the so-called ‘investment advisers’. Both these psychological features are not good for your money and, hence, beware of them. The lesson from this is: “either you act on your own judgement or entirely on the judgement of another” and that another should be a family member with equal stake in the outcome of the decision and not just a friend or worse than a financial adviser having vested interest. 
    Certain simple steps to avoid big financial mistakes, over time, are:
    • Take proper insurance and let it be pure insurance (term policy).
    • Make proper retirement plans.
    • Pay off credit card bills with so-called ‘emergency’ funds lying idle in your savings account.
    • Make proper asset allocation and diversify your investments.
    • Put maximum of your equity allocation in index funds; it will save you a lot in fund management expenses and avoid the randomness bias of fund managers.
    • Review your assets and take stock of your entire portfolio including investments in securities, real estate, art, retirement plans, etc.
    • Set up a ‘direct payroll deduction’ to some kind of recurring savings / SIP.
    • Keep reviewing your plan.
     
    Achieving financial freedom is a simple, boring and mechanical process. Avoid the common financial mistakes and you would be fine. 
  • Like this story? Get our top stories by email.

    User

    We are listening!

    Solve the equation and enter in the Captcha field.
      Loading...
    Close

    To continue


    Please
    Sign Up or Sign In
    with

    Email
    Close

    To continue


    Please
    Sign Up or Sign In
    with

    Email

    BUY NOW

    online financial advisory
    Pathbreakers
    Pathbreakers 1 & Pathbreakers 2 contain deep insights, unknown facts and captivating events in the life of 51 top achievers, in their own words.
    online financia advisory
    The Scam
    24 Year Of The Scam: The Perennial Bestseller, reads like a Thriller!
    Moneylife Online Magazine
    Fiercely independent and pro-consumer information on personal finance
    financial magazines online
    Stockletters in 3 Flavours
    Outstanding research that beats mutual funds year after year
    financial magazines in india
    MAS: Complete Online Financial Advisory
    (Includes Moneylife Online Magazine)
    FREE: Your Complete Family Record Book
    Keep all the Personal and Financial Details of You & Your Family. In One Place So That`s Its Easy for Anyone to Find Anytime
    We promise not to share your email id with anyone