The Right Approach to Investing

The Right Approach to Investing

• Understand your own risk tolerance (...if volatility makes you nervous then risky investments such as stocks and equity mutual funds may not be the ones for you. You then might as well invest in fixed income instruments instead, such as fixed deposits, PPF, etc.)
  
• Ascertain the risk involved while investing (...you see, every asset class - equity, gold, debt and real estate - has risk associated with it and therefore it is necessary to know about the same before investing your hard earned money)
  
• Know your investment objective (... It is important to know that there are various investment avenues which are meant to cater to respective investment objectives. So enough care should be taken while investing your hard earned money. Ideally each of your investments should match your investment objectives)
  
• Consider your age (...this can help you have the right investment instruments appropriate for your age)
  
• Consider the time period before you need money (...Remember: The longer you are away from the time you require your hard earned money, the more risk you can take, and hopefully even earn more by investing in risky asset classes.)
  
• Do sufficient research (...It is vital not to get carried away by exuberance and / or what your friends and family say. Instead, undertake solid fundamental research on respective investments, and please do not get caught up in hype....understand how the product works)
  

• Evaluate cost of investing (...Remember: gains can be easily eroded if you don't consider cost of investing and thus it is vital to keep an eye on terms and conditions associated with the investment avenue. Very often many indulge in trading in the stock market to make a quick buck without really understanding the associated costs they are paying for regular trading or churning)
  
• Aim at investing in investment products that can help you earn more than inflation(...if your investments manage to outpace inflation, it will help you achieve your financial goals smartly and efficiently)
  
• Recognise the tax implication (...this is important...after all, the objective is also to earn tax efficient returns. If you do not plan well, you may end up paying higher tax on your returns)
  
• Always start early (...as there are benefits of doing so. You can understand it well by taking a look at the following table and chart)
  
  

An Early Bird Gets A Bigger Pie
Let us take an example of 3 friends - Vijay, Ajay and Sanjay - All 3 had good jobs and wanted to retire at the age of 60. Vijay being the smarter of the lot, started planning for his retirement at the very initial stage, at 25, and invested Rs. 7,000 per month. Ajay realised the importance of planning for retirement once he was 30, while Sanjay could feel the guilt of being left out only when he was 35. See what they accumulated when they were on the verge of their retirement. 

Particulars	Vijay	Ajay	Sanjay
Present age (years)	25	30	35
Retirement age (years)	60	60	60
Investment tenure (years)	35	30	25
Monthly investment (Rs.)	7,000	7,000	7,000
Returns per annum	10%	10%	10%
Sum accumulated (Rs)	2,65,76,466	1,58,23,415	92,87,834

(Source: PersonalFN Research)
Disclaimer: The names and figures are fictitious and used for example purpose only.
Also, return per annum mentioned above is for illustration purpose only.

Not only this, they also noticed a wide deviation in the proportion of growth they saw on their invested corpus. While Vijay's money grew around 9 times, Ajay's money grew 6 times and Sanjay saw a growth of just 4 times


(Source: PersonalFN Research)
Disclaimer: The names and figures are fictitious and used for example purpose only.

Points to Remember for You to Save & Invest Wisely!
(Finally, to wrap-up this session of learning, here are some points one must keep in mind, now that you may have recognised why investing is imperative once you have saved)


To Save

• Do not splurge all what you earn...SAVE! (...Remember: It is important to economise on your expenses and save for a rainy day)
  
• It is never too early to save (...in fact, savings can help you feel financially secure and even sleep better at night)
  
• Start small but maintain the regularity 
  

While Investing

• Do not rush with investing (...undertake thoughtful research by doing a holistic study)
  
• Investing is a serious activity (...in fact, it could be essentially boring, and not exciting)
  
• Do not speculate (...while it can be a thrilling experience, it can be killing as well if the tide turns against you. So it is best not to fall for excitement and exuberance)
  
• Never use contingency funds to invest (...Remember, they are put aside as part of your savings to meet your requirements on a rainy day)
  
• Never invest from borrowed funds (...except in the case of investing in real estate or your own business; but again, while investing therein don't go beyond your means)
  
• Know your investment product (...understand how it works and undertake research; recognise the risk-reward relationship the product offers)
  
• Diversify (...Remember, this can help you reduce your risk to your overall portfolio if you diversify wisely)
  

Some Important Ratios to Track Your Personal Finance

Savings to Income Ratio =	Total Annual Savings
	Total Annual Income

This ratio simply tells you what part of your income you are saving annually. Higher the ratio, the better it is, as it facilitates you to invest and lets your money work for you. 

Total investment to Income Ratio =	Current Value of Total Investments
	Total Annual Income

This ratio helps you understand the current value of investments done as a ratio of current income. 

At a younger age this ratio tends to be lower. However with time one needs to accumulate enough savings and invest to fulfil various financial goals in life. 

Debt to Income Ratio =	Total Debt
	Total Annual Income

This ratio would help you evaluate the proportion of total debt as against the total annual income you earn. 

Lower the ratio, the better it is. 

Following these ratios, which you have just learned of, can help you keep a track of your finances.

Investing

Investing Meaning:

• An act of laying out your 'money saved' for productive use with an expectation of earning return more than inflation to preserve purchasing power of money
  
• A process of making your 'money saved' work for you (instead of simply stacking in your vault / bank locker or under the mattress)
  

Advantages of Investing

• Can grow your savings
  
• Helps your money work for you since it is put to productive use
  
• Can help in countering inflation and maintain purchasing power of money (You see, as money tends to lose its value over time due to inflation - which eats into your hard earned savings - you can counter the inflation bug by investing and maintain the purchasing power of money for your future)
  
• You can achieve your financial goals in life (...which could be...buying a dream home, a car, taking care of children's education needs, their marriage and your retirement amongst a host of others)
  
• Helps wealth creation
  
• Provides a sense of financial security 

Are You Saving OR Are You Investing

Are You Saving OR Are You Investing?

Alright so now let's get started.

Many people often misconstrue savings with investments. But let us tell you that there is indeed a difference between the two.

Merely putting aside money under the mattress, or in a vault, bank locker or savings bank account after meeting your expenses and liabilities may not mean that money works for you.

In times where the inflation bug is eating into your earnings, you need to move a step forward and invest. More importantly, invest wisely!

By now many of you may have realized that there is indeed a difference between saving and investing. So let's delve a little deeper and understand the difference between the two...which can help us march forward in our journey of wealth creation.

Savings Meaning:

• An act of putting aside money after defraying expenses and liabilities (...therefore the unspent income results in savings)
  

Savings = Income - All expenses including obligations towards borrowed money



• It's an act of economising 
  
• In Personal Finance parlance:
  

Savings refers to preservation of wealth for future use


The Right Approach to Increase Savings

• Refrain from impulsive buying (...It is imperative to stick to your immediate priority. Have a list while you go out shopping and be rational while making the list.)
  
• Make a monthly budget (...Ascertain your income... frame the budget in a way that allows you to save more.)
  
• Economise on expenses (...try to avoid those expenses which aren't necessary)
  
• Avoid excessive borrowing / credit (So while you may own and use a credit card, use it thoughtfully knowing your means - Remember: excessive credit can lead to a debt trap!)
  
• Start saving at an early age (...it always helps to plan for your future. Remember, you can always postpone your decision to buy your favourite gadget, but you should save for a rainy day.)
  
• You may start small, but save regularly (....Remember, your every bit of savings can help you attain financial freedom)
  

Conclusive remark on savings: 

Now that we have seen the right approach to savings, the question is, can saving alone help you achieve your life's goals? - Which could be: buying your dream home, your dream car, your children's education, their marriage, your retirement; amongst a host of other ones. 

Think about it. 

Do you know, over the years, the money that you have saved - kept aside in your vault, bank locker, savings account, or under the mattress - may lose value as the inflation bug eats into your savings if it is not allowed to grow at a decent pace? Therefore, in order for it to grow, you need to put your 'money saved' to productive use - and make money work for you! 

And what should you do to make money work for you? 

Well, the answer lies in INVESTING!

Morgan Stanley has cut its 2014 gold target

For over a decade, gold had a tremendous bull run before the precious metal suffered a correction in 2013. What more, it is likely that these losses could be extended in 2014 as well. That is why Morgan Stanley has cut its 2014 gold target by around 12% to US$ 1,160 an ounce. One of the reasons why gold found so many takers was the loose monetary policies of central bankers around the world. As the value of paper currencies began to be questioned, gold came to be regarded as a tangible, real asset having value. It was looked upon as a safe haven and a hedge against inflation. The tide turned against the precious metal in 2013 when the US Fed declared its intention of tapering the QE program. As equities began to evince interest, gold lost ground.

As per an article in Money news, Morgan Stanley is of the view that there is more pain to come for gold because US equities will continue to perform strongly. We believe that while the Fed has decided to reduce its bond purchase program, interest rates still continue to hover near zero. Besides, whatever recovery has been seen in the US economy has been the product of Fed policies. So once the Fed withdraws support, there is the possibility of the economy slumping once again. This may prompt the Fed to loosen its strings again. Which is why we believe the case for gold remains strong from a longer term perspective. And any correction should be looked upon as an opportunity for the metal to form part of one's portfolio.       

Risks associated with Fixed Income Products

In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments . We had also looked into some of the factors, which affect the pricing and valuations of bonds . Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows: Interest rate risk Reinvestment rate risk Yield curve risk Call and prepayment risk Credit risk Liquidity risk Exchange rate risk Risk associated with inflation and erosion of purchasing power Risk due to political & regulatory events and government actions Interest rate risk:  Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice-versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period. Maturity Date Coupon Rate (%) Last traded price (Rs) Years to Maturity Yield to Maturity (%) 22-Nov-07 6.8 74 5.9 22.7 15-May-06 6.8 84.5 4.4 15.7 26-Jul-03 6.5 90.1 1.5 12 1-Sep-02 11.2 102.6 0.6 9.7 13-Dec-10 8.8 103.9 8.9 6.7 22-Apr-05 9.9 107.6 3.3 5.9 24-May-13 9 108.4 11.4 4.6 30-May-13 9.8 112.7 11.4 3.3 30-May-21 10.3 114.2 19.4 3 Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield. Call and prepayment risk:  The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed). IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a non-government bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk:  The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk:  For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk. Default risk  is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture. Credit spread risk  is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk:  It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and the general political condition in the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk:  It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bid-ask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity. Maturity Date Coupon Rate (%) Last traded qty (nos.) Last traded price (Rs) Current yield (%) Years to Maturity Yield to Maturity (%) 11-Jun-10 11.5 2,500 115.5 10 8.4 3.5 11-Sep-26 10.2 1,500 115 8.9 24.7 2.7 24-Jun-06 13.9 1,200 121.4 11.4 4.5 2.8 19-May-15 10.8 100 108 10 13.4 6.5 5-Aug-11 11.5 54 117.1 9.8 9.6 2.7 19-Jun-08 12.1 50 116.4 10.4 6.4 3.6 23-May-03 11 45 99.8 11 1.4 11.1 21-May-05 10.5 28 110.4 9.5 3.4 5 Source: NSE web site Exchange rate risk:  When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk. Inflation risk:  It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk:  These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations. Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks.

Are fixed income products truly risk free?

	Majority of the Indian household savings are channeled towards fixed income instruments. These instruments are considered to be virtually risk free with high safety quotient. However, this is a myth. Let us understand why these investments are not completely risk free and how prospective investors should go about choosing them. Predominantly, there are two types of risks associated with the fixed income instruments. The interest rate risk and the default risk. Now, let us understand these risks in greater detail. We know that interest rates and bond prices are inversely related. As interest rates increase, bond prices decrease and vice-versa. Now, let us assume that interest rates are bound to decrease. In this case, the investor would benefit as bond prices would increase. But he would lose out on higher future interest income as interest rates now, have been lowered. Thus, his future re-investment income has been reduced. If the reinvestment loss exactly offsets capital gain effect from declining interest rates, the impact on bond return would have been neutral. But more often than not one factor dominates the other which affects the returns of a bond investor. This is called interest rate risk. And this affects all fixed income instruments. Even default risk is an important factor to be considered while investing in fixed income instruments. The default risk is a risk of non-payment of principal and interest by the bond issuing company. Rating agencies typically analyze the financial health of bond issuers and assign a rating to them. This helps investors in gauging the default risk associated with the company's debt. Lower the rating, higher the default risk and higher the interest rate. A higher interest rate is offered to compensate for the risk associated with the company's debt. Thus, it should be noted that companies offering higher interest rate on their debt are not necessarily best investment avenues. Reinvestment risk, a component of interest risk, also affects fixed income returns. Say for instance, you have invested in a 5 year fixed rate bond at 9% pa (per annum). Suddenly, the interest rate in the economy increase and a new issue hits the market with 11%. In such cases, investors who invested at 9% stand to lose out. Here, floating rate instruments offer a better hedge as their interest rates are periodically aligned to the market interest rates. Lastly, it should be noted that interest rates which influence bond prices are governed by inflationary trends. Lower the expected inflation, lower the interest rate environment and higher the bond prices. Thus, inflation influences bond prices indirectly. As seen here, fixed income instruments are subject to a host of risk factors and investors should take them into consideration while making their investment decisions.