Q&A with CMMB Securities

Q. In your column you tell people to diversify their investments. Why do you stress it so much and why would that reduce any risks? I would have thought that if you spread your money around in too many places it’s like being “jack of all trades and master of none.”

Christopher, Rio Claro

A: There is an old adage in life “do not put all your eggs in one basket.” It is also relevant to investments and is the essence of diversification. Spreading your investments across a variety of instruments reduces the overall risk of your investment portfolio. A portfolio is the group of investments you are holding. There is no mystery to diversification. For example, if one or more investments are not performing well, then the others may be doing better than expected thus maintaining an overall high composite return on the portfolio. This is diversification in action. In this way the probability of attaining the expected return on a portfolio is increased when income is coming from a variety of sources rather than from just one or two. You are right, spreading your investments does tend to require that you know a little of a lot of different things. However the market has been structured in such a way to prevent one from becoming too much of a “jack of all trades and master of none.” Investment managers are now being given incentives to become highly specialised in a particular field of finance. For example there may be analysts who know a lot about biotech stocks, but little about banking stocks. The overall manager of a diversified mutual fund would thus have to hire other specialists from different sectors of the market to draw on expertise from a variety of areas. A mutual fund would have many different managers, each hired to take care of a particular sector.

Q. I heard in the last Budget Speech that the Government plans to remove the tax on savings. How would this affect me?

Joanne, Gasparillo

A: This measure would affect all resident individual investors in a very tangible way. Currently, there is a withholding tax of 5% on the interest earned on deposits or a money market account. For example, if you earn 10% per year on a $1,000 deposit, the gross interest proceeds due to you would be $100. However, since there is a withholding tax of 5% on the interest earned the financial institution would pay you the $1000 less 5% of the interest earned. In this case the withholding tax of 5% on the $100 is $5. Therefore the amount you would get in your hand would be $100 less $5, which amounts to $95. So under the existing arrangements instead of earning a stated 10% on your funds you really earn an effective after tax return of 9.5%. This erosion of your return from 10% to 9.5% is a result of the withholding tax paid. Now the Government has announced its intention to remove this tax for resident investors. This means that whatever you are earning on your fixed deposits you would now receive the full amount of your computed interest whereas before there would have been a deduction for taxes. In the example above the investor would now receive the full $100 instead of the $95 when the 5% tax was involved. This measure is not only a positive from an individual perspective, but on a larger scale would result in an increase in national savings as individuals have a greater incentive to save and generate interest. A high level of national savings is a prerequisite for growth in a developing economy.

Q. Before the Budget was read you indicated that a secondary effect of budgetary measures is its impact on the level of interest rates. What do you see are the implications of this particular budget on interest rates in TT over the next three to five years?

Selwyn, Arima

A: The level of liquidity determines the level of interest rates in the financial system. If liquidity expands rates fall, while if liquidity contracts rates would increase. The level of liquidity in the financial system is itself determined by the Government’s borrowing requirements. An increasing borrowing requirement would reduce the level of money supply in the short-term, all things remaining constant. Government’s borrowing requirements would increase if its revenues begin to fall. A lot of our revenues are still linked to the price of oil, which is a very volatile commodity. If the price of oil falls, our revenues fall and hence the amount the country has to borrow to fund expenditure would increase. As borrowing increases money supply decreases and so interest rates tend to increase, all things remaining constant. It therefore follows that a fall in the price of oil could lead to higher interest rates in Trinidad and Tobago. Research by the International Monetary Fund has shown that in 2002 there was a one in six chance of the price of oil falling by US$2 per barrel even in the midst of the high prices. So it is quite possible that oil prices could fall due to expanding supply from Iraq by March 2004 which could result in upward pressure on interest rates in Trinidad and Tobago. It is also quite possible that the Central Bank may adopt counter-balancing measures to expand liquidity and neutralise the impact of increased borrowing. However, this intervention is not sustainable in the long term and if increased borrowing continues interest rates from 2005 and beyond could experience some upward pressure unless the country receives significant windfall revenues. So in the short-term rates may stay flat or fall a bit further, but if the current borrowing trend continues then rates could well begin to rise again from 2005 and beyond.

Questions can be sent to PO Box 1830, Wrightson Road, Port-of-Spain
e-mail — cmmb@mycmmb.com