Foundation — Goals, asset classes and the risks that attach to them

Chapter 1 — Investment Landscape

1.1 Start with "why"

The chapter opens by rejecting the questions everybody actually asks:

That is the frame for the whole workbook. A distributor who recommends a scheme before understanding the investor has done the job backwards.

The four illustrative investors

Mrs D'Souza's case is the interesting one, and the chapter says so: "she has a need for income from investments in the immediate term, but the same must also continue for a long and uncertain period, as the income is required for life." Rabindra reaches the same position on retirement — which is why "the retirement goal can be broken into two parts – ACCUMULATING a sum for retirement and then TAKING INCOME OUT of the corpus thus accumulated."

1.2 Objectives become goals

Common goals named: funding a child's education, cost of the marriage of a son or daughter, funding the lifestyle in retirement, buying a vehicle, buying or renovating a house, taking a big vacation. Less common: starting one's own business, taking a sabbatical, funding one's higher education.

The four steps of goal setting

1. Identify the events. Some are desirable and can be planned; some are undesirable surprises — "the death of a family member, hospitalization, accident, theft, fire." Crucially: "One CANNOT plan to fund the expenses associated with such events through investments, though we can create an EMERGENCY FUND using some savings and investment products. Apart from the emergency fund, one may buy INSURANCE POLICIES to cover the risks of such events."
2. Assign priorities. "Retirement or children's education fall into the RESPONSIBILITY'S category, whereas a grand vacation may be a GOOD-TO-HAVE goal." And the limit on the adviser's role: "it is only the individual and the family that can decide which is which. A financial advisor or a mutual fund distributor may only GUIDE AND HELP one take an appropriate decision."
3. Assign a timeline and an amount. "Both the timeline and amount are critical."
4. Classify by horizon — near term or far in the future.

The goal matrix

The chapter compares it to Stephen Covey's time management matrix from The Seven Habits of Highly Effective People:

1.3 Inflation and the goal value

The Shalini case study. Cost of higher education ₹50 lakh in today's price, needed in 10 years, education inflation 8% p.a. → the parents must provide ₹1,07,94,625 in 10 years. "Else, the parents may plan to accumulate Rs. 50 lacs, which would be grossly insufficient."

The chapter flags the honest caveat: "There are too many assumptions involved here–the course Shalini would pursue, the cost of the education, and the inflation. However, one needs to start with some assumptions to plan properly."

Household inflation illustration. Monthly expenses of ₹30,000 at 6% p.a. inflation:

And the boundary: "inflation has a long-term impact, and hence while planning for funding all the LONG-TERM goals, one must consider inflation... On the other hand, the IMMEDIATE TERM AND NEAR-TERM goals may not have a big impact due to changes in price."

The Pool Approach

The one thing common to all financial goals: "a MISMATCH OF CASH FLOWS. Either the expenses are far higher than the income at that point in time, or there is no income at the time of funding these goals."

1.4 Savings or investments?

1.5 Factors to evaluate investments

The closing caution: "no factor should be seen in isolation. One also must consider the INVESTOR'S SITUATION while evaluating the avenues."

1.6 The four asset classes

Real estate

• "Location is the most important factor" affecting performance
• Illiquid
• Not a divisible asset
• Can be held in physical as well as financial form
• Generates current income in the form of rents, besides capital appreciation
• Transaction costs are quite high — brokerage, registration — which "would bring down the return on investment"
• Maintenance costs and taxes must be adjusted before calculating return, "something that many individual investors do not"
• Investments are accounted at transaction price excluding all transaction costs

And the important distinction: "in majority of cases, individuals purchase real estate for SELF-OCCUPATION. This should NOT be considered as an investment, since selling the same may have a negative impact on one's lifestyle."

Commodities

Most consumed commodities cannot be invested in — "either perishable... or storage of the same could take a lot of space." Commodity derivatives exist but "it may not be wise to call these 'investments' for two reasons: (1) these are LEVERAGED CONTRACTS... making it highly risky and (2) these are normally SHORT-TERM CONTRACTS, whereas the investors' needs may be for longer periods."

Gold and silver are the two familiar investment commodities: prices "almost in sync across the world", making them globally accepted assets; gold considered by many a SAFE HAVEN asset; the gold standard was abandoned decades ago yet "most of the central banks hold gold in their reserves."

Two limitations: "An investor in these commodities would have to count ONLY ON CAPITAL APPRECIATION since these DO NOT GENERATE ANY CURRENT INCOME", and purity — "for a large majority of investors, it is almost impossible to make out the level of purity. If we opt for a purity certificate, the cost goes up and without one, the risk of getting lower quality metal is high."

Fixed income

Borrowing through marketable instruments like bonds and debentures (the workbook uses the two words interchangeably). Issuers: "Companies, Union Government, State Governments, Municipal Corporations, banks, financial institutions, public sector enterprises."

Key point on gains: "if someone has invested at the time of ISSUANCE of the bond and hold the same TILL MATURITY, in almost all cases, there would be NO CAPITAL GAINS. On the other hand, a transaction through SECONDARY MARKET... may result into capital gains or losses."

"Bonds are generally considered to be safer than equity. However, these are NOT TOTALLY FREE FROM RISKS." Sub-classification is by issuer type (government or corporate) or by maturity: short term (ideal for liquidity needs), medium term, and long-term (income generation needs).

Equity

"This is the OWNER'S CAPITAL in a business... this is RISK CAPITAL, since the owner's earnings from the business are linked to the fortunes, and hence the risks, of the business."

The Sensex is described as "BSE's benchmark index representing shares of 30 large-sized companies... one of the bellwether indices, a barometer of what is happening in the stock market in India."

And the summary: "equity share prices generally FLUCTUATE A LOT, OFTEN WITHOUT REGARD TO THE BUSINESS FUNDAMENTALS. However, over long periods of time, the share prices FOLLOW THE FORTUNES OF THE FIRM."

The four comparisons across asset classes

International assets: shares listed abroad, bonds in other currencies, real estate abroad — adding exposure to currency movement on top of the asset's own nature.

Table 1.1 — investment avenues by asset category

Note that endowment and money back policies are classified as fixed income, and that hybrid and others sit outside the four broad classes.

1.7 The five investment risks

Inflation risk

"Inflation erodes the purchasing power of money." The workbook's table, at 8% p.a.:

Seen the other way: ₹10,000 buying 100 units today buys only 68 units after 5 years and 46 units after 10 years.

Nominal versus real: "The return on investment WITHOUT factoring inflation is known as the 'NOMINAL RATE'. However, when this number is ADJUSTED FOR INFLATION, one gets the 'REAL RATE OF RETURN'." A 7% deposit under 8% inflation grows more slowly than prices.

And the trade-off stated bluntly: "when one seeks the TOTAL SAFETY of invested capital, along with ANYTIME LIQUIDITY, the investment returns are usually LOWER THAN INFLATION."

Liquidity risk

Full benefits require holding till maturity; early exit may attract charges or may not be available at all. PPF is given as an example offering "no liquidity for a certain period, and even after that... only partial liquidity." Real estate has very low liquidity — "often it takes weeks or months to sell."

And the opposite case: "Some investment options offer INSTANT ACCESS to funds, but the VALUE of the investment may be subject to fluctuations" — listed equity shares. "Such investments are not appropriate for funding SHORT TERM liquidity needs."

Credit risk

Three possibilities: "(1) the issuer honours all commitments in time, (2) the issuer pays the dues, BUT WITH SOME DELAY, and (3) the issuer DOES NOT PAY principal and the interest at all. Credit risk is all about the possibility that the SECOND OR THE THIRD situation may arise."

Two causes: "(1) the ABILITY of the borrower, or (2) the INTENTION of the borrower." Ability is a function of business stability and profitability; "stable companies, which may be market leaders... may pose a lower risk, in comparison to a new company, or a small-sized company in the same industry."

"The bonds issued by the government of their own country would be considered to be the SAFEST for investors. Such bonds normally offer the LOWEST interest rates for the citizens of the country... All the other bonds/debentures available in the country would offer a HIGHER rate of interest."

Market risk and price risk

"There are TWO types of risks to a security—BROAD MARKET RISK and SPECIFIC PRICE RISK."

• Market-wide: a war-like situation causing "the prices of all stocks... [to] witness a fall."
• Company specific: a company's sales fall due to technological change or a better product, and its share price falls "during such times, there could be many other companies, whose share prices may rise."
• Industry-specific sits between the two: a government policy change or a new technology affecting all firms in an industry — the chapter's example being that "when mobile phones started becoming popular, the pager industry vanished in less than a couple of decades."

And the rule that matters: "The risk SPECIFIC to the security CAN BE REDUCED THROUGH DIVERSIFICATION across unrelated securities, but the one that is MARKET-WIDE CANNOT be reduced through diversification."

Interest rate risk

"The risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds/debt instruments MORE DIRECTLY than stocks."

"The relationship between interest rates and bond prices is INVERSE." The worked example: a bond issued at ₹1,000 for one year at 8%; rates rise so new bonds offer 8.5%; the old bond "becomes less attractive" and can only be sold at a discount. The reverse holds if rates fall.

And the maturity effect: "Those with LONGER maturity would witness HIGHER price fluctuations in comparison to those with shorter maturities." Interest rate risk is "a MARKET-WIDE factor affecting the prices of all bonds."