Know your money: Debt and equity for dummies

There are 4 routes in which you can invest your money in India.

  • Debt — PPF, Fixed Deposits, Corporate bonds
  • Equity — Shares of companies, Mutual Funds and ETFs
  • Commodities — Gold, Silver, many others
  • Real Estate

Of these, debt and equity are the most misunderstood, so here’s my attempt at demystifying them.

Imagine your local vegetable seller Ajay came up to you, and the following conversation ensued:

Ajay: Sirji / Madamji, I have a favour to ask you.

You: Yes Ajay, tell me.

Ajay: I need Rs. 50000 to expand my business.

You: What are you going to use it for?

Ajay: I’m going to replace my cart with a new one. I also have to pay off my creditors for previous deliveries. I’m planning to hire a boy to help me with my work. All this is going to cost me Rs. 50000.

Now you have 2 options in front of you. Lets say you offer to lend him the money, that is, you go with the DEBT option.

You: Ok, I will give you the money. But I expect some return on my money. So lets say I’ll loan you the money at 12% for 36 months.

Ajay: I have no idea what that means! Could you please explain it to me?

You: Sure! I will give you the Rs. 50000 today. Conveniently it happens to be the 1st of the month. For the next 36 months, you will give me Rs. 1613 at the end of the month. You have to pay me regardless of whether you actually make any money that month or not.

Ajay: And what happens if I have no money to pay you back?

You: I will come after you with all the resources I have. I can make you sell your produce at throwaway prices, take away your cart, and whatever possessions you may have. I could even sue you in court!

Ajay: Wow, I’m not sure I like this plan. Is there any alternative?

You: Yes there is! I could become a partner in your business!

Ajay: That does sound better. How does that work?

You: Simple! I’ll give you Rs. 25000, half of what you asked for. You have to find Rs. 25000 of your own. Once we do that, we are 50–50 partners! From now on, if you make Rs. 100 as a profit, I get Rs. 50 out of that. If you lose Rs. 100, I pay Rs. 50 out of that. If you don’t make anything, I don’t make anything either. This arrangement stands from today till eternity, in principle atleast.

Ajay: You’re definitely more tolerable as a partner than a loan shark! But what if I get tired of giving you half of what I make every single day?

You: Well, you could buy out my share. But if you do good business, my share could be worth a lot more than Rs. 25000 a few years later. It would depend on your reputation, the quality of vegetables you sell, the area you service, and so many other things!

Ajay: I think I can worry about that at a later stage. And what if you are my partner and we go bankrupt? What do we do then?

You: Nothing! Its a loss for both of us. All we can do is sell your vegetables and the hand cart, and divide up the money equally.

Let me summarize that for you:

If I loan you money, I could stand to earn 12% on my money if your business goes well. If it fails, I will lose a massive chunk of it, but I hope that I can liquidate your assets and recover some of my money at the very least. The conservative part of me loves this deal, because I can’t lose a lot of money in the worst case, and get a decent return on my money in the best case.

On the other hand, if I become a partner, I could stand to lose every single rupee I invest in you. But if things go well, I could stand to gain an infinite amount of money! The risk taker in me is very interested in this proposition.

It is this table that sets up the entire idea of risk and return, which is heavily abused in financial media. The idea is that if you take on high risk, you will be rewarded with higher returns. If you restrict yourself to low risk, you will make lesser returns. This logic works well in the situation shown here, but beware of the pundits who will make you believe the same is true for a large cap vs a small cap stock.

Why is that not true for large caps vs small caps? That’s a story for another day! Let me know what questions I can answer for you in the comments below, or on facebook.