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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.
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
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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.
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.
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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.
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.
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.
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
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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.
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
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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.
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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
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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
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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.
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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
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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
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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.
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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.
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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
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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.).
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
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
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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.
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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.
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.
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.
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.
27
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%.
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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 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
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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.
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.
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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
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.
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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.
Minimum Rs 200/- and thereafter in multiples of Rs. 200/No Maximum Limit - Any amount can be invested
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
Maturity Value
Rs. 100 becomes Rs. 200/- after the full term of 8 years & 7 months
Amount
The bonds can be purchased for any amount in multiples of Rs. 1,000/- without any upper
limit
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Joint account holder can not be anybody other than spouse HUFs and Non Residents are
not allowed to invest
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.
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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.
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.
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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
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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.
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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.
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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.
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.
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.
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
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.
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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
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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.
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
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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.
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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.
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
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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.
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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.
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.
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.
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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.
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Conclusion
There isn't just one strategy that can be used to invest successfully.
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
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