Theoretically mutual funds offer the entire spectrum of investment options in terms of risk – right from the low risk liquid funds to high risk derivatives based funds or those investing in unlisted equity. Most of these are available to a common investor in India today. That makes it interesting to investigate what drives an investor to place his savings at a particular point on the spectrum.
I can visualise three basic drivers : the transactions driver, the precautionary driver and the income driver.
The first driver arises from the fact that the time patterns of flow of our income and expenditure over a short period do not usually match. Similarly the time pattern of earning income during our lifetime does not always match the time pattern of our expenditure during our lifetime. Therefore we need to carry purchasing power, from when we have more of it, to when we have less of it. Investment is thus used as storage of purchasing power.
The precautionary driver to invest arises from the investor’s desire to provide for an unforeseen event. It is very similar to the transactions driver. But with a difference : while the transactions driver makes the investor invest for a foreseen and planned need in future, the precautionary driver is about an unforeseen need.
Income driver is very different from the rest of the two. When an investor is investing driven by the first two drivers, he is trying to carry his purchasing power into future. But when he invests for income driver, he is not trying to carry over his purchasing power into future; rather, he is trying to increase his future purchasing power. In other words, his sole purpose in saving and investing is to increase his future income.
Now, when an investor is driven by transactions or precautionary motive he needs to conserve his purchasing power, not grow it. So he would prefer a low risk, low return fund; as against this, income driver requires him to grow his future income; so he would prefer a high risk, high income fund. Well there cannot be a low risk, high return investment !