Why do Banks let you Store Money?
Lakhs of people keep their money in the bank.
The bank knows that not everybody will come to them asking for all their money back (under normal circumstances).
In addition, they offer you facilities like ATMs, net banking, etc.
But they don’t charge anything.
That’s because they use your money to make money.
They keep some money aside and the rest, they give out loans - home, car, personal, commercial, you name it. They earn interest from these loans.
They share some with you in the form of savings interest or FD interest and some they keep as their profit. That’s how every bank works. For centuries.
Enter a relatively new concept. Securitization.
Instead of keeping the loans with themselves, the bank sells the loan to another institution. Since the bank has sold the loan, it again has money on its hands. It can give out new loans. The institutions sell these loans to investors who want to earn interest.
But here’s a problem. How do you know if the loan you’re buying is a good one or a bad one?
What if the person whose loan you’re getting is a person who will default and not pay back?
Diversification.
The institution mixes a bunch of loans together. So instead of one investor buying one loan, 100 investors (example) buy smaller portions of 100 loans.
Thanks to diversification, the risk has been spread out.
You realize what just happened?
One person defaulting can be disastrous for an individual investor. But 1 out of 100 persons defaulting is a small dent.
Securitization.
In the early 2000s, what banks were doing was very similar to what we’ve written above.
They were giving out loans and selling off the loans to institutions who in turn sold them to investors in diversified packages.
The institutions had complicated ways of mixing up these loans.
One way to understand would be, let’s say a small daily supplies shop owner from New York took a loan and another shop owner took a similar loan but he was from Chicago.
Considering geographical reasons (storms, weather, other local economic and political conditions, etc.) whatever affects Chicago is less likely to affect New York. So, a loan from Chicago and New York mixed together is less risky than two loans from Chicago. This did wonders for the system - at least for a while.
This reduction in risk resulted in everyone becoming bolder.
Banks started giving out more loans. Soon they ran out of good people to give loans to.
So you start giving out loans to slightly less good people. And then you move further down to people who are even less likely to pay back.
These loans were sold to investors too. A vicious cycle began.
More loan-taking pushed the prices of homes up.
Higher amount loans were given out.
And then, it imploded.
When enough people weren’t able to pay back, people started defaulting. House prices started falling.
Great, but diversification would save investors, right?
Unfortunately, no.
When the house prices started collapsing, it affected the entire country of the USA. Diversification didn’t really help.
From our example earlier, yes, a loan from Chicago mixed with a loan from New York is lower risk, but it isn’t exactly no-risk.
This is what we investors need to make peace with.
The same kind of diversification does not continue to lower risk.
This isn’t about one asset.
This is about true diversification.
You have 1 stock. Your friend has 10 stocks. Your friend is more diversified and has lower risk. But that doesn’t mean if you continue to diversify to 1000 stocks, your risk will go down to 0.
After a certain point, buying more stocks will do nothing to reduce risk. But investing in other assets like bonds, deposits, metals, real estate, etc. will reduce your risk.
And this holds for every asset you invest in, not just stocks.
Think of it like this.
You can buy a house near a university to benefit from student rents. And diversify by buying a house beside an office to get salaried employee rent. And then another one beside a commercial hub for businessperson rent.
But if the entire city experiences a building-breaking earthquake, you will stop earning rent.
Don’t keep all your eggs in one basket. Yes.
Ask different people to carry them in different baskets on different vehicles. Even better.
Source: Groww Digest
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