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Investor's World

The Thin Line between Gambling and Investing

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For some gambling is a pass time but to others it’s a way of life and a means to make a fortune. It is a bit uncomfortable to note that gambling and investing even though look worlds apart have a lot in common even though they occupy opposite ends of a spectrum. Let us start by looking at a few dictionary definitions of what the two terms mean.

Dictionary.com has three definitions for gambling but the one that is very relevant to the discussion is “to stake or risk money, or anything of value on the outcome of something involving chance”.

Britannica. com has an even longer definition of gambling: Betting or staking of something of value with consciousness of risk and hope of gain, on the outcome of a game, a contest or an uncertain event whose result may be determined by chance or accident or have an unexpected result by reason of the bettor’s miscalculation”.

The words that jump at you when you read the two definitions are chance and risk and anybody who has come into contact with gambling will agree to the fact that there is a lot of risk and the whole outcome depends on chance.

Investing is a straight forward term to define, but it branches into at least three basic definition depending on the context: general, economic or financial. Investopedia.com does a wonderful job of simplifying all the three contexts. The general definition for investing is “purchase of an item or asset with the hope that it will generate income or will appreciate in the future”.

The economists insist investing is the purchase of goods that are not consumed today but used in future to create wealth. The financial definition of investing that suits the comparison between gambling and investing is to look at investing as the purchase of a monetary asset with the idea that the asset will provide income in the future or will be sold at a higher price for a profit.

Thus in simple terms, investing is for the purchase of an asset with the idea (I am tempted to say “hope”) it will provide income or be higher in value in future. There is however the uncertainty that the investment might not provide the expected income and the value of the investment might not increase or even fall in future. An example might bring the picture hope.

Let us take the example of a man working the slot machines in a casino, who is aware of the fact that he can hit the jackpot or lose all his money. The odds are not in his favor but he is still willing to take the risk.

The teenager at SafariBet betting on a Manchester United match also thinks the same way but for him there is a false confidence that he can accurately predict the outcome of the match. Contrast this picture with someone who invests in the stock market with the same misguided notion he can predict the performance of the stocks on the market.

The investor’s issue is a bit different from the SafariBet teenager because seasoned investors will tell you that the performance of the market can be predicted by assessing the fundamental strength of the companies and be able to point out which of the company’s will outperform going forward. We have all witnessed both bad market performance and extremely good ones and the market has seen companies with strong fundamentals perform poorly.

Investors, and especially investors in stocks, should be aware that there is always a chance that the stock you invest in will not behave as you expect to it. Which means that there is an inherent risk in investing and at the end of the day there is a chance the investment will not go as plan.

That is what defines gambling but in gambling the odds are stacked heavily against the gambler. I know! I can hear the argument already, that we cannot compare investing to gambling but when you look at stock market investing and the dynamics associated with it, you are led naturally to begin to look at it wearing the lens as a gambler. Let me also add that there is a term called the random walk theory that states that stock market prices change according to a random walk and therefore stock prices cannot be predicted.

There are some truths to the random walk theory even though the theory has been challenged by practitioners and academics alike. The point, however, remains that it is very difficult to beat the stock market as a whole because trying to predict the stock market is akin to the toss of coin. The idea that unites a gambler and an investor is risk.

The gambler is prepared to take very high risk with his money in the hope of making it big even when the odds of winning are very slim. A gambler bets against the house but it is a well-known fact that the house always wins.

It is easier to tell the difference between those working the slot machines, betting on the outcome of a football match or trying to hit the jack pot in a lottery and those putting their money into investment products after assessing the risk and return dynamics of the product.

It is however very difficult to differentiate between those operating in the gray area between gambling and investing. These individuals parade themselves as investors but in actual fact are gamblers.

It is a bit tricky to differentiate between the true investor and one who is behaving like a gambler. Investment literature will tell you putting all your investment eggs into one basket is gambling. Diversification plays a very important role in reducing the risk in an investment and therefore failing to diversify your investments reduces you to a gambler.

Another group in this category are individuals who take on excessive risk with the aim of making unprecedented profit. You don’t need to go far to get examples of these people. The recent microfinance crisis in Ghana gave us insights into how these gamblers behave.

What makes the situation very precarious for them is the fact that most of them are not able to independently assess the inherent risk in an investment and therefore assume these investments are safe.

If the expected returns on an investment are very high then you should expect that the investment will be riskier than one with a lower return. It is harsh to call these people gamblers, but the level of risk and the stakes transform it into a gamble.

A third group of gamblers parading as investors is those who put their money into investments without knowing or understanding what they are getting themselves into. Most gamblers have a fair idea of the odds against them even though they may not have adequate knowledge about the statistics involve. The investment sector in Ghana has a lot of such people with little or no knowledge about the investment environment.

They are the group that disrupts the performance of most markets. You cannot tell the story of gambling and investing without mentioning the speculators. Speculators are considered as investors but some but to win speculators need to gamble.

Gordon Geko in the movie Wall Street said “Speculation is the mother of all evils”. Speculators have been demonized in the past but history has showed that they are a necessary evil for the markets. Speculators were implicated in the recent significant depreciation of the Ghanaian cedi.

Speculators sometimes take on excessive risk to the point that it becomes very difficult to differentiate them from gamblers.

Gambling has been with humanity for a long time and it is huge industry that contribute a lot to some economies. Individuals gamble for various reasons and begrudging anyone who gambles will not achieve much.

There are gambling addicts, people who gamble for fun and those who undertake it as profession. The only problem is with gamblers who parade themselves as investors. To be a true investor far removed from gambling, the individual needs to reduce the level of the two elements that separate investors from gamblers: risk and chance.

As has been mentioned, gamblers take very high risk with a very high chance of losing their money. To reduce the risk of investing and increase your chances of success, the investor needs to diversify your investments to reduce risk, understand the interplay between risk and reward and have a clear knowledge about any investment undertaken. Diversification is a very easy concept to understand.

It is not a good idea to put all your eggs into one basket. The best is to put funds into investments that do not behave in like manner. Low correlated investments will ensure that a bad performing investment will be supported by a good performing one. Care must be taken when diversifying a portfolio because over-diversification will have the opposite effect of reducing returns.

It has been said time again that risk and return go together but many investors do not consider this when making investment decisions. Returns from investments do not appear out of the blue but are possible only after risks are taken.

Any investment that promises very high return is invariably taking a correspondingly high risk no matter what you are told. This point cannot be stressed more.

Let me echo the point for emphasis: risk begets return and anything else comes from the devil. The last safeguard to avoid gambling your funds away to understand any investment product you are getting yourself into. If not for anything at all it pays to have a clear idea about how the investment will make money for you otherwise your fingers will be burnt.

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Investor's World

LIFE AND DEBT OF A COMPANY

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There is a documentary made some years back which used the first part of the title of this article. The documentary was made in Jamaica and looked at the impact of the International Monetary Fund and the World Bank’s structural adjustment policies.

Here, we’ll look at life and debt from the perspective of a company or a business establishment and try to look at the most suitable time in the life of a company when debt is appropriate. To start with, there are two main ways a company can access funds to expand or run the business: debt and equity. Let me just provide a brief definition of the two terms to lay the foundation for my argument and build on from there.

“…it pays to understand the various stages in the life of a company and life taking into consideration the growth cycles it goes through.”

The first is equity investment, which is one of two key ways of raising funds for a business, and it is a way of raising funding for a business by giving out some of stake in the business in exchange for money. Equity investors become part owners of the business and share in the fortunes of the company or otherwise.

Equity investors receive dividends and other share-based distribution as the potential sources of income from the investment. Distributions to equity owners are however not an obligation and are only made when there is money to be distributed.

Investors who provide funding for companies in the form of debt are entitled to periodic interest payment from the company and the return of the principal at the end of the investment period. In the perking order of interest, debt holders have priority over equity investors and are therefore paid interest before any distribution can be made to equity holders.

This means that equity investors are exposed to more risk than their debt counterparts. Firms normally use a combination of debt and equity to fund their operations and proportions used is dictated by the capital structure the company intends to use. The capital structure is the financing mix used to support the implementation of the company’s strategy.

The challenge that most companies face is being able to identify the appropriate capital structure to use. There is a huge body of literature on the optimum and most efficient capital structures that organizations can use.

I will save you all the complexities and calculations involved in selecting an appropriate capital structure and simply say that the right capital structure depends on the financial policy of the firm, the supply and demand for the various sources of funding, the prevailing interest rate on the market and strength of the economy as a whole.

The capital structure also has a direct implication on the level of risk the company is exposed to. This is due to the fact that the obligations attached to the two main sources of funding are different. The more debt a company has in its capital structure, the more levered the company is and the more risk it is exposed to-measured by debt-to-equity or debt-to-total assets.

This means that a company’s capital structure also conveys information about how much risk it intends to take to implement its strategy but that decision is almost always influenced by the availability of the funding mix selected. It therefore becomes relevant to understand when in a company’s life is debt financing appropriate and when it is the least appropriate option.

To understand when it is appropriate for a company to fund its operations by adjusting the capital structure to accommodate more debt, it pays to understand the various stages in the life of a company and life taking into consideration the growth cycles it goes through.

My arguments will be based on the assumptions that the market for debt and equity is stable, interest rates are at their historic average and demand and supply for debt and equity securities are fairly balanced. Once upon a time, long before the glitz and the glam, a mortal conceived a brilliant business idea and decided to make it a reality.

To implement this idea the entrepreneur (let us call him that to at least boost his ego) will need to obtain funding which will mainly come from life savings and contributions from family and friends.

The funding for startups is mostly from the owner’s life savings and loans from friends and family who either believe in the business idea or who out of pity contribute their share. Sometimes personal loans are obtained by the owner(s) from their banks to provide initial support for the venture. When the business idea is implemented, public acceptance of the company’s product takes time and a lot of energy.

As history has showed, most businesses make losses due, in part, to a low patronage of its product and to challenges associated with starting a new venture. At this stage in company’s life using equity to keep the business afloat is the most ideal funding strategy. This is because equity investors are only paid dividend when there is one to be declared.

It goes without saying that dividends are only declared when the company makes profits. Raising equity capital is in essence selling a part of your business to investors for money and what better time to do than when the success of the business is not assured. Equity investors also share in the risk and the potential reward.

Using debt in the form of a bank loan and other short term instruments to finance the business operations will be suicidal and I must add that investors who make debt investments and banks who make out loans to startups are doing so with the express knowledge that there is a high possibility of the company not being able to make promised interest payments.

If they are not aware of this risk then I can’t think far. In the early growth stage of a business, product acceptance is beginning to take form and revenues are steadily growing. Here, a company can resort to debt financing because revenues will be stable enough to provide the cushion to absorb interest payment-related that comes about due to debt financing.

Another reason why debt is good at this stage is that when the business is doing well, it does make sense, to a business, to reduce its ownership stake because most of the risk attributable to early stages of the business would have begun subsiding.

As a company becomes more successful in the growth stage, it becomes very prudent to fund that growth and expansion with debt. As an added advantage, debt also enhances the value of the company because deductions for interest payments are made before corporate taxes are calculated and therefore debt provides a tax shield for the company.

Please don’t worry about what tax shield means. It simply means that the company pays less taxes when it uses debt in its capital structure than when it uses equity. The issue of contention is that equity is more expensive than debt financing because of the inherent risk that equity investors are exposed to and therefore it makes a lot of sense to start introducing debt financing into the company’s capital structure.

The caveat here is to not use shortterm debt to fund long term projects and vice versa. Also total interest expense should not exceed what financial experts have come to call net operating income, measured by the good old coverage ratio: the ratio that measures how much the company is able to cover in its interest expense.

Debt is however a two edge sword; it can be force for good and one that destroys absolutely. Debt is good financing option when a company is making stable or rising revenue and the operating income is healthy and can cover the required interest payment. Debt becomes problematic when a company uses too much of it in the company’s capital structure.

It is a well-documented fact that financial crisis that started in 2007 and took the whole world by storm can be attributed to high levels of debt taken by both businesses and individuals. The debt market in Ghana is taking shape and some companies have been able to raise debt funding from the Ghana Alternative Exchange (GAX).

Companies should however not be in a rush to raise debt funding from the market because the downfall of most companies have been attributed to the excessive use of debt. Where does the investor stand when it comes to debt securities issued by companies that want to fund their growth and expansion by using debt? The investor is covered a bit because debt has a priority over equity but debt investors will need to do detailed due diligence work on the issuers of these debt securities.

There is an adage that goes like “companies issue debt when they think the risk in the business is reduced and the future prospect look good and issue equity when the inherent risk in the business is high and therefore would want to share that risk with other equity investors”.

This is more like concentrating the gains for yourself and democratizing the losses. It is safe to say in the end that the most appropriate time for a business to fund their growth and expansion by issuing debt is when revenue and the profits are steady and rising and the company has the capacity to absorb the interest payment.

Excessive debt is however not good for a company no matter the growth stage of the business because beyond a certain threshold the benefits attributed to debt is eroded leading to risk that can threaten the very existence of the company.

Investors should also focus on assessing the capacity of a debt issuer to make periodic interest payment on the back of steady growth in revenues and profits.

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