Fundamentals of Investment Planning

What is Investing?
Investment refers to a commitment of funds to one or more assets that will be held over some
future time period. It is important to understand the difference between Savings and Investments.
Anything not consumed today and saved for future use can be considered as savings. Almost all
of us save money. In fact we are a nation of savers where the domestic savings is a high
percentage of Gross Domestic Product
sometimes as high as 26-27%. It is important to channel these savings into productive
investment avenues.
Almost all individuals have wealth of some kind, ranging from the value of their services in the
workplace to tangible assets to monetary assets.. For our purposes, investment will mean a
measurable asset retained in order to increase ones personal wealth. A financial asset is one that
generates income and contributes to accumulation and growth of wealth over a period of time.
The two elements in investments are generation of income on a periodic basis and/or growth in
value over a period of time.

Investment scenario in India

A pick-up in investment, reflecting the high business optimism, not only strengthened industria
performance but also reinforced the growth outlook itself. The rally in gross domestic capital
formation (GDCF) that had commenced in 2002-03 continued and as a proportion of GDP it
reached a high of 30.1 per cent in 2004-05.
1The increasing trend in gross domestic savings, which provided most of the resources for
investment, as a proportion of GDP observed since 2001-02 continued with the savings ratio
rising from 26.5 per cent in 2002-03 to 28.9 per cent in 2003-04 and further to 29.1 per cent in
2004-05.2 India is a nation of savers and the domestic savings is a very high percentage of GDP.
That is extremely good. It is shocking to note that more than 45% of domestic savings is invested
in bank deposits and only about 2/3% in equity and equity related investments. This clearly
shows that while as a nation we are very good savers we are very poor investors because it is
equally important for the savers to invest in avenues that fetch decent returns after considering
factors like inflation, taxation, etc. Bank deposits not only offer lower returns but they are hardly
tax efficient and thus do not serve the cause of earning high post tax & net of inflation returns. In
developed countries the proportion of savings being diverted to equity and equity related
instruments is in the region of 20-25% of GDP while around 20% of savings are parked in bank
deposits. Some investors have failed to recognize the less obvious, but potentially more
damaging, risk of diminished income from staying completely invested in low yielding fixed
income securities or bank deposits.
The financial planner should ensure that investors take a hard look at the fixed income
components of their portfolios and rethink this strategy in the context of more comprehensive,
long-term objectives. Understanding where the clients are coming from, the priorities in their life
and the challenges they face in a rapidly changing investment horizon. Succeeding in career,
planning childrens education, marriages and having more than enough for an enjoyable
retirement are some of the objectives most people aim at.

The financial planner in India hence, has a very important role to play. The planners job in
India is more challenging because of Indian mind set and the aversion to risk. It will be part of
his job to educate his clients on concepts of risks and returns and their relationship.

Why Invest?
We all work for money. It is equally important to ensure that money works for us. We should
inculcate the habit of reliance on a secondary source of income. We invest to improve our future
welfare. Funds to be invested come from assets already owned, borrowed money, and savings or
foregone consumption.
By foregoing consumption today and investing the savings, we expect to enhance our future
consumption possibilities. Anticipated future consumption may be by other family members,
such as education funds for children or by ourselves, possibly in retirement when we are less
able to work and produce for our daily needs. Regardless of why we invest we should all seek to
manage our wealth effectively, obtaining the most from it. This includes protecting our assets
from inflation, taxes and other factors.
Investment fundamentals
Some of the fundamental rules of investments are:
START EARLY
INVEST REGULARLY
ENSURE HIGHER RETURNS ON YOUR INVESTMENTS
The following table will demonstrate the difference, very graphically:
It is assumed that an investor invests Rs 1,000/- p.m., at the end of each month, systematically, in
different invest plans which yield 5%, 8%, 12% and 15% p.a. returns. Look at the big difference
in the maturity values as the term gets longer and longer and as the returns are higher.

Indian investors have always preferred fixed income securities where there turns are assured
and have compromised on the returns.In general investors are risk averse and more so Indian
investors. It is the job of the financial planner to advise the investors on the concept to
2

focusing on higher returns for better stability and higher capital building over a longer period
of time .The above table veryclearly illustrates how a higher rate of return over longer period
of time can make a world of difference to the capital at the end of the term.

Understanding Investment Risk

Risk
In the context of investments risk refers not only to the chance that a person may lose his
capital but more importantly to the chance that the investor may not get the desired return on an
investment vehicle. We invest in various investment products which generally comprise: 1. Fixed
Income Instruments and 2. Growth oriented investments. In the case of Fixed Income
Instruments with a definite coupon rate there is virtually no risk of not being able to get the
desired returns but in the case of other instruments an investor goes with an expectation of a
certain amount of return and the term risk in this context refers to the probability of the
investor not getting the desired/expected returns
The notion of risk is an integral and primary concept in the understanding of investments. Risk
can be defined as the uncertainty of an outcome from an investment decision. In making an
investment decision, an investor forms an exception regarding that decisions outcome. Any
departure form that expected outcome can be considered the risk of that decision. Thus, another
way to consider risk is to consider the possibilities of unexpected outcomes. The outcome form
an investment decision may unexpectedly increase or decrease the principal amount invested.
While most people consider the decrease in value as the investment risk, we will observe that in
measuring risk, both positive and negative unexpected
outcomes must be considered. Before considering the issues regarding the measurement of risk
let us begin by enumerating the different types of risk that may exist for an investment.
The issue of risk being incorporated in both positive and negative surprises can be explained
with a simple example. Assume you are explaining the possible outcomes of an investment
decision toa client where the client may receive a return of either 8% (poor outcome) or a 16%
(good outcome). You also explain that the client may expect to receive a simple average of the
two returns, or 12%, from the investment decision. Your client now states that she is averse to the
8% outcome and wants to know if the investment can yield 12% or better. That is, the client
wishes to remove the poor outcome altogether.
Notice that if this were possible, then the simple average of the new investment decision, or the
expected outcome would now be 14% ((16%+12%)/2) and the new poor outcome would now be
12%. In other words, risk, or the unexpected outcomes, cannot go away. It is only meaningful in
the context of an expected outcome and both positive and negative unexpected outcomes. There
are many different ways in which the principal invested can be unexpectedly changed. We will
now consider each of these types of risk.

Risk Avoidance
Investment planning is almost impossible without a thorough understanding of risk. There is a
risk/return trade-off. That is, the greater risk accepted, the greater must be the potential return as
reward for committing ones funds to an uncertain outcome. Generally, as the level of risk rises,
the rate of return should also rise, and vice versa.
3

Before we discuss risk in detail, we should first explain that risk can be perceived, defined and
handled in a multitude of ways. One way to handle risk is to avoid it. Risk avoidance occurs
when one chooses to completely avoid the activity the risk is associated with. An example would
be the risk of being injured while driving an automobile. By choosing not to drive, a person
could avoid that risk altogether. Obviously, life presents some risks that cannot be avoided. One
may view a risk in eating food that might be toxic. Complete avoidance, by refusing to eat at all,
would create the inevitable outcome of death, so in this case, avoidance is not a viable choice. In
the investment world, avoidance of some risk is deemed to be possible through the act of
investing in risk-free investments. Short-term maturity Government bonds are usually equated
with a risk-free rate of return. In the Indian market place risk free returns are the
returns available on Treasury Bills of a certain tenor; necessarily less than one year and about
90daysor 180 days. Stock market risk, for example, can be completely avoided by choosing not
to investequities and equity related instruments.

Risk Transfer
Another way to handle risk is to transfer the risk. An easy to understand example of risk transfer
is the concept of insurance. If one has the risk of becoming severely ill (and unfortunately we all
do), then health insurance is advisable. An insurance company will allow you to transfer the risk
of large medical bills to them in exchange for a fee called an insurance premium. The company
knows that statistically, if they collect enough premiums and have a large enough pool of insured
persons, they can pay the costs of the minority who will require extensive medical treatment and
have enough left over to record a profit. Risk transfer can also occur in investing. One may
purchase a put option on a stock or on the market index which allows that person to put to or
sell to someone their stock or the index at a set price, regardless of how much lower the stock or
the index may drop. There are many examples of risk transfer in the area of investing.

The Risk Averse Investor

Do investors dislike risk? In economics in general, and investments in particular, the standard
assumption is that investors are rational. Rational investors prefer certainty to uncertainty. It is
easy to say that investors dislike risk, but more precisely, we should say that investors are risk
averse. A risk-averse investor is one who will not assume risk simply for its own sake and will
not incur any given level of risk unless there is an expectation of adequate compensation for
having done so. Note carefully that it is not irrational to assume risk, even very large risk, as long
as we expect to be compensated for it. In fact,
investors cannot reasonably expect to earn larger returns without assuming larger risks.
Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing
to incur. Some investors choose to incur high levels of risk with the expectation of high levels of
return. Other investors are unwilling to assume much risk, and they should not expect to earn
large returns. We have said that investors would like to maximize their returns. Can we also say
that investors, in general, will choose to minimize their risks? No! The reason is that there are
costs to minimizing the risk, specifically a lower expected return. Lower the risk, lower the
return. Taken to its logical conclusion, the minimization of risk would result in everyone
holding risk-free assets such as savings accounts and Treasury bills. Thus, we need to think in
terms of the expected return/risk trade-off that results from the direct relationship between the
risk and the expected return of an investment.

Influence of Time on Risk

Investors need to think about the time period involved in their investment plans. The objectives
being pursued may require a policy statement that speaks to specific planning horizons. In the
case of an individual investor this could be a year or two in anticipation of a down payment on a
home purchase or a lifetime, if planning for retirement. Generally speaking, the longer the time
horizon the more risk ca be incorporated into the financial planning. Globally as well as in India
it is well established on the basis of track record of performance that equities as a class of asset
has outperformed other asset classes and delivered superior returns over longer periods of time.
With these statistics available why wouldnt everyone at all times be 100 percent invested in
stocks? The answer is, of course, that while over the long term stocks have outperformed, there
have
been many short term periods in which they have underperformed, and in fact, have had negative
returns. Exactly when short term periods of underperformance will occur is unknown and thus
there I more risk in owning stocks if one has a short term horizon than if there exists a long term
horizon. A
financial planner has to take into account the time horizon while structuring investment
portfolios and the general rule is that the younger a person is, the longer can be his time horizon
and hence more exposure to equities this follows the rule that risk and returns go up with time.
Time has a different effect when analyzing the risk of owning fixed income securities, such as
bonds. There is more risk associated with holding a bond long term than short term because of
the uncertainty of future inflation and interest rate levels. If one were to lock in a rate of 8
percent for a bond that matured in one year, an upward move in inflation or interest rates would
have a less adverse effect on the price of that bond than a 8 percent bond that matured in thirty
years. That is because the bond could be redeemed in one year and reinvested in a bond with a
presumably higher interest rate. The thirty year bond, however, will continue to pay only 8
percent for the rest of its thirty year life.

Types of Investment Risk

Systematic versus Unsystematic Risk
Modern investment analysis categorizes the traditional sources of risk causing variability in
returns into two general types: those that are pervasive in nature, such as market risk or interest
rate risk, and those that are specific to a particular security issue, such as business or financial
risk. Therefore, we must
consider these two categories of total risk. The following discussion introduces these terms. Total
risk can be divided into its two components, a general (market) component and a specific (issuer)
component. Then we have systematic risk and nonsystematic risk, which are additive:
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Unsystematic risk

Systematic Risk
An investor can construct a diversified portfolio and eliminate part of the total risk, the
diversifiable or non market part. What is left is the non diversifiable portion or the market risk.
Variability in a securitys total returns that is directly associated with overall movements in the
general market or economy is
called systematic (market) risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic
ris directly encompasses interest rate, market and inflation risks. The investor cannot escape this
part of the risk because no matter how well he or she diversifies, the risk of the overall market
cannot be avoided. If the stock market declines sharply, most stocks will be adversely affected; if
it rises strongly, most stocks will appreciate in value. These movements occur regardless of what
any single investor
does. Clearly, market risk is critical to all investors.

Unsystematic Risk
The variability in a securitys total returns not related to overall market variability is called the
unsystematic
(non market) risk. This risk is unique to a particular security and is associated with such factors
as business and financial risk as well as liquidity risk. Although all securities tend to have some
non systematic risk, it is generally connected with common stocks. Remember the difference:
Systematic (Market) Risk is attributable to broad macro factors affecting all
securities. Nonsystematic (Non-Market) Risk is attributable to factors unique to a security.

Market Risk
A market is a place where goods and services are traded. Events occur within a market that
similarly affect all the goods traded in that market. For example, when the Reserve Bank of India
unexpectedly changes interest rates, most financial securities are affected similarly. Other
examples of events that affect all securities are the possibilities of war, severe natural
catastrophes, recessions, structural changes in the economy, tax law changes, even changes in
consumer preferences etc. When the unexpected change in values is systematic to the whole
market, that risk is termed as market or systematic risk.

Reinvestment Risk
In the context of bonds investors look at the current yield as well as Yield To Maturity (YTM)
the return one would get if the security were held till the maturity and redeemed with the issuing
institution. It is important to understand that YTM is a promised yield, because investors earn the
indicated yield only if the bond is held to maturity and the coupons (the periodic interest
payments) are reinvested at th calculated YTM (yield to maturity). It is important to reinvest the
periodic payments, at the same rate as the YTM, to obtain the YTM yield on the security. In the
context of long term bonds during the tenor of

which the interest rates may fluctuate in any economy it is virtually difficult for the investor to
invest periodic coupon payments at YTM and hence the risk of not being able to get the desired
return (YTM) and this risk is referred to as reinvestment risk. Obviously, no trading can be done
for a particular bond if the YTM is to be earned. The investor simply buys and holds. What is not
so obvious to many investors, however, is the reinvestment implications of the YTM measure.
Because of the importance of the reinvestment rate, we consider it in more detail by analyzing
the reinvestment risk. The YTM calculation assumes that the investor reinvests all coupons
received from a bond at a rate equal to the computed YTM on that bond, thereby earning interest
on interest over the life of the bond at the
computed YTM rate. In effect, this calculation assumes that the reinvestment rate is the yield to
maturity. If the investor spends the coupons, or reinvests them at a rate different from the
assumed reinvestment rate of 10 percent, the realized yield that will actually be earned at the
termination of the investment in
the bond will differ from the promised YTM. And, in fact, coupons almost always will be
reinvested at rates higher or lower than the computed YTM, resulting in a realized yield that
differs from the promised yield. This gives rise to reinvestment rate risk. This interest-oninterest concept significantly affects the potential total dollar return. The exact impact is a
function of coupon and time to maturity, with reinvestment becoming more important as either
coupon or time to maturity, or both, rises. Specifically:
a. Holding everything else constant, the longer the maturity of a bond, the greater the
reinvestment risk.
b. Holding everything else constant, the higher the coupon rate, the greater the dependence
of the total return from the bond on the reinvestment of the coupon payments.
The notion of reinvestment rate risk is particularly easy to see in the retirement planning process.
In assisting a client with a retirement plan, an assumed rate of return is built into the retirement
forecast as to estimate the annual contributions the client will be required to make to the
retirement plan. It is assumed that the funds will build at that rate of return until the client retires.
What we see in reality is varying rates of return throughout the life of the portfolio. Some
realized rates of return may be better than the forecast and some may be worse than the forecast.
Either way, as the retirement plan grows,
we will not see the steady, forecasted rate of return on the retirement portfolio. If the rates of
return are consistently lower than the original forecast, the clients will not have enough funds at
retirement to meet their need. In this case, the reinvestment risk is the cause of the problem.

Interest Rate Risk

The variability in a securitys return resulting from changes in the level of interest rates is
referred to as interest rate risk. Such changes generally affect securities inversely; that is, other
things being equal, security prices move inversely to interest rates. The reason for this movement
is tied up with the valuation of securities. Interest rate risk affects bonds more directly than
common stocks and is a major risk faced by all bondholders. As interest rates change, bond
prices change in the opposite direction.
As a financial planner, while considering investments in various fixed income securities it is
desirable to explain the concepts of interest rate risk as well as reinvestment risk and build the
7

same while structuring client portfolios. If the current scenario is such that the interest rates may
rise in the near future and may
keep rising for some time to come, then may be more of short term debt instruments would find
place in the portfolio and in a scenario where the interest rates have reached historic peaks and
may fall in the future, then it would make sense to commit funds for long term and hence
investors should be advised
to get into long term bonds/annuities of insurance companies, etc. to protect from these two risks
that we have discussed.
The values of all financial and real assets are in some part dependent on the general levels of
interest rates in an economy. Therefore, any unexpected change in the general level of interest
rates will also unexpectedly affect the values of all such assets. Financial assets such as bonds are
especially affected
by such changes. As we shall see later, the values of bonds and all other fixed income securities
are inversely related to interest rates, i.e. when interest rates increase, these values decrease and
vice versa. Values of stocks are also affected by changes in interest rates, though understanding
the impact of interest rate changes on stock values is less straightforward than for bonds. Real
assets such as real
estate are also tremendously impacted by changes in interest rates. When changes in interest rates
are unexpected, the uncertain changes in asset values are said to arise form interest rate risk. The
reader can appreciate why participants in the financial markets so engrossed in pending activities
of the Reserve Bank of India which through its policy making decisions, has a considerable
influence on interest rates.

Purchasing Power Risk

Inflation risk is also known as purchasing power risk because the ability to purchase different
quantities of goods and services is dependent upon the changing levels of prices of all items in an
economy. For example, assume a client wishes to invest a sum ofRs. 2,90,000 which is expected
to result in a certain outcome of Rs. 3,00,000. Now also consider that the client wishes to
purchase a car, either today or on year from now and which is valued today also at Rs. 2,90,000.
Suppose the price of this car increases to Rs. 3,10,000 over the year. In this case, the investor
would have been better off if she had bought th car instead of investing the amount. Thus the
investor has a choice in how the money may be used. If the money is invested then the client will
need an additional Rs. 10,000 to purchase the car. In other words, the inflation in the cars price
has eroded the purchasing power of the invested sum. If we that the increase in the price of the
car was unexpected, then we can consider the effect of the
outcome as arising out of inflation risk. Inflation risk is especially important to investment
decisions where the financial securities being utilized are interest rate sensitive. Such as bonds. A
factor affecting all securities is the purchasing power risk also known as inflation risk. This is the
chance that the purchasing power of invested money may decline. With uncertain inflation, the
real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury
bond). This risk is related to interest rate risk, since interest rates generally rise as inflation
increases, because lenders demand additional inflation premiums to compensate for the loss of
purchasing power.

Liquidity Risk
Liquidity in the context of investment in securities is related to being able to sell and realize
cash with the least possible loss in terms of time and money. Liquidity risk is the risk associated
with the particular secondary market in which a security trades. An investment that can be
bought or sold quickly and without significant price concession is considered liquid. The more
the uncertainty about the time element and the price concession, the greater the liquidity risk. A
Treasury bill has little or no liquidity risk, whereas a small cap stock listed in a regional stock
exchange may have substantial liquidity risk. Liquidity is concerned with the ability to convert
the value of an asset into cash. Any event or condition that affects this ability is termed as
liquidity risk. For example, an investor may wish to sell her holding in a stock. If the investor
cannot find a buyer for the stock, then her position in that stock cannot be liquidated. Hence, in
this example, she faces liquidity risk. Assets differ from each other by liquidity risk. Securities
offered by the government (such as Treasury bills) are very liquid because there are many
participants seeking to trade in these securities. Treasury bills can be sold almost instantaneously,
and hence are considered to be highly liquid. At the other end of the spectrum, stocks of very
small and little known companies are considered to contain high liquidity risk because they are
thinly traded. When investors make purchase decisions that may require to be quickly converted
to cash, they will always seek securities which have low liquidity risk. For example, firms that
temporarily place excess cash in financial (marketable) securities in order to enhance yields will
seek highly liquid securities that do not increase the firms liquidity risk exposure.

Regulation Risk
Some investments can be relatively attractive to other investments because of certain regulations
or tax laws that give them an advantage of some kind. Interest earned on Public Provident Fund
accounts are totally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). As a
result of that special tax exemption on the interest as well as the invested amount qualify for
deduction from income u/s 80C the yield on PPF account is much higher than its current interest
rate of 8%. The risk of a regulatory change that could adversely affect the stature of an
investment is a real danger. A special committee has advised the Government of India to do away
with various sections of The Income Tax Act which allow exclusions and deductions. If its
recommendations are accepted by the Government then the attractiveness of this investment
avenue will drop dramatically. Dividends on shares and equity mutual
funds are tax free in the hands of investors. These avenues become attractive because of the tax
concessions (which are matters of legislation) and these can change. That is one risk associated
with investments which cannot be avoided. The best solution lies in periodic review of
investment plans.

Business Risk
The risk of doing business in a particular industry or environment is called business risk. For
example, some commodities like fertilizers and oil are highly price sensitive I the Indian context
and the Government policies of subsidies substantially affect the profitability of the companies
engaged in manufacturing/ marketing these products. The risk associated with the changes in a
firms abilities to measure up to expectations is known as business risk or unsystematic risk.
Business risk can be further segregated into operating risk and
9

financial risk. The risk that a business may not be able to meet its fixed operating costs, such as
rent, management salaries, etc., is known as operating risk. The risk that the firm may not be able
to meet its fixed financial obligations, such as paying interest on its debt or lease payments, is
known as financial
risk. Financial risk is also known as credit risk since lenders or creditors of funds seek to assess
the ability of the firm to meet its debt services obligations.

International Risk
International Risk can include both Country risk and Exchange Rate risk.

Exchange Rate Risk

All investors who invest internationally in todays increasingly global investment arena face the
prospect of uncertainty in the returns after they convert the foreign gains back to their own
currency. Unlike the past when most Indian investors ignored international investing alternatives,
investors today must recognize and understand exchange rate risk, which can be defined as the
variability in returns on securities caused by currency fluctuations. Exchange rate risk is
sometimes called currency risk. The market for potential assets in which to invest spans the
entire globe. Investors are not constrained to invest only in their home countries. However, when
an investor purchases a security in a foreign country, it must be paid for in a foreign currency. At
the time of the purchase, the value
of the foreign security is derived form the current, or spot, exchange rate. The exchange rate that
will prevail when the investor sells the security in the future cannot be predicted with any
certainty, and hence, the conversion value becomes uncertain. This uncertainty can be considered
as exchange rate risk. We illustrate this risk by a simple example. For example, a U.S. investor
who buys an Indian stock denominated in Indian Rupees must ultimately convert the returns
from this stock back to dollars. If the exchange rate has moved against the investor, losses from
these exchange rate movements can partially or totally negate the original return earned. A stable
rather than a depreciating foreign currency (in this case Indian Rupee) is what the investor would
be looking for while deciding to invest in that country. The returns to an international investor is
always
the market returns + or the foreign currency appreciation or depreciation in the intervening
period.
Obviously, the investors who invest only in domestic markets do not face this risk, but in todays
global environment where investors increasingly consider alternatives from other countries, this
factor has become important. Currency risk affects international mutual funds, global mutual
funds, closed-end single country funds, American Depository Receipts, foreign stocks, and
foreign bonds.

Country Risk
Country risk, also referred to as political risk, is an important risk for investors today. With more
investors investing internationally, both directly and indirectly, the political, and therefore
economic, stability and viability of a countrys economy need to be considered. More and more
international investors ar investing in the Indian market because of the political and economic
stability of India in the last few years
10

and the belief of continued stability on these fronts. Transparent economic policies and political
stability are key factors for attracting more foreign investments in India. Many firms operate in
foreign political climates that are more volatile than those in the United States. Firms can face
the danger of the foreign operations being nationalized by the local government or can
experience imposed restriction of capital flows from the foreign subsidiary to the parent. Danger
from aviolent overthrow of the political party in power can also have an effect on the rate of
return investors receive on foreign investments. Many countries have also been unable to meet
their foreign debt
obligations to banks and other foreign institutions which contain important political and
economic implications. The informed investor must have some feel for the political/economic
climate of the foreign country in which he or she invests. Political risk represents a potential
deterrent to foreign investment. The best
solution for the investor is to be sufficiently diversified around the world so that a political or
economic development in one foreign country does not have a major impact on his or her
portfolio.

11

Measurement of Risk
We invest in various investment vehicles expecting some amount of return from these avenues.
The investment risk refers to the probability of actually not earning the desired or expected
return and may be a lower or negative return. A particular investment is considered riskier if the
chances of lower than expected returns or negative returns are higher. n Standard deviation (si)
measures total, or stand-alone, risk. n The larger the si, the lower the probability that actual
returns will be close to the expected return.

Standard Deviation
When an investor goes in for an investment option, he may do so expecting to get a return of say
15% in one year. This is only a one-point estimate of the entire range of possibilities. Given that
an investor
must deal with the uncertain future, a number of possible returns can and will occur. In the case
of a Treasury bill, of say 90 days, paying a fixed rate of interest, the interest payment will be
made with 100 per cent certainty barring a financial collapse of the economy. The probability of
occurrence is 1.0, because no other outcome is possible. With the possibility of two or more
outcomes, which is the norm for stock market investment, each
possible likely outcome must be considered and a probability of its occurrence assessed. The
result of considering these outcomes and their probabilities together is a probability distribution
consisting of the
specification of the likely returns that may occur and the probabilities associated with these
likely returns. Probabilities represent the likelihood of various outcomes and are typically
expressed as a decimal
(sometimes fractions are used.) The sum of the probabilities of all possible outcomes must be
1.0, because they must completely describe all the (perceived) likely occurrences. How are these
probabilities and associated outcomes obtained? The probabilities are obtained on the
basis of past occurrences with suitable modifications for any changes expected in the future. In
the final analysis, investing for some future period involves uncertainty and, therefore, subjective
estimates.
Investors and analysts should be at least somewhat familiar with the study of probability
distributions. Since the return which an investor earns from investing is not known, it must be
estimated. An investor
may expect the TR (total return) on a particular security to be 10 per cent for the coming year,
but in truth, this is only a point estimate.
Probability distributions can be either discrete or continuous. With a discrete probability
distribution, a probability is assigned to each possible outcome. With a continuous probability
distribution an infinite
number of possible outcomes exist. The most familiar continuous distribution is the normal
distribution depicted by the well-known bell-shaped curve often used in statistics. It is a twoparameter distribution
in which the mean and the variance fully describe it. To describe the single most likely outcome
from a particular probability distribution, it is necessary to calculate its expected value. The
expected value is the average of all possible return outcomes, where each outcome is weighted
by its respective probability of occurrence. For investors, this can be described We invest in
12

various investment vehicles expecting some amount of return from these avenues. The
investment risk refers to the probability of actually not earning the desired or expected return
and may be a lower or negative return. A particular investment is considered riskier if the
chances of lower than expected returns or negative returns are higher. n Standard deviation (si)
measures total, or stand-alone, risk. n The larger the si, the lower the probability that actual
returns will be close to the expected return.

Standard Deviation
When an investor goes in for an investment option, he may do so expecting to get a return of say
15%
in one year. This is only a one-point estimate of the entire range of possibilities. Given that an
investor
must deal with the uncertain future, a number of possible returns can and will occur. In the case
of a Treasury bill, of say 90 days, paying a fixed rate of interest, the interest payment will be
made with 100 per cent certainty barring a financial collapse of the economy. The probability of
occurrence is 1.0, because no other outcome is possible. With the possibility of two or more
outcomes, which is the norm for stock market investment, each
possible likely outcome must be considered and a probability of its occurrence assessed. The
result of considering these outcomes and their probabilities together is a probability distribution
consisting of the
specification of the likely returns that may occur and the probabilities associated with these
likely returns. Probabilities represent the likelihood of various outcomes and are typically
expressed as a decimal
(sometimes fractions are used.) The sum of the probabilities of all possible outcomes must be
1.0, because they must completely describe all the (perceived) likely occurrences. How are these
probabilities and associated outcomes obtained? The probabilities are obtained on the
basis of past occurrences with suitable modifications for any changes expected in the future. In
the final analysis, investing for some future period involves uncertainty and, therefore, subjective
estimates.
Investors and analysts should be at least somewhat familiar with the study of probability
distributions. Since the return which an investor earns from investing is not known, it must be
estimated. An investor
may expect the TR (total return) on a particular security to be 10 per cent for the coming year,
but in truth, this is only a point estimate.
Probability distributions can be either discrete or continuous. With a discrete probability
distribution, a probability is assigned to each possible outcome. With a continuous probability
distribution an infinite number of possible outcomes exist. The most familiar continuous
distribution is the normal distribution depicted by the well-known bell-shaped curve often used
in statistics. It is a two-parameter distribution
in which the mean and the variance fully describe it. To describe the single most likely outcome
from a particular probability distribution, it is necessary to calculate its expected value. The
expected value is the average of all possible return outcomes, where each outcome is weighted
by its respective probability of occurrence. For investors, this can be described

13

In this case, the expected return is calculated as under:

Expected return = Sum (returns*probability)
= (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1)
= .004+.016+.048+.032+.02
= 0.12 or 12%
It is a normal distribution curve as pictorially depicted below:

Standard Deviation
We have mentioned that its important for investors to be able to quantify and measure risk. To
calculate the total risk associated with the expected return, the variance or standard deviation
is used. This is a measure of the spread or dispersion in the probability distribution; that is, a
measurement of the dispersion of a random variable around its mean. Without going into further
details, just be aware that the larger this dispersion, the larger the variance or standard deviation.
Since variance, volatility and risk can in this context be used synonymously, remember that the
larger the standard deviation, the more uncertain the outcome.

Calculating Standard Deviation

Lets use the same table that we did for calculating the expected returns and find out the standard
deviation of the same:

14

Standarddeviationissquarerootofvariance.
Variance=Sumof{Probabilities*(actualreturnexpectedreturn)2}
Variance=

Pro

bability*(actualreturnexpectedreturn)2

So,basedonthefiguresinthetablewecanworkoutthevarianceasunder;Expectedret
urnalreadycalculatedtobe12%

Variance=sumoflastcolumn=(6.4+3.2+0+3.2+6.4)=19.2Standar
ddeviation=Squarerootofvariance=4.3817

What Standard Deviation Means

Say a fund has a standard deviation of 4% and an average return of 10% per year. Most of the
time (or, more precisely, 68% of the time), the funds future returns will range between 6% and
14% (or its 10% average plus or minus its 4% standard deviation). Almost all of the time (95%
of the time), its returns will fall between 2% and 18%, or within two standard deviations i.e. [10(2*4) or 10 + (2*4)]

Limitations of Standard Deviation

Using standard deviation as a measure of risk can have its drawbacks. For starters, its possible to
own a fund with a low standard deviation and still lose money. In reality, thats rare. Funds with
modest standard deviations tend to lose less money over short time frames than those with high
standard

15

deviations. The bigger flaw with standard deviation is that it isnt intuitive. Certainly, a standard
deviation of 7% is
higher than a standard deviation of 5%, but these are absolute figures and one can not reach a
conclusion as to whether these are high or low figures. Because a funds standard deviation is not
a relative measure, which means its not compared to other funds or to a benchmark, it is not
very useful to the investor without some context.

Beta
Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification. Beta measures non-diversifiable risk. Beta shows the price of an individual stock
which performs with changes in the market. In effect, the more responsive the price of a stock to
the changes in the market, the higher is its Beta. Beta is a relative measure of risk the risk of an
individual stock relative to the market portfolio of all
stocks. If the securitys returns move more (or less) than the markets returns as the latter
changes, the securitys returns have more (or less) volatility (fluctuations in price) than those of
the market. It is important to note that beta measures a securitys volatility, or fluctuations in
price, relative to a benchmark, the market portfolio of all stocks. Securities with different slopes
have different sensitivities to the returns of the market index. If the slope of this relationship for a
particular security is a 45-degree angle, the beta is one (1). This means that for every one percent
change in the markets return, on average, this securitys returns change one (1) per cent. The
market portfolio has a beta of one (1). A security with a beta of 1.5 indicates that, on average,
security returns are 1.5 times as volatile as market returns, both up and down. This would be
considered an aggressive security because when the overall market return rises or falls 10 per
cent, this security, on average, would rise or fall 15 per cent. Stocks having a beta of less than 1.0
would be considered a more conservative investment than the overall market. Betas can be
negative or positive. But generally, betas have been found to be positive which means that
the direction of the movement of individual stock generally tends to be in line with the market:
falling when the market is falling and rising when the market is rising.
Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is
used by investors to judge a stocks risk. Stocks can be ranked by their betas. Because the
variance of the market is a constant across all securities for a particular period, ranking stocks by
beta is the same asranking them by their absolute systematic risk. Stocks with high betas are said
to be high-risk securities.
Given below are different scenario showing how the portfolio return moves relative to market for
Beta
equal to 1, 0.5, and 2

16

17

The beta of a security is a historical measure and it is arrived at by plotting the actual returns on
the security over long periods of time with market returns as shown in the earlier charts. A line is
drawn which depicts beta of the security.
To determine the beta of any security, youll need to know the returns of the security and those of
the benchmark index you are using for the same period. Using a graph, plot market returns on the
X-axis and the returns for the stock over the same period on the Y-axis. Upon plotting all of the
monthly returns for the selected time period (usually one year), we draw a bestfit
line that comes the closest to all of the points. This line is called the regression line. Beta is the
slope of this regression line. The steeper the slope, the more the systematic risk, the shallower
the slope, the less exposed the company is to the market factor. In fact, the coefficient (Beta)
quantifies the expected return for the stock, depending upon the actual return of the market.

Calculating Beta

Rs = a + BsRm
Where,
Rs = estimated return on the stock
a = estimated return when the market return is zero
Bs = measure of the stocks sensitivity to the market index
Rm = return on the market index
Allowing for random errors, some times beta is calculated as under:
Rs = a + BsRm+ e
Where,
e is the random error term embodying all of the factors that together make up the unsystematic
return.
If we want to compare the return on the security related to the risk free avenues, then the formula
is:
Rs = Rf + Bs (Rm - Rf)
Where the concept of Rf is the risk free return return that can be obtained by investing in risk
free securities like treasury bills.

18

Managing Risk in Investments

Risk is an integral part of investments. Risk in the context of investments not only refers to the
chance of losing ones capital, but mainly to the chance/probability of getting less than expected
returns from an investment vehicle. Thus, risk in investments can not be avoided but it can be
managed to suit ones risk profile and investment objectives.
Risk in investments is categorized as systematic and unsystematic risk; which are also
called non diversifiable and diversifiable risk. Unsystematic risk can be reduced through
diversification while systematic risk is a market risk which can not be reduced through
diversification. Investors can resort to different strategies to manage risk in investments. Lets
look at some strategies that investors can adopt to manage risk.

Diversification
It is well established in investments that in order to be able to obtain required returns, it is
essential to reduce the risk and this can be achieved through diversification. Diversification
reduces the risk and can be achieved through diversifying investments:
n Across different asset classes equity; debt; commodities; precious metals; real estate and so
on. n Across different countries (geographies) India; USA; UK; Japan; Singapore; Australia;
Middle East and so on.
n Across different securities and so on Different stocks; bonds, etc. n Across maturities short
term; long term; for life; etc.

Diversification across different asset classes

As financial planners, we should ensure that the investments are diversified across different asset
classes and that proper allocation among different assets is made as decided in the Asset
Allocation Plan. It is important to decide the quantum of investments in risky asset classes like
equity, real estate,
etc. based on the age, risk appetite, etc. of the investor. Over dependence on a particular asset
class can also be quite risky. For example, if an investor is highly risk averse and has little or no
exposure to equities, then he will find the going tough if the interest rates in the economy were to
fall. He will continue to earn less over a period of time and may even suffer loss on existing
investing because of fall in bond prices. Hence, exposure to equity should be considered in such
cases.
Similarly, a very high exposure to equity can prove very tricky because the stock market over a
long period of time may turn bearish and the investor may get very little return and capital
appreciation in this period. The chances of capital loss are also quite high in such cases. Equity is
a long term asset class and should be accordingly planned while deciding the Asset Allocation
Plan.

19

Portfolio of Securities
While investing in stocks, it is essential to invest in a number of stocks and not just a few to
reduce the risk. But the purpose of diversification will be achieved only if the stocks belong to
different sectors and that some of the sectors are not related to each other. Let us look at the
following example to understand the co-relationship between two securities in a portfolio
Suppose you live on an island where the entire economy consists of only two companies: one
sells umbrellas while the other sells sunscreen lotion. If you invest your entire portfolio in the
company that sells umbrellas, youll have strong performance during the rainy season, but poor
performance when its
sunny outside. The reverse occurs with the sunscreen company, the alternative investment: your
portfolio will be high performance when the sun is out, but it will tank when the clouds roll in.
Chances are youd rather have constant, steady returns. The solution is to invest 50% in one
company and 50% in the other. Since you have diversified your portfolio, you will get decent
performance year round instead of,
depending on the season, having either excellent or terrible performance. It is a well established
fact as borne out by the following diagram that diversification across securities
reduces the risk:

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25
to 30 stocks will yield the most cost-effective amount of risk reduction. Investing in more
securities will still yield further diversification benefits, albeit at a drastically smaller rate.
So, it is only sensible to hold a certain number of securities and monitor the same periodically
rather than holding too many securities in a portfolio which will serve the purpose of
diversification in a very limited way. Further, diversification benefits can be gained by investing
in foreign securities because they tend to be less closely correlated to domestic investments. For
example, an economic downturn in the Indian economy
may not affect Japans economy in the same way. Therefore, having Japanese investments would
allow an investor to have a small cushion of protection against losses due to an Indian economic

20

downturn. The following important conclusions can be drawn regarding diversification across
securities:
1. The number of securities should be limited to say 20 to 30 and not more.
2. The securities should ideally belong to different industrial sectors, and if possible, even
different geographical regions.
3. The co-relation of market movements may be built in selecting stocks in a portfolio (oil
marketingcompanies and automobiles; export oriented and import dependant companies; lending
companies and borrowing companies, etc.).

Returns on the portfolio

In a portfolio containing a number of securities, the returns on the same will depend upon the
return on individual securities as well as weightage of each of the security in the total portfolio.
While deciding on the securities to be invested in the weightage of each security, the portfolio is
also decided at the point
of investment. The weightage may change over a period of time with change in prices of
underlying securities as well the portfolio value. The weights are calculated on the basis of initial
investment value. We can express the same in the following formula for return on the portfolio:

Where
E i(RP) is the expected return on the portfolio,
Wii is the weight of security i in the portfolio and,
E(ri) is the expected return on security I

Risk of the Portfolio Measurement

Risk on a portfolio is calculated by considering the standard deviation of individual securities
included in the portfolio as well as interactive risk among securities, measured by covariance.

Covariance
Any two securities whose prices react to information similarly are said to have a positive
covariance Securities with a negative covariance have returns that vary inversely, or that their
prices move in opposite directions as reactions to the same information event. The covariance
between two securities is calculated as follows:
As you can see, the covariance of these two securities is 0.14. This means that these two
securities tend to move in opposite directions. Without calculating the correlation coefficient, it is
21

difficult to determine the extent to which they move together. Since the covariance is calculated
similar to the standard deviation, we know that this is an absolute number. That is why it is
necessary to use the covariance to calculate the correlation coefficient.

Correlation Coefficient
The correlation coefficient measures the strength of the relationship between two securities and
the coefficient is always a value between 1 and + 1. If the value is 1, it can be said that the
returns of the securities are perfectly negatively correlated, meaning that the prices change
equally but in opposite
directions, where direction implies increase and decrease. If they value is + 1, the two securities
are perfectly positively correlated and that the security prices change equally and in the same
direction as well. If the correlation coefficient equals zero, it means that the two securities do not
move together in
any meaningful way.

Risk Reduction through Product Diversification

It is important to have a dynamic asset allocation plan diversified among different asset classes.
Financial investment products comprise direct equity; indirect equity through the mutual fund
route; balanced fund which focuses on both debt and equity; debt corporate and government;
fixed income instruments like small saving schemes; government bonds, fixed deposits bank
and corporate, etc. Risk on the total portfolio is reduced through investments among different
products, in a pre-determined proportion, depending upon the risk profile of the investor and
managed through periodic review of the proportion.

Risk Reduction through Time Diversification

When it comes to equity investments, it is a well established fact, especially in respect of retail
investors that they cannot time the market. It is the time one stays invested that would determine
the returns on equity investments over a period of time and not market timing. Many investors
tend to take higher exposure to equity at market highs and tend to reduce their exposure during
market lows due to emotional swings.
These investors invariably end up losing money. The best and time tested solution lies in
systematic investment and sticking to asset allocation plans. The quantum of funds allocated to
equities can be invested over a period of time through systematic investment plans. Almost all
mutual funds offer SIPs where the people can invest in these funds on a monthly basis at
predetermined dates and fixed amounts per month. Auto debit and ECS make it very convenient
for investors to invest on a systematic basis. Another very important strategy could be parking
the available funds in Floating Rate Debt funds and transferring fixed quantum of funds on a
monthly basis through a Systematic Transfer Plan out of floaters through SIPs into equity funds.
In this strategy, the funds may earn decent returns in floating rate funds with less interest-rate
risk while the equity market timing-risk is reduced through SIPs.

22

Hedging
Diversification reduces unsystematic risk in a portfolio. Unsystematic refers to a specific
individual
corporate or country financial risk event. Therefore, as the number of securities increase in a
portfolio, the portfolios unsystematic risk decreases. The remaining risk is called systematic or
market risk. Systematic risk cannot be diversified out of a portfolio; however, systematic risk can
be hedged.
Consider a portfolio consisting of an indexation of the BSE Sensex. By holding positions in these
30 companies, a portfolio has reduced the unsystematic risk. Now the dependence and exposure
on the fortune or failure of each company is an approximation of a 1 in 30 chance. The
portfolios remaining risk is viewed as systematic or market risk. This means that the portfolio
value will swing with the benchmark market. A manager can reduce this systematic risk by
hedging. To offset the systematic risk, a fund manager would establish a hedge. This hedge
would offset the value changes in the underlying portfolio position. Typically, this offset is
accomplished with the futures, options, or other derivative markets.

Measuring Investment Returns

23

We all make investments to get returns/rewards from the investment vehicles. There are two
types of returns viz. realized return and expected return. Realized return is what the term implies;
it is ex post (after the fact) return, or return that was or could have been earned. Realized return
has occurred and can be measured with the proper data. Expected return, on the other hand, is the
estimated return from an asset that investors anticipate (expect) they will earn over some future
period. As an estimated return, it is subject to uncertainty and may or may not occur. The
objective of investors is to maximize expected returns, although they are subject to constraints,
primarily risk. Return is the motivating force in the investment process. It is the reward for
undertaking the investment. An assessment of return is the only rational way (after allowing for
risk) for investors to compare alternative investments that differ in what they promise. The
measurement of realized (historical) returns is necessary for investors to assess how well they
have done or how well investment managers have done on their behalf. Furthermore, the
historical return plays a large part in estimating future, unknown returns. Return on a typical
investment consists of two components:
1. Yield: The basic component that usually comes to mind when discussing investing
returns is the periodic cash flows (or income) on the investment, either interest or
dividends. The distinguishing feature of these payments is that the issuer makes the
payments in cash to the holder of the asset on a periodic basis. Yield measures relate
these cash flows to a price for the security, such as the purchase price or the current
market price.

2. Capital gain (loss): The second component is also important, particularly for stocks but
also for long-term bonds and other fixed-income securities. This component is the appreciation
(or depreciation) in the price of the asset, commonly called the capital gain (loss). It is the
difference between the purchase price and the price at which the asset can be, or is, sold.

Total return
Given the two components of a securitys return, we need to add them together (algebraically) to
form the total return, which for any security is defined as:
Total return = Yield + Price change where:
the yield component can be nil or positive the price change component can be nil, positive or
negative.

Measurement of Total return

Total return = {Cash payments received + Price change over the period}/purchase price of the
asset The price change over the period = end price open price (can be negative)

Types of Returns

24

Investors use various methods by which they measure investment returns. We will discuss
several type of returns; the nominal rate of return, the real rate of return, the real after tax rate of
return, total return and risk adjusted return. We will briefly discuss each of these concepts.

Nominal Rate of Return

The nominal rate of return is simply the return that one can earn on an investment. If for
instance, you invest your money in a Certificate of Deposit that promises to pay 7 percent per
year, a Rs. 100 investment will yield Rs 107, one year later. In this example, the nominal rate of
return is 7 percent, the rate you can earn before considering the effects of inflation or taxes on
your investments.

Required Rate of Return

The required rate or return is a key concept in investment planning. However, it is also a
difficulty and complex concept to understand for reasons that require further discussion. Thus, it
is worthwhile for us to spend some time on this issue.
When an investor assesses an investment opportunity, they may conduct much research and
analysis to gauge the attractiveness of the investment. Ultimately, the investor will boil down the
research and analysis to two factors; the risk of the investment opportunity and the return the
investor expects to earn on this investment. The rate of return that an investor expects to earn on
a risk-free security (e.g. A Treasury Bill) is the return that an investor expects to earn on a
security that is free of default risk. All other securities contain the possibility of defaulting on
their obligations. Hence, an investor will require returns in addition to the risk free rate as
compensation for assuming the higher risk. We can think of this compensatory additional return
as the securitys risk premium. Thus we may express the required rate of return as follows:

Required rate of return = risk-free return + risk premium

What the planner needs to comprehend is that in arriving at a required rate of return, the primary
assessment is the nature and extent of risk of an investment opportunity. The greater our
understanding of the riskiness of a security, the more accurate our understanding of the risk
premium we must receive,
as compensation, in order to be induced to invest in that particular security. For example,
suppose an investor, or planner, is considering an investment in two securities a small cap stock
and a highly rated bond. The planner will understand that the bond contains lower default risk
than the small Cap stock and will provide a greater assurance of an income stream and a
redemption value at maturity. On the other
hand, the small cap stocks price will most likely fluctuate greatly and a higher probability will
exist that the firm may well go bankrupt. Thus, from the planners or investors perspective, the
bond will be considered a much safer investment and the risk premium that the investor will
require to invest in the bond will be much lower than what will be assessed for the stock. When
these risk premiums are added to the risk free rate, the rate or return that the investor will require
for the small cap stock will be much higher than the bond. In summary, the required rate of
return may be considered as the gauge of the
securitys riskiness. There are two other related return concepts that are also worth discussing
briefly. Under various economic conditions, the performance of securities with varying
characteristics will differ. For example, when the economy is in a recessionary stage, we expect
25

most stocks to perform poorly, in terms of the returns they generate during this period. In this
example, this rate would be the stocks expected rate. If the investors required rate for this stock
was higher than the expected rate, then the investor would not consider this investment, since the
expected rate would not compensate the bearing of the risk of this particular security, as
determined by the required rate. Similarly, in an economic growth cycle, the
expected rate may equal or exceed the required rate and the investment would be made. Thus, we
observe that both the required rate and the expected rate are assessed and compared and which
lead to the eventual trading decision. Finally, note that the assessment of both the required rate
and the expected rate begin before the investment decision and they continue to exist during the
tenure of that decision, i.e. As long as the security is held. Once the investor sells the security,
then the rate that was actually earned, or the realized rate, can be calculated. The realized rate
may well be, and usually is, different form both the expected rate and the required rate.

The Real Rate of Return

The decision to invest is, in a sense, decision not to consume. Alternately, an investment decision
is a decision that implies a postponement of current consumption. To understand this further,
consider this example; suppose you made a return of 12 percent in one year and 15 percent the
following year, did you truly do better in the second year? The answer to this question depends
on what your earnings could buy at the end of each of those years, or the purchasing power of
your earnings. If the general level of prices, or inflation was very mild in the first year and severe
in the second, your earnings would stretch further (purchase more) in the first year than in the
second and hence you would have actually done better in the first year. Thus, the investment
decision is related to the purchasing power of your earnings. This relationship, in turn, allows us
to describe the concept of the real rate of return.

Real After Tax Rate of Return

Many of the returns that investors earn are not tax-free. Short-term capital gains are taxed at the
investors marginal tax rate. Recall that short-term capital gains are those gains that are held for
less than one year in case of financial assets like equities, Debt etc. and three years in case of real
assets like real estate, work of arts etc. Long-term capital gains are gains from increases in
security prices where the security was held (owned) for one year, three years or longer. Such
gains are currently taxed at 20 percent with indexation or 10% flat without indexation for most
individuals. In advising a client to sell a
financial instrument, the real after tax rate of return must be taken into consideration in order to
relay a true picture of return to the client. Taxes are relevant to all of us, but those clients in high
income tax brackets are particularly affected by after tax returns.
The formula for the real after tax rate or return is:
r = ( R) (1-t) I
where r is the real after tax rate or return, R, is the nominal rate of interest, and t is the tax rate at
which the investment will be taxed and I is the inflation rate for the period. In this formula, we
took the rate of inflation into consideration because it reduces the purchasing power
of our returns. If the nominal rate of interest on a security is yielding 9 percent, the individual s
tax rate is 30 percent and the inflation rate is an equal to 4 percent, the real after tax rate of return
is:
R = (0.0 0.09) (1- 0.30) 0. 0.04 = 2.3 %
26

Risk Adjusted Return

Risk premium is a percentage return that an investment must expect to earn in order for an
investor to assume a given level of risk. The risk premium will be different for each investment
once all investment have different risk profiles and different expected returns. For example, for a
deposit at a bank or RBI Treasury bill, the risk premium approaches zero. For common stock, the
investors required return may carry a 9 -10 percent risk premium in addition to the risk-free rate
of return. If the risk-free rate were 8% percent, the investor might have an overall required
return of 17 to 18% percent on common stock.
n Real rate 5%
n Anticipated inflation 5%
n Risk free rate 8%
n Risk premium 9 10%
n Required rate of return 19 20%
Corporate bonds fall somewhere between short-term government obligations (generally no risk)
and common stock in terms of risk. Thus, for bonds, the risk premium may be 3 to 4% percent.
Like the real of return and the inflation rate, the risk premium is not stagnant but changes from
time to time; for instance, if the issuing companys risk profile changes or if the macroeconomic
outlook becomes more uncertain, then the risk premium will change. If investors are very fearful
about the economic outlook, the risk premium may be 12- 14% .

27

Building an Investment Portfolio

We now consider how investors go about selecting stocks to be held in portfolios. Individual
investors often consider the investment decision as consisting of two steps:
Asset allocation
Security selection
The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in
other words, how much of the portfolios funds are to be invested in stocks, how much in bonds,
money market assets, and so forth. Each weight can range from zero percent to 100 percent. If it
is possible to
make investments globally, then we have to ask the following questions:
1. What percentage of portfolio funds is to be invested in each of the countries for which
financial markets are available to investors?
2. Within each country, what percentage of portfolio funds is to be invested in stocks,
bonds, bills, and other assets?
3. Within each of the major asset classes, what percentage of portfolio funds goes to various
types of bonds, exchange-listed stocks versus over-the-counter stocks, and so forth?
Many knowledgeable market observers agree that the asset allocation decision may be the most
important decision made by an investor. According to some studies, for example, the asset
allocation decision accounts for more than 90 per cent of the variance in quarterly returns for a
typical large pension fund.
The rationale behind this approach is that different asset classes offer various potential returns
and various levels of risk, and the correlation coefficients may be quite low.
Correlation determines the extent to which a variable moves in the same direction as other
variable, such as inflation. It is statistically determined and labeled as the correlation coefficient.
Correlation can help in making decisions concerning diversification among mutual fund
categories. The asset allocation decision involves deciding the percentage of investible funds to
be placed in stocks, bonds, and cash equivalents. It is the most important investment decision
made by investors because it is the basic determinant of the return and risk taken. This is a result
of holding a well-diversified portfolio,
which we know is the primary lesson of portfolio management.
The returns of a well-diversified portfolio within a given asset class are highly correlated with
the returns of the asset class itself. Within an asset class, diversified portfolios will tend to
produce similar returns over time. However, different asset classes are likely to produce results
that are quite dissimilar. Therefore, differences in asset allocation will be the key factor over time
causing differences in portfolio performance.
Factors to consider in making the asset allocation decision include the investors return
requirements (current income versus future income), the investors risk tolerance, and the time
horizon. This is done in conjunction with the investment managers expectations about the
capital markets and about individual assets.

28

According to some analyses, asset allocation is closely related to the age of an investor. This
involves the so-called life-cycle theory of asset allocation. This makes intuitive sense because the
needs and financial positions of workers in their 50s would differ, on average, from those who
are starting out in their 20s. According to the life-cycle theory, for example, as individuals
approach retirement, they become more risk averse. Stated at its simplest, portfolio construction
involves the selection of securities to be included in the portfolio and the determination of
portfolio funds (the weights) to be placed in each security. The Markowitz model provides the
basis for a scientific portfolio construction that results in efficient portfolios. An efficient
portfolio is one with the highest level of expected return for a given level of risk, or the lowest
risk for a given level of expected return.

Asset Classes
Portfolio construction listing out the asset classes, where money can be invested are:
Cash (or cash equivalents such as money market funds)
Stocks
Bonds
Real Estate (including Real Estate Investment Trusts)
Foreign Securities
Each investor must determine which of these major categories of investments is suitable for
him/her, in consultation with the financial planner. The next step, as discussed in the preceding
section on asset allocation, is to determine which percentage of total investable assets should be
allocated to each category
deemed appropriate. Only then should individual securities be considered within each asset class.

Diversification
Diversification is the key to the management of portfolio risk because it allows investors to
minimize risk without adversely affecting return. Random diversification refers to the act of
randomly diversifying without regard to relevant investment
characteristics such as expected return and industry classification. An investor simply selects a
relatively large number of securities randomly. For randomly selected portfolios, average
portfolio risk can be reduced to approximately 19 per cent. As we add securities to the portfolio,
the total risk associated with the portfolio of stocks declines rapidly.
The first few stocks cause a large decrease in portfolio risk. Based on these actual data, 51 per
cent of portfolio standard deviation is eliminated as we go from 1 to 10 securities. Unfortunately,
the benefits of random diversification do not continue as we add more securities. As subsequent
stocks are added, the marginal risk reduction is small. Nevertheless, adding one more stock to the
portfolio will continue to reduce the risk, although the amount of the reduction becomes smaller
and smaller. It is also established in the US through studies that by adding foreign securities to
the portfolio, the risk is reduced dramatically to the extent of 33%.

29

Risk Reduction in the Stock Portion of a Portfolio

1. Law of Large Numbers
One simple way of going about risk reduction is through increasing the number of securities
held. As we add securities to this portfolio, the exposure to any particular source of risk becomes
small. According to the Law of Large Numbers, the larger the sample size, the more likely it is
that the sample mean will be close to the population expected value. Risk reduction in the case of
independent risk sources can be thought of as the insurance principle, named for the idea that an
insurance company reduces its risk by writing many policies against many independent sources
of risk.

Asset Allocation and Diversification

This chapter presents two key investment concepts: Investment Policy Statements (IPS) and
Asset Allocation. The former concept is an essential part of any investment plan in that an IPS
lays the framework and objectives of how an investment plan will be managed, why such a path
is chosen and how it will serve the client. The asset allocation decision is the most notable
decision managers have to make in managing client portfolios. Each of these two concepts are
explained in detail, in this chapter. Managerial implications of these two concepts are also
discussed in the latter sections of the chapter.

Investment Policy Statement

An Investment Policy Statement (IPS) serves as a plan that guides the investor and the planner in
long term financial and investment decisions. While investors may differ in type or form, each
requires a clear investment policy statement in order to achieve long-term goals and investments
objectives. Investors may be categorized as being either institutional investors or individual
investors. Though financial planners will most often interact with individual investors, there will
be occasions when an institutional investor may require the planners service and advice. Hence,
it is important for the planner to be able to understand the needs of both types of clients and
articulate IPSs for both types. Of course, the obvious client for most financial advisors is the
individual investor. Generally, institutional investors differ from individuals in the amount and
size of the portfolios under management. Within the institutional category of investors, there are
subcategories, each of which differ
in their investment needs. Examples of such sub-categories of institutional investors include
mutual funds, pension funds, endowment funds, insurance companies, etc.
To understand how these institutions differ in their investment need, consider the example
between the needs of a defined benefit pension plan and an endowment fund. The primary goal
of pension plan mangers is to ensure the availability of cash that requires to be distributed to plan
beneficiaries every year. Thus, pension plan management and policy is integrally involved in
investments that match cash outflows with inflows. In a pension plan, the amounts of distribution
to be made are generally known in advance; this in turn, determines to a large extent the choice
of investment vehicles required to meet those distribution needs. Thus, IPSs for pension funds
are much more guided by regulatory and compliance needs, which in turn protect the interests of
the plan beneficiaries.
Consider now the issues surrounding the management of investment assets for an endowment
fund. An endowment fund is an accumulation of donations that is provided to a non-profit
30

organization by its donors. Generally the investment objectives of endowment funds are much
more attuned to the needs of the nonprofit organization, Sometimes, the donors may impose
managerial clauses themselves. Typically, endowment funds seek to produce a small stream of
income to augment the operating budget of the organization and to grow the rest of the corpus at
a very moderate rate, such that the income may take the form of a perpetual stream. Thus, the
IPS of an endowment fund is generally very different from that of a pension fund. Banks and
insurance companies are other examples of institutional entities that need investment policies.
Both these institutions are similar to pension funds in that their investment needs are dictated by
those who lend them the investment funds. Insurance companies invest in order to ensure
sufficient availabilities of future funds required to be distributed as payouts to policy holders.
Banks invest in order to meet short and long term obligations that it promise to pay depositors on
specific savings deposits. All types of investors, their needs and the appropriate investment
policies, are discussed in the following sections.

Investment Policies For Individual Investors

Life Cycle Indentification
Investment goals of the individual client naturally emerge from the financial planning process. It
is important to note that the goals of an individual will change over time as the client progresses
through various stages of his/her life. Thus, the investment objectives will also change over time
as the client ages and succeeds at achieving previously set goals.
The investment goals that are generally associated with various stages of a clients life are known
as the clients life-cycle needs. Generally, the needs of various individuals at certain stages of life
tend to be similar. For example, early career individuals want to accumulate wealth, whereas in
the late career stage individuals seek to protect wealth more. Thus, we can classify these typical
investment needs at various life cycles. These classifications provide us with a tool to apply in
the investment planning process.

Investment Objectives
Once the goals, life cycle, and time horizons for the goals have been identified, the investment
objectives become easier to identify. Investment objectives identify the goals of the portfolio in
relation to the reasons for the individuals financial needs. Investment objectives can be further
classified into four
types current income, capital growth, total return, and preservation of capital. Current income is
a strategy whereby the main objective of the portfolio is to generate an immediate and
ongoing flow of cash to the client. That is, the investor requires income generation from the
principal balance of the portfolio via interest or dividend payments. An investor who relies on the
portfolio for income in this way needs the cash for living purposes. Thus the investments tend to
be conservative in
nature. Common investment securities are corporate bonds, government bonds, government
mortgage backed securities preferred stocks and perhaps stable Blue Chip stocks that pay regular
dividends. Capital growth is a strategy whereby the portfolio funds are invested over the long
term with the objective of capital appreciation in mind. Because the objective is growth over the
long term, the riskiness of the portfolio tends to be higher. The most common securities for this
type of approach are equities, particularly those in high growth companies or sectors. However, it
31

is always a good idea to diversify the portfolio holdings among various sectors and industries.
Further, stocks of very large companies that lead their
industries (blue chip) in this case, can help to diversify the portfolio while achieving some of the
same growth objectives. Mutual funds, which invest in various sectors or industries can also help
to diversity a portfolio at a reasonable cost.
The total return approach is a strategy that blends the current income and capital growth
approaches. Thus, the investor wants the portfolio to grow over time, but wishes to have income
generated from it right away as well. Obviously having two objectives from the same portfolio
can be challenging to manage, but it can be done if applied correctly. Thus, this strategy would
use a blend of methods of the two strategies above. Those investors interested in presentation of
capital are most interested in ensuring that the amount of money invested in the portfolio does
not decrease. Therefore, the investment choices are safe vehicles. Large returns are not important
for these clients and types of investments are typically government bonds, certificates of deposit
money markets (funds), and fixed annuities.

Risk for Individual Investors

Although we may have determined the goals and the investment objectives of our client, we
cannot seriously discuss the minute details of an investment policy without first assessing the
risk tolerance of the client. Without a meaningful assessment of client risk attitudes, the
investment policy will be useless.
Finance professionals often think of risk in terms of the standard deviation of returns and stock
betas. In some cases, individual investors may understand these concepts but more often than
not, most investors do not fully understand these concepts. After all, that is why they seek out
investment advisors for such
expertise. Since the client may not understand the intricacies of integrating investor risk
preferences in financial applications, it is even more important for the advisor to determine the
clients risk preference before structuring appropriate portfolios. Many clients describe risk in
terms of losing money so it may be a good starting point upon which to discuss the notion of
risk. This notion of loss can be seen from several perspectives, so it can be helpful if the client
can articulate risk to the planner in one of these ways. Loss to some individuals occurs when the
original value of the portfolio has decreased in either absolute terms or relative return
percentages.

Macroeconomic Factors
A good planner is always aware of macroeconomic factors that can ultimately affect investments.
These factors should be integrated into the plan. For instance, historical inflation rises, which
affect the real rate of return on assets, should be discussed in any plan in order to sustain the
purchasing power of the
client to the greatest extent possible. Other factors that should be taken into consideration are
interest rates, economic growth or decline as a whole or in specific industries, unemployment,
political stability, and the legal environment. While this list is not exhaustive, it is meant to give
the advisor an appreciation
of the areas that can affect the investment policy. As the planner gets to know the client, he or she
can integrate those areas within the macroeconomic environment into the clients plan.
32

Small Saving Schemes

These are ideal investment vehicles for the small investor the retail resident Indian investors.
No resident Indians are not allowed to invest in these schemes. Let us look at the salient features
of these schemes.
1. Public Provident Fund
2. Post Office Monthly Income Scheme
3. Post Office Time Deposit
4. National Saving Certificate
5. Kisan Vikas Patra
6. Government of India Taxable Savings Bond
7. Senior Citizen Saving Scheme

1. Public Provident Fund (PPF)

Who can invest?

An adult individual in his own name

An adult on behalf of a minor for whom he is the guardian.
HUFs can not open new accounts now; with effect from 13.5.2005. Existing PPF
accounts opened in the name of HUF shall continue till maturity and deposits can be
made in the account as per rules. A PPF account is in addition to Employee Provident
Fund and GPF for government employees. N other words who contribute to EPF and
GPF can also open PPF account.

Where can one open a PPF account?

One can open a PPF account in Head Post-Office,
G.P.O.,
Any Selection Grade Post Office,
Any branch of the State Bank of India and
Selected branches of Nationalised Banks.

How much can one invest?

Minimum investment Rs. 500 in a financial year
n Maximum of Rs. 70,000/- in a financial year
Can be invested in a lump sum or in convenient instalments.
Total number of credits per year is restricted to 12
Minimum investment each time is Rs. 5 Interest
8% p.a. credited to the account, once a year, as on 31st March of each year.
Deposits made on or before the 5th of the calendar month are eligible for interest for the
month. It is the date of deposit and not date of realization that is considered for this
purpose.
Interest is calculated on monthly product basis and credited to the account as on 31st
March.
33

The interest rate can be changed by the Government of India at any time and the new rate
will affect the balance lying in the account from that date.
Past interest rates were as under:
Upto 14.1.2000 12%
15.1.2000 to 28.2.2001 11%
1.3.2001 to 28.2.2002 9.5%
1.3.2002 to 28.2.2003 9%
1.3.2003 onwards 8%

Term

PPF is a 15 year account.

The term of the account can be extended by 5 years at a time by making an application in
a
specified form to the deposit office; within one year.
An account can be extended any number of times.

The entire balance can be withdrawn in full after the expiry of 15 years from the close of
the financial year in which the account was opened.

2. Post Office Monthly Income Scheme:

Who can Invest?

An adult individual in his own (single account)

An adult on behalf of a minor for whom he is the guardian
An adult individual jointly with other adult individuals (joint account) the total number
of account holders restricted to 3

Where can one invest?

In all GPOs
In all selection grade Post Offices
In select sub post offices

How much can one invest?

Minimum Rs. 1,000/ Maximum Rs. 3,00,000/- in single account (including all the deposits made earlier)
Maximum Rs. 6,00,000/- in joint account (including all the deposits made earlier)
The maximum limit of Rs. 3,00,000/- is applicable per individual and deposits in joint
accounts are considered as having been made equally by all the depositors for the purpose
of determining the ceiling.

34

Interest
n 8% per annum payable monthly
n In select post offices ECS facility is available where the interest is credited every month
directly to
the saving bank account of the depositor automatically through the Electronic Clearing Service.
n A depositor may open a SB account with the same Post Office where he has deposited his
POMIS amount and give standing instructions for crediting the interest amount directly to this
SB account on a monthly basis.

3. Post office Time Deposit

Who can Invest?

An adult individual in his own (single account)

An adult on behalf of a minor for whom he is the guardian
An adult individual jointly with other adult individuals (joint account) the total
number of account holders restricted to 3
Provident funds, charitable trusts, institutions, co-operative societies and Government
bodies are not permitted to invest in this scheme after 13th May 2005.

How much can one invest?

Minimum Rs 200/- and thereafter in multiples of Rs. 200/No Maximum Limit - Any amount can be invested

4. National Saving Certificates (NSC) VIII Issue

Who can purchase?

An adult individual in his own name.

An adult individual jointly with another on Jointly or survivor basis ( A type).
An adult individual jointly with another on Either or survivor basis ( B type).
Parents and guardians on behalf of a minor.
HUFs are not allowed to purchase NSCs from 13th May 2005.

Where can one invest?

Can be purchased from all post offices which are allowed to open Savings account.

Amount

National saving certificates are available in denominations of Rs. 100, Rs. 500, Rs.
1,000, Rs. 5,000 and Rs. 10,000
Can be purchased for any amount without any ceiling
Can be purchased for amounts in multiples of Rs 100

5. Kisan Vikas Patra

Who can purchase?

An adult individual in his own name

35

An adult individual jointly with another on Jointly or survivor basis (A type)

An adult individual jointly with another on Either or survivor basis (B type)
Parents and guardians on behalf of a minor
HUFs, Trusts are not allowed to purchase KVPs from 13th May 2005

Where can one purchase Kisan Vikas Patra?

It can be purchased from all post offices which are allowed to open Savings account.
Amount
Kisan Vikas Patras are available in denominations of Rs. 100, Rs. 500, Rs. 1,000, Rs.
5,000, Rs 10,000 and Rs. 50,000
Can be purchased for any amount with out any ceiling
Can be purchased for amounts in multiples of Rs 100

Maturity Value

Rs. 100 becomes Rs. 200/- after the full term of 8 years & 7 months

6. Government of India 8% Taxable Savings Bonds

Who can purchase?

An adult individual in his own name

An adult individual jointly with another on Jointly or survivor basis
An adult individual jointly with another on Either or survivor basis type)
Parents and guardians on behalf of a minor
Hindu Undivided Family
Charitable Institutions or a University {approved u/s 80G or 35(1)(ii)/(iii) of Income Tax
Act
From where can one purchase these bonds?
Bonds can be purchased from designated branches of State Bank of India; its subsidiaries
and Nationalised Banks; ICICI Bank; IDBI Bank; UTI Bank; HDFC Bank and Stock
Holding Corporation of India Ltd. (SHCIL)

Amount

The bonds can be purchased for any amount in multiples of Rs. 1,000/- without any upper
limit

7. Senior Citizen Savings Scheme, 2004

Who can invest?

An individual who has attained the age of 60 years or above

An adult individual who is above 55 years or more and who has retired voluntarily or
otherwise (within one month from the date of receipt of retirement benefit and an amount
not exceeding the retirement benefit within the overall ceiling of the account)n The
account can be opened singly or jointly with spouse (the spouse may be below 60 years
of age)

36

Joint account holder can not be anybody other than spouse HUFs and Non Residents are
not allowed to invest

Where can one open this account?

The account can be opened in Select Post Offices and branches of banks which accept
PPF deposits

Amount

Any number of accounts can be opened with each deposit in multiples of Rs. 1,000/Maximum permissible investment Rs. 15,00,000/Only one deposit account permitted in one calendar month for each depositor
If both husband and wife are eligible to invest then each of them can invest up to Rs.
15,00,000/- taking the total to Rs. 30 lacs.

37

Fixed Income Instruments

Short Term Instruments Money Market Instruments
The following are the short term instruments of less than 1 year maturity. These instruments are
essentially institutional plays and retail investors dont get to participate in this directly.

1. Call Money Market

This is basically an inter-bank market where the day-to-day surplus funds are made available/lent
to banks that have a short fall. The loans have a maturity of 1 day to about 14 days and are
repayable on demand at the option of either the lender or the borrower. In terms of liquidity this
is slightly lower than cash in other words the liquidity is very high

2. Repos
Repos or repurchase agreements (ready forward) are transactions in which one party sells
security to another party simultaneously agreeing to purchase it in future at a specified date and
time for a predetermined price. The difference in the prices is the cost of borrowing to one party
and income to the party lending the money. These transactions are secured and hence the counter
party risk is highly reduced. Therefore, the interest rate is also lower compared to call money
rates. In repos the purchase acquires the title to securities and he can enter into further
transactions on these securities. Repos are generally for a period of about 14 days or less though
there is no such restriction on the maximum period for which a repo can be done. Government
Securities, Treasury bills and PSU bonds are the instruments used as collateral security for repo
transactions.

3. Treasury Bills
Treasury Bills are borrowings of Government of India for periods of less than 1 year and the
normal tenors are 91 days, 182 days and 364 days. The main holders of Treasury Bills are banks
and primary dealers, which are required to hold government securities as part of their liquidity
requirements (SLR The statutory liquidity ratio banks are required to keep a certain
percentage of their total demand and time liabilities invested in government securities
Investments in Treasury banks serve the purpose of meeting SLR requirements currently SLR
is 25%) On 91 days Treasury Bills, currently, the yield is around 5.9% to 6.40% p.a. while the
yield on 364 days Treasury bill hovers around 6.9% to about 7.1 p.a. Banks subscribe to Treasury
Bills through an auction process and Reserve Bank of India acts on behalf of Government of
India in this regard. Government of India also makes longer term borrowings to which banks
subscribe. The securities where the term is 1 year or more are called Dated Securities.

4. Commercial Paper (CP)

CPs are short term, unsecured, usance promissory notes issued by large corporations. The rate of
interest will depend on over all short term money market rates as well as credit standing of the
38

issuer company. Individual investors can invest in Commercial Paper. These are issued at
discounts to the
face value and the extent of discount will determine the yield on the paper. Banks are not
permitted to co-accept or underwrite CPs issued by companies. The CPs are regulated by
Reserve Bank of India and companies can issue CPs to meet their short term requirement of
funds, subject to norms laid by RBI from time to time. A company is eligible to issue CP only if
its tangible net worth is more than Rs. 4 crores and if it has a sanctioned working capital limit
from a bank or a financial institution. The minimum credit rating required for CPs is P-2 of
CRISIL or its equivalent of other credit rating agencies. The period is 15 days to less than a year
and the denomination is Rs 5 lacs and its multiples.

5. Certificates of Deposit (CD)

Instruments very similar to CPs but issued by banks are called Certificates of Deposit. These are
negotiable short term bearer deposits issued by banks. These are interest bearing, maturity dated
obligations forming part of the time deposits of banks. In the past when interest rates on bank
deposits were regulated CDs became handy for banks to raise short term deposits even at rates
lower than the regular fixed deposit interest rates.

6. Forward Rate Agreements (FRA)

A Forward Rate Agreement(FRA) is a forward contract in which one party pays a fixed interest
rate, and receives a floating interest rate equal to a reference rate (the underlying rate). The
payments are calculated over a notional amount over a certain period of time and netted i.e only
the differential is paid. It is paid on the termination date. The reference rate is fixed one or two
days before the termination date, dependent on the market convention for the particular currency.
FRAs are over-the-counter derivatives. A swap is a combination of FRAs. The payer of the fixed
interest rate is also known as the borrower or the buyer whilst the receiver of the fixed interest
rate is the lender or the seller.

7. Interest rate swaps (IRS)

An Interest Rate Swap is the exchange of one set of cash flows for another. A pre-set index,
notional amount and set of dates of exchange determine each set of cash flows. The most
common type of interest rate swap is the exchange of fixed rate flows for floating rate flows. A
counter-partys creditworthiness is an assessment of their ability to repay money lent to them
over time. If a company has a good credit rating, they are more likely to be able to pay back a
loan over time than a company
with a poor credit rating. This effect is magnified with time. By making it easier for less
creditworthy agents to borrow in the short term than in the long term, lenders make sure that they
are less exposed to this risk.
Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying fixed and
receiving floating is usually the less creditworthy of the two counterparties. The interest rate
swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a
cheaper rate than they could raise such funds in the capital markets by taking advantage of the
entitys relative advantage in raising funds in the shorter maturity buckets.

39

Fixed Income Instruments Long Term

This segment deals with securities and deposits that have maturity periods one year or longer and
where coupon/interest is paid periodically, as opposed to discounted prices in case of short term
instruments, discussed earlier. These vehicles are attractive for investors who seek regular
income with relative safety. Some of the most popular avenues of fixed income instruments are
as under:

GOI dated securities Government Bonds

GILT edged securities
Government of India borrows for long term through these securities. Banks, financial
institutions, insurance companies and mutual funds subscribe to these bonds through the auction
process initiated by Reserve Bank of India. These bonds are plain vanilla bonds of face value Rs
1000/- where on the coupon/interest is paid to the holders on half yearly basis. These bonds are
quoted as 8% GOI bonds 2014 which indicate the coupon rate and maturity of these bonds.
The prices of these bonds fluctuate based on the prevailing interest rates, the nearness to payment
of coupon and of course, market factors of liquidity/ demand/supply, etc. These bonds are
generally issued for periods ranging from 3 years to 20 years. Because of the longer term, bigger
size and illiquidity of these bonds these have not been attractive for retail investors. However,
investors can participate in the government securities, indirectly, through the mutual fund route.
Some mutual funds have launched GILT funds which invest only in Government securities
while Income Funds of mutual funds predominantly invest in fixed income securities including
Government securities. The Government of India issues securities in order to borrow money
from the market. One way in which the securities are offered to investors is through auctions.
The government notifies the date on which it will borrow a notified amount through an auction.
The investors bid either in terms of the rate of interest (coupon) for a new security or the price
for an existing security being reissued. Since the process of bidding is somewhat technical, only
the large and informed investors, such as, banks, primary dealers, financial institutions, mutual
funds, insurance companies, etc generally participate in the auctions.

PSU Bonds
Public Sector Undertaking, Public Sector Enterprises and local authorities, but supported by
State/ Central Government issue securities similar to Central Government Securities. Normally
the respective Government offers guarantee for payment of interest and repayment of principal
amount of these PS borrowings. These bonds, as they carry sovereign guarantee, are considered
less risky compared tocorporate bonds/debentures but more risky compared to Government
securities. Many State Government corporations have floated bonds in the past and have raised
moneys for infrastructure projects and the Indian retail investors have participated in the issues in
a big way. The investors have received excellent returns while the corporations could raise much
needed capital funds for major projects. It is also expected that Government of India will allow
Municipal Corporations to raise funds from the market, for developmental projects, through issue
of tax free bonds at attractive rates of interest.
40

Corporate Bonds/Debentures
Companies can borrow directly from the market through issue of securities, subject to capital
market regulations for meeting their capital requirements. These are typically debentures
which are borrowings of the companies and these may be secured against a charge on the assets
of the company or these may be unsecured. The term of the debentures will depend upon the
need of the company. Companies can issue Non Convertible Debentures which are pure fixed
income instruments and also partly convertible or fully convertible debentures. The convertible
debentures normally bear interest till the date of conversion and/or on the non-convertible
portion till redemption. Where the tenor of the debentures is 18 months or more credit rating for
the debentures is mandatory. The non convertible debentures and the nonconvertible portion of
partly convertible debentures are redeemed on maturity at par or with a premium. The rate of
interest will depend on market conditions as well as creditworthiness of the company and the
credit rating for the debentures. Companies in the past found it convenient to tap the capital
market and funds through issue of NCDs and PCDs and they preferred this route to long term
borrowing from banks. The investors also preferred NCDs because the debentures were secured
and the interest rates were quite high. Now that the rates of interest have come down the
debentures dont continue to enjoy the same patronage from the retail investor. To the investor
interest on debentures is taxable and also subject to TDS. Companies have tapped the market
with Zero Coupon Bonds as well Optional Fully Convertible Debentures. These special
instruments serve some purpose for the investors as well as the companies from the point of
taxation as well as postponing interest liabilities, etc.

Corporate Deposits
Companies are allowed to borrow from the public through public deposits for meeting their
medium term capital requirements. The acceptance of deposits by Indian companies is subject to
the provisions of Section 58A and 58AA of the Companies Act, 1956 and Companies
(Acceptance of Deposits) Rules, 1975 (as amended).

Manufacturing Companies:

The public deposit mobilized by a company should not exceed 25% of Tangible Net
worth of the company (capital + free reserves) this fixes the maximum amount a
company can borrow from the public through fixed deposits route.
A company can borrow from its share holders also and this amount should not exceed
10% of its net worth taking the total borrowings through public deposits to 35% of the
companys net worth. In respect of Government companies the limit is 35% of the
companys net worth.
The maximum term of deposit cannot exceed a term of 3 years while the minimum term
is 6 months
The company is free to fix the rate of interest payable on its fixed deposits within the
overall limits laid down under the Companies (Acceptance of Deposits) Rules, 1975 and
notifications made there under from time to time
41

The interest received by the depositor is taxable

A company is liable to deduct tax at source where the interest per annum per depositor is
likely to exceed Rs. 2,500/-. This limit may change as per provisions of Income Tax Act.
Credit rating of fixed deposits is not mandatory
Fixed deposits are unsecured borrowings of the company

Non Banking Finance Companies:

Only NBFCs which are registered with RBI can accept fixed deposits
Credit rating of Fixed Deposits is mandatory
An NBFC can accept fixed deposits only if credit rating is above Minimum rating fixed
by RBI from time to time
These companies are allowed to raise much higher amounts by way of fixed deposits in
relation to their net worth
To the investor Fixed Deposits with NBFCs offer a higher risk higher return investment
option
The interest is taxable and subject to TDS
Housing Finance Companies also accept fixed deposits and TDS is made only when the
interest on deposits is likely to exceed Rs. 5,000/- p,a, per depositor whereas in respect
of other companies the limit is Rs. 2,500/- Bank deposits
Banks accept fixed deposits for short term as well long term offering specific fixed rate
of interest.
This is the most popular investment vehicle for the retail investors in India because
investors find banks very convenient to deal with.
These deposits are perceived to be highly safe and liquid
Interest rates tend to be lower compared to other fixed income avenues of comparable
maturities
Interest is taxable
Interest is subject to TDS where interest on term deposit is likely to exceed Rs 5,000/per annum per depositor per branch the bank is required to deduct tax at source
Bank deposits are highly flexible in their features and banks accept term deposits with
extremely investor friendly features
Investment in a Bank Fixed Deposit with a 5 year lock-in period qualifies for deduction
from income under sec 80C of Income Tax Act.
Bank deposits can be insured against risk of default, by bank, with Deposit Insurance
and Credit Guarantee Corporation of India Ltd. to the maximum limit of Rs. 1,00,000/per depositor per bank. Investors in relatively smaller banks and co-operative banks find
this an important protection.

42

Features of fixed income securities

The return or the yield which comprises of regular flow through coupon/interest and
capital appreciation or loss, if any, on maturity.

The liquidity. Investors some times prefer securities of shorter term as well as vehicles
where the exit is easier. The fixed income options like Money Market Mutual Funds and
call deposits are found ideal by investors who want to park their money for short term.
Risk: This is a major factor. The risk of default is a factor which determines where the
investor would like to invest his savings. Unsecured company fixed deposits, especially
the ones which are not rated, can be considered quite risky. The better the credit rating of
an instrument the lower could be the return on the same.

Taxability and tax deduction at source are also important factors that determine flow of
money to a particular avenue. 8% GOI taxable savings bonds and small saving schemes
like Post Office Monthly Income Schemes have managed to attract huge funds flow
because the interest on these, though taxable, is not subjected to tax deduction at source
while Public Provident Fund, though a longer term option, attracts substantial investor
interest because of tax benefits.

Convenience of handling is a parameter on which bank deposits score over many other
avenues. A large net work of branches and ATMs make banks very easy to handle.

43

Mutual Funds
A Mutual fund is a collective investment vehicle where the resources of a number of unit holders
are pooled and invested as per objectives disclosed in the offer document. A mutual fund is set up
as a trust which supervises the function of An Asset Management Company (AMC) which
manages the investments collected in the mutual fund schemes.

A mutual fund investor enjoys the following advantages

1. Professional management
The funds are invested by professional fund management team that analyses the performance and
prospects of companies and selects suitable investments in line with the objectives of the
schemes.

2. Diversification
It is impossible for a small investor to diversify across different investment vehicles as well as
over a large number of companies. He invariably runs the risk of non diversification on his
investments because of low capital. The mutual fund provides him the best option where on a
small capital invested the uni holder gets a diversified portfolio.

3. Regulated operation
The mutual fund administration and fund management are subject to stringent regulations by Self
Regulatory Organisation voluntarily set up mutual funds viz. Association of Mutual Funds of
India (AMFI) and also by Securities and Exchange Board of India (SEBI). Thus the interest of
the investors is kept protected.

4. Higher returns
As these funds are well managed and well diversified they tend to perform better than the market
over a longer period of time; there is potential for the unit holders to get better returns compared
to fixed income avenues over a longer period of time.

5. Transparency
The NAVs of open ended funds are disclosed on a daily basis while the portfolio is disclosed on
a monthly basis ensuring transparency to the investors.

6. Liquidity
Open ended funds can be redeemed at any time; there is no lock-in period; provides excellent
liquidity; the redemptions are also very fast and investors in equity funds tend to get money
back.
44

7. Tax Benefits
Mutual funds enjoy tax benefits on the incomes received by them as well as on capital gains. The
uni holders also enjoy certain tax benefits on the income earned; the capital gains made and on
amount invested in certain types of funds.

8. Flexibility
Mutual funds offer a lot of flexibility where the investments can be lump sum investments or
Systematic investment Plans on a monthly/quarterly basis with very small amounts of
investments. Withdrawal can be also full or part or on a systematic basis.

Different types of mutual fund schemes

Schemes according to Maturity Period

A mutual fund scheme can be classified into open-ended scheme

or close-ended scheme depending on its maturity period.
Open-ended Fund/ Scheme
An open-ended fund or scheme is one that is available for subscription and repurchase on a
continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently
buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis.
The key feature of openend schemes is liquidity.

Close-ended Fund/ Scheme

A close-ended fund or scheme has a stipulated maturity period e.g. 3- 5 years. The fund is open
for subscription only during a specified period at the time of launch of the scheme. Investors can
invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the
units of the scheme on the stock exchanges where the units are listed. In order to provide an exit
route to the investors, some close-ended funds give an option of selling back the units to the
mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that
at least one of the two exit routes is provided to the investor i.e. either repurchase facility or
through listing on stock exchanges. These mutual funds schemes disclose NAV generally on
weekly basis. The market prices in respect of listed close ended funds tend to be at a discount to
NAV. Similarly when mutual funds offer limited repurchase on a periodic basis at intervals they
charge a hefty exit load especially in the first few years since inception the loads tend to get
smaller as more time elapses. Thus the liquidity in close ended fund comes with a cost higher
than open ended funds.

Schemes according to expenses

Load funds and no load funds: Funds which collect charges at the time of entry or exit or both
from the investors are known as load funds. Funds which do not collect any of these charges at
all are called No load funds - Issue expenses; distribution and marketing expenses are borne by
45

AMCs or sponsors. However AMCs are allowed to charge higher management fees in respect
of no load funds compared to load funds. Load charged at the time of purchase is called entry
load while load charged at the time of redemption is called exit load. Mutual funds want
investors to invest for longer terms with them. Hence some times they charge a Contingent
Deferred Sales Charge (CDSC) which will be charged only if the investor exits the fund before a
certain period of time say 6 months; this motivates the investors to stay invested in the fund for
at least that period of time. SEBI has stipulated the maximum load that can be charged by mutual
funds and how the same can be levied. Initial expenses should not exceed 6% of initial resources
raised/funds mobilized under the scheme. In respect of a New Fund Offer (NFO) launch of a
new mutual fund scheme the offer document which is also called KIM (Key information
memorandum) should contain all details regarding expenses.
If the fund charges entry load of say 2.25% then the initial investors in the fund will be sold units
of Face Value Rs 10.00 at a price of Rs 10.225 and in respect of existing fund the load will be
charged at specified rates on closing NAV for the day.

Schemes according to Investment Objective

A scheme can also be classified as growth scheme, income scheme, or balanced scheme
considering its investment objective. Such schemes may be open-ended or close-ended schemes
as described earlier. Such schemes may be classified mainly as follows:

Growth / Equity Oriented Scheme

The aim of growth funds is to provide capital appreciation over the medium to long- term. Such
schemes normally invest a major part of their corpus in equities. Such funds have comparatively
high risks. Growth schemes are good for investors having a long-term outlook seeking
appreciation over a period of time.

Income / Debt Oriented Scheme

The aim of income funds is to provide regular and steady income to investors. Such schemes
generally invest in fixed income securities such as bonds, corporate debentures, Government
securities and money market instruments. Such funds are less risky compared to equity schemes.
These funds are not affected because of fluctuations in equity markets. However, opportunities of
capital appreciation are also limited in such funds. The NAVs of such funds are affected because
of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely
to increase in the short run and vice versa. However, long term investors may not bother about
these fluctuations.

Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest
both in equities and fixed income securities in the proportion indicated in their offer documents.
These are appropriate for investors looking for moderate growth. They generally invest 40-60%
in equity and debt instruments. These funds are also affected because of fluctuations in share
prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared
to pure equity funds.
46

Money Market or Liquid Fund

These funds are also income funds and their aim is to provide easy liquidity, preservation of
capital and moderate income. These schemes invest exclusively in safer short-term instruments
such as treasury bills, certificates of deposit, commercial paper and inter-bank call money,
government securities, etc. Returns on these schemes fluctuate much less compared to other
funds. These funds are appropriate for corporate and individual investors as a means to park their
surplus funds for short periods.

Gilt Fund
These funds invest exclusively in government securities. Government securities have no default
risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic
factors as is the case with income or debt oriented schemes.

Index Funds
Index Funds are equity funds and they replicate the portfolio of a particular index such as the
BSE Sensex S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same
weightage comprising an index. NAVs of such schemes would rise or fall in accordance with the
rise or fall in the index, though no exactly by the same percentage due to some factors known as
tracking error in technical terms. These funds are also called passive funds as not much fund
management skills are involved and these funds are expected to perform in line with the market.
The expenses of fund management tend to be lower in index funds and these funds are suitable to
investors who are happy with market returns.

Exchange Traded Funds (ETF)

ETFs are traded like stocks and thus offer more flexibility than conventional mutual funds.
Investors can purchase or sell ETFs at real time prices as against day end NAVs in case of open
ended mutual funds. ETFs provide investors an opportunity to take advantage of intra day
swings in the market and can be used to hedge their long positions in the equity market. ETfs
are cheaper than even Index funds but in the Indian market place this concept has not picked up.
NIFTY Bees and UTI SUNDER are two listed ETFs. These are traded on very low volumes
with a high spread between bid and offer prices higher spread increases the cost and decreases
the attractiveness of the ETF.

47

Stock market investments

One of the most important asset classes is equity shares. In a clients portfolio the equity
investments
direct and indirect form an essential component. We have discussed indirect equity investments
through the mutual fund route. We shall now deal with direct investments in shares. An investor
has the choice between primary and secondary markets to invest in stocks.

Primary market
Certain eligible companies may tap the capital market for their capital
requirements. Eligibility criteria have been laid down by SEBI the capital market
regulator, and discussed in this chapter elsewhere. The eligible companies who
need funds approach SEBI registered Merchant Bankers for tapping the
capital market. The merchant bankers advise the company on matters of regulation,
compliance with statues, marketing, pricing, timing and other issues which are of
vital importance. Where the issue size is large companies prefer to appoint more
than one merchant banker for this purpose with specific functions. As per the
advice of the merchant banker a company may choose to issue shares with fixed
price or a price band where the price will be discovered in a book building process.
The company may be entering the capital market for the first time where upon its
shares are to be listed on the stock exchanges such an issue is called Initial Public
Offering (IPO). An existing listed company may come out with a subsequent issue
to raise capital and such an issue is called Follow on Public Offering (FPO)
Fixed price issues:
These are issues where a company enters the capital market and invites
subscription from the public to its issue of equity capital at a fixed price at par or
at a premium. Fixed price issues was the norm until some years ago, especially
before the book building concept was introduced in India but now we find more
and more companies adopting the book building route to raise capital.
Book building issues:
Here the companies announce a price band for the issue and the investors can exercise their
options in the application and bid for the same at whatever price they are prepared to pay
48

for the issue but within the price band. The price band essentially consist of two prices the floor
price and the cap price. The difference between the two cannot be more than 20%. In case of an
FPO the listed company can announce the price band just a day before the issue opens for
subscription while in the case of IPOs the price bands are mentioned in the application form
itself.
The bid lots are also decided by the issuer. Essentially a person applying for a book building
offer of shares shall bid in multiples of prescribed lot sizes and within the price band. The bidder
can make three bids in the prescribed application form and can also revise or withdraw his bid
before the close of the
offer. Here the investor has the freedom to decide the price at which he shall be interested, of
course within a band. Individuals in single or joint names, HUFs, Body Corporate, Banks and
Financial Institutions, Mutual funds, Non Resident Indians, Insurance Companies, Venture
capital funds and others can apply for the issues. In order to present a level playing field for the
small investors SEBI has stipulated that a certain minimum percentage of the issued shares
should be reserved for allotment to Retail Individual Investors in case of over subscription of
the issue. The reservation for retail individual investors is 35%
of the net public offer and in the event of the issue getting oversubscribed it should be ensured
that at least 35% of the shares are allotted to retail individual investors. Retail individual
investor means an investor who applies or bids for securities of or for a value of not more than
Rs.1,00,000 The allocation for non institutional investors, who are not retail investors, the
reservation is 15% and the reservation for qualified institutional bidders (QIB) the reservation is
50%. Subscription list for public issues shall be kept open for at least 3 working days and not
more than 10 working days. In case of Book built issues, the minimum and maximum period for
which bidding will be open is 37 working days extendable by 3 days in case of a revision in the
price band. The public issue made by an infrastructure company may be kept open for a
maximum period of 21 working days. Rights issues shall be kept open for at least 30 days and
not more than 60 days rights issues are issues of companies to raise further capital but only
existing share holders of the company are entitled to apply for the same; the rights can be
renounced by an existing share holder, in which case the renouncee gets the right to apply for the
shares. The retail investor can tender his bids at the specified centres where his bids will be
accepted and registered in the book. Many broking houses have provided facilities for applying
to an IPO/FPO through the internet; applications can be made online also. One of the important
advantages is, book building is a transparent process and while the book is open it is easy for the
potential investor to know the details of bids already received; the prices at which the
bids have been made; extent of subscription in relation to the issue size (over subscription or
under subscription levels) etc. Many times the extent of subscription already received and the
quantum of institutional participation influence investor decisions. After the book is closed the
price of the issue is discovered. If the issue is over subscribed, at the cap price, then it is up to the
company (in consultation with the Book Running Lead Manager) to decide the price at which
shares would be allotted. Many times it is done at the cap price but some times it is even done at
prices lower than the cap price. The shares can be allotted at discounts in relation to the
discovered price for the retail individual investors
some public sector companies which came out with issues offered shares to retail individual
investors at discount to the discovered price. Even if a person has bid at prices higher than
discovered price the person will be allotted at discovered price only and not at the highest bid
price. In case of fixed price issues, the investor is intimated about the allotment/refund within 30
49

days of the closure of the issue. In case of book built issues, the basis of allotment is finalized by
the Book Running lead Managers within 2 weeks from the date of closure of the issue. The
registrar then ensures that the demat credit or refund as applicable is completed within 15 days of
the closure of the issue. The listing on the stock exchanges is done within 7 days from the
finalization of the issue. Banks offer to lend to the investor in select IPOs in which case the
investor pays only the margin money, of about 40%, while the bank pays the balance and puts in
the application thus leveraging is possible while applying to IPO/ FPOs with attendant risks
and costs.
Some investors traditionally have preferred to invest in stocks through the IPO/FPO route only.
These investors believe that this process is less risky. It is a well established fact that IPOs are
more risky because the availability of information to the investing public compared to existing
listed companies is much lower in IPOs. Decisions based purely on information provided in the
offer document (the prospectus) can prove to be tricky when the pricing is free. It is less risky to
invest in an existing listed company because price history and performance history can be
studied, in detail, whereas that does not happen to be the case in IPOs. It is also true that issuers
price the issue in such a way that they leave something on the table for the IPO investors. But
it is not the case all the time. Hence investors should study the offer documents carefully;
understand the pricing and the future potential of the company very well before deciding to apply
in a public issue of shares

. Secondary market
Client registration
An investor can invest in shares through the secondary market. He can invest in a stock which is
already listed in one of the stock exchanges. In India there are 23 stock exchanges but only two
of them are most important viz. National Stock Exchange (NSE) and The Stock Exchange,
Mumbai (BSE). Investors who would like to buy or sell shares directly from the market will have
to register themselves as clients with brokers or sub brokers. Brokers are members of stock
exchanges while sub brokers work under a specific broker both should be SEBI registered
Stock market intermediaries. It is mandatory for the market participant to get the full details of
the client in a format prescribed by SEBI called KYC Know Your Client. Personal information
of the client is obtained in this specified format and proof of the supplied information like
residence proof, personal identity proof, Income Tax PAN details, demat account and bank
account details, etc. are taken along with duly filled KYC form. Then the client and broker enter
into an agreement in the format prescribed by SEBI for this purpose. Thereafter the client is
registered with the market participant and allotted a unique client ID. Now the client can trade on
the stock exchange through the broker/sub broker.

Trading
There are basically two trading mechanisms adopted by stock exchanges the world over to
provide liquidity to investors. The two mechanisms are:
Quote Driven Mechanism of Trading &
Order Driven Mechanism of Trading
Quote Driven Mechanism is adopted by less liquid and emerging stock exchanges where trading
requires some stock brokers to provide two-way quotes. These liquidity providers, who trade on
their own account, are called market makers or specialists or jobbers (in India). This is a less
50

efficient mechanism because the price spread between bid and offer tends to be high thanks to
lower liquidity and less competition.
This mechanism is generally adopted in stock exchanges where trading is done on the floor of
the exchange on a face to face basis. In India this was the mechanism adopted by BSE for more
than a century before moving over to the more efficient Order Driven Mechanism of trading in
line with newer National Stock Exchange. In India, now on both NSE and BSE we follow the
Order Driven Mechanism of trading where the trader places his order through his brokers
trading terminal. The trader is also allowed to trade on the internet and he can place his orders on
a particular stock exchange through the internet by special trading facilities provided by the stock
broker. The order placed by the registered client is accepted first by the broker - the acceptance is
subject to the order meeting certain requirements in terms of trading limits set for the client
(based on the margin lying with the broker), etc. Then the order goes into the trading system of
the stock exchange and gets stacked on a time price priority basis. It is mandatory that the order
entered in the system is clearly identifiable to the specific client through the usage of unique
client ID. The order will get executed if the price condition, if any, specified by the trader, is met.

Types of securities
Equity shares the most common form of securities ; (the conventional stock or common
stock or ordinary share) is the equity share issued by a company and the investors in equity
shares are owners of the company to the extent of their share holding. These share holders are
entitled to dividend and other benefits declared by the company and are also entitled to vote.
Companies may issue shares without voting rights also. Normally the shares traded are fully paid
up but in certain cases partly paid shares are also listed and traded on the stock exchanges.

Convertible debentures: A company may choose to issue debentures which could be

converted partly or fully into equity shares at a later date. These securities are also listed and
traded on the stock exchanges.

Warrants are essentially issued to share holders and the holder of the warrant will be able to
exercise his right to purchase shares of the company at a future date. Till the prescribed date for
exercising the rights to additional shares these warrants are also traded on the stock exchanges.

Preference shares can also be issued by a company. This is a not a popular instrument with
the stock market investors because this is essentially a fixed income instrument with no scope for
capital appreciation.

Bonus Shares: Companies reward the share holder by issuing bonus shares. Bonus shares are
free shares distributed by the company to its share holders, as on a given date, in a proportion
which is decided by the board and approved by the share holders and subject to certain limits, as
prescribed by SEBI in this regard. A 1:1 bonus implies that a share holder having 100 shares will
get another 100 shares free of cost ; similarly a 2:3 bonus implies that a share holder having 3
shares will get 2 bonus shares. As a point of valuation a bonus per se does not add value to share
holders because the price of the stock adjusts for the bonus shares after the same are issued.
However, a bonus declaration is a signal, to the market, from the company management that they
are very confident about their future performance and that they will be able to service the
51

expanded capital. In the market place it is common to find that companies that reward the share
holders with frequent bonuses get better valuations compared to similar but conservative
companies.

Rights Shares Issue of additional shares to existing share holders to raise capital is called
Rights Issue. The difference is that compared to bonus shares which are issued free here the
share holder has to pay a price for getting additional shares the price could be market related
and may be at a discount to the market price of the stock. If the company issues rights shares to
raise money for expansion/modernization/new acquisitions, etc then that is considered quite
positive. It may be worth while to understand how the market price gets adjusted for rights issues
when trading on cum right and ex right basis.

52

Investment strategies
Passive strategy
Some investors perceive that the securities markets, particularly the equity markets, are efficient.
There is a belief that the stock market is a barometer of the economy and that the market
perfectly reflects the strengths and weaknesses of the economy over long term while in the short
term there can
be temporary aberrations (and over reactions of optimism and pessimism). In an efficient market,
the prices of securities do not depart for any length of time from the justified economic values
that investors calculate for them. Economic values for securities are determined by investor
expectations about earnings,
risks, and so on, as investors grapple with the uncertain future. If the market price of a security
does depart from its estimated economic value, investors act to bring the two values together.
Thus, as new information arrives in an efficient marketplace, causing a revision in the estimated
economic value of a security, its price adjusts to this information quickly and, on balance,
correctly. In other words, securities are efficiently priced on a continuous basis and the long term
investors who are holding on to securities need not resort to any action of buying and selling but
continue to hold. These investors believe that it is not worth their efforts in terms of time and
cost to trade on the temporary aberrations but hold on to qualitative securities that shall perform
in line with the market over a period of time. That is, after acting on information to trade
securities and subtracting all costs (transaction costs and taxes, to name two), the investor would
have been as well off with a simply buy-and-hold strategy. If the market is economically
efficient, securities could depart somewhat from their economic (justified)
values, but it would not pay investors to take advantage of these small discrepancies. A natural
outcome of this belief in efficient markets is to employ some type of passive strategy in owning
and managing common stocks. If the market is totally efficient, no active strategy should be able
to beat the market on a risk-adjusted basis. The Efficient Market Hypothesis has implications for
fundamental analysis and technical analysis, both of which are active strategies for selecting
common stocks. Passive strategies do not seek to outperform the market but simply to do as well
as the market. The emphasis is on minimizing transaction costs and time spent in managing the
portfolio because any expected benefits from active trading or analysis are likely to be less than
the costs. Passive investors act as if the market is efficient and accept the consensus estimates of
return and risk, accepting current market price as the best estimate of a securitys value.
In adopting the passive strategy the investor will simply follow a buy-and-hold strategy for
whatever portfolio of stocks is owned. Alternatively, a very effective way to employ a passive
strategy with common stocks is to invest in an indexed portfolio. We will consider each of these
strategies in turn.

Buy And Hold Strategy

A buy-and-hold strategy means exactly that - an investor buys stocks and basically holds them
until some future time in order to meet some objective. The emphasis is on avoiding transaction
costs, additional search costs, and so forth., The investor believes that such a strategy will, over
53

some period of time, produce results as good as alternatives that require active management
whereby some securities are deemed not satisfactory, sold, and replaced with other securities.
These alternatives incur transaction costs and involve inevitable mistakes. Notice that a buy-andhold strategy is applicable to the investors portfolio, whatever its composition. It may be large
or small, and it may emphasize various types of stocks. Also note that an important initial
selection must be made to implement the strategy. The investor must decide initially to buy
certain stocks and not to buy certain other stocks. Note that the investor will, in fact, have to
perform certain functions while the buy-and-hold strategy is in existence. For example, any
income generated by the portfolio may be reinvested in other securities.
Alternatively, a few stocks may do so well that they dominate the total market value of the
portfolio and reduce its diversification. If the portfolio changes in such a way that it is no longer
compatible with the investors risk tolerance, adjustments may be required. The point is simply
that even under such a strategy investors must still take certain actions. In other words a passive
strategy also requires some action on the part of the investors much less frequently compared
to active strategies. An interesting variant of this strategy is to buy-and-hold the 10 highest
dividend-yielding stocks among the BSE Sensex at the beginning of the year, hold for a year, and
replace any stocks if necessary at the beginning of the next year with the newest highest-yielding
stocks in the BSE Sensex. This strategy does not require stock selection since it is based only on
using the easily calculated dividend yield for 30 identified stocks, and making substitutions when
necessary.

Index Funds
Some investors prefer indirect investment to direct investment in equities. For this class of
investors the best passive strategy could be buying into an Index Fund. In an Index fund the fund
manager pools the resources of a number of investors and invests in stocks that comprise the
index in the same weightage as in the Index. These funds are designed to duplicate as precisely
as possible the performance of some market index.
A stock-index fund may consist of all the stocks in a well known market average such as the
NSE Nifty. No attempt is made to forecast market movements and act accordingly, or to select
under-or overvalued securities. Expenses are kept to a minimum, including research costs
(security analysis), portfolio managers fees, and brokerage commissions. Index funds can be run
efficiently by a small staff. Surprisingly, at times the passive index funds have been found to
perform better than some most actively managed funds mainly because the active funds might
have under performed the market during that period of time.These are open ended funds where
the loads are the least and the returns in line with the market index which they propose to
replicate.

Active strategy
Investors, who do not accept the Efficient Market Hypothesis and those who believe that it is
possible to out perform the market consistently over a period of time through active management
of stocks selected, pursue active investment strategies. These investors believe that they can
identify undervalued securities and that lags exist in the markets adjustment of these securities
prices to new (better) information. These investors generate more search costs (both in time and
money) and more transaction costs, but they believe that the marginal benefit outweighs the
54

marginal costs incurred. Investors adopt two pronged strategies to perform better than the market
proper stock selection and timing the entry and exit points.

Stock Selection
Most investment techniques involve an active approach to investing. In the area of common
stocks the use of valuation models to value and select stocks indicates that investors are
analyzing and valuing stocks in an attempt to improve their performance relative to some
benchmark such as a market index.

Maturity Selection
Investors make investments to meet specific demand on funds over a certain period of time.
Some of these time horizon related needs could be:
1. Buying a bigger house in about 5 years
2. Regular income flows every year after a term to meet education expenses of the children
3. Lump sum requirement after a few years to meet marriage expenses of children especially the
daughter
4. Regular flow of income, on a monthly basis, after a certain period of time post retirement
needs and so on
The investment strategy involved in meeting this type of time related fund requirements would
depend upon the time span after which the requirement will arise:
a. Short term say requirement within 3/5 years
b.
b. Long term not less than 5 years The investment vehicle will be decided upon whether the
need is expected to arise over short term or long term. If the need is short term then it may not be
wise to park the funds in equity and equity related
instruments as the risk associated with this avenue is especially higher in the short term. A debt
fund or a fixed income instrument is preferred in such cases. If the need is medium, say, for
meeting education and/or marriage expenses of children over the next 5 to 10 years then an
investor can invest in Balanced funds or specific child care funds of mutual funds or
specific children plans of life insurance companies.
The equity or equity related instruments would be ideal for building capital over long period of
time. It is a well established fact that equities have delivered superior returns compared to other
asset classes over longer period of time while in the short term the returns can be erratic and
even negative. At the same time since this is a high risk avenue the returns also tend to be higher
and hence capital building becomes that much easier. There are specific deferred annuity plans of
life insurance companies where investments are made on a systematic basis while in service, by
the salaried class of investors, so that a certain amount of pension becomes payable on
retirement. These are essentially long term low risk low return kind of plans most suited for the
conservative investors. Thus one can conclude that the strategy of investments can not only be
classified as Passive and Active but also based on the Time Horizon of the investible funds and
the requirements for the funds over time. Many times it is the time based requirement of funds
that determines where the money is invested.
55

Asset Allocation
The important decision that an investor is required to take is on Asset Allocation. There are
different asset classes like equities, bonds, real estate, cash and even foreign investments to a
limited extent available to Resident Indian investors now. It has been a well established fact that
Asset allocation than even stock selection and timing issues. Asset allocation is the key to
portfolio returns and hence it is of paramount importance. The asset allocation decision involves
deciding the percentage of investable funds to be placed in stocks, bonds and cash equivalents. It
is the most important investment decision made by investors because it is the basic determinant
of the return and risk taken. This is a result of holding a welldiversified
portfolio, which we know is the primary lesson of portfolio management. Thus asset allocation
serves the purpose of diversification among different asset classes and diversification among
different securities within an asset class.
The returns of a well-diversified portfolio within a given asset class are highly correlated with
the returns of the asset class itself. In other words the returns on a stock portfolio will depend on
the market returns to a great extent no stock is expected to give phenomenal returns when the
market returns are low or negative. Within an asset class diversified portfolios will tend to
produce similar returns over time. However, different asset classes are likely to produce results
that are quite dissimilar. Therefore, differences in asset allocation will be the key factor, over
time, causing differences in portfolio performance. Factors to consider in making the asset
allocation decision include the investors return requirements (current income versus future
income), the investors risk tolerance, and the time horizon. This is done in conjunction with the
investment managers expectations about the capital markets and about individual assets.
According to some analyses, asset allocation is closely related to the age of an investor. This
involves the so-called life-cycle theory of asset allocation. This makes intuitive sense because the
needs and financial positions of workers in their 50s should differ, on average, from those who
are starting out in their 20s. According to the life-cycle theory, for example, as individuals
approach retirement they become more risk averse and hence they should allocate fewer amounts
in percentage terms to equity and equity related instruments in their portfolio.

Asset class risk

Risk in the context of investments has different meanings for different people. To the common
investor risk means the probability that he may lose his capital or suffer loss on the investment.
To the analyst it is the chance that the investment vehicle may not deliver the required or
expected returns and thus not fulfill the financial goals. It is also well established through
research over long periods that equity as an asset class, international as well as domestic, is the
most volatile of asset classes. In equities the range of returns as well as the potential for capital
loss is the greatest, especially in the short term. While equity may be riskier asset class it also has
the potential to earn superior returns over long term. It is also well established that over the long
term equities, foreign as well as domestic, have delivered returns much higher than other classes
of financial assets. Hence equities will find a place in every bodys portfolio but the extent could
vary depending on the risk profile, age, need for higher returns, time frame, etc. Types of asset
allocation The two models of asset allocation are Strategic Asset Allocation and Tactical Asset
Allocation.
56

Strategic Asset Allocation

It is essentially a long term investment plan

It is the structuring the individual asset classes within a portfolio to meet long term
investment objectives.
No switches between securities or asset classes is normally done in the short term
Defined exposures are made to different assets providing for some minor adjustments
within the asset class without shifting the focus of the portfolio.
A right allocation among different classes of assets shall ensure that investors
investment objectives are met.

Tactical Asset Allocation

AA is a dynamic portfolio technique that seeks to take advantage of the short term
movements and opportunities in the market.
The asset allocation of a portfolio is changed, in this process, on a short term basis to
take advantage of perceived differences in the values of various asset class changes.
It works on the underlying principle that in the short term the securities market may not
be properly valued resulting in under valuation and over valuations it is possible to
take advantage of these aberrations through switches between asset classes and within
securities.
All the same a balance is maintained and it is ensured that each asset class in the model
is maintained within the permitted range for that asset class
A range for each asset class is fixed and short term movements/switches are made within
the range to take advantage of market movements.

Fixed and flexible allocation

Fixed allocation is sticking to an allocation proportion among asset classes and following the
same religiously, till the same is revised based on the changed requirements, advancing age,
sudden changes in the economy, etc. Flexible allocation is something similar to TAA where the
range is fixed for different
asset classes and periodic switching between asset classes is done. The flexible asset allocation
is not necessarily an aggressive investment planning. This helps the alert investor to make use of
some opportunities that come periodically in the market due to random developments which
simply cannot be predicted in advance.
Asset Allocation is an Investment Planning Tool, not an Investment Strategy... Investment
Strategies are used to select and to manage the securities that are allocated to either the Equity
or Debt/fixed income securities.
An Asset Allocation Formula is a long-range, semi-permanent, planning decision that has
absolutely nothing to do with market timing or hedging of any kind. Certainly, a 40% asset
allocation to Fixed Income may soften the fall in the portfolio bottom line during a stock market
downturn, but that has nothing to do with the purpose of Fixed Income Securities nor is it in any
way related to the reasons for having an asset allocation
57

plan in the first place. Similarly, the movement of a persons assets from a falling bond market to
a rising stock market or vice versa is about as far away from the principles of asset allocation as
one can get
Investors should arrive upon the most suitable Asset Allocation Plan
Investors should not focus exclusively on market value,
Investors should not dwell upon comparisons of ones own unique portfolio with Market
Averages
Investors should not expect performance during specific time intervals as this
investment plan is expected to perform over a long period of time

Portfolio rebalancing
Once an asset allocation plan is finalized; then securities are chosen for investments and the
investment process is completed. Thereafter the portfolio of investments comprising of debt,
equity, etc. should be monitored on a periodic basis. The frequency of review could be once in 6
months or even once a year
a higher frequency is generally not necessary for a long term investment plan but sometimes,
some economic developments may necessitate an urgent review. One of the most important
factors that will have a big influence on the performance of the portfolio is the interest rate
(which generally moves with inflation). Whenever large scale, protracted interest rate
movements are expected then a rebalancing will become absolutely essential in a rising interest
rate scenario the corporate profitabilites will suffer and consequently the stock prices will fall.
Bond prices dip to adjust to the current yields of the market. Reducing equity exposure of the
portfolio may become necessary and moving from long term debt swiftly into short term or from
fixed rate long term debt funds to floating rate and short term debts could also become necessary.
If economic slow down is seen, through falling growth rates, then portfolio rebalancing will
become necessary again. These economic factors are external factors that will have to be taken
into account as their long term impact on the portfolios will be severe and hence suitable
rebalancing will have to be done. It should simultaneously be remembered these are turn around
situations and these happen over long term.
There can be some internal family developments also that may make portfolio rebalancing
necessary.
A portfolio is built to meet certain financial objectives; not all objectives are met at the same
time. One after the other the financial goals get completed, over a period of time, as the investor
gets older and older. Some of the common objectives are buying a bigger home; buying a new
car; education of
children; marriage of children; retirement capital etc. As these objectives are fulfilled the return
requirements may come down and it may be necessary to switch to less aggressive asset
allocation plan reducing the exposure to equities and increasing the exposure to debt may be
made. . It is an established fact that the proposition, that a rebalancing strategy can increase
expected return is incorrect but on the contrary rebalancing costs definitely reduces expected
returns.
Probably the best rule of thumb on rebalancing is to look at the overall stock/bond ratio
quarterly, since it is the primary determinant of expected returns, and examine individual equity
asset classes once a year, or so. Rebalance only when asset classes, and particularly, the
equity/fixed ratio, gets out of
balance far enough to produce a significant expected difference in returns.
58

Monitoring and revision of portfolios

It is the financial planners function to monitor clients portfolios. When the portfolios are
monitored it could be observed that the proportion among different asset classes has changed
substantially.
For example if the original Asset allocation was Equity 40%, Debt 55% and Cash 5% but on
monitoring if it was found to have changed to Equity 50% Debt 45% and Cash 5% then it
amounts to higher exposure to equity than originally planned. This situation might have arisen
mainly because of rising stock market and the appreciation of stocks held in the portfolio. While
deciding on an asset allocation plan a formula is generally discussed and agreed upon. This
formula for revision essentially hinges on defining substantial shift in emphasis of a particular
asset class or even a particular security in an asset class. It could be, say 5% which means that if
the Equity proportion has moved above the fixed proportion of 40% by 5% or more, then a
rebalancing would be done by selling excess equity and moving to debt or cash to maintain the
Asset allocation proportions decided earlier. Thus monitoring helps in maintaining a balanced
portfolio all the time but also ensures profit booking when the markets are high and buying when
the market prices fall substantially. The formula could vary from investor to investor but it is
essential so that portfolios are properly monitored to deliver the desired returns over the long
term. A portfolio revision may become necessary because of government policy changes;
economic factors of growth rate; budget and fiscal deficits; inflation and interest rates, strength
of domestic currency, etc.
While implementing the investment plan certain securities were bought based on their and the
over all economic fundamentals. These factors may change over time; fortunes of companies
also fluctuate, generally in line with the over all economy but some times on their own as well.
For example a strong domestic currency may not be good for export oriented companies but will
benefit import dependant companies. A lower interest rate on loans may not be good news for
banks and financial institutions but good news for consumer durables; automobiles and housing
sector as the same spurs demand. While a Buy and Hold strategy is fine it makes sense to
observe crucial economic factors that may specifically affect some of the securities held and it
would be prudent at time to switch out of these securities and move into others.

Monitoring and review

This is a very important step in the investment process. A proper monitoring and review system
is as critical to the success of the investment plan as selecting the right securities and going
ahead with the right mix of assets. While monitoring performance of the funds is considered
carefully. Funds and stocks have been selected on the basis of certain criteria. A review is to
ensure that these funds/stocks are performing in line with the expectations. This exercise will
enable the investors to take into consideration the developments in the capital market and various
economic factors such as inflation, interest rates, performance of
companies, performance of the economy, etc. Gradual changes in some of these economic
fundamental factors will drive portfolio restructuring decisions. The portfolio has been created
59

with certain objectives. The percentage of assets within the asset class for example the
percentage of equity in the portfolio may undergo changes because of changes in the
values of these assets with the market movements. For example when the stock market goes up
the values of equities will go up and consequently the proportion of equities in the total portfolio
will also go up. This will necessitate some selling of equity shares and moving funds to debts to
bring down the
proportion of equities to the desired level, as per the asset allocation plan. Thus a rebalancing
becomes necessary in a constant proportion asset allocation model. Rebalancing may be required
to adjust the market risks in a portfolio or because of maturity selection as well. The client and
the planner while implementing the financial plan can lay down certain parameters for review
generally time based and at times event based. A review can be more frequent; say once in 3
months if active strategies are being employed otherwise a periodic review of debts say once a
year and stocks and equity funds, say once in 3 months could be a good suggestion to the client.

60

Conclusion

Investing is about making your money work for you.

61

Reinvesting your earnings allows you to take advantage of compounding.

Each investor is different in his or her objectives and risk tolerance.

There isn't just one strategy that can be used to invest successfully.

Each investment vehicle has its own unique characteristics.

Diversifying investments in a portfolio helps to manage risk.

Together, all these points make up a foundation of knowledge with which any investor should be
comfortable. However, these concepts mean nothing unless you can put them into practice. It's
great to know that compounding accelerates your investment earnings, but the real question is
how do you take advantage of compounding and actually make money
Bibliography
www.investopedia.com
www.scribd.com

62