Looking beyond credit ratings: financial literacy
How many of you have the tendency to save from the petty cash you earn from the surveys you take on the internet?
About 33% of the Indian population belongs to the middle-income group (source: NES 2014). This particular income group believes in saving their hard-earned money for a rainy day, and according to them, the safest way to do so is through a fixed deposit in the bank.
The widespread obsession with savings in middle-income families arises due to their belief that if one invests in equity, they incur substantial losses. However, the principal cause of this belief is nothing but misinformation. People assume this statement to be true is as they do not understand that speculation is different from actual investing. This issue persists even with other financial instruments like Mutual Funds, where several different stocks are analysed and compiled into a portfolio by experienced professionals after conducting an extensive study.
Cultivation of such beliefs based purely on misinformation proves the fact that financial literacy, which aims to provide an individual with essential knowledge on the proper utilisation of money, is not as widespread a concept as it should be. This claim is proven further when we look at a report from S&P, which ascertains that almost 76% of Indians are still financially illiterate. Moreover, only about 3% of Indians invest in equity, as compared to the global average of 34%. These statistics prove that the Indian population still lacks the confidence and courage to invest in equity or even other higher-yield financial instruments like mutual funds, despite India being one of the fastest-growing economies.
To further understand this behaviour, let us talk about risk.
Simply put, risk is the probability of incurring a loss. Consequently, higher the risk, higher is the profit earned. However, the discrepancy arises in the fact that while risk is a function of profit as well as loss, a common man perceives a direct relationship between risk and loss and tends to ignore the profit aspect, changing its definition entirely. As a result of such a perception, middle-income groups in India remain unfamiliar with the process of making responsible financial decisions.
This idea can be explained better with the help of Loss-Aversion Theory (or the prospect theory) which suggests that people express a different degree of emotion towards gains than towards losses. According to this theory, individuals experience higher distress at the idea of prospective losses than happiness from an equal amount of profits. That is if there is a 50% probability of taking a gamble wherein you may either entirely lose the amount you bet or gain its double, you will not play the wager! The Prospect Theory, when coupled with the old saying of “Prevention is better than cure” creates an investor mindset of preventing losses before they happen, which is prevalent in the Indian middle class to this date.
Now, this is where credit and rating agencies come in. These agencies are specialised companies which provide advisory services for long term investments. The advisors use specialised statistical models which measure variables like average returns and asset volatility, and after doing rigorous analysis on particular security, provide you with recommendations and ratings on financial instruments like equity, mutual funds, debt etc.
The next question that comes to mind- Which rating to trust? The answer is, it depends entirely on the past track record of the rating agency. For example – CRISIL (Credit Rating Information Services of India Limited) and ICRA (Investment Information and Credit Rating Agency of India Limited) are popular agencies in India and are considered to be very reliable. The ratings of these agencies are used by many mutual fund houses to market their products.
The success of these agencies can be attributed to the fact that these are primarily credit rating agencies. These agencies focus more on understanding the creditworthiness of a business and, besides the necessary quantitative analysis, also use a value-based approach to provide better results to their consumers.
While investors worldwide usually rely on Moody’s or S&P, Indians cannot rely on these agencies due to the lack of Indian companies on the indices of other countries, leading to lack of expertise of these agencies regarding Indian firms. Thus, analysis for Indian companies can only be carried out by companies based in India. However, a key piece of advice for every investor remains to not blindly trust these rating agencies, as they tend to rate financial instruments based on their recent past. Hence, whenever conducting their research, an investor must keep in mind other factors, such as the volatility of the asset during a financial crisis, as it is a variable which may not be considered by the agencies, and can lead to significant losses in the future.
Usually, an intelligent investor can prevent such losses. For example, during the ongoing COVID-19 Pandemic, if an investor would have invested in a fund keeping in mind its performance during the Subprime Housing Crisis in 2008, they would have prevented massive capital losses.
The development of proper communication and marketing channels and the rising popularity of campaigns like “Mutual Fund Sahi Hai” have helped influence investor behaviour in the right direction. However, how do we talk about the complex ideas of credit ratings and Loss Aversion Theory in a way that even a family of doctors and software engineers can understand them? Such an outcome will only be possible if all of us take action. We must help our fellow citizens in learning and understanding how to take care of their finances by encouraging discourse on the ideas of financial literacy. We must all learn, as well as educate before it is too late!
