BALANCE APPROACH: AN ANLYSIS
WITH RESPECT TO
portfolio balance approach
liquidity preference curve
Open- ended questions
– J. PRIYA THARSHINI
portfolio balance theory was proposed by James Tobin. James Tobin was an
American economist who served on the council of economic advisers and he board
of governors of the Federal Reserve System and taught at Harvard and Yale Universities.
His notable works include portfolio theory, Keynesian economics, Tobin’s Q,
Tobin tax, Mundell-Tobin effect, Tobit model. He won the John Bates Clark Medal
in the year 1955, Nobel Prize in Economics in the year 1981 for his
contribution to the field of economics.
TOBIN’ PORTFOLIO BALANCE APPROACH:
in his theory of liquidity preference stated the people hold their portfolio
comprising either totally of cash or bonds. This was not realistic. Tobin came
up with the theory of Tobin’s portfolio balance approach which overcame the
limitations of the Keynesian’s Theory. In this theory Tobin states that
individuals should and will maintain a portfolio which is a mixture of both
cash and bonds. He also makes a valid assumption stating that people always
prefer to increase their wealth rather than to decrease it. Tobin says that
people wealth not only consists of cash and bonds but also includes risky
shares. In the real world people hold a
diversified portfolio where the contents of the portfolio is decided upon by
the people on the basis of their tendency to take risk and the people are
basically risk averters who take less risk for a given rate of return, says Tobin.
The reason for him to say that people prefer to diversify their portfolio is
because he says that they are uncertain in their minds about the movement of
the future rate of interest. Now let’s take two cases, first the portfolio
which consists fully of bonds, n this case te person is willing to take risk
and thus his average income will be more in comparison with the person in the
second case where he/she is willing to hold only cash thus foregoing an
interest income that he/she could have potentially got from investing that
TOBIN’S LIQUDITY PREFERENCE CURVE:
liquidity preference curve talks about the relationship between the rate of
interest and the demand for money. Tobin says that the demand for money and the
rate of interest are inversely related, which explains that when the rate of
interest shoots up people will prefer bonds to dominate their portfolio and the
cash maintained by them will be less, thus decreasing the demand for money and
vice-versa. The liquidity preference curve is depicted in fig.19.1, where the
demand for money and the rate of changes in rate of interest is measured along
the X-axis and Y-axis respectively and Md is the liquidity preference curve
which traces the path of money demand with respect to the changes in he rate of
interest. We can in the fig.19.1 clearly see that at lower rates of interest
the demand for money is the highest and at high rates of interest the demand
for money is at the lowest and vice-versa.
INDIAN MONETARY MANAGEMENT:
Monetary management here is with respect to the
investors and about how the Indian investors maintain their portfolios in
coming to terms with the risk and return trade-off.
Since the establishment of the first stock exchange
in India in 1875, which was Bombay stock exchange there has been a constant changes in not only
the number of investors but also in the contents of the investors’ portfolio. One
study states that the financial penetration is interestingly not dependent on
literacy rather it is dependent on the rate of urbanisation and gross state domestic
product (GSDP). According to recent data, Maharashtra alone contributes to
about one-fifth of India’s stock market investors. It is followed by the states
of Gujarat, Tamil Nadu and West Bengal. These states contribute to little less
than 60% of India’s stock market investors. It was found that urbanisation and
GSDP had a correlation of 0.69 with the state’s stock market penetration as
compared to literacy which had a mere 0.30 correlation with the state’s stock
Another study done by SEBI in the year 2015 states:
Estimated investor and non-investor households by
rural and urban (per cent):
Estimated investor and non-investor households by rural
and urban (million):
Distribution of investors across investment
portfolio (per cent):
The recent data for number of investors across
investment portfolio is not available, however the below survey which was done
on small scale aims to study the behaviour of Indian investors and the extent
to which they are risk-averters.
you a salaried employee?
you aware of foregoing the interest income by way of maintaining liquid cash
you invest in shares on a monthly basis?
you immediately sell the shares if their prices are falling?
you feel there is much optimism in the stock market will you invest from your
your investment history (monthly or yearly), did you feel that, the returns
were worthwhile of the previously taken risk?
a certain extent
you interested in maintaining a portfolio dominated by investment, even
though your financial constraints don’t allow you to do so in reality?
much percentage of your monthly income do you maintain as cash monthly?
percentage of your total income do you invest in shares?
percentage of capital gain did you manage to garner in the previous year against
your anticipated return of 100% (hypothetical) capital gain?
*here refers to the maximum and minimum percentage
limit stated among all the respondents and not the frequency of that answer
among all the respondents.
Survey link; https://www.surveymonkey.com/r/5LDC65Z
Survey analysis link: https://www.surveymonkey.com/results/SM-8ZDYGWGX8/
This survey was done on a small scale and it is a
compilation of 31 respondents’ answer. The behaviour of these investors with
respect to their portfolio is interpreted below,
Many answers in the survey suggest that Indians are
risk averters to a large extent. This can be drawn from the answers of
questions such as, ‘if there is much optimization in the stock market, would
you immediately invest in it?’ the answer for which was consisted of approximately
70% yes and 29% no. Its known fact that any average human would that but what I
really want to draw from it is that a major chunk doesn’t want to experiment
when there is not much of optimisation in the markets and really do research
and try to understand how the market will move further, this is a typical
behaviour of a risk-averter. This further denotes they Tobin’s inverse
relationship between demand for money and the rate of interest is proved by the
investors’ behaviour, that is, they tend to reduce their cash portfolio when
the market is doing well. Here it must also be noted that this above stated
analysis is not to generalise but stating the condition of the major part of
the population. It can also be seen that
proportion of the income maintained as cash is higher than that of the
proportion maintained for the sake of investment, thus, we can know that a
majority of them maintain a cash-dominated portfolio. Many of the respondents
also don’t seem to invest on a monthly basis. It is surprising to know that
many actually want to maintain a portfolio dominated by investments had it not
been bee for their financial constraints and commitments, since, 32.26% have
answered positively compared to that of 19.35% negative answers. The only
answer which is interesting and surprising at the same time is the answer for
the question ‘Will you sell the shares immediately, if the prices are falling?’
for which a whopping 93.55% answered negatively, at the same time it is also
well known that, it isn’t wise to think that people will sell their shares due
the mere fact of the share prices falling, because the fall of prices doesn’t
alone influence the behaviour of the investors. From the survey it can also be
traced that many are aware of the opportunity cost of maintaining a
cash-dominated portfolio and that majority feel that they have been awarded
fairly with returns for the risks taken in the past.
In conclusion, it can be clearly noted and suggested
from the survey that Indians are actually exhibiting the behaviour of a little
more than a risk-averter; thus, we can say that they are willing to experiment.
This tendency of the investors was nurtured majorly after the New Economic
Policy of 1991 and after the financial crisis of 2007-2009. In conclusion, it
is worth mentioning that individuals’ portfolio is determined by their attitude
towards risk, as mentioned by Tobin.